FINANCIAL MANAGEMENT (unit-9)

Unit – 9

FINANCIAL MANAGEMENT

 Introduction

Money required for carrying out business activities is called business finance. Finance is needed to establish a business, to run it, to modernize it, to expand or diversify it.

Meaning of Financial Management

Financial management is the activity concerned with the planning, raising, controlling and administering of funds used in the business. It is concerned with optimal procurement as well as usage of finance. It aims to reduce the cost of funds. It also aims at ensuring availability of enough funds whenever required as well as avoiding idle finance.

Objectives of Financial Management

(A) Primary Objective:

• Wealth Maximisation:The main objective of Financial management is to maximise shareholder’s wealth. Example- If Mr. X purchases 100 shares @ ` 100 of ABC Ltd. his wealth in company’s is ` 10,000/-. After some time, the market price of share increases to ` 130/-. Therefore, his wealth would be ` 13,000/-. His wealth increases by ` 3,000/-. If the market price of the share decreases to ` 90/- he loses his wealth by ` 1,000/- The market price of a company shares is linked to three basic financial decisions and shareholder’s wealth maximisation. Wealth of shareholders = number of shares x market price per share.

(B) Other objectives:

1. To procure sufficient funds for the organisation:Adequate and regular supply of funds is to be maintained for smooth operations of the business.

2. To ensure effective utilisation of funds.

3. To ensure safety of funds : The chances of risk in investments should be minimum possible.

Finance Functions (Financial Decisions)

1. Investment Decision – It is concerned with how firm’s valuable funds are to be invested in various

assets. It will include the following:

a. Long term investment decisions (capital budgeting decision) E.g., Purchasing a new machine, opening a new branch etc.

b. Short term investment decision (working capital decision) – related to the day to day working of a business. E.g., Level of cash in hand, inventory etc.

Factors affecting Capital Budgeting (Investment Decision)

a. Cash flow of the project – The inflow and outflow of cash in the business should be considered before making capital budgeting decisions. Some projects will take a long period of time to start inflow of cash.

b. The rate of return – While selecting a project, the rate of return must be considered. If two projects having 10% return and 15% return with almost equal risk, normally, the 2nd one may be selected.

c. Investment criteria involved – Investment decisions must be based on certain capital budgeting techniques or calculations regarding the amount of investment, rate of return, interest rate, cash flow etc.

2. Financing Decision – it is concerned with the quantum of finance to be raised from various long term sources. They are shareholders’ fund and borrowed fund such as shares, debentures, loans etc. But a proper mix of the above securities is very much essential for maintaining a good capital structure of the company.

Factors affecting financing decision

a. Cost – Try to obtain the fund from cheaper sources.

b. Risk – Risk factor in each source must be considered.

c. Flotation coast – Cost of raising finance should be less.

d. Cash flow position – A stronger cash flow position recommends more debt financing.

e. Fixed cost – If fixed operating costs like rent, insurance premium, salaries etc. are high, it is better to reduce debt financing having fixed interest burden.

f. Control – More dependence on owners fund will reduce control among the existing shareholders.

g. Capital market condition – During rising trends in capital market, it is easy to

accumulate shareholders fund, otherwise better to depend on borrowed fund.

3. Dividend Decision – It is concerned with the disposal of profits. Profits are required for different purposes. A portion of the profit is to be retained in the business for growth and expansion. That part of profit is called retained earnings and the rest of the profit is to be distributed to the shareholders in the form of dividends. Here is the role of financial management that, how much is to be retained and what would be distributed. Factors affecting dividend decision

a. Amount of earnings – Dividend decision is always depend on the amount of profit during the current period.

b. Stability of earnings – Stable earnings promotes higher dividend.

c. Stability of dividend – It will improve the confidence of shareholders and higher reputation for the company.

d. Growth opportunities – Fewer dividends may be given to the investors if the company is having growth and expansion projects.

e. Cash flow position – Payment of dividend involves outflow of cash, therefore, enough cash must be available for the declaration of dividend.

f. Shareholders’ preference – Normally, shareholders want to get regular income from their investment, hence at least a minimum dividend may be distributed every year.

g. Taxation Policy – If tax on dividend is higher, it is better to pay less by way of dividends. But the dividends are free of tax in the hands of shareholders as a dividend distribution tax is levied on companies. In the present tax policy, shareholders may demand higher dividend.

h. Stock Market Reaction – Investors generally evaluate the companies on the basis of their dividend declaration status. Higher the rate of dividend gives a positive impact in the market.

i. Access to Capital Market – Reputed companies generally have easy access to the capital market and therefore they may depend less on retained earnings to finance their growth. So that they may declare high rate of dividend than small companies.

j. Legal Constraints – While declaring dividends, the companies have to follow the restrictions laid down by Companies Act.

k. Contractual Constraints – While granting loans to a company, sometimes the lender may impose certain restrictions on the payment of dividends in future.

Financial Planning – When the process of planning employed in finance, it is called financial planning. It involves the estimation, procurement, utilization and administration of funds. Its objective is to ensure that enough funds are available at right time, but having no surplus funds. It involves the following aspects:

a. Estimation of quantum of finance

b. Determining the pattern of financing – proportion of various securities to be issued.

c. Proper utilization of finance – through effective policies and programs.

Types of financial planning

a. Long term financial planning – focuses on capital expenditure for long term growth and investment in business – usually 3 to 5 years.

b. Short term financial planning – in the form of budget – usually for a period of 1 year or less.

Objectives of Financial Planning

1. To ensure availability of funds whenever required – it includes estimation of funds for long term and short terms needs of the organization.

2. To ensure that the firm does not raise resources unnecessarily – it will help to minimizethe loss due to idle fund in the organization.

Importance of financial planning

1. Forecasting – It helps the organization to foresee the future financial requirements in advance.

2. Avoiding uncertainties – Helps in meeting unexpected situations by arranging necessary funds.

3. Coordination – Helps to coordinate the activities of all departments in the organization by allotting them necessary funds in time.

4. Reduces wastages – Through proper planning about the financial requirements helps to reduce wastages and duplication of efforts.

5. Easy evaluation – It helps to evaluate the actual performance of the organization based on the plans formulated in advance.

Capital Structure

Capital structure refers to the mix or composition of long term sources of funds such as equity share capital, preference share capital, debentures, long term loans and reserves and surplus. In other words, it refers to the proportion of borrowed funds to owner’s funds. (It is a mix between owners’ funds and borrowed funds). Owners’ funds are called equity and borrowed funds as debt.

The capital structure of a company consists any of the following forms:

1. Equity shares only.

2. Equity shares and preference shares.

3. Equity shares and debentures.

4. Equity shares, preference shares and debentures.

5. Equity, Preference, debentures and long term loans.

Financial Leverage – The proportion of debt in the capital structure is called financial leverage or capital gearing or trading on equity. When the proportion of owners’ funds in capital structure is very small, it is said to be high geared, whereas if borrowed fund is less than equities, it is called a low geared company. As the financial leverage increases (highly geared) the cost of funds declined and therefore more earnings per share, but the financial risks increases. The impact of financial leverage on profitability:

Descriptions                           Company A                      Company B                                   Company C

No. Equity shares

  @ Rs.10                                  30,000                                20,000                                            10,000

Equity Capital                        3,00,000                              2,00,000                                       1,00,000

10% Debentures 

(borrowed fund)                       NIL                                     1,00,000                                      2,00,000

Total Capital                            3,00,000                             3,00,000                                       3,00,000

Profit @ 20% 

on investment                         60,000                                   60,000                                         60,000

Interest on debentures              NIL                                   10,000                                         20,000

Net Profit                                 60,000                                50,000                                          40,000

Earnings per share                   2.00                                       2.50                                           4.00

Leverage                              Unlevered                                  Low                                            High

Note: Income tax on profit is ignored.

Trading on equity – It refers to the use of fixed income securities such as debentures and preference capital in the capital structure so as to increase the return on equity capital. In other words, equity share holders get additional profits with the help of employing others fund. It is also known as financial leverage or capital gearing.

For example, A company raises Rs.50,000 through equity shares and earns a profit of Rs.5000. Here the rate of return is 10%. On the other hand, if the company raises Rs.40000 by way of 6% debentures and Rs.10000 through equity shares, the rate of return to equity shareholders is increased to 26% as follows:

Total Investment 40000 +10000 = 50,000

Total Profit = 5,000

Interest on debentures 40000 * 6% = 2,400

Balance of Profit to equity shareholders (5000-2400) = 2,600

Rate of return on equity share capital (2600/10000*100) = 26%

Factors Affecting the Choice of Capital Structure

1. Cash flow position – The size of projected cash flow must be considered before we include the borrowed fund in capital structure. This cash flow in future must be enough to meet the payment obligations in the matter of normal business operations, investment in fixed assets and to meet the debt service commitments such as payment of interest and repayment of principal.

2. Interest coverage ratio – ICR refers to the number of times, earnings before interest and taxes (EBIT) covers the interest obligation. Higher the ratio means lower the risk for the company to pay off interest in time.

3. Debt Service Coverage Ratio (DSCR) – The cash profits generated from the operations must be enough to service the debts and preference share capital.

4. Return on Investment (ROI) – If  ROI is higher than rate of interest for debt, borrowed fund can be increased in capital structure, otherwise, increase in equity portion is good.

5. Cost of debt – If the firm is able to borrow at a lower rate, it may prefer more debt than equity in capital structure.

6. Tax rate – Income tax liability can be reduced by employing borrowed funds in capital structure, as the interest on debt is a deductible expense.

7. Cost of Equity – When a company increases debt in their capital structure, the financial risk faced by the equity shareholders may increase, so that the company cannot use debt beyond a point.

8. Floatation cost – It is the cost incurred for floating (issue) securities such as brokerage, underwriting commission etc. It is generally less in case of debts.

9. Risk Consideration – A business has two types of risks; they are financial risk (to pay interest, preference dividend, repayment of debt etc.) and business risk (operating risk). It must be considered while choosing a suitable capital structure.

10. Flexibility – The capital structure should be capable of being adjusted according to the needs of changing conditions. To maintain flexibility, the company should maintain some borrowing power to take care of unforeseen circumstances.

11. Control – If the control of the management is to be retained, debt financing is recommended for raising additional fund.

12. Regulatory Framework – Rules and regulations framed by SEBI etc. must be considered while choosing a capital structure.

13. Stock Market Conditions – During depression in capital market, investors will prefer fixed interest bearing securities for safety and hence it is not advisable to issue shares that time. In a booming situation, issue of share will be more preferable.

14. Capital Structure of other Companies – Capital structure followed by other companies in the same industry may be adopted by considering whether they are in conformity with the industry norms or not.

FIXED CAPITAL AND WORKING CAPITAL

Fixed Capital

Fixed capital represents a long term investment which needed to acquire fixed assets like land and building, plant and machinery, vehicles etc., benefits of which are expected to be received over a number of years in future.

Management of fixed capital – It refers to the allocation of firm’s capital to different projects or assets which will have a long term implications in the business.

Importance of management of fixed capital

1. Long term growth – This capital is invested in fixed assets and long term projects, therefore, it will affect the future prospects of business.

2. Large amount of funds involved – A major portion of capital may be blocked in this areas, hence careful planning and detailed analysis is very essential in this segment.

3. High risk – Investment decisions involving huge capital outlay influence the overall performance of the business.

4. Irreversible decision – Once the decision to acquire a permanent asset is taken, it becomes very difficult to reverse that decision. It is possible but with huge losses.

Factors affecting the requirement of fixed capital

1. Nature of Business – The nature and character of business determine how much fixed capital is required. In a manufacturing concern fixed assets require huge investments.

2. Scale of Operations – Large scale business generally require huge investments in fixed capital than a small scale business organization.

3. Choice of technique – Highly mechanized and automated industries require large amount of fixed capital.

4. Technology up gradation – Assets in certain industries become obsolete sooner, this requires replacement faster which will demand more fixed capital, e.g., computers, mobile phone manufacturing equipments etc.

5. Growth prospects – Higher investment in fixed capital is necessary, if the organization is in the way of growth and expansion.

6. Diversification – When a firm diverts its operations to new segments, higher fixed capital requirement arises, e.g., ITC Company diverted its business to note books manufacturing along with their traditional item of cigarettes.

7. Method of acquiring fixed assets (financing alternatives) – If it is on hire purchase or lease system, less amount of investment is required for cash purchase.

8. Collaboration – By collaborating with other firms, the requirement of fixed capital can be reduced, e.g., establishment of ATM counters by cooperative banks by collaborating with certain scheduled banks.

Working Capital

Working capital is that part of capital required for investing in short term or current assets like inventory (raw materials, work in progress and finished goods), bills receivables, sundry debtors, cash required for day to day affairs like salaries, wages, rent, etc. There are two concepts of defining working capital as follows:-

i. Gross working capital = Total investment in current assets

ii. Net working capital = Current assets – Current Liabilities

Factors affecting Working Capital Requirements

A business concern must neither have excessive nor inadequate working capital. Both the situations are dangerous. Following are the factors influencing working capital requirements:

1. Nature of business – Concerns which do not keep very high stock of finished goods and sells on cash basis can manage with less working capital.

2. Scale of Operations – Generally big enterprises have to keep higher working capital.

3. Business Cycle – In boom period, the production and sales will be larger and hence huge amount of working capital is required. But in case of depression, it will be less.

4. Seasonal Factors – Industries that produce and sell seasonal goods require large amount of working capital.

5. Production cycle – Longer the period of manufacture, larger is the amount of working capital required.

6. Credit allowed – A liberal credit policy results in higher amount of debtors and thereby more working capital requirement.

7. Credit availed – If a business gets credit facility from its suppliers for goods, lesser would be the working capital requirement.

8. Operating efficiency – If cash, debtors and inventories are efficiently managed, working capital requirement can be reduced.

9. Availability of raw materials – If raw materials are available regularly without any shortage, less working capital is needed.

10. Growth prospects – If a firm is growing fast, it will require large amount of working capital to meet higher production and sales.

11. Level of competition – In case the competition is high, more shall be the stock of finished goods, this increases working capital requirement.

12. Inflation – Huge amount of working capital is needed at the time of inflation (price rises) to maintain a constant volume of production and sales.