Chapter 9

FINANCIAL MANAGEMENT

BUSINESS FINANCE - Money required for carrying out business activities is called business
finance.

FINANCIAL MANAGEMENT
 Financial Management is concerned with optimal procurement as well as the usage of
finance. Its objective is to increase the shareholders’ wealth
 For optimal procurement, different available sources of finance are identified and compared
in terms of their costs and associated risks.
 Similarly, the finance so procured needs to be invested in a manner that the returns from
the investment exceed the cost at which procurement has taken place.
 Financial Management aims at reducing the cost of fund procured, keeping the risk under
control and achieving effective deployment of such funds.
 It also aims at ensuring availability of enough funds whenever required as well as avoiding
idle finance. Needless to emphasise, the future of a business depends a great deal on the
quality of its financial management.

Objectives of Financial Management

 The primary aim of financial management is to maximise shareholders’ wealth, which is
referred to as the wealth –maximisation concept.
 The market price of a company’s shares is linked to the three basic financial decisions.
 This is because a company funds belong to the shareholders and the manner in which they
are invested and the return earned by them determines their market value and price.
 It means maximisation of the market value of equity shares.
 The market price of Wealth Maxamisation
Financial Decisions
equity share Concept
increases, if the
benefit from a
decision exceeds the
cost involved.
 The shareholders
gain if the value of
shares in the market
increases.
Wealth of shareholders= No. of shares x market
price per share

FINANCIAL DECISIONS
Financial management is concerned with the solution of
three major issues relating to the financial operations of
a firm:
(i) investment, (ii) financing and (iii) dividend decision.

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I. Investment Decision
 A firm’s resources are scarce in comparison to the uses to which they can be put.
 A firm, therefore, has to choose where to invest these resources, so that they are able to
earn the highest possible return for their investors.
 The investment decision, therefore, relates to how the firm’s funds are invested in different
assets.
 Investment decision can be long-term or short-term.

 A long-term investment decision is also called a Capital-Budgeting decision.

 It involves committing the finance on a long-term basis.
 For example, making investment in a new machine to replace an existing one or acquiring a
new fixed asset or opening a new branch, etc.
 These decisions are very crucial for any business since they affect its earning capacity in
the long run.
 The size of assets, profitability and competitiveness are all affected by capital budgeting
decisions.
 Moreover, these decisions normally involve huge amounts of investment and are
irreversible except at a huge cost.
 Therefore, once made, it is often almost impossible for a business to wriggle out of such
decisions.
 A bad capital budgeting decision normally has the capacity to severely damage the financial
fortune of a business.

 Short-term investment decisions (also called working capital decisions) are concerned
with the decisions about the levels of cash, inventory and receivables.
 These decisions affect the day-to-day working of a business.
 These affect the liquidity as well as profitability of a business.
 Efficient cash management, inventory management and receivables management are
essential ingredients of sound working capital management.

Factors affecting Capital Budgeting Decision

 There are certain factors which affect capital budgeting decisions.

1. Cash flows of the project:

 When a company takes an investment decision involving huge amount it expects to
generate some cash flows over a period.
 These cash flows are in the form of a series of cash receipts and payments over the life of
an investment.
 The amount of these cash flows should be carefully analysed before considering a capital
budgeting decision.

2. The rate of return:

 The most important criterion is the rate of return of the project.
 These calculations are based on the expected returns from each proposal and the
assessment of the risk involved.
 Suppose, there are two projects, A and B (with the same risk involved), with a rate of return
of 10 per cent and 12 per cent, respectively, then under normal circumstance, project B
should be selected.
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3. The investment criteria involved:

 The decision to invest in a particular project involves a number of calculations regarding the
amount of investment, interest rate, cash flows and rate of return.
 There are different techniques to evaluate investment proposals which are known as capital
budgeting techniques.
 These techniques are applied to each proposal before selecting a particular project.

II. Financing Decision

 This decision is about the quantum of finance to be raised from various long-term sources.
 It involves identification of various available sources.
 The main sources of funds for a firm are shareholders’ funds and borrowed funds.
 The shareholders’ funds refer to the equity capital and the retained earnings.
 Borrowed funds refer to the finance raised through debentures or other forms of debt.
 A firm has to decide the proportion of funds to be raised from either source, based on their
basic characteristics.
 Interest on borrowed funds has to be paid regardless of whether or not a firm has earned a
profit.
 Likewise, the borrowed funds have to be repaid at a fixed time.
 The risk of default on payment is known as financial risk which has to be considered by
a firm to make these fixed payments.
 Shareholders’ funds involve no commitment regarding the payment of returns or the
repayment of capital.
 A firm, therefore, needs to have a judicious mix of both debt and equity in making financing
decisions, which may be debt, equity, preference share capital, and retained earnings.
 The cost of each type of finance has to be estimated.
 Some sources may be cheaper than others.
 For example, debt is considered to be the cheapest of all the sources, tax deductibility of
interest makes it still cheaper.
 Associated risk is also different for each source, e.g., it is necessary to pay interest on debt
and redeem the principal amount on maturity.
 There is no such compulsion to pay any dividend on equity shares.
 Thus, there is some amount of financial risk in debt financing.
 The overall financial risk depends upon the proportion of debt in the total capital.
 The fund raising exercise also costs something. This cost is called floatation cost.
 Financing decision is, concerned with the decisions about how much to be raised from
which source.
 This decision determines the overall cost of capital and the financial risk of the
enterprise.

Factors Affecting Financing Decisions

The financing decisions are affected by various factors which are as follows:
1. Cost:
The cost of raising funds through different sources is different. A prudent financial manager
would normally opt for a source which is the cheapest.

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2. Risk:
The risk associated with each of the sources is different.

3. Floatation Costs:
Higher the floatation cost, less attractive the source.

4. Cash Flow Position of the Company:

A stronger cash flow position may make debt financing more viable than funding through
equity.

5. Fixed Operating Costs:

If a business has high fixed operating costs (e.g., building rent, Insurance premium, Salaries,
etc.), It must reduce fixed financing costs. Hence, lower debt financing is better. Similarly, if
fixed operating cost is less, more of debt financing may be preferred.

6. Control Considerations:
Issues of more equity may lead to dilution of management’s control over the business. Debt
financing has no such implication. Companies afraid of a takeover bid would prefer debt to
equity.

7. State of Capital Market:

Health of the capital market may also affect the choice of source of fund. During the period
when stock market is rising, more people invest in equity. However, depressed capital market
may make issue of equity shares difficult for any company.

III. Dividend Decision

 The third important decision that every financial manager has to take relates to the
distribution of dividend.
 Dividend is that portion of profit which is distributed to shareholders.
 The decision involved here is how much of the profit earned by company (after paying tax)
is to be distributed to the shareholders and how much of it should be retained in the
business.
 While the dividend constitutes the current income re-investment as retained earnings
increases the firm’s future earning capacity.
 The extent of retained earnings also influences the financing decision of the firm.
 Since the firm does not require funds to the extent of re-invested retained earnings, the
decision regarding dividend should be taken keeping in view the overall objective of
maximising shareholder’s wealth.

Factors Affecting Dividend Decision

How much of the profits earned by a company will be distributed as profit and how much will be
retained in the business is affected by many factors. Some of the important factors are
discussed as follows:

1. Amount of Earnings:
 Dividends are paid out of current and past earning.
 Therefore, earnings are a major determinant of the decision about dividend.

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2. Stability Earnings:
 Other things remaining the same, a company having stable earning is in a better position to
declare higher dividends.
 As against this, a company having unstable earnings is likely to pay smaller dividend.

3. Stability of Dividends:
 Companies generally follow a policy of stabilising dividend per share.
 The increase in dividends is generally made when there is confidence that their earning
potential has gone up and not just the earnings of the current year.
 In other words, dividend per share is not altered if the change in earnings is small or seen
to be temporary in nature.

4. Growth Opportunities:
 Companies having good growth opportunities retain more money out of their earnings so as
to finance the required investment.
 The dividend in growth companies is, therefore, smaller, than that in the non–growth
companies.

5. Cash Flow Position:

 The payment of dividend involves an outflow of cash.
 A company may be earning profit but may be short on cash.
 Availability of enough cash in the company is necessary for declaration of dividend.

6. Shareholders’ Preference:
 While declaring dividends, managements must keep in mind the preferences of the
shareholders in this regard.
 If the shareholders in general desire that at least a certain amount is paid as dividend, the
companies are likely to declare the same.
 There are always some shareholders who depend upon a regular income from their
investments.

7. Taxation Policy:
 The choice between the payment of dividend and retaining the earnings is, to some extent,
affected by the difference in the tax treatment of dividends and capital gains.
 If tax on dividend is higher, it is better to pay less by way of dividends.
 As compared to this, higher dividends may be declared if tax rates are relatively lower.
 Though the dividends are free of tax in the hands of shareholders, a dividend distribution
tax is levied on companies.
 Thus, under the present tax policy, shareholders are likely to prefer higher dividends.

8. Stock Market Reaction:

 Investors, in general, view an increase in dividend as a good news and stock prices react
positively to it.
 Similarly, a decrease in dividend may have a negative impact on the share prices in the
stock market.
 Thus, the possible impact of dividend policy on the equity share price is one of the
important factors considered by the management while taking a decision about it.

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9. Access to Capital Market:

 Large and reputed companies generally have easy access to the capital market and,
therefore, may depend less on retained earning to finance their growth.
 These companies tend to pay higher dividends than the smaller companies which have
relatively low access to the market.

10. Legal Constraints:

 Certain provisions of the Companies Act place restrictions on payouts as dividend.
 Such provisions must be adhered to while declaring the dividend.

11. Contractual Constraints:

 While granting loans to a company, sometimes the lender may impose certain restrictions
on the payment of dividends in future.
 The companies are required to ensure that the dividend does not violate the terms of the
loan agreement in this regard.

FINANCIAL PLANNING

 Financial planning is essentially the preparation of a financial blueprint of an

organisation’s future operations.
 The process of estimating the fund requirement of a business and specifying the
sources of funds is called financial planning.
 The objective of financial planning is to ensure that enough funds are available at
right time.
 If adequate funds are not available the firm will not be able to honour its commitments and
carry out its plans.
 On the other hand, if excess funds are available, it will unnecessarily add to the cost and
may encourage wasteful expenditure.

o It must be kept in mind that financial planning is not equivalent to, or a substitute for,
financial management.
o Financial management aims at choosing the best investment and financing alternatives by
focusing on their costs and benefits.
o Its objective is to increase the shareholders’ wealth.
o Financial planning on the other hand aims at smooth operations by focusing on fund
requirements and their availability in the light of financial decisions.

Twin Objectives of Financial Planning

1. To ensure availability of funds whenever required:

 This includes a proper estimation of the funds required for different purposes such as for
the purchase of long-term assets or to meet day-to-day expenses of business etc.
 Apart from this, there is a need to estimate the time at which these funds are to be made
available.
 Financial planning also tries to specify possible sources of these funds.

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2. To see that the firm does not raise resources unnecessarily:

 Excess funding is almost as bad as inadequate funding.
 Even if there is some surplus money, good financial planning would put it to the best
possible use so that the financial resources are not left idle and don’t unnecessarily add to
the cost.
 Thus, a proper matching of funds requirements and their availability is sought to be
achieved by financial planning.

IMPORTANCE of FINANCIAL PLANNING

The importance of financial planning can be explained as follows:

(i) It helps in forecasting what may happen in future under different business situations. It makes
the firm better prepared to face the future.
o For example - a growth of 20% in sales is predicted; it may result in growth rate of 10% or
30%.
o Many items of expenses shall be different in these three situations.
o By preparing a blueprint of these three situations the management may decide what must
be done in each of these situations.
o This preparation of alternative financial plans to meet different situations is clearly of
immense help in running the business smoothly.

(ii) It helps in avoiding business shocks and surprises and helps the company in preparing for
the future.

(iii) If helps in coordinating various business functions, e.g., sales and production functions,
by providing clear policies and procedures.

(iv) Detailed plans of action prepared under financial planning reduce waste, duplication of
efforts, and gaps in planning.

(v) It tries to link the present with the future.

(vi) It provides a link between investment and financing decisions on a continuous basis.

(vii) With detailed objectives for various business segments, it makes the evaluation of actual
performance easier.

CAPITAL STRUCTURE
On the basis of
ownership –
 One of the important decisions under financial The Sources of
management relates to the financing pattern or the Business Finance
proportion of the use of different sources in raising
funds.
 Capital structure refers to the mix between owners Owners’ funds - equity Borrowed funds - loans,
share capital, preference debentures, public deposits
and borrowed funds. share capital and reserves etc. - borrowed from banks,
other financial institutions,
and surpluses or retained
 It can be calculated as Debt-Equity ratio i.e. earnings.
debenture-holders and public
deposits

 or as the proportion of debt out of the total capital

i.e.,

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 Debt and equity differ significantly in their cost and riskiness for the firm.
 The cost of debt is lower than the cost of equity for a firm because the lender’s risk is lower
than the equity shareholder’s risk, since the lender earns an assured return and repayment
of capital and, therefore, they should require a lower rate of return.
 Additionally, interest paid on debt is a deductible expense for computation of tax liability
whereas dividends are paid out of after-tax profit.
 Increased use of debt, therefore, is likely to lower the over-all cost of capital of the firm
provided that the cost of equity remains unaffected.
 Debt is cheaper but is more-risky for a business because the payment of interest and the
return of principal is obligatory for the business.
 Any default in meeting these commitments may force the business to go into liquidation.
 There is no such compulsion in case of equity, which is therefore, considered riskless for
the business.
 Higher use of debt increases the fixed financial charges of a business.
 As a result, increased use of debt increases the financial risk of a company.
 Financial risk is the chance that a firm would fail to meet its payment obligations.
 Capital structure of a company, thus, affects both the profitability and the financial risk.
 A capital structure will be said to be optimal when the proportion of debt and equity
emphasise on increasing the shareholders’ wealth.
 The proportion of debt in the overall capital is also called financial leverage. Financial
leverage is computed as Or when D is the Debt and E is the Equity.

 As the financial leverage increases, the cost of funds declines because of increased use of
cheaper debt but the financial risk increases.
 The impact of financial leverage on the profitability of a business can be seen
through EBIT-EPS (Earnings before Interest and Taxes-Earning per Share) analysis
as in the following example. Three situations are considered.

EBIT-EPS Analysis
Example I (Positive Leverage) Example II (Negative Leverage)
Company X Ltd. Company Y Ltd.
Total Funds used Rs. 30 Lakh Total Funds used Rs. 30 Lakh
Interest rate 10% p.a. Interest rate 10% p.a.
Tax rate 30% Tax rate 30%
EBIT Rs. 4 Lakh EBIT Rs. 2 Lakh
Situation I Situation II Situation III Situation I Situation II Situation III
Rs. 10 Rs. 20 Rs. 10 Rs. 20
Debt Nil Debt Nil
Lakh Lakh Lakh Lakh
Equity@ Rs. 10 Rs. 30 Rs. 20 Rs. 10 Equity@ Rs. Rs. 30 Rs. 20 Rs. 10
each Lakh Lakh Lakh 10 each Lakh Lakh Lakh
EBIT 4,00,000 4,00,000 4,00,000 EBIT 2,00,000 2,00,000 2,00,000
Less: Interest NIL 1,00,000 2,00,000 Less: Interest NIL 1,00,000 2,00,000
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EBT(Earnings EBT(Earnings
4,00,000 3,00,000 2,00,000 2,00,000 1,00,000 NIL
before taxes) before taxes)
Less: Tax 1,20,000 90,000 60,000 Less: Tax 60,000 30,000
EAT(Earnings 1,40,000 EAT(Earnings
2,80,000 2,10,000 1,40,000 1,70,000
after taxes) after taxes)
No. of shares of No. of shares
3,00,000 2,00,000 1,00,000 3,00,000 2,00,000 1,00,000
Rs.10 of Rs.10
EPS(Earnings EPS(Earnings
0.93 1.05 1.40 0.47 0.35 ---------
per share) per share)
Q. Why is the EPS rising with higher debt?
Ans. It is because the cost of debt is lower than the return that company is earning on funds
employed.
 The company X is earning a return on investment (RoI) of 13.33%.
 This is higher than the 10% interest it is paying on debt funds.
 With higher use of debt, this difference between RoI and cost of debt increases the EPS.
 This is a situation of favourable financial leverage.
 In such cases, companies often employ more of cheaper debt to enhance the EPS.
 Such practice is called Trading on Equity.
 Trading on Equity refers to the increase in profit earned by the equity shareholders
due to the presence of fixed financial charges like interest.
 Now consider the following case of Company Y.
 All details are the same except that the company is earning a profit before interest and
taxes of Rs. 2 lakh.
 EPS of the company is falling with increased use of debt.
 because the Company’s rate of return on investment (RoI) is less than the cost of debt.
 The RoI for company Y is , i.e., 6.67%, whereas the interest rate on debt is
10%.
 In such cases, the use of debt reduces the EPS.
 This is a situation of unfavourable financial leverage.
 Trading on Equity is clearly unadvisable in such a situation.

Even in case of Company X, reckless use of Trading on Equity is not recommended. An increase
in debt may enhance the EPS but as pointed out earlier, it also raises the financial risk. Ideally, a
company must choose that risk-return combination which maximises shareholders’ wealth. The
debt-equity mix that achieves it, is the optimum capital structure.

Factors affecting the Choice of Capital Structure

Important factors which determine the choice of capital structure are as follows:

1. Cash Flow Position:

 Size of projected cash flows must be considered before borrowing.
 Cash flows must not only cover fixed cash payment obligations but there must be sufficient
buffer also.
 It must be kept in mind that a company has cash payment obligations for
(i) normal business operations;
(ii) for investment in fixed assets; and
(iii) for meeting the debt service commitments i.e., payment of interest and repayment of
principal.

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2. Interest Coverage Ratio (ICR):

 The interest coverage ratio refers to the number of times earnings before interest and taxes
of a company covers the interest obligation.
 This may be calculated as: ICR
 The higher the ratio, lower shall be the risk of company failing to meet its interest payment
obligations.
 However, this ratio is not an adequate measure.
 A firm may have a high EBIT but low cash balance.
 Apart from interest, repayment obligations are also relevant.

3. Debt Service Coverage Ratio (DSCR):

 Debt Service Coverage Ratio takes care of the deficiencies referred to in the Interest
Coverage Ratio (ICR).
 The cash profits generated by the operations are compared with the total cash required for
the service of the debt and the preference share capital.
 It is calculated as:
 A higher DSCR indicates better ability to meet cash commitments, so the company’s can
increase debt component in its capital structure.

4. Return on Investment (RoI):

 If the RoI of the company is higher, it can choose to use trading on equity to increase its
EPS, i.e., its ability to use debt is greater.
 We have already observed in Example I that a firm can use more debt to increase its EPS.
 Example – Cost of debt (Interest) 10% p.a.
o If the firm is earning a RoI of only 6.67% which is lower than its cost of debt, then use of
higher debt is reducing the EPS.
o If the firm is earning an RoI of 13.33%, then trading on equity is profitable.
 It shows that, RoI is an important determinant of the company’s ability to use Trading on
equity and thus the capital structure.

5. Cost of debt:
 A firm’s ability to borrow at a lower rate increases its capacity to employ higher debt.
 Thus, more debt can be used if debt can be raised at a lower rate.

6. Tax Rate:
 Since interest is a deductible expense, cost of debt is affected by the tax rate.
 If the firms is borrowing @ 10% and the tax rate is 30%, the after tax cost of debt is only
7%.
 A higher tax rate makes debt relatively cheaper and increases its attraction vis-à-vis equity.

7. Cost of Equity:
 Stock owners expect a rate of return from the equity which is commensurate/corresponding
with the risk they are assuming.
 When a company increases debt, the financial risk faced by the equity holders, increases.
 Consequently, their desired rate of return may increase.
 It is for this reason that a company cannot use debt beyond a point.

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 If debt is used beyond that point, cost of equity may go up sharply and share price may
decrease inspite of increased EPS.
 Consequently, for maximisation of shareholders’ wealth, debt can be used only upto a level.

8. Floatation Costs:
 Process of raising resources also involves some cost.
 Public issue of shares and debentures requires considerable expenditure.
 Getting a loan from a financial institution may not cost so much.
 These considerations may also affect the choice between debt and equity and hence the
capital structure.

9. Risk Consideration:
 As discussed earlier, use of debt increases the financial risk of a business.
 Financial risk refers to a position when a company is unable to meet its fixed financial
charges namely interest payment, preference dividend and repayment obligations.
 Apart from the financial risk, every business has some operating risk (also called business
risk). Business risk depends upon fixed operating costs.
 Higher fixed operating costs result in higher business risk and vice-versa.
 The total risk depends upon both the business risk and the financial risk.
 If a firm’s business risk is lower, its capacity to use debt is higher and vice-versa.

10. Flexibility:
 If a firm uses its debt potential to the full, it loses flexibility to issue further debt.
 To maintain flexibility, it must maintain some borrowing power to take care of unforeseen
circumstances.

11. Control:
 Debt normally does not cause a dilution of control.
 A public issue of equity may reduce the managements’ holding in the company and make it
vulnerable to takeover.
 This factor also influences the choice between debt and equity especially in companies in
which the current holding of management is on a lower side.

12. Regulatory Framework:

 Every company operates within a regulatory framework provided by the law e.g. public
issue of shares and debentures have to be made under SEBI guidelines.
 Raising funds from banks and other financial institutions require fulfillment of other norms.
 The relative ease with which these norms can, be met or the procedures completed may
also have a bearing upon the choice of the source of finance.

13. Stock Market Conditions:

 If the stock markets are bullish, equity shares are more easily sold even at a higher price.
 Use of equity is often preferred by companies in such a situation.
 However, during a bearish phase, a company may find raising of equity capital more difficult
and it may opt for debt.
 Thus, stock market conditions often affect the choice between the two.

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14. Capital Structure of other Companies:

 A useful guideline in the capital structure planning is the debt-equity ratios of other
companies in the same industry.
 There are usually some industry norms which may help.
 Care however must be taken that the company does not follow the industry norms blindly.
 For example, if the business risk of a firm is higher, it can not afford the same financial risk.
 It should go in for low debt.
 Thus, the management must know what the industry norms are, whether they are following
them or deviating from them and adequate justification must be there in both cases.

FIXED AND WORKING CAPITAL

Meaning
 Fixed assets are those which remain in the business for more than one year, usually for
much longer, e.g., plant and machinery, furniture and fixture, land and building, vehicles,
etc.
 Current assets are those assets which, in the normal routine of the business, get converted
into cash or cash equivalents within one year, e.g., inventories, debtors, bills receivables,
etc.

Management of Fixed Capital

 Fixed capital refers to investment in long-term assets.
 Management of fixed capital involves allocation of firm’s capital to different projects or
assets with long-term implications for the business.
 These decisions are called investment decisions or capital budgeting decisions and affect
the growth, profitability and risk of the business in the long run.
 These long-term assets last for more than one year.
 It must be financed through long-term sources of capital such as equity or preference
shares, debentures, long-term loans and retained earnings of the business.
 Fixed Assets should never be financed through short-term sources.
 Investment in these assets would also include expenditure on acquisition, expansion,
modernization and their replacement.
 E.g - purchase of land, building, plant and machinery, launching a new product line or
investing in advanced techniques of production, major expenditures such as advertising
campaign or research and development programme having long term implications.

Importance of management of fixed capital or investment or capital budgeting decisions is

as following reasons:
1. Long-term growth:
 These decisions have bearing on the long-term growth. The funds invested in longterm
assets are likely to yield returns in the future.
 These will affect the future prospects of the business.
2. Large amount of funds involved:
 These decisions result in a substantial portion of capital funds being blocked in long-term
projects.
 Therefore, these investments are planned after a detailed analysis is undertaken.
 This may involve decisions like where to procure funds from and at what rate of interest.
3. Risk involved:
 Fixed capital involves investment of huge amounts.
 It affects the returns of the firm as a whole in the long-term.

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 Therefore, investment decisions involving fixed capital influence the overall business risk
complexion of the firm.
4. Irreversible decisions:
 These decisions once taken, are not reversible without incurring heavy losses.
 Abandoning a project after heavy investment is made is quite costly in terms of waste of
funds.
 Therefore, these decisions should be taken only after carefully evaluating each detail or
else the adverse financial consequences may be very heavy.

Factors affecting the Requirement of Fixed Capital

1. Nature of Business

Trading concern - Manufacturing organisation -

Lower investment Higher investment

Since it does not require to purchase
plant and machinery, etc.

2. Scale of Operations

Larger organisation -
Small organisation -
Higher investment Lower investment
Since it needs bigger plant, more space etc. Since requires lower investment in fixed assets

3. Choice of Technique

Capital intensive organisation - Labour intensive organisation -

Higher investment Require less investment in fixed assets

Because of more investment in plant and machinery
4. Technology Upgradation

Industries where assets become obsolete Organisations which use

sooner - assets which are less prone to
obsolescence
Higher investment
Since replacements become due faster. Lower fixed capital.

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5. Growth Prospects

Higher growth - Lower Growth -

Higher investment Less investment

To create higher capacities in order to meet the
anticipated higher demand quicker.

6. Diversification

Diversify its operations Not diversify its operations

More investment Less investment

e.g., a textile company is diversifying and
starting a cement manufacturing plant.

7. Financing Alternatives

Availability of leasing facilities Non-availability of leasing facilities

Less investment More investment

When an asset is taken on lease, the firm pays lease
rent. So, it avoids huge sums required to purchase it.

8. Level of Collaboration

More Collaboration Less Collaboration

Lower investment Higher investment

For example, a bank may use another’s ATM or
some of them may jointly establish a particular
facility.

WORKING CAPITAL
 Apart from the investment in fixed assets every business organization needs to invest in
current assets.
 This investment facilitates smooth day-today operations of the business.
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 Current assets are usually more liquid but contribute less to the profits than fixed assets.
 Examples of current assets, in order of their liquidity, are as under.
1. Cash in hand/Cash at Bank 4. Debtors 7. Raw materials
2. Marketable securities 5. Finished goods inventory 8.Prepaid expenses
3. Bills receivable 6. Work in progress
 Some part of current assets is usually financed through short-term sources, i.e., current
liabilities.
 The rest is financed through long-term sources and is called net working capital.
NWC = CA – CL (i.e. Current Assets - Current Liabilities.)
 Thus, net working capital may be defined as the excess of current assets over current
liabilities.

FACTORS AFFECTING THE WORKING CAPITAL REQUIREMENTS

1. Nature of Business

Trading organisation Manufacturing business

Smaller working capital Higher investment
Because there is usually no processing. Raw material needs to be converted into
finished goods
No distinction between raw materials and
finished goods.

Service industry
Lower investment
Because do not have to
maintain inventory.

2. Scale of Operations

Higher scale of operation Lower scale of operation

Higher working capital Lower working capital
Because the quantum of inventory and
debtors required is generally high.

3. Business Cycle

Boom Depression
Higher working capital Lower working capital
Because sales as well as production are likely to be larger As the sales and production will be small.

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4. Seasonal Factors

Peak season Lean season

Higher working capital Lower working capital
Because of higher level of activity. As the level of activity will be lower.

5. Production Cycle

Longer production cycle Shorter production cycle

Higher working capital Lower working capital

Production cycle is the time span between the receipt of raw material and their conversion into
finished goods.

6. Credit Allowed

Liberal credit policy Non Liberal credit policy

Higher working capital Lower working capital
Because of higher amount of debtors.

These depend upon the level of competition that a firm faces as well as the credit worthiness of
their clientele.
7. Credit Availed

More credit availed from suppliers Less credit availed from suppliers
Lower working capital Higher working capital

8. Operating Efficiency

High operating efficiency Low operating efficiency

Lower working capital Higher working capital
 Higher operating efficiency is reflected through - higher inventory turnover ratio, a better
debtors turnover ratio.
 Better sales effort may reduce the average time for which finished goods inventory is held.
 Such efficiencies may reduce the level of raw materials, finished goods and debtors.

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9. Availability of Raw Material

Un-interrupted availability Not un-interrupted availability

Lower working capital Higher working capital
Because lower stock levels may suffice. Because higher stock levels may be
 In addition, the time lag between the placement required.
of order and the actual receipt of the
materials (also called lead time) is also relevant.
 Larger the lead time, larger the quantity of material to be stored and larger shall be the
amount of working capital required.

10. Growth Prospects

Higher growth potential Lower growth potential

Higher working capital Lower working capital
So that it is able to meet higher production and
sales target.

11. Level of Competition

Higher level of competitiveness

Higher working capital Lower level of competitiveness
Because of need of larger stocks of finished Lower working capital
goods to meet urgent orders from customers.

12. Inflation Rate

Lower rate of inflation

Higher rate of inflation Lower working capital
Higher working capital
Because larger amounts are required to maintain
a constant volume of production and sales.

 It must, however, be noted that an inflation rate of 5%, does not mean that every
component of working capital will change by the same percentage.
 The actual requirement shall depend upon the rates of price change of different
components (e.g., raw material, finished goods, labour cost,).

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B.St. Notes - XII Financial Management

TEST YOUSELF ASIGNMENT

1. Shenoy tries to compare two projects. The projects have equal quantum of risk. According to this
parameter he finds both projects at a par. However, when it comes to know the rate of return of the
two projects, he finds that projects 'A' will earn a rate of return of 10% and project 'B' will earn a rate
of return of 12%. So, he decides 'B'.
a) Identify and state the type of financial decision highlighted above.
b) Also identify and explain the factor of that financial decision highlighted above.
2. State whether a company will retain profit or distribute it as dividend in the following situations:
i. If dividend distribution tax rate is high.
ii. Smaller companies which have relatively low access to the market.
iii. A company having stable earnings.
iv. Companies having good growth opportunities.
v. Availability of enough cash in the opportunities.
3. The newly elected government has decided to levy more taxes on dividends. A company which
pays good dividend every year to its shareholders has decided to keep the retained earnings high
this year. This step will definitely bring the dividend down in comparison to the expectations to the
expectations of the shareholder.
Identify and explain the factor affecting dividend decision shown above.
4. Wadhwa Ltd. has decided to improve its image in the stock market and wants the investors to invest
more money in its shares. The highly ambitions company has planned to increase the dividends of
its shares for the third successive year. The increase has also been substantial. The idea is to send
great news in the market regarding the performance of the company in order to booster its image.
Identify and explain the factor affecting dividend decision highlighted above.
5. 'A business that doesn't grow dies', says Mr. Shah, the owner of Shah, the owner of Shah Marble
Ltd. with glorious 36 months of its grand success having a capital base of Rs 80 crores. Within a
short span of time, the company could generate cash flow which not only covered fixed cash
payment obligations but also create sufficient buffer. The company is on the growth path and a new
breed of consumers is eager to buy the Italian marble sold by Shah Marble Ltd. To meet the
increasing demand, Mr. Shah decided to expand his business by acquiring a mine. This required an
investment of Rs 120 crores. To seek advice in this matter, he called his financial advisor Mr. Seth
who advised him about the judicious mix of equity (40%) and Debt (60%). Mr. Set also suggested
him to take loan from a financial institution as the cost of raising funds from financial institutions is
low. Though this will increase the financial risk but will also raise the return to equity shareholders.
He also apprised him that issue of debt will not dilute the control of equity shareholders. At the same
time, the interest on loan is a tax-deductible expense for computation of tax liability.
After due deliberations with Mr. Seth, Mr. Shah decided to raise funds from a financial institution.
a) Identify and explain the concept of Financial Management as advised by Mr. Seth in the
above situation.
b) State the four factors affecting the concept as identified in part 'a' above which have been
discussed between Mr. Shah and Mr. Seth.
6. Will a firm prefer debt or equity in the following situations?
i. A stronger cash flow position.
ii. If a business has high level of fixed operating costs.
iii. During the period when the stock market is rising.
iv. Firm wants to maintain flexibility in capital structure.
v. When the firm does not want to lose control over the business.
vi. If tax rate is high and firm wants to save tax.
vii. If ICR is more.
viii. If DSCR is less.
ix. If return on investment is more than rate of interest.
x. Source where risk associated is less.
xi. Source which is the cheapest.
xii. When a company is observing other companies' ways of raising finance.
7. State with reason whether the following high or low fixed capital:
i. A computer manufacturing firm.
ii. A company operating at large scale.
iii. When two firms share each other's facilities.
iv. When a company choose to diversify its operations.
v. A company with higher growth plans.
vi. A company which prefers to use labour intensive technique of production.
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vii. A company in which assets become obsolete sooner.

viii. A manufacturing concern.
8. Radhika and Vani who are young fashion designers left their job with a famous fashion designer
chain to set up a company 'Fashionate Pvt. Ltd.' They decided to run a boutique during the day and
coaching classes for entrance examination of National Institute of Fashion Designing in the evening.
For the coaching centre they hired the first floor of a nearby building. Their major expense was
money spent on photocopying of notes for their students. They thought of buying a photocopier
knowing fully that their scale of operations was not sufficient to make full use of the photocopier.
In the basement of the building of 'Fashionate Pvt. Ltd.' Praveen and Ramesh were carrying on a
printing and stationery business in the name of 'Neo Prints Pvt. Ltd.' Radhika approached Praveen
with the proposal to buy a photocopier jointly which could be used by both of them without separate
investment, Praveen agreed to this.
Identify and explain the factor affecting fixed capital requirements of 'Fashionate Pvt. Ltd.'
9. Super Fragrances Ltd. is a well-known manufacturer of perfumes, hair care and skin care product.
The company now wants to diversify into high fashion garments for women. It is also planning to
open exclusive retail outlets in all the metropolitan cities of India in the coming five years.
Identify and explain any two factors highlighted above affecting the fixed capital requiement of the
company.
10. Miracle Ltd. deals in the sale of stationery and office furniture. They source the furnished products
from reputed brands who give them four to six months credit. Because of increase in the demand for
electronic items, they are planning to sell these items also. For this, they have decided to join hands
with a Japanese electronic good manufacturer, to open sales outlets throughout India.
State any three factors affecting working capital requiement of Miracle Ltd. other than the factors
discussed above.

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