BY NANDINI SAREEN

Concept of Financial Management

Financial Management is concerned with optimal procurement as well as the usage of finance.Financial
Management aims at reducing the cost of funds 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.

Decisions taken in Financial Management (or Financial Decisions)

⚫Investment Decision
The investment decision relates to how the firm's funds are invested in-different assets so that they are able
to earn the
highest possible return for their investors.Investment decisions can be long-term or short-term.

(1)Long-term investment decisions

(also called a Capital Budgeting decision) 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.

(2)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

Essential ingredients of sound working capital management

(1) Efficient cash management

(2) Efficient inventory management
(3) Efficient receivables management

2. Financing Decision

This decision is about the quantum of finance to be raised from various long-term sources.
The main long-term sources of funds are shareholders' funds and borrowed funds
Shareholders' funds (equity) refer to the equity share capital, preference share capital and reserves and
surpluses or retained earnings.
Borrowed funds (debt) refer to the finance raised through debentures, long-term loans, public deposits, etc.

3. Dividend Decision

. Dividend decision involves 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.

Objectives of Financial Management

The primary aim/objective of financial management is to maximise shareholders' wealth, which is referred to
as the wealth-maximisation concept.It means maximisation of the market value of equity shares

Role of Financial Management

1.Financial Management is concerned with optimal procurement as well as the usage of finance

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2.Good financial management aims at procuring funds at a lower cost, keeping the risk under control and
achieving effective deployment of such funds

3.It also aims at ensuring availability of enough funds whenever required as well as avoiding idle finance.

4.The financial statements, such as Balance Sheet and Statement of Profit and Loss Account, of a business
are largely determined by financial management decisions taken earlier

Long-Term Investment Decision/Capital Budgeting Decision

A long-term investment decision/A capital budgeting decision involves committing the finance on a long-
term basis It is also called 'Management of Fixed Capital
Examples of capital budgeting decisions
 Acquiring a new fixed asset such as land, building, plant and machinery, etc.
 Opening a new branch
 Expenditure on acquisition, expansion, modernisation and their replacement
 Launching a new product line Investing in advanced techniques of production
 Major expenditures on advertising campaign or research and development programme

Why are investment or capital budgeting decisions important?

Capital budgeting decisions are very crucial for any business since they affect its carning capacity in
the long run.
These decisions affect the growth profitability and risk of the business in the long run

1. Long-term growth: These decisions have bearing on the long-term growth.

2. Large amount of funds involved: These decisions normally involve huge amounts of funds being
blocked in long-term projects

3. Risk involved: Fixed capital involves investment of huge amounts. It affects the returns of the
firm as a whole in the long-term. 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.capital budgeting decisions should be taken with utmost care A bad capital budgeting
decision normally has the capacity to severely damage the financial fortune of a business

Factors affecting Capital Budgeting Decision

1. The rate of return: If there is

only one project, its viability is seen in terms of the rare of return. However, if there are more than
one projects, a particular project with the highest rate of return is selected.

2. Cash flows of the project: When a company takes an investment decision involving huge amount
of funds, it expects to generate some cash flows over a period The amount of these cash flows
should be carefully analysed before considering a capital budgeting decision

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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, such as Pay Back Period, Net Present Value (NPV), Internal Rate of
Return(IRR).etc. to evaluate investment proposals which are known as capital budgeting
techniques. These techniques are applied to each proposal before selecting a particular project

Financing Decision
Financing decision relates to the financing pattern or the proportion of debt and equity. It is
concerned with the decisions about how much to be raised from which source

1.Cost of debt is lower than cost of equity for a firm because Debt Equity the lender's risk is lower
than the equity shareholder's risk.
2.interest paid on debt is a deductible expense
3.Therefore, increased use of debt is likely to lower the overall cost of capital of the firm.

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.

Financial risk is the chance that a firm would fail to meet its payment
obligations, i.e., interest and principal amount Thus, financing decision
determines the overall cost of capital and the financial risk of the
enterprise.

Factors Affecting Financing Decision

1. Cash Flow Position: A stronger cash flow position may make debt financing more viable than
funding through equity. On the other hand, if the cash flow position of a company is weak more
debt financing is not recommended because interest on debt has to be paid regardless of whether
or not there is availability of cash.

2. Fixed Operating Costs If a business has high fixed operating costs (eg, building rent, insurance
premium, salaries, etc.), it must reduce fixed financing costs(i.c. interest on debt

3. Cost: A prudent financial manager would normally opt for a source which is the cheapest. For example, debt is
considered to be the cheapest of all the sources;

4.RISK: Financial risk is the chance that a firm would fail to meet its payment obligations, i.e.,
interest and principal amount Thus, financing decision determines the overall cost of capital
and the financial risk of the enterprise.

5.Flotation Costs: The fund raising exercise also costs something (e.g. brokerage, commission, printing
of applications and advertising, etc.). This cost is called floatation cost. Higher the floatation cost, less attractive
the source. Public issue of shares and debentures requires considerable expenditure. Getting a loan from a
financial institution may not cost so much.

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6. Control Considerations: Debt normally does not cause a dilution of control. Issues of more equity however,
may reduce the management's holding in the company Therefore, companies afraid of a takeover bid would
prefer debt to equity

7. State of Capital Market:

 During the period when stock market is rising(ie, a bullish phase), more people invest in equity Use of equity
is often preferred by companies in such a situation
 However, during the period of depressed capital market(I.e., a bearish phase) a company may find raising of
equity capital more difficult and it may opt for debt

Dividend Decision

Dividend decision involves how much of the profits earned by a company (after paying tax) will be distributed as
profit and how much will be retained in the business

Factors affecting dividend decision

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

2. Stability Earnings: Other things remaining the same, a company having able earnings 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 stable dividend per share. The increase in
dividends is generally made when the earning potential of the company increases and not just the earnings of the
current year.

4. Growth Opportunities: Companies having good growth opportunities retain more money out of their earning

5. Cash Flow Position The payment of dividend involves an outflow of cash Availability of enough cash in the
company is necessary for declaration
of dividend

6. Shareholders' Preference: 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 investment

7. Stock Market Reaction: Generally, investors view an increase in dividend as a good news and hence market
price of shares increases in the stock market. On the contrary, a decrease in dividend reduces the market price of
shares

8. Access to Capital Markets Large and reputed companies generally have easy access to the capital marker and,
therefore, may depend less on retained earning to finance their growth. These companies are likely to pay higher
dividends than the smaller companies which have relatively low access to the market

9. Legal Constraints Certain provisions of the Companies Act place restrictions on pay outs as dividend. Such
provisions must be adhered to while declaring the dividend

10. Contractual Constraints While granting loans to a company, sometimes banks/financial institutions
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

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Concept of Financial Planning

Financial planning is essentially the preparation of financial blueprint of an organisation's future operations, It
takes into consideration the growth, performance, investments and requirement of funds for a given period
The process of estimating the fund requirement of a business and specifying the sources of funds is called
financial planning

Objectives of Financial Planning

1.To ensure availability of funds whenever required: It involves estimation of the funds required, the time at
which these funds are to be made available and the sources of these funds. If adequate funds are not available
the firm will not be able to honour its commitments and carry out its plans.
2. To see that the firm does not raise resources unnecessarily: If excess funds are available, it will unnecessarily
increase the costs and the funds will remain idle. It may also encourage wasteful expenditure,
Excess funding is almost as bad as inadequate funding.

Importance of Financial Planning

1.It helps in forecasting what may happen in future under different business situations For example, a growth of
20% in sales is predicted. However, it may happen that the growth rate eventually turning out to be 15% or 25%
By preparing a blueprint of these three situations, the management may decide what must be done in each of
these situations
2.It helps in avoiding business shocks and surprises and helps the company in preparing for the future.
3. It helps in coordinating various business functions, e.g., sales and production functions, by providing clear
policies and procedures.
4.It provides a link between investment and financing decisions on a continuous basis.
5.It helps in reducing waste, duplication of efforts, gaps in planning and confusion
6.It serves as a control technique as it makes evaluation of actual performance easier
7.It tries to link the present with the future

Types of Financial Planning

Financial planning includes both short-term as well as long-term planning

Long-term financial planning relates to long term growth and investment. It focuses on capital
expenditure programmes.

Short-term financial planning covers short-term financial plan called "budget"

Financial Planning Process

1. Preparation of a sales forecasts Financial planning usually begins with the preparation of a sales forecast.

2. Preparation of financial statements: Based on sales forecast. the financial statements are prepared keeping in
mind the requirement of funds for investment in the fixed capital and working capital.

3. Estimation of expected profits. Then the expected profits during the period are estimated so th idea can be
made of how much of the fund requirements can be met internally Le, through sets earnings (after dividend pay
ours). This results in an estimation of the requirement for external fund A.

4.Estimation of sources of external funds The sources from which the external funds requirement can be met
are identified.

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4. Preparation of cash budget Cash budgets are made incorporating the above factors.

Concept of Capital Structure

Capital structure refers to the mix between shareholders' funds (equity) and borrowed funds(debt)

It can be calculated As debt-equity ratio, ie DEBT

Equity

Or as the proportion of debt in the total

capital

The proportion of debt in the total capital is also called financial leverage . It can be computed as

Example 1: Company X Lrd. has total capital employed of 30 lakh rs. Tax rate is 30%. Rate of interest on debt
10% pa., EBIT = 4lakh. Three situations are considered
Situation I: There is no debt (Ie, unlevered firm).
Situation II: There is debt of 10 lakh.
Situation III: There is debt of 20 lakh

The Company X Led. earns 0.93 per share if it is unlevered. With debt of 10 lakh its EPS is 71.05. With a 21.40 This
is called Trading on Equity, which refers to the increase in profit earned by the equity shareholder still higher
debt of 20 lakh, EPS rises to due to presence of fixed financial charges like interest. Thus, the shareholders are
likely to gain due to debt/loan component in the total capital employed.
Hour With higher debt. EPS rises. ? It is because the cost of debt (rate of interest) is lower than the company's
Return On Investment (ROI), which is calculated as EBIT
Total capital employed

ROI OF X LTD. = 4,00,000 100

13.33%
30,00,000