Dr.

Virendra Swarup Institute of Computer Studies - Kanpur

UNIT III Functions of Financial Management

Meaning of Financial Management 1. Estimation of capital requirements: A finance

manager has to make estimation with regards to
Financial Management means planning, organizing, capital requirements of the company. This will
directing and controlling the financial activities such as depend upon expected costs and profits and future
procurement and utilization of funds of the enterprise. It programmes and policies of a concern. Estimations
means applying general management principles to financial have to be made in an adequate manner which
resources of the enterprise. increases earning capacity of enterprise.
Scope/Elements 2. Determination of capital composition: Once the
estimation have been made, the capital structure
have to be decided. This involves short- term and
1. Investment decisions includes investment in fixed
long- term debt equity analysis. This will depend
assets (called as capital budgeting). Investment in
upon the proportion of equity capital a company is
current assets are also a part of investment
possessing and additional funds which have to be
decisions called as working capital decisions.
raised from outside parties.
2. Financial decisions - They relate to the raising of
3. Choice of sources of funds: For additional funds
finance from various resources which will depend
to be procured, a company has many choices like-
upon decision on type of source, period of
a. Issue of shares and debentures
financing, cost of financing and the returns
b. Loans to be taken from banks and financial
thereby.
institutions
3. Dividend decision - The finance manager has to
c. Public deposits to be drawn like in form of
take decision with regards to the net profit
bonds.
distribution. Net profits are generally divided into
two:
a. Dividend for shareholders- Dividend and Choice of factor will depend on relative merits and
demerits of each source and period of financing.
the rate of it has to be decided.
b. Retained profits- Amount of retained
profits has to be finalized which will 4. Investment of funds: The finance manager has to
depend upon expansion and diversification decide to allocate funds into profitable ventures so
plans of the enterprise. that there is safety on investment and regular
returns is possible.
5. Disposal of surplus: The net profits decision have
Objectives of Financial Management
to be made by the finance manager. This can be
The financial management is generally concerned with done in two ways:
procurement, allocation and control of financial resources a. Dividend declaration - It includes
of a concern. The objectives can be- identifying the rate of dividends and other
benefits like bonus.
1. To ensure regular and adequate supply of funds to b. Retained profits - The volume has to be
the concern. decided which will depend upon
2. To ensure adequate returns to the shareholders expansional, innovational, diversification
which will depend upon the earning capacity, plans of the company.
market price of the share, expectations of the 6. Management of cash: Finance manager has to
shareholders. make decisions with regards to cash management.
3. To ensure optimum funds utilization. Once the Cash is required for many purposes like payment
funds are procured, they should be utilized in of wages and salaries, payment of electricity and
maximum possible way at least cost. water bills, payment to creditors, meeting current
4. To ensure safety on investment, i.e, funds should liabilities, maintainance of enough stock, purchase
be invested in safe ventures so that adequate rate of of raw materials, etc.
return can be achieved. 7. Financial controls: The finance manager has not
5. To plan a sound capital structure-There should be only to plan, procure and utilize the funds but he
sound and fair composition of capital so that a also has to exercise control over finances. This can
balance is maintained between debt and equity be done through many techniques like ratio
capital. analysis, financial forecasting, cost and profit
control, etc.

Instructor – Anuj Srivastava

Accounts - BCA – Second Semester
 Dr. Virendra Swarup Institute of Computer Studies - Kanpur
Meaning of Capital Structure plans. Therefore, in order to make the capital
structure possible, the company should go for issue
Capital Structure is referred to as the ratio of different of debentures and other loans.
kinds of securities raised by a firm as long-term finance. 4. Choice of investors- The company’s policy
The capital structure involves two decisions- generally is to have different categories of
investors for securities. Therefore, a capital
a. Type of securities to be issued are equity shares, structure should give enough choice to all kind of
preference shares and long term borrowings investors to invest. Bold and adventurous investors
(Debentures). generally go for equity shares and loans and
b. Relative ratio of securities can be determined by debentures are generally raised keeping into mind
process of capital gearing. On this basis, the conscious investors.
companies are divided into two- 5. Capital market condition- In the lifetime of the
i. Highly geared companies - Those company, the market price of the shares has got an
companies whose proportion of equity important influence. During the depression period,
capitalization is small. the company’s capital structure generally consists
ii. Low geared companies - Those companies of debentures and loans. While in period of boons
whose equity capital dominates total and inflation, the company’s capital should consist
capitalization. of share capital generally equity shares.
6. Period of financing- When company wants to
Factors Determining Capital Structure raise finance for short period, it goes for loans
from banks and other institutions; while for long
1. Trading on Equity- The word “equity” denotes period it goes for issue of shares and debentures.
the ownership of the company. Trading on equity 7. Cost of financing- In a capital structure, the
means taking advantage of equity share capital to company has to look to the factor of cost when
borrowed funds on reasonable basis. It refers to securities are raised. It is seen that debentures at
additional profits that equity shareholders earn the time of profit earning of company prove to be a
because of issuance of debentures and preference cheaper source of finance as compared to equity
shares. It is based on the thought that if the rate of shares where equity shareholders demand an extra
dividend on preference capital and the rate of share in profits.
interest on borrowed capital is lower than the 8. Stability of sales- An established business which
general rate of company’s earnings, equity has a growing market and high sales turnover, the
shareholders are at advantage which means a company is in position to meet fixed commitments.
company should go for a judicious blend of Interest on debentures has to be paid regardless of
preference shares, equity shares as well as profit. Therefore, when sales are high, thereby the
debentures. Trading on equity becomes more profits are high and company is in better position
important when expectations of shareholders are to meet such fixed commitments like interest on
high. debentures and dividends on preference shares. If
2. Degree of control- In a company, it is the directors company is having unstable sales, then the
who are so called elected representatives of equity company is not in position to meet fixed
shareholders. These members have got maximum obligations. So, equity capital proves to be safe in
voting rights in a concern as compared to the such cases.
preference shareholders and debenture holders. 9. Sizes of a company- Small size business firms
Preference shareholders have reasonably less capital structure generally consists of loans from
voting rights while debenture holders have no banks and retained profits. While on the other
voting rights. If the company’s management hand, big companies having goodwill, stability and
policies are such that they want to retain their an established profit can easily go for issuance of
voting rights in their hands, the capital structure shares and debentures as well as loans and
consists of debenture holders and loans rather than borrowings from financial institutions. The bigger
equity shares. the size, the wider is total capitalization.
3. Flexibility of financial plan- In an enterprise, the
capital structure should be such that there is both
contractions as well as relaxation in plans.
Debentures and loans can be refunded back as the
time requires. While equity capital cannot be
refunded at any point which provides rigidity to

Instructor – Anuj Srivastava

Accounts - BCA – Second Semester
 Dr. Virendra Swarup Institute of Computer Studies - Kanpur
What is Capitalization of the company. The result is deficiency in
company. To fill up the deficiency, fresh capital is
Capitalization comprises of share capital, debentures, raised which proves to be a costlier affair and
loans, free reserves,etc. Capitalization represents leaves the company to be over- capitalized.
permanent investment in companies excluding long-term 3. Over-estimation of earnings- When the
loans. Capitalization can be distinguished from capital promoters of the company overestimate the
structure. Capital structure is a broad term and it deals with earnings due to inadequate financial planning, the
qualitative aspect of finance. While capitalization is a result is that company goes for borrowings which
narrow term and it deals with the quantitative aspect. cannot be easily met and capital is not profitably
invested. This results in consequent decrease in
Capitalization is generally found to be of following types-
earnings per share.
 Normal
Effects of Overcapitalization
 Over
 Under
1. On Shareholders- The over capitalized companies
have following disadvantages to shareholders:
Overcapitalization a. Since the profitability decreases, the rate of
earning of shareholders also decreases.
Overcapitalization is a situation in which actual profits of a b. The market price of shares goes down
company are not sufficient enough to pay interest on because of low profitability.
debentures, on loans and pay dividends on shares over a c. The profitability going down has an effect
period of time. This situation arises when the company on the shareholders. Their earnings
raises more capital than required. A part of capital always become uncertain.
remains idle. With a result, the rate of return shows a d. With the decline in goodwill of the
declining trend. The causes can be- company, share prices decline. As a result
shares cannot be marketed in capital
1. High promotion cost- When a company goes for market.
high promotional expenditure, i.e., making 2. On Company-
contracts, canvassing, underwriting commission, a. Because of low profitability, reputation of
drafting of documents, etc. and the actual returns company is lowered.
are not adequate in proportion to high expenses, b. The company’s shares cannot be easily
the company is over-capitalized in such cases. marketed.
2. Purchase of assets at higher prices- When a c. With the decline of earnings of company,
company purchases assets at an inflated rate, the goodwill of the company declines and the
result is that the book value of assets is more than result is fresh borrowings are difficult to be
the actual returns. This situation gives rise to over- made because of loss of credibility.
capitalization of company. d. In order to retain the company’s image, the
3. A company’s floatation n boom period- At times company indulges in malpractices like
company has to secure it’s solvency and thereby manipulation of accounts to show high
float in boom periods. That is the time when rate of earnings.
returns are less as compared to capital employed. e. The company cuts down it’s expenditure
This results in actual earnings lowering down and on maintainance, replacement of assets,
earnings per share declining. adequate depreciation, etc.

1. Inadequate provision for depreciation- If the Undercapitalization

finance manager is unable to provide an adequate
rate of depreciation, the result is that inadequate An undercapitalized company is one which incurs
funds are available when the assets have to be exceptionally high profits as compared to industry. An
replaced or when they become obsolete. New undercapitalized company situation arises when the
assets have to be purchased at high prices which estimated earnings are very low as compared to actual
prove to be expensive. profits. This gives rise to additional funds, additional
2. Liberal dividend policy- When the directors of a profits, high goodwill, high earnings and thus the return on
company liberally divide the dividends into the capital shows an increasing trend. The causes can be-
shareholders, the result is inadequate retained
profits which are very essential for high earnings

Instructor – Anuj Srivastava

Accounts - BCA – Second Semester
 Dr. Virendra Swarup Institute of Computer Studies - Kanpur
1. Low promotion costs company in order to raise capital. Further equity share
2. Purchase of assets at deflated rates capital means all share capital excluding preference share
3. Conservative dividend policy ca voting rights capital. The shareholders of equity shares
4. Floatation of company in depression stage have voting rights proportionate to the paid up equity
5. High efficiency of directors capital. A public limited company may raise funds from
6. Adequate provision of depreciation public or promoters as equity share capital by issuing
7. Large secret reserves are maintained. ordinary equity shares. Ordinary shareholders are those
who receive dividend and return of capital after the
Efffects of Under Capitalization payment to preference shareholders.

1. On Shareholders
a. Company’s profitability increases. As a Features
result, rate of earnings go up.
b. Market value of share rises.  It is one of the most important long-term sources of fund.
c. Financial reputation also increases.  There are no fixed charges attached to ordinary equity
d. Shareholders can expect a high dividend. shares. If the there is sufficient profit earned by the
2. On company company then only the equity shareholders get dividend
a. With greater earnings, reputation becomes but there is no legal obligation to pay dividends.
strong.
b. Higher rate of earnings attract competition Equity shares have no maturity date and thus there is no
in market. obligation to redeem.
c. Demand of workers may rise because of  The firm with the longer equity base will have greater
high profits. ability to raise debt finance on favourable terms. Thus issue
d. The high profitability situation affects of equity share increases the credit worthiness of the firm.
consumer interest as they think that the
company is overcharging on products.  The company can further issue share capital by making
right issue and bonus issue.
 In India, returns from the sale of ordinary shares in the
form of capital gains are subject to capital gains tax rather
Five long term sources of fund for a company
than corporate tax.
 Once the company earns profit it pays more dividends, thus
bringing more investors and leads to appreciate the market
Sources of fund
value of equity shares of the company.
Sources of fund are classified into three distinct categories
on the basis of time-period i.e. short term fund, medium
Preference shares
term fund and a long term fund. Herein we are going to
discuss the long term source of fund meaning capital Preference share means share which enjoys the preferences
requirement for a period of more than 5 yrs to 10, 15, 20 or in the following two rights over equity i.e. right to dividend
more depending upon the factors. Expenditures in fixed at a predetermined rate before payment of dividend to
assets like plant machinery, land, building etc are funded equity shareholders and right to receive payment of the
by long term fund. Therefore, long term source of funding capital in the event of winding up before repayment of
can b in the form of Equity shares, Preference share, equity shareholders.
debentures, loans and financial institution and retained
earnings.
Features

5 long term sources of fund  Company can issue long term fund by issuing preference
shares.
 If the profit is earned, dividend is paid to the preference
Equity shares shareholders but if no profit is earned then the company is
under no legal binding to pay preference dividend.
Shares are share in a share capital of a company. It is
basically smallest indivisible unit which is issued by the There is maximum advantage as it has fixed charges.

Instructor – Anuj Srivastava

Accounts - BCA – Second Semester
 Dr. Virendra Swarup Institute of Computer Studies - Kanpur
 Preference share capital is generally regarded as part of net of project for which the loan is needed. Term loans are
worth. Hence it increases the creditworthiness of the firm. secured borrowings and a significant source of finance for
investment in the form of fixed assets and also in the form
 Assets are not secured in favour of preference shareholders.
of working capital needed for new project.
The mortgageable assets of the company are freely
available.

Retained earnings
Debentures
Retained earnings is basically a part of undistributed profit
Debenture is a document given by a company under its which a company keeps as free reserves and thus is utilized
common seal as an evident of debt to the holder. It includes for further expansion and diversification programs. Also
debenture stock, bonds and any other security of the known as Ploughing back of profits or retained earnings. It
company whether charge on assets of the company or not. increases net worth of the business because it belongs to
Company can issue redeemable or irredeemable equity share holders.
debentures. Redeemable providing specific date of
redemption whereas irredeemable providing no
Although it is essentially a means of long-term financing
undertaking to repay. It is an instrument for raising long-
for expansion and development of a firm, and its
term debt. Debenture holders are the creditors of the
availability depends upon a number of factors such as the
company. They have no voting rights in the company.
rate of taxation, the dividend policy of the firm,
Debenture may be issued by mortgaging any asset or
Government policy on payment of dividends by the
without mortgaging the asset, i.e., debentures may be
corporate sector, extent of profit earned and upon the
secured or unsecured.
firm’s appropriation policy etc.

Features
Features
 Cost of debenture is much lower than the cost of equity or
 Cheapest method of raising funds.
preference share since interest on debenture is a tax-
deductible expense.  Provides sufficient capital for expansion and development.
 Also interest on debentures is charge against profit. It is an Entity does not depend upon lenders or outsiders if retained
admissible expense for the purpose of taxation so tax earnings are readily available.
liability on company’s profit is reduced which results in
 It increases reputation of the business, hence promoting
debenture as a source of finance.
investors to influx capital.
 Investors prefer debenture investment than equity or Cost of Capital:
preference investment as the former provides a regular
flow of permanent income. Thus bringing more number of The cost of capital is the minimum rate of return required
investors to the company resulting as a source of finance.
on the investment projects to keep the market value per
 Investors prefer debenture investment than equity or
preference investment as the debenture provides a regular share unchanged.
flow of permanent income.
In other words, the cost of capital is simply the rate of

Loans and Financial Institutions return the funds used should produce to justify their use
within the firm in the light of the wealth maximisation
In India, long term financial assistance is provided to
public and private firms through commercial financial objective.
institution. Generally, firms obtain long-term debt by
raising term loans. Term loans refer to as term finance;
represent a source of debt finance which is repayable in Explicit cost and implicit cost:
less than 10 years. Giving long term is not an easy task.
Before giving a term loan to a company the financial The explicit cost of capital is the internal rate of return of
institutions must be satisfied regarding the technical, the financial opportunity and arises when the capital is
economic, commercial, financial and managerial viability

Instructor – Anuj Srivastava

Accounts - BCA – Second Semester
 Dr. Virendra Swarup Institute of Computer Studies - Kanpur
raised. The implicit of capital arises when the firm preference capital, the dividend rate to the common
considers alternative uses of the funds rained. The methods shareholders is not fixed. However, the shareholders invest
of calculating the specific costs of different sources of their money in common shares with an expectation of
funds are discussed. receiving dividends.

1. Cost of debt: The market value of the share depends on the dividends
It is relatively easy to calculate cost of debt, it is rate of expected by the shareholders. Therefore, the required rate
return or the rate of interest specified at the time of debt of return which equates the present value of the expected
issue. When a bond or debenture is issued at full face value dividends with the market value of share is the equity
and to be redeemed after some period, then the before tax capita).
cost of debt is simply the normal rate of interest.
Retained earnings:
Before tax cost of debt, Kd = Interest/ Principal The companies are not required to pay any dividends on
retained earnings. Therefore, it is sometimes observed that
2. Cost of preference capital:
this source of finance is cost free. But retained earnings is
The measurement of the cost of preference capital poses
the dividend foregone by the share holders.
some conceptual difficulty. In the case of debt, there is a
binding legal obligation on the firm to pay interest and the
interest constitutes the basis to calculate the cost of debt.

However, when reference to the preference capital, it may

be stated that the payment of dividends on preference
capital is not legally binding on the firm and even if the
dividends are paid, it is not a charge on earnings, rather it is
a distribution or appropriation of earnings to a class of
owners. It may, therefore, be concluded, that the dividends
on preference capital do not constitute cost. This is not
true.

3. Cost of equity capital:

It is sometimes argued that tine equity capital is free of
cost. This is not true. The reason for advancing such an
argument is that it is not legally binding on the company to
pay dividends to the common shareholders. Also, unlike
the interest rate on debt or the rate of dividend on

Instructor – Anuj Srivastava

Accounts - BCA – Second Semester