Financial

Management
Class 12
Financial management (FM)
decisions related to sources of funds, application of
funds in long term and short term assets and
distribution of earnings to owners (Dividend)

The main objectives of FM is

- to reduce the cost involved in procuring funds,
- to control risk and
- to achieve effective utilisation of funds.
Importance of FM
1. Size and composition of fixed assets i.e. amount of money to be invested in
tangible and intangible assets to give maximum return.
2. Amount and composition of current assets: The quantum of current assets and
its constituents like cash, bills receivable, inventory etc. It is also dependent
on the amount invested in fixed assets, decisions about credit and inventory
management etc.
3. Amount of long-term and short-term funds to be used: In case a firm requires
more liquid assets, then it will prefer to have more long-term finance even
when their profits will decrease due to payment of more interest in
comparison to short-term debts.
Importance of Financial Management
4. Proportion of debt and equity in capital: decisions regarding the
proportion of debt and/or equity.
5. All items in profit and loss account: All items in the profit and
loss account are affected by financial management decisions. For
example, higher amount of debt will lead to increase in the
expense in the form of interest payment in the future
Types of Financial Management
A. Investment Decisions

Decision related to the investment of funds such that it can earn maximum returns.
 Long-term investment decisions (Capital budgeting) decisions are related to
investment in a new fixed asset, new machinery or land. It affects a firm’s long-term
earning capacity and profitability and also has long-term implications on the business.
Moreover, such investment involves a large amount of money, so it is very difficult to
revert such decisions.
Example: Decision to purchase a new fixed asset, opening a new branch etc.
 Short-term investment decisions (Working Capital) decisions that affect day-to-day
business operations. It also affects the liquidity and profitability of a business.
Example: Decisions related to cash management, inventory management etc
Factors influencing capital expenditure decisions

1. Availability of Funds: All the projects are not requiring the same level of
investments. Some projects require huge amount and having high
profitability. If the company does not have adequate funds, such projects may
be given up.
2. Minimum ROI: Every management expects a minimum rate of return or cut-
off rate on capital investment. It refers to the point of below which a project
would not be accepted.
3. Future Earnings: The future earnings may be uniform or fluctuating. Even
though, the company expects guaranteed future earnings in total which
affects the choice of a project.
4. Quantum of Profit Expected: It is necessary to assess the quantum of profit
expected on implementation of selected project. Here, the term profit refers to
realized amount of projects as per the accounting records.
Factors influencing capital expenditure decisions
5. Cash Inflows The term cash inflows refers to profit after tax but before
depreciation. The reason is that recording of depreciation is a book entry and
there is no actual cash outflow. Hence, depreciation amount is included in the
cash inflow.
6. Legal Compulsions The management should consider the legal provisions while-
selecting a project. In the case of leather and chemical industries, there are
number of legal provisions created to protect environment pollution. Now, the
management gives much importance to legal provisions rather than cost and
profit.
7. Ranking of the Capital Investment Proposal Sometimes, a company has two or
more profitable projects in hand. If there is only one profitable project out of
many and huge amount is available in the hands of management, there is no need
of ranking of capital investment proposal. Ranking is necessary if there is many
profitable projects in hand and limited funds is available in the hands of
management.
Types of Financial Management
B. Financial Decisions

Identification of sources of finance.

There are two main sources of raising funds, namely shareholders’ funds (equity) and
borrowed funds (debt).

Taking into consideration factors such as cost, risk and profitability, a company must
decide an optimum combination of debt and equity.

For eg: while debt proves to be cheaper than equity, it involves greater financial risk.

Financial decisions must be taken judiciously as they have an impact on the overall cost
of capital of the firm and also involves financial risk.
Generally, a mixture of both debt and equity funds proves to be beneficial for the
company.
Factors affecting the Financial Decision
Cost Generally, the source of fund which is the cheapest will be chosen

Risk Funds with moderate or low risk are chosen.

Flotation cost Higher the flotation cost, less attractive is the source of fund

Fixed operating High Fixed operating costs- Less Debt

cost Low Fixed operating costs- More Debt
 Factors affecting the Financial Decision
Cash flow Strong cash flow position  Invest more in debt
position Weak cash flow position  Invest more in equity.

Control Wants to dilute the level of control  Invest more in debt,

Considerations Do not wants to dilute the level of control  Invest more in Equity

State of capital Stock market is bullish  More people invest in equity,

market Stock market is bearish,  Difficult for companies to issue equity shares
Types of Financial Management
C. Dividend Decisions
Decisions regarding how the company would distribute its profit or surplus.
Dividend is basically a part of profit which is distributed to shareholders.

The company decides whether to distribute it to equity shareholders in the form

of dividends or to keep it in the form of retained earnings.

So, the main decision is regarding how much profit is to be distributed and how
much is to be retained in the business.

This decision is generally taken considering the objective of maximising

shareholder’s strength and also retaining earnings to increase the future earning
capacity of the organisation.
Factors affecting the Dividend Decision
Amount of Main consideration for payment of dividends by the company to its
earnings shareholders is current and past earnings.
Higher earnings  better position to pay dividends.
Low earnings  lower or no dividends.

Stable Stable or smooth earnings  can pay higher dividends.

earnings Unstable earning  lower or no dividends.

Stable  Generally, companies try to stabilise their dividends such that there is
dividends not much fluctuation in the dividends they distribute.
 They opt for increasing the dividends only when there is a consistent
increase in their earnings.

Growth Higher growth prospects  Retain a greater portion of earnings for future
prospects reinvestment and pay lower or no dividends.
Factors affecting the Dividend Decision
Cash flow Low liquidity (less cash inflows)  Low or no dividends.
position High liquidity (Surplus cash inflows)  Pay out more dividends.

Preference of • The preference of shareholders must also be considered while taking

shareholders dividend decisions.
• For instance, if the shareholders prefer that a certain minimum amount
of dividends be paid, then the company is likely to declare the same.

Taxation policy • Taxation policy of the government is an important factor in taking the
dividend decision.
• For instance, if the rate of taxation on payment of dividend by
companies is high, then the company may distribute less by way of
dividends.
Stock market • Dividend decisions taken by a company affect the market price of its
reactions stock.
• If a company declares higher dividends, then it is seen positively by
investors, and its stock price increases.
Financial planning
It involves designing the blueprint of the overall financial operations of a company such
that the right amount of funds are available for various operations at the right time.

Main Objectives of Financial Planning

1. An estimation is made regarding the amount of funds which would be required for
various business operations. In addition, an estimation is made regarding the time at
which the funds would be needed.

2. It ensures that situations of both excess or shortage of funds are avoided. This is
because while inadequate funds obstruct operations of the firm, excess funding leads
to wasteful expenditure by the firm.

Thus, proper financial planning ensures optimal utilisation of funds by the firm.
Importance of Financial Planning
Helps in facing • Forecasts things that are to happen
eventual • Helps to face future situations in a better manner
situations • Provides alternative situations and helps mgmt. in advance to
tackle changed current situations
Improves • Helps in coordinating various business functions like sales,
Coordination production and finance departments by providing clear rules,
policies and procedures
Helps in • Ensures reduction of wastes, thereby leading to good management
optimum of funds
utilisation of
funds
Evaluation of • By providing detailed business objectives and showing all the
performance financial plans for varied business segments, it makes it easier to
evaluate segment-wise business performance
Importance of Financial Planning
Avoiding • Helps a company to prepare itself for future shocks and surprises
surprises &
shocks

Reduces • Detailed plans of action helps in reducing wastage and avoids duplication
wastage & of efforts
duplicity

Acts as a • Tries to link the present with the future

link • Provides a link between investment and financing decisions
Differences between financial planning and
financial management
Financial planning Financial Management
Estimating the amount of funds to be It refers to the efficient acquisition,
required and determining the sources allocation and usage of funds of the
through which these would be obtained. company.
It aims at ensuring smooth operations by Aims at determining the best investment
considering the requirement of funds against alternative by considering the relative costs
their availability. and benefits.
Narrow scope & is a part of FM It has a wider scope.

The objective is to ensure availability of The objective is to manage various activities

funds as and when required and that related to finance.
unnecessary fund raising is avoided.
Capital structure
Combination of different financial sources which a firm uses to raise funds.

There are two broad categories of sources of funds, namely borrowed funds and owner’s funds.

Borrowed funds refer to borrowings in the form of loans, borrowings from banks, public deposits etc.
In general, ‘borrowed funds’ are simply called debt.

On the other hand, owner’s funds can be in the form of reserves, preference share capital, retained
earnings etc. In general, owner’s funds can be called equity.

Accordingly, capital structure can be simply stated as the combination of debt and equity used by a
firm.

The capital structure of a company affects the profitability as well as the financial risk of the company.

Hence, it needs to be taken after considering various aspects.

The way capital structure is framed by the company depends on three main factors—cost, risks and
returns
Factors affecting capital structure
1. Cost considerations

Debt is a cheaper source of finance than equity. Cost of debt remains low
because of fixed and assured returns which means low risk and due to this
lower rate of return and lower cost to the company. Interest paid on debt
provides tax savings.

Equities are more expensive than tax as they involve flotation cost as well.
Also dividends paid to shareholders are not tax deductible.
2. Financial risk

Debt involves financial risk because of compulsion to repay the debt amount
in a fixed period of time. Any default in repayment may even lead to
liquidation of the firm.
Factors affecting capital structure
In case of equity, there is no financial risk as it is not mandatory to pay
dividends to shareholders
• 3) Return: Debt offers higher return because the difference between cost and
return is greater which results in higher EPS.
• Conclusion: Debt is cheaper and offers higher return but also increases the
financial risk of the company. So, the decision regarding the capital structure
shall be taken after considering these factors involved.
Factors Affecting Capital Structure
Cash flow Strong cash flow position  More debt
position Weak cash flow position  More equity
Interest It refers to the number of times of EBIT of a company cover
coverage ratio the interest obligation.
High ICR = High Debt
Low ICR = Low Debt
ROI Higher ROI  More debt
Lower ROI  Lower debt
Cost of Debt Cost of Debt  Proportion of Debt 
Cost of Debt  Proportion of Debt 
Tax rate Tax Rate  Proportion of Debt 
Tax Rate  Proportion of Debt 
Factors Affecting Capital Structure
Flotation cost Refers to the costs involved in the issue of shares and debentures like
advertising, underwriting, statutory fees etc.
Higher flotation costs Lower proportion of that source

Risk Risk  Proportion of Debt 

Risk  Proportion of Debt 

Control Management wants to retain control  More debt

Management wants to share control  More equity

Stock market Boom condition  Easy to opt for equity

Recession condition  May opt for debt

Debt service DSCR = (PAT + Dep + Interest + Non cash expenses) /

coverage (Pref Div. + Interest + Repayment of Obligations) Higher DSCR
ratio  More Debt
Lower DSCR  Less Debt
Fixed Capital
It refers to investment in long-term assets.

Management of fixed capital includes allocating a firm’s capital to different projects/assets.

Such decisions are known as investment decisions or capital budgeting decisions. These
decisions affect the growth, profitability and risk of the business in the long run.

Fixed assets should be financed through long-term sources of capital:

 Equity or preference shares
 Debentures or Long-term loans
 Retained earnings

Examples: Purchase of land, building, plant and machinery, Launching of a new product line,
Investment in advance techniques of production, Expenditure on advertising campaigns and
research and development which have long-term implications for the organisation
Factors affecting the requirement of fixed
capital
 Nature of business: is a very essential factor like fixed capital requirement
is more in a manufacturing company than in a trading company.
 Scale of operation: Large-scale companies require more fixed capital
because of purchase more machinery and plants for their operations and
require more space than small companies.
 Technique of production: If company opts for capital intensive technology,
more fixed capital is required but for labour intensive technique less
investments in fixed assets are required.
 Technology upgradation: If industries upgrades frequently like smartphone,
the company requires more fixed capital for replacing old machinery with
new machinery to upgrade technology. While upgradation is slow, the fixed
capital requirement will be less.
Factors affecting the requirement of fixed
capital
 Growth prospects: To attain higher growth by expanding business activities,
more fixed capital is required as compared to companies having no such
objectives.
 Diversification: Companies diversifying their range of production activities
will require more fixed capital to produce goods.
 Availability of finance and leasing facility: When companies are provided
leasing facilities, they can avoid purchase of fixed assets. This leads to
reduction in fixed capital requirements.
 Level of collaboration: Companies which prefer collaborations will require less
fixed capital as they can share available machinery with their collaborators.