ee ea Financial Management: Concept, Decisions, Objectives Price @ cy CG Concept of Financial Management | Financial Management is concerned with optimal procurement as well a the usage of finance * For optimal procurement, different available sources of finance are identified and. comp. their costs and associated risks. * Similarly, che 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 anc Management aims at reducing the cost of funds procured, keeping the risk under control and achieving fective deployment of such funds. Ic also aims at ensuring availability of enough funds whenever required as well as avoiding idle finance, in terms of DEFINITIONS OF FINANCIAL MANAGEMENT + Financial Management is concemed with management of flow of funds and involves decisions relating to procurement of funds, investment of funds and distribution of earnings to the owners. Financial Management means planning, organising, directing and controlling the financial activities of an organisation. Decisions taken in Financial Management (or Financial Decisions) Financial management is concerned with three broad financial decisions— investment, financing and dividend decisions 1. Investment Decision The investment decision relates to how the firm's funds are Tnvested in-different assets so that they are able to earn the highest possible return for their investors! ) Investment decision can be long-term or short-term. + Long-term investment decision (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, et. + Short-term investment decisions (also called Wor! Capital decisions) are concerned ‘ith the decisions about the levels of Gash) {aventory Jand (fccivables These decisions affect the day-wo-day worl 4 business. Essential ingredients of sound working capital ‘management. (i) Efficient cash management (ii) Efficient inventory management 4 Nie (ii) Efficient receivables management Financial Decisionsey Per tail 2. Financing Decision [ ‘This decision is about the quantum of finance to be raised from various Jong-term sources jers' funds and borrowed fune @:: Tip ae Short-term sources are studied under the ‘working capital management | ee i CVA firm has £0 decide th The main long-term sources of funds are sharehold de ‘istics. proporgion of funds co be raised from either sources, based on their basic characteril Uf Shareholders! funds (equity) refer co the equity share capital, preference share capital an mid surpluses or retained earnings. long-term loans, publi deposits, et. _y Borrowed funds (debt) refer to the finance raised through debentures, 3. Dividend Decisi ‘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 Aistributed to shareholders Dividend decision involves how much of the profit éarned 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, te- investment as retained carning, 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 jon retained earnings. A. Top Tip The decision rei Objectives of Financial Management [ithe primary aim/objective of financial management is to maximise shareholders’ wealth, wi ich is referred to as the wealth-maximisation comer ‘The market price of a company's shares linked to the three basic financial decisions. This is because a company garding dividend should be taken keeping in view the overall objective of maximising shareholder's wealth funds belong to the shareholders and the manner in which they are invested and the return earned by them : 7 determines their market value and price It_means O16 2017 26h8 2613 2020 é ssaximisation of the market value of equity shares, The i: er price oF equity share increases, if the benefit Pe se from a financial decision exceeds the cost involved. All financial decisions aim at ensuring that each decision is I some value, Such value additions tend ares. Therefore, those share Price Un) 100 290 300 400. soo efficient and adds to increase the market price of s Wealth Maximisation Co; a ‘market value of investment in sh €., Maximising the 1ares of the companyeee EAC Sao financial decisions are taken which will ultimately prove gainful from the point of view of the shareholders. The shareholders gain if the value of shares in the market increases. Those decisions which result in decline in the share price are poor financial decisions. Thus, the objective of financial management is to maximise the current price of equity shares. of the company or to maximise the wealth of owners of the company, that is, the shareholders. Therefore, when a decision is taken about investment in a new machine, the aim of financial management is to censure that benefits from the investment exceed the cost so that some value addition takes place. Similarly, when finance is procured, the aim is to reduce the cost so that the value addition is even higher. In fact, in all financial decisions, major or minor, the ultimate objective that guides the decision-maker is that some value addition should take place. The objective of maximisation of shareholders’ wealth is achieved by: 1. Ensuring availability of sufficient funds at reasonable cost. 2. Ensuring effective utilisation of funds. 3. Ensuring safety of funds procured by creating reserves, reinvesting profits, etc. Role of Financial Management The overall financial health of a business management. " A. Financial Management is concerned with optimal procurement as well as the usage of finance. ‘Je \Good financial management aims at procuring funds at a lower cost, keeping the risk under control and achieving effective deployment of such funds\in most productive activities, so that they are able to earn the highest possible return for their investors. A. Iealso 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 se and Loss Account, of a business future depends a great deal on the quality of its finan are largely determined by financial management decisions taken earli Example Suppose Krishna Ltd., a steel manufacturing company in India, is enjoying a buoyant demand for its products as economic growth is about 10%-12% and the demand for steel is growing. It is planning to set up a new steel plant to cash on the increased demand. Itis estimated that it will require about % 500 crore to set up and about % 50 crores of working capital to start the new plant. This is a capital budgeting decision (i.c., a long-term investment decision). ‘* It will raise the size of fixed assets block in the Balance Sheet by % 500 crores. * With an increase in the investment in fixed assets, there is a commensurate increase in the working capital requirement, say %50 crores. Therefore, the quantum of current assets and its break-up into cash inventory and receivables is also influenced by this decision. * Of the total long-term finance, the proportions to be raised by way of debt and/or equity is a financing decision, which affects the amounts of debt and equity. * These financial decisions will also affect the items in the Statement of Profit and Loss, e.g. Interest, Depreciation, etc. Long-Term Investment Decision/Capital Budgeting Decision [A tong-term investment decision/A capital budgeting decision involves committing the finance on a long-term asis| In other words, it refers to investment in long-term assets or fixed assets. These long-term assets last fo morethan one year. Capital budgeting decision involves allocation of firm’s capital to different projects or assets with long: term implications for the business. Iris also called ‘Management of Fixed Capital’rr Examples of capital budgeting decisions: ‘Acquiring a new fixed asset such as land, building, plant and machinery i & Opening a new branch tion; expansion, modernisation and shel =etaauanay ees on acq} Launching a new product line 7 Investing in advanced techniques of production *+__Major expenditures on advertising campaign or research and development programme shares, debentures, long-term loans rt-term sources. J op Tip "i€must be financed through long-term sources of capital such as equity or preference and retamed earnings of the business. Fixed Assets should never be financed through sho! Why are investment or capital budgeting decisions important? z (Capital budgeting decisions are very erucial for any business since they affect its earning capacity 1 og pe run. petitiveness are all affected by capital budgeting decisions Thess Ce Cy 9, Flexibility ur maintain some borrowing power to take care of unforeseen circumstances firm uses its debt potential co the full, it loses flexibility to issue further debt, To maintain flexibiligy, it must 10. Interest Coverage Ratio (ICR) It refers to the number of times Earnings Before Interest and Tax ‘ EBIT) of a company covers the interest obligation, are Interest higher the ICR, the lower shall be the risk of company failing to meet its interest payment obinons] However, this ratio is not an adequate measure because sometimes, a firm may have high EBIT but low cash balance. Also, apart from interest, repayment obligations are also relevant. 11. Debt Service Coverage Ratio (DSCR) Debr service coverage ratio takes care of the deficiencies referred to in the IOR. The cash profits generated by the operations are compared with the toral cash required for the service of the debt and preference share capital Aoser = Eamings afer cr Gash expense (c.g., Depreciation) Preference dividend + Interest + Re payment obligation es the company’s potential to increase [ahigher DSCR indicates beter ability.go meet cash commitments, Ie debt component in its capi tie ) E12. Stock market conditions During the period when stock market is rising(ie., a bullish phase), more people invest in equity: 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 the period of depressed capital market(ie., a bearish phase) a company may find raising of equity capital more difficult and it may opt for debt. 13. Capital structure of other companies [Debs equity ratios of other companies in the same industry isa useful guideline for planning the capital structure However, it should not follow the industry norms blindly] For example, if the business risk of a firm is higher, it tannot raise more debt (which raises financial risk) co follow industry norms because in such a situation, overall tisk will be higher: 14. Regulatory framework Brery company operates within a regulatory framework provided by the law, For example, public issue of shares 4nd debentures are made according co the guidelines of the Indian Companies Act, 2013 and SEBI guidelines) raising funds from banks and other financial instcusions require fulfillment of other norms his haa Similarly, bearing on capital structure decision. me Concept of Capital Structure | Capital structure refers to the mix between owners’ funds and borrowed funds, (OR Capital structure means the proportion of debt and equity used for financing the operations of @ business itcan be calculated as debtequity ratio, ie, Debt/Equity or as the proportion of debt in the total capital, Le., Debt/ (Debt + Equity OED. jrsn com ae ‘As the fnancial leverage increases, the cost of funds declines because of increased use of cheaper debt, but the financial risk increases.Ce auc uC ‘Ans. (2) EBIT ~ EPS Analysis [Particulars a ee | Earnings before Interest and Tax (EBIT) %8,00,000 | Less: Interest (10% of 40,00,000) %4,00,000 | Earnings before Tax (EBT) %4,00,000 | Less: Tax @ 40% yio %1,60,000 Earnings after Tax (EAT) 3 %2,40,000 _| No. of Shares of €10 each - ” 6,00,000 | Earnings Per Share 'S) = EAT = No. of Shares = & 2,40,000 = 6,00,000 0.40 | Thus, on diversification the shareholders of the ¢ompany lost in terms of EPS because EPS falls from 20.50 to 20.40 with the use of debt. It is because Return On Investment (ROL) of the company is less than the cost of debt. (b) Factors (Explain these factors affecting capital structure) (Control (ii) Tax rate (iii) Cash flow position Q4 The Return on Investment (ROI) of a company ranges between 10-12% for the past three years. To finance its future fixed capital needs, it has the following options for borrowing debt : Option ‘A’ : Rate of interest 9% Option ‘B’ : Rate of interest 13% Which source of debt, ‘Option A’ or ‘Option BY, is better ? Give reason in support of your answer. Also state the concept being used in taking the decision. (CBSE 2018)(3 marks) ‘Ans. Option ‘A’ is better. This is because in this option, Return on Investment (10-1296)is higher than’ the Rate of interest (9%). The concept being used in taking the decision is Trading on Equity. (Give the meaning) | 9.4 | Fixed and Working Capital Fixed Capital [Fixed capital refers to investment in long, term assets or fixed assets] Fed asts ate those which remain in the business for more thar. one | Wonmng Carreax = year, usually for much longer, e-g., plant and machinery, furniture and fixture, land and building, vehicles, etc. Factors affecting fixed capital requirements: 1. Nature/Type of business: The type of business haya b upon the fixed capital requirements. For example,Lal €onceth needs lower investment in fixed assets compared with a ricturing organisa cit does not require to purchase plant and machinery, ete: cale of operations: A\larger organisatiod operating at a higher scale needs bigger plant.“more and therefore, requires higher investment in fixed assets when compared with thefumall organisatio”) 3. Choice of technique: A requires higher investment in plant and machinery as it relies less on manual labour. The requirement of fixed capital for such organisations would be higher. (Labour intensive organisations) on the other hand, requite less investment in fixed assets. Hence, their Axed capital requirement is lower.POT Lae ear obsolete sooner, Consequen therefore, be required fh sooner than say, fur higher fixed capi. become 4, Technology upgradation{ In gertain industries, assets replacements become due fastes] Higher investment in fixed assets m™a¥: cases| For example, computers become obsolete faster and are replaced muc Thus, such organisations which use assets which are prone to obsolescence Feats purchase such asse Growth prospects Higher growth of an organisation generally requi such growth is expected, a company may choose to create higher higher demand quicker. This requires larger investment in fixed assets ans 6. Di veriication| Wh diversification, fixed capital requirements increase and starting a cement manufacturing plant. Obviously, its investment 7. Financing alternatives: A developed financial marker may provide least outright purchase| When an asset is taken o1 the firm pays lease rentals and uses it. By doing ic avoids huge sums tequired to purchase it. Avalablity of leasing feelities, ths, may feduce che fund required to be invested in fixed assets, thereby reducing the fixed capital requirements. Such a strateg specially suitable in high risk lines eee 8. Level of collaboration At times, certain business organisations sl a bank may use another's ATM or some of them may jointly establish a part res higher investment in fixed asse 3} capacity in order ro meet the anticipa .d thus, larger fixed capital. eg, a textile company is diversif fixed capital will increas ilities as an alternative share each other's facilities. For examp! cular facility|This is feas collaboration reduces the level of investment in fixed assetslfor each one of the participating organisation Working Capital Working capital refers tq investment in current assets. This investment facilitates smooth day-to-day operations of the busines] Current assets are expected to get converted into cash or cash equivalents within a period of one year. Example of current assets (in order of their liquidity) are cash in hand/cash at bank, marketable securities, bills receivable debtors, finished goods inventory, work-in-progress, raw materials and prepaid expenses, Top Tip = ingot eons te Gay we oo Working capital refers to investment in curFent assets. CUTremassets are more liqui No re more liquid but less profi : See e aida Uquidty tothe business. An asset's more laud ff can be conver eae ase] reduction in value quicker and withos reaflent Investment in current asets nay make It mare dificult or an organisation to meet We pasment oi rent obligation: However, these assets provide little or low return, Hence, a balance needs to be struck between liquidity and profitability. Current liabilities are those payment obligations which are due for payment withi in one year; payable, creditors, outstanding expenses and advances received from customers, ete ee = bil Top Tip Aeurrent assets are financed partly fro term sources and puis ar Curren ee Tassels franced trough shorc-term sours Le: caret Eiege ee SOURS. 1 vevking Copital may be defined as The exes of curren assets over current abmmes suppose capital employed of a company is 875 crore, which consiseora vested 260 crore in fixed assets (i.e. fixed capital is 260 crore) t means the cogs and eoUtY £50 crore 'ans the company can invest? invest 215 crore vs currentassets are 840 crore. Thisis because re smpany su Ae current assets of 825 cror Suppose fre, short-term sourees). The ining 215 crore (Le, 840 crore —¥: sr eaate financed through current liabil ognanced through long-term sources nt assets— current liabllities or work capital! ee ‘Explanation: S . ‘The company I! ssets. 25 crore or currer if the scale of operations of each one of them is not fo ient to make full use of the facility 1Chapter 9: Financial Management Factors affecting the working capital requirements: 1. Nature of business: A needs less amount of working capital because there is no processing. Therefore, there is no distinction berween raw materials and finished goods. Sales can be effected immediately upon the receipt of materials, sometimes even before that. However, working capital requirements of a is more since raw material needs to be converted into fi rods before any sales can become possible Similarly, [service industries like transport, banking, advertising, warchousing and courier services, etc y do nog have to maintain inventory require less working capital since they usua 2. Scale of operations: Ajarge-scale organisation requires larger amount of wor! a ecause the quantum of inventory, debtors and cash required is generally high. 43, Business eyele: Different phases of business cycles affect the requirement of working capital by a firm. g capital as compared 10 In case of the sales as well as production are likely to be larger and, therefore, larger amount of working capital is required. As against this, the requirement for working capital will be lower during the period eso the sales as well as production will be small. 4. Seasonal factors: Most business have some seasonality in their operations. In{peak season} because of higher level of activity, larger amount of working capital is required. As against shis, the Tevel of activity as well as the requirement for working capital will be lower during the[fean season 5. Production cycle/Processing cycle;| Je is the time span between the receipt of materials and their conversion into Some businesses have aflonger production cycle (eg., manufacturing of motor cars) while some haf a shorter one (e-g.. production of bread). A longer production cycle increases the amount of funds required for raw materials and expenses, resulting in higher requirement of working capital. On the other eal caries lower is the working capital requirements. 6. Level of competitions Higher level of competition| may necessitate larger stocks of finished goods to meet urgent orders from customers, This increases the working capital requirement] ‘Competition may also force the firm to extend liberal credit terms 7/Neredie allowed: Different firms allow different credit terms to their customers. These depend upon he level of competition that a firm faces as well as the credit worthiness of their clientele.]A liberal credit Polic} results in higher amount of debtors, increasing the requigement of working capital edit availed: Ja fia eircom EE ny get credit from‘Tts suppliers. To the extent it avails the credit op purchases, the working capital Fequirement is reduced..) 9. Availability of raw mari the raw materials can i proce ei and continuously, the firm will require to Teacup Saal working capital requirements will be low. However, if the raw materials are\not easily and continuously available, working capital requirements will be high’ In addition, the time Tag between the placement of order and actual receipt of the material (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 wosfing capital required. 10. Growth prosp. the growth potential of an enterprise is higher, it will require larger amount of working capital fo that it is able to meet higher production and sales target whenever required. La. natiasonf rising prices, larger amounts are required to maintain a gonstant volume of production and sales. [will result in an increase in the working capital aac famine’ noced thar an inflation rate of 5%, does not mean that every component of working capital will change by che same percentage. The actual requirement shall depend upon the rates of price change of different components (eg,, raw material, finished goods, labour cost, etc.), finished goods as well as their proportion in the total working capital requirement. a 12, Operating efficiency] Efficiency in managing raw materials (reflected in higher inventory «urnover tatio), reducing the amount tied up in debrors and receivables (i.e. higher trade receivables turnover fat) and beter sales effors by the managemicn may fedlae te level of aw aieeyale tee receivables and finished goods respectively, resulting in lower requirement of working ea aii f1 Part-B - by Subhash Dey Pe ae f ing Cycle ier Peas serials and the receipt of cash through cash sales or Debtors > Cash Longer the operating cycle, larger will be the working capital requirement because in operating cyele cash outflow takes place stage but cash inflow takes place only at the end of the operating cycle. RECAP. = orccne] | Fixed Capital - Factors Affecting Fixed capital refer to investment in fixed assets (e.g, plant and machi 8. plant and machinery, land ai Factors affecting Fixed Copital Requirements ep ananea! 1. Nature of business: A trading concern needs a | est lower investment in fixed assets as Fre eee fee re purchave(piant aqdiinaeinany assets as compared to a manufacturing conce” Scale of operations: A larger organisation operatin 2. Seale of operations: A larger organisation operating ata higher scale needs bigger pl investment in fixed assets. ger plant and more space and hence highet 3. Choice of technique: A capital intensive organisation requires higher invest higher fixed capital than a labour intensive organisation. iment in plant and machinery and thus require’ 4, Technology upgradation: Industries where assets b r e assets become obsolete purchase such assets. ete (e.g, computers) sooner require higher fixed ql e fe higher fixed capital t 5. Growth prospects: Higher growth prospects require higher investment in fixed &._ Financing alternatives: Availabilty of leasing facilites requires lower investment ac et entilbated demand qui! fred capital. Such a strategy is specially suitable in high risk lines of business” *S4 a58ets and hi Sires in fixed assets fo 7. Collaboratio requirement is lower. Te ore) howe coe! Ration: With diversification, the fixed capi ation capital requirements will increase as the investment in fixed ixed capital 8, Divers