Introduction – Finance refers to money, cash or fund available to carry out business operations. It is the life blood of
business. A business enterprise requires funds at different stages - to start a
business, to operate and expand it.
Financial Management
“Financial
management is considered to be the management of the finance function”. It
deals with planning, organizing, directing and controlling financial activities
like procurement and utilization of funds and distribution of earnings to
owners.
“Financial management deals with procurement of funds and their effective utilization in the business” – S.C. Kuchhal.
Role and Importance of
Financial Management
All items in the financial
statements (Balance Sheet and P/L Account) of a business are directly or
indirectly affected by the financial management decisions, some of them are
given below:
a. The size and composition of fixed assets – A decision to invest
(capital decision) Rs. 100 crores in
fixed assets would result in the increase of fixed capital.
b. The amount of current assets – Cash, inventory, accounts receivables etc. are
also affected by the financial
management decisions.
c. Amount of long term and short term funds – Financial management
decisions will directly influence
the availability of long term as well as short term funds in the business; it
will affect the liquidity and profitability of the organizations.
d. Debt – equity ratio – Decisions regarding finance will determine the
amount of debt, equity capital, preference
capital etc.
e. All items in the Profit and loss account – Financial management
decisions will affect all the items
in P/L account also. For instance, if the organization is depending highly on
borrowed funds, it may call for higher interest expense, which will result in
poor profits.
Objectives of financial
management
1.
Profit maximization- The financial management
should ensure maximum return on investment
to the shareholders.
2.
Wealth maximization – The ultimate objective of
decision makers must be to increase the
wealth of shareholders or investors.
Wealth of owners = Number of shares held X
market price per share
The financial
management focuses on three major financial decision areas namely investment, financing and dividend
decisions. They are collectively known as the finance functions of business.
Finance
Functions
1.
Investment Decision – It is concerned with how firm’s valuable funds are to be invested
in various assets. It will include the following:
a.
Long term investment decisions (capital budgeting decision) E.g.,
Purchasing a new machine, opening a new branch etc.
b.
Short term investment decision (working capital decision) – related to
the day to day working of a business. E.g., Level of cash in hand, inventory
etc.
Factors
affecting Capital Budgeting (Investment Decision)
a.
Cash flow of the project – The inflow and outflow of
cash in the business should be considered
before making capital budgeting decisions. Some projects will take a long
period of time to start inflow of cash.
b.
The rate of return – While selecting a project,
the rate of return must be considered. If
two projects having 10% return and 15% return with almost equal risk,
normally, the 2nd
one may be selected.
c.
Investment criteria
involved – Investment
decisions must be based on certain capital
budgeting techniques or calculations regarding the amount of investment,
rate of return, interest rate, cash flow etc.
2.
Financing Decision – it is concerned with the
quantum of finance to be raised from various
long term sources. They are shareholders’ fund and borrowed fund such as
shares, debentures, loans etc. But a proper mix of the above securities is very
much essential for maintaining a good capital structure of the company.
Factors
affecting financing decision
a.
Cost – Try to obtain the fund from cheaper sources.
b.
Risk – Risk factor in each source must be considered.
c.
Flotation coast – Cost of raising finance should be less.
d.
Cash flow position – A stronger cash flow position recommends more
debt financing.
e.
Fixed cost – If fixed operating costs
like rent, insurance premium, salaries etc. are high, it is better to reduce debt financing having fixed interest
burden.
f.
Control – More dependence on owners
fund will reduce control among the existing
shareholders.
g.
Capital market condition – During rising trends in
capital market, it is easy to accumulate
shareholders fund, otherwise better to depend on borrowed fund.
3.
Dividend Decision – It is concerned with the
disposal of profits. Profits are required for different purposes. A portion of the profit is to be retained in
the business for growth and expansion. That part of profit is called retained
earnings and the rest of the profit is to be distributed to the shareholders in
the form of dividends. Here is the role of financial management that, how
much is to be retained and what would be distributed.
Factors affecting dividend
decision
a.
Amount of earnings – Dividend decision is always
depend on the amount of profit during
the current period.
b.
Stability of earnings – Stable earnings promotes higher dividend.
c.
Stability of dividend – It will improve the
confidence of shareholders and higher reputation
for the company.
d.
Growth opportunities – Fewer dividends may be
given to the investors if the company is
having growth and expansion projects.
e.
Cash flow position – Payment of dividend
involves outflow of cash, therefore, enough
cash must be available for the declaration of dividend.
f.
Shareholders’ preference – Normally, shareholders want
to get regular income from their
investment, hence at least a minimum dividend may be distributed every year.
g. Taxation Policy – If tax on dividend is
higher, it is better to pay less by way of
dividends. But the dividends are free of tax in the hands of shareholders
as a dividend distribution tax is levied on companies. In the present tax
policy, shareholders may demand higher dividend.
h.
Stock Market Reaction – Investors generally
evaluate the companies on the basis of their
dividend declaration status. Higher the rate of dividend gives a positive
impact in the market.
i.
Access to Capital Market – Reputed companies generally
have easy access to the capital
market and therefore they may depend less on retained earnings to finance their
growth. So that they may declare high rate of dividend than small companies.
j.
Legal Constraints – While declaring dividends,
the companies have to follow the restrictions
laid down by Companies Act.
k.
Contractual Constraints – While granting loans to a
company, sometimes the lender may
impose certain restrictions on the payment of dividends in future.
Financial Planning – When the process of planning employed in
finance, it is called financial planning.
It involves the estimation, procurement, utilization and administration of
funds. Its objective is to ensure that enough funds are available at right
time, but having no surplus funds. It
involves the following aspects:
a. Estimation
of quantum of finance
b. Determining
the pattern of financing – proportion
of various securities to be issued.
c. Proper
utilization of finance – through
effective policies and programs.
Types of financial planning
a.
Long term financial planning
– focuses
on capital expenditure for long term growth
and investment in business – usually 3 to 5 years.
b.
Short term financial
planning – in
the form of budget – usually for a period of 1 year or less.
Objectives of Financial
Planning
1. To ensure availability of
funds whenever required – it includes estimation of funds for long term and
short terms needs of the organization.
2. To ensure that the firm
does not raise resources unnecessarily – it will help to minimize the loss due
to idle fund in the organization.
Importance
of financial planning
1.
Forecasting – It helps the organization
to foresee the future financial requirements in advance.
2.
Avoiding uncertainties – Helps in meeting unexpected
situations by arranging necessary
funds.
3.
Coordination – Helps to coordinate the
activities of all departments in the organization by allotting them necessary funds in time.
4.
Reduces wastages – Through proper planning
about the financial requirements helps to
reduce wastages and duplication of efforts.
5.
Easy evaluation – It helps to evaluate the
actual performance of the organization based
on the plans formulated in advance.
Capital
Structure
Capital structure refers to
the mix or composition of long term sources of funds such as equity share
capital, preference share capital, debentures, long term loans and reserves and
surplus. In other words, it refers to the proportion of borrowed funds to owner’s
funds. (It is a mix
between owners’
funds and borrowed funds). Owners’ funds are called equity and borrowed funds as debt.
The capital structure of a company consists any
of the following forms:
1. Equity shares only.
2. Equity shares and preference shares.
3. Equity shares and debentures.
4. Equity shares, preference shares and debentures.
5. Equity, Preference, debentures and long term
loans.
Financial Leverage – The proportion of debt in the capital structure
is called financial leverage or capital gearing or trading
on equity. When the proportion of owners’ funds in capital structure is very
small, it is said to be high geared, whereas if borrowed fund is small than
equities, it is called a low geared company.
As the financial leverage
increases (highly geared) the cost of funds declined and therefore more
earnings per share, but the financial risks increases.
The impact of financial leverage on
profitability:
Descriptions
|
Company A
|
Company B
|
Company C
|
|||
No. Equity shares @ Rs.10
|
30,000
|
20,000
|
10,000
|
|||
Equity Capital
|
3,00,000
|
2,00,000
|
1,00,000
|
|||
10% Debentures (borrowed
fund)
|
NIL
|
1,00,000
|
2,00,000
|
|||
Total Capital
|
3,00,000
|
3,00,000
|
3,00,000
|
|||
Profit @ 20% on
investment
|
60,000
|
60,000
|
60,000
|
|||
Interest on debentures
|
NIL
|
10,000
|
20,000
|
|||
Net Profit
|
60,000
|
50,000
|
40,000
|
|||
Earnings per share
|
2.00
|
2.50
|
4.00
|
|||
Leverage
|
Unlevered
|
Low
|
High
|
|||
Note: Income tax on
profit is ignored.
|
||||||
Trading on equity – It refers to the use of
fixed income securities such as debentures and preference capital in the capital structure so as to increase the return
on equity capital. In other words, equity share
holders get additional profits with the help of employing others fund. It is
also known as financial leverage or capital
gearing.
For example, A company
raises Rs.50,000 through equity shares and earns a profit of Rs.5000. Here the
rate of return is 10%. On the other hand, if the company raises Rs.40000 by way
of 6% debentures and Rs.10000 through equity shares, the rate of return to
equity shareholders is increased to 26% as follows:
Total Investment 40000 +10000
|
= 50,000
|
|
Total Profit
|
=
|
5,000
|
Interest on debentures 40000 * 6%
|
=
|
2,400
|
Balance of Profit to equity shareholders (5000-2400)
|
=
|
2,600
|
Rate of return on equity share capital (2600/10000*100)
|
=
|
26%
|
Factors Affecting the
Choice of Capital Structure
1. Cash flow ability for servicing the debt – Servicing debts means
paying interest and principal amount
of loans as and when it is due for payment. If a debt is to be included in the
capital structure, the company should estimate the future cash flow to ensure
the coverage.
2. Interest
coverage ratio – The interest coverage ratio is used to determine how easily a company can pay their interest expenses on outstanding debt. The ratio is calculated by dividing a company's earnings before interest and taxes (EBIT) by the company's interest expenses for the same period.
3. Debt Service Coverage Ratio (DSCR) – The cash profits generated from the operations must be enough to service
the debts and preference share capital.
4. Return on Investment (ROI) – If ROI is higher than rate of interest for debt,
borrowed fund can be increased in
capital structure, otherwise, increase in equity portion is good.
5. Cost of debt – If the firm is able to borrow at a lower rate, it may prefer more debt
than equity in capital structure.
6. Tax rate – Income tax liability can be reduced by employing borrowed funds in
capital structure, as the interest
on debt is a deductible expense.
7. Cost of Equity – When a company increases debt in their capital structure, the financial risk faced by the equity
shareholders may increase, so that the company cannot use debt beyond a point.
8. Floatation cost – It is the cost incurred for floating (issue) securities such as brokerage, underwriting commission
etc. It is generally less in case of debts.
9. Risk Consideration – A business has two types of risks; they are
financial risk (to pay interest,
preference dividend, repayment of debt etc.) and business risk (operating
risk). It must be considered while choosing a suitable capital structure.
10. Flexibility – The capital structure should be capable of being adjusted according to
the needs of changing conditions. To
maintain flexibility, the company should maintain some borrowing power to take
care of unforeseen circumstances.
Control – If the control of the management is to be retained, debt financing is recommended for raising additional
fund
12. Regulatory Framework – Rules and regulations framed by SEBI etc. must
be considered while choosing a
capital structure.
13. Stock Market Conditions – During depression in capital market, investors
will prefer fixed interest bearing
securities for safety and hence it is not advisable to issue shares that time.
In a booming situation, issue of share will be more preferable.
14. Capital Structure of other Companies – Capital structure followed
by other companies in the same
industry may be adopted by considering whether they are in conformity with the
industry norms or not.
Fixed Capital and Working Capital
Fixed Capital
Fixed capital represents a
long term investment which needed to acquire fixed assets like land and
building, plant and machinery, vehicles etc., benefits of which are expected to
be received over a number of years in future.
Management of fixed capital – It refers to the allocation of firm’s capital to
different projects or assets which
will have a long term implications in the business.
Importance of management of
fixed capital
1.
Long term growth – This capital is invested in
fixed assets and long term projects, therefore,
it will affect the future prospects of business.
2.
Large amount of funds
involved – A
major portion of capital may be blocked in this areas, hence careful planning and detailed analysis is very
essential in this segment.
3.
High risk – Investment decisions
involving huge capital outlay influence the overall performance of the business.
4.
Irreversible decision – Once the decision to
acquire a permanent asset is taken, it becomes
very difficult to reverse that decision. It is possible but with huge losses.
Factors affecting the
requirement of fixed capital
1. Nature of Business – The nature and character of business determine
how much fixed capital is required.
In a manufacturing concern fixed assets require huge investments.
2. Scale of Operations – Large scale business generally require huge
investments in fixed capital than a
small scale business organization.
3. Choice of technique – Highly mechanized and automated industries
require large amount of fixed
capital.
4. Technology up gradation – Assets in certain industries become obsolete
sooner, this requires replacement
faster which will demand more fixed capital, e.g., computers, mobile phone
manufacturing equipments etc.
5. Growth prospects – Higher investment in fixed capital is necessary, if the organization is in the way of growth and expansion.
6. Diversification – When a firm diverts its operations to new segments, higher fixed capital requirement arises, e.g., ITC
Company diverted its business to note books manufacturing along with their
traditional item of cigarettes.
7. Method of acquiring fixed assets (financing alternatives) – If it is on hire purchase or lease system, less amount of
investment is required for cash purchase.
8.
Collaboration – By collaborating with other
firms, the requirement of fixed capital can
be reduced, e.g., establishment of ATM counters by cooperative banks by
collaborating with certain scheduled banks.
Working Capital
Working capital is that
part of capital required for investing in short term or current assets like
inventory (raw materials, work in progress and finished goods), bills
receivables, sundry debtors, cash required for day to day affairs like
salaries, wages, rent, etc. There are two concepts of defining working capital
as follows:-
i.
Gross
working capital = Total investment in current assets
ii.
Net
working capital = Current assets – Current Liabilities
Factors affecting Working
Capital Requirements
A business concern must
neither have excessive nor inadequate working capital. Both the situations are
dangerous. Following are the factors influencing working capital requirements:
1.
Nature of business – Concerns which do not keep
very high stock of finished goods and
sells on cash basis can manage with less working capital.
2.
Scale of Operations – Generally big enterprises have to keep higher
working capital.
3.
Business Cycle – In boom period, the
production and sales will be larger and hence huge amount of working capital is required. But in case of
depression, it will be less.
4.
Seasonal Factors – Industries that produce and
sell seasonal goods require large amount
of working capital.
5.
Production cycle – Longer the period of
manufacture, larger is the amount of working capital required.
6.
Credit allowed – A liberal credit policy
results in higher amount of debtors and thereby more working capital requirement.
7.
Credit availed – If a business gets credit
facility from its suppliers for goods, lesser would be the working capital requirement.
8.
Operating efficiency – If cash, debtors and
inventories are efficiently managed, working
capital requirement can be reduced.
9.
Availability of raw
materials – If
raw materials are available regularly without any shortage, less working capital is needed.
10.
Growth prospects – If a firm is growing fast,
it will require large amount of working capital
to meet higher production and sales.
11.
Level of competition – In case the competition is
high, more shall be the stock of finished
goods, this increases working capital requirement.
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