Chapter 9

FINANCIAL MANAGEMENT
Meaning: Money required for carrying out business activities is called business finance.
Finance ie needed to establish a business to run it, to modernize it, to expand it, to diversify
it, or for buying variety of assets. Finance is also required to running the day to day
operations of business like buying material, paying bills and salaries etc. So business is
required at every stage in the life of business activity. Availability of adequate finance is very
causal for the survival and growth of a business.
Financial Management (FM) : FM is concerned with optimal procurement as well as usage of
finance. For optimal procurement, different sources of finance are identified and compared in
terms of cost and less risk are to be select. Financial Management deals with planning,
organizing, directing and controlling of financial activities. Financial Management aims at
reducing the cost of funds procured, bring the risk under control, effective utilization of fund
and ensuring the availability of fund at correct time.
Importance of Financial Management (Important aspects which affects financial management
decisions)
The financial statements such as balance sheet and P&L A/c reflect a firms financial
position and financial health. The financial statements of a business are affected directly or
indirectly through some financial management decisions. Following are the various aspects
affected by Financial decisions.
a)
b)
c)
d)
e)

The size and the composition of fixed assets of the business.

The quantum of current assets and its break-up into cash, inventory and receivables.
The amount of long term and short term funds to be used.
Bradk up of long term financing into debt, equity etc.
All the items in the P&L A/c hike interest expense , depreciation etc.

Objectives of Financial Management : The primary aim of financial management is to

maximize share holders wealth which is known as wealth maximization. Wealth
maximization can be achieved through by maximizing the current market price of equity
shares of the company. The market prize of shares have linked to three basic financial
decisions such as investment decision, financing decision and devident decisions.
Important decisions of Financial Management: Financial decisions, Financial function
The finance function is concerned with three broad decisions. They are
1) Investment decision
2) Financing decision
3) Dividend decisions
1) Investment decision: Investment decision is concerned with where to invest the firms
funds which are able to earn the highest possible return for their investors. Investment
decision can be long term or short term. The long term investment decision is also called

capital budgeting of decision. Decisions concerned with making investment in a new

machine acquiring a new fixed asset or opening a new branch etc are examples of long
term investment decisions (working capital decision) are concerned with the decisions
about the level of cash, inventory and receivables. These decisions affect the day to day
working of a business
Factors affecting capital budgeting decision (long term investment decision)
Decision of allocation of funds to long-term assets is called capital budgeting. There are
certain factor which affects capital budgeting decisions. They are as follows.
a) Cash flow of the project: Every company expects some cash flows when it takes an
investment decision involving huge amount. The cash flows are in the form of the
series of cash receipts and payments over a period of time. These cash flows should
be carefully analyzed before taking capital budgeting decisions. (Cash in flow and
cash out flow.)
b) The rate of return: The expected return from each proposal and risk involved are to be
carefully assessed before taking a long term investment decision.
c) Investment criteria involved: Every investment decision involves a number of
calculations regarding the ant of investment, interest rate cash flows and rate of
return. These capital budgeting techniques should be applied before selecting a
particular project.
d) Financing Decisions: Financing decisions is concerned with ascertainment of total
funds required by the firm and the slection of differnet sources of funds. The financial
manager must make sure that there should be neither over capitalism nor under
capitalism. The capitalization should be fair. The main sources of funds for a firm are
shareholders fund borrowed fund. A firm needs a judicious mix of both debt and
equity in making financing decisions. Cost and risk of different sources of fund
should be carefully analysed before selecting a particular source of fund.
Factors affecting financing decisions: Various factors affecting financing decisions are as
follows.
a) cost: The cost of raising funds through different sources are different. A prudent
financial manager should opt a source which is the cheapest.
b) Risk: The risk associated with each sources are different. A project which have
controllable risk should be opted.
c) Flotation cost: It is the cost of raising funds. Higher the flotation cost less attractive is
that source.
d) Cash flow position of the company: If the company has a stronger cash in flow
position may adopt debt finance because it can pay interest by using the cash inflow.
e) Fixed operating cost: If a business has high fixed operating cost like building rent
insurance, premium, fixed salaries etc. lower debt financing is better.

f) Control considerations: Issuing more equities may leads to dilution of most control
because the comers have voting rights. If a company wish not to loss control it is good
to issue debt capital because they have no voting rights.
g) State of capital marketing: If the stock market is raising it is easy to raise funds
through issuing equity. But in a depressed capital market raising funds through equity
is difficult.
2) Dividend decision: In dividend decision every finance manager has to take decision
regarding the distribution of dividend is that portion of profit which is distributed to
share holders. The dividend decision is concerned with how much profit should be
distributed as dividend to share holders and how much profit should be retained in the
business.
Factors affecting dividend decision: Important factors affecting dividend decision are as
follows.
a) Amt of earning: Devi dents are paid out of current and past earning. if the earning are
high dividend will be also high.
b) Stability of earning: If a company have a stable earning can declare high rate of
dividend.
c) Stability of dividends: if the company follows a stable dividend policy, the dividend per
all share is not altered whatever may be the level of earning.
d) Growth opportunity: If a company have good growth opportunity will retain more
profits so as to finance the future investment. The dividend distributed in such growth
companies is smaller.
e) Cash flow positions: If a company have less cash inflow will distribute smaller amounts
as dividend due to the inadequacy of cash in hand.
f) Shareholders preference (Clintele effect) Some shareholders like retired hands, widows
who depend upon a regular income for t heir livelihood. While declaring dividends,
management must keep in mind the preference of those type of shareholders also.
g) Taxation policy: The ant of dividend and retained earnings is also affected by the tax
treatment of dividends and capital gains. If tax rate on dividend is higher it is better to
pay less dividend.
h) Stock Market reaction: Increase in devident rate will also resulted in the increase in the
share price. The decrease in dividend may have a negative impact in the share price on
the stock market. If the company want to increase its share price in the stock market
they will declare a high rate of dividend.
i) Access to capital market: Large and reputed companies have an easy access to the
capital market and may depend less on retained earnings. Such a company can declare
high rate of dividend than smaller companies.
j) Legal constraints: Certain provisions of the companies act plays restrictions on payment
of dividend. Such provisions must be adhered while declaring the dividend. The
important constraints are as follows.
Capital impalement rule: Dividend should not be paid out of capital

Net profit rule: The firm cannot pay cash dividend greater than current profit plus
accumulated earnings.
Insolvency rule: This rule prohibited to pay dividend if the firm is in insolvent
condition.
k) Contractual Constraints: While granting loans to a company sometimes the lender may
impose certain restrictions on the payment of dividend in future. Dividend should not be
paid when there are redemption of paid when there are redemption of debenture,
repayment of loan, preference share redemption etc.
Financial Planning: Financial planning is essentially the preparation of financial blue print
of an organizations future operations. Financial planning decides in advance the capitalization
and capital structure of the company. It helps in determining the amount and type of capital
required for the commencement and smooth functioning of the business enterprises. The
objective of financial planning is to ensure that enough funds are available at right time. If
adequate funds have at right time. If adequate funds have not available the firm cannot meet
its commitments and carry out its plans.
The purpose of estimating the funds requirement of a business and specifying the sources of
funds is called financial planning. Financial planning include both short term and long term
planning. Short term planning covers short term financial plan is called budget. Long time
planning relate to the long term investment and growth. It focuses on capital expenditure
programmed.
Objectives of financial planning.: Financial planning has the following twin objectives
1) To ensure availabiltiy of funds whenever required. This includes a proper estimation
of the funds required for different pruposes and estimate the time at which this funds
are to be made available.
2) To see the firm doesnot raise resources unnecessarly. Excess funding is almost as bad
as inadequate funding. The financdial resources are not left idle and dont unncesserly
add to the cost.
Typically financial planning is done for three to five years. But for longer periods it
become more difficult and less useful. Plans made for periods of one year or less than
one year is called budget. Financial planning usually begins with the preparation of
the sales forcast.
Importance of financial planning.
Following are the importance of financial planning:
1) It helps in forecasting what may happen in future under different business situation. It
makes the firm better prepared to face the future.
2) It helps in avoiding business shocks and surprises and helps the company in preparing
for the future.
3) It helps in co-ordinating various business functions.

4) Detailed plans of action prepared under financial planning reduce waste duplication of
efforts and gaps in planning.
5) It tries to link the present with the future.
6) It provides a link between investment and financing decisions on a continues basis.
7) It makes the evaluations of actual performance easier.
Capital Structure: Capital structure refers to the mix between owners and borrowed fund.
According Gersten berg Capital structure refers to the makeup of its capitalisation. It is the
mix or composition of long term sources of fund such as debenture long term debt, preference
share capital, equity share capital and reserve and surplus. It is the proportion of borrowed
fund to debt to owners fund (equity) the total capital raised by the business. The proportion of
debt and equity is called debt-equity ratio.
ie. debt/ equity
The capital structure of a company affects both the profitability and financial risk. A capital
structure will be said to be optimal, when the promotion of debt and equity will result in an
increase in the value of equity share. It should increase shareholders wealth. The proportion
of debt in the overall capital is also called financial leverage.
Financial leverage= debt/ equity or Debt/ Debt + Equity
The optimal capital structure minimizes the firms overall cost of capital and maximizes the
value of the firm.
Factors affecting capital structure: Capital structure of a firm involves determining the
relative proportion of various type of funds. The important factors which determine the
choice of capital are as follows.
1) Cash flow position: The size of projected of cash flows must be considered before
borrowing. It must be kept in mind that a company has cash payment obligation for
normal business operations, for investment in fixed asset and for meeting the debt
service commitment. (Paging interest and repayment of principle) If a company has
enough cash inflow it can depend more debt fund in its capital structure because it can
pay interest and other fixed commitment.
2) Interest coverage ratio (ICR) The interest coverage ratio refers to the number of types
of earnings before interest and taxes of a company covers the interest obligation. The
higher to the ratio, lower shall the risk of the company in payment of interest
obligation.
ICR = EBIT/ Interest
3) Debt Service Coverage Ratio (DSCR) : DSCR take care of the deficiencies referred in
the interest coverage ratio. The cash profit generated by the operation are compared
with the total cash required for the service of the debt and the preference share capital.
The cash profit generated is higher the company can adopt debt capital and preference
share capital more.

4) Return on Investment (ROI): If the ROI of the company is higher, it can choose to use
trading on equity to increase its EPS. ROI is an important determinant of the
companys ability to use trading on equity and thus the capital structure.
5) Cash of debt: A firms ability to borrow at a lower rate increase its capacity to employ
higher debt. Thus, more debt can be used of debt can be raised at a lower rate.
6) Tax Rate: Interest is a deductable expense, cost of debt is affected by the tax rate. A
higher tax rate, thus, makes debt relatively chapter and increase its attraction vis a
vis equity.
7) Cast of equity: Stock owners expect a rate of return from the equity which is
commensurate with the risk they are assuming. When a company increases debt, the
financial risk faced by the equity holders, increases. If debt is used beyond that point,
cost of equity may go up sharply and share price may decrease inspite of increased
EPS. For maximization of share holders wealth debt can be used only up to a level .
8) Flotation Cost: Process of raising resources also involves some cost. Public issue of
share and debentures requires considerable expenditure. Getting a loan from a
financial institution may not cost so much. These considerations may also affect the
choice between debt and equity and hence the capital structure. If the company unable
to meet flotation cost, it may adopt borrowed funds.
9) Risk consideration: Use of debt increases the financial risk of a business. Financial
risk refers to position when a company is unable to meet its fixed financial charge
namely interest payment, preference dividend and repayment obligations. Apart from
the financial risk every business has some operating risk also called business risk.
Higher fixed operating cost also called business risk. Higher fixed operating cost
result in higher business risk and vice versa. If a firms business risk is lower, it
capacity to use debt is higher and vice versa.
10) Flexibility: If a firm uses its debt potential to the full, it loses flexibility to issue
further debt. To maintain flexibility, it must maintain some borrowing power to take
care of unforeseen circumstances.
11) Control: Debt normally does not cause a dilution of control. A public issue of equity
may reduce the managements holding in the company and make it vulnerable to
takeover. This factor also influences the choice between debt and equity especially to
companies in which the current holding of management is on a lower side.
12) Regulatory Frame work: Every company operates with a regulatory framework
provided by the law. eg. Public issue of shares and debentures have to be made under
SEBI guidelines. Raising funds from banks and other financial institutions require
fulfillment of other norms.
13) Stock Market conditions: If the stock markets are bullish, equity shares are more
easily sold even at a higher price. During a bearish market company, may find raising
of equity capital more difficult and it may opt for debt.
14) Capital structure of other companies: A useful guideline in the capital structure
planning is the debt equity ratios of other companies in the same industry. The
management must know what the industry norms are, whether they are following
them or deviating from them and adequate justification must be there in both cases.

Fixed and working capital: Every company needs funds to finance its assets and activities.
Investment is required to be made in fixed assets and current assets. Fixed assets are those
which have long term implications such as plant, machinery, furniture etc. The decision
regarding how much amount to be invested in fixed asset is called capital budgeting decision.
Current assets are those assets which is used for the normal routine of the business.
Management of Fixed Capital: Fixed capital refers to investment in long term assets.
Management of fixed capital involves allocation of firms capital to different projects or assets
with long term implications for the business. These decisions are called investment decision
or capital budgeting decisions.
Importance of capital budgeting decision. Following are the importance of capital budgeting
decision.
1) Long term growth: Investment in fixed assets is concerned with the long term
growth of the business. The firms invest in long term assets to get a higher return in
future. These will affect the future prospects of the business.
2) Large amount of funds involved: These decisions is concerned with the substantial
portion of capital funds being blocked in long term projects. Therefore, these
investments are planned after a detailed analysis is undertaken because they cannot be
take back. This may involve decisions like where to procure funds from and at what
rate of interest.
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 of the firm.
4) Irreversible decisions: These decisions once taken, are not reversible without
incurring heavy loses. Abandoning a project after heavy investment is made is quite
costly in terms of waste of funds. So these decisions should be taken carefully.
Factors affecting the requirement of fixed capital
1) Nature of business: A trading concern needs lower investment in fixed assets since it
does not require purchasing plant and machinery etc. Whereas a manufacturing
organization require a huge investment in fixed asset.
2) Scale of operations: A larger organization operating at a higher scale needs higher
investment in fixed assets whereas the small organization require less investment in
fixed asset.
3) Choice of technique: An organization which uses capital intensive technique requires
higher investment in plant and machinery. On the other hand labour intensive
organizations require less investment in fixed assets.
4) Technology up gradation: In an organisation which uses assets which are become
sooner require higher investment in fixed capital to purchase such assets.
5) Growth prospects: For the higher growth of an organisation generally requires higher
investment in fixed capital in order to meet the anticipated demand.

6) Diversification: A firm which tries to diversify its operations require huge fixed
capital investment.
7) Financing Alternatives: Availability of leasing facilities may reduce the firms funds
requirement to be invested in fixed assets.
8) Level of collaboration: At times certain business organisaiton share each others
facilities. In collaboration a companyu can use asset of other company. Collaboration
reduces the level of investment in fixed assets.
Eg. ATM, Mobile Tower.
Working Capital: Apart from the investment in fixed assets every business organisation needs
to invest in current assets. Current assets are usually more liquid. The order of their liquidity
are as follows:
1)
2)
3)
4)
5)
6)
7)
8)

Cash in hand/ Cash at bank.

Marketable securities
Bills receivable
Debtors
Fianncial goods inventory
Work in progress
Raw materials
Prepaid expenses.

Factors affecting the working capital

1) Nature of business: A trading organisation requires samller amount of working capital
whereas a manufacturing organisation needs higher amount of working capital.
2) Scale of operations: As the scale of business operations increases the requirement of
working capital also increases and vice versa.
3) Business Cycle: If the business cycle is in the stage of boom the scale as well as
production are likely to be larges and hence larger amount of working capital is
required whereas in the depression stage less amount of working capital is required.
4) Seasonal Factors: In peak season, the firm require large amount of working capital
because of higher level of activity. On the other hand, in lean season less working
capital is required.
5) Production cycle: Production cycle is the times pan between the receipt of raw
materials and their conversion into finished goods. Working capital requirement is
higher in firms with longer possessing cycle and lower in firms with shorter
processing cycle.
6) Credit allowed: Different firms allow different credit terms to their customers. A
liberal credit policy results in higher amount of debtors, increasing the requirement of
working of capital.
7) Credit availed: The firm also get credit from its suppliers. To the extent avails the
credit on purchases, the working capital requirement is reduced.

8) Operating efficiency: If the management of the organization operates efficiently the

requirement of working capital may reduced by the efficient usage of raw materials.
Otherwise it increase the amount of working capital.
9) Availability of raw material: If the raw materials are available freely and
continuously, lower stock levels may sufficient. It reduces the working capital
requirement.
10) Growth prospects: If a firm want to higher growth if require huge amount of
working capital in order to meet the higher production needs.
11) Level of competition: Higher level of competitiveness may necessitate larger stock
of finished goods. This increases the working capital requirement.
12) Inflation: With rising prices a larger amount of working capital is required for the
firm. Thus the working capital requirement of a business become higher with the
higher rate of inflation.
What you meant by trading on equity (financial liverage): Trading on equity means
employing more debt fund in the capital structure in order to increase the rate of return of
equity shareholders. If the debt capital is more cheaper than ROI then the company will
include more debt in its capital structure.