Revision Notes for Class 12 Business Studies Chapter 9 Financial Management
Here we are providing Revision Notes for Class 12 Business Studies Chapter 9 Financial Management. These are the important points related to the chapter. Students should remember these points.
CONCEPT OF FINANCIAL MANAGEMENT
Financial Management is concerned with optimal procurement as well as usage of finance.
It involves two aspects :
(a) Optimal procurements of funds
(b) Optimal utilisation of funds
Financial management is deemed to be a barometer of financial health of an enterprise which is reflected through various financial statements like Balance sheet and Profit and Loss statements.
OBJECTIVES OF FINANCIAL MANGEMENT
The prime objective of financial management is to maximise shareholder’s wealth by maximising the market price of a company’s shares. The wealth of shareholders is computed as :
Wealth of shareholders = Number of shares held by the shareholder X market price per share.
IMPORTANCE/ROLE OF FINANCIAL MANAGEMENT
The following aspects further highlight the importance of financial management:
(a) To determine the capital requirements of business both long-term and short-term.
(b) To determine the capital structure of the company and determine the sources from where required capital will be raised keeping in view the risk and return matrix.
(c) To decide about the allocation of funds in to profitable avenues, keeping in view their safety as well.
(d) To decide about the appropriation of profits.
(e) To ensure efficient management of cash in order to ensure both liquidity and profitability.
(f) To exercise overall financial controls in order to promote safety, profitability and conservation of funds.
FINANCIAL DECISIONS INVOLVED IN FINANCIAL MANAGEMENT
The three important decisions involved in financial management are :
A. Investment Decision
B. Financing Decision
C. Dividend Decision
A. Investment Decision
Investment decisions reflect as to how the firm’s funds have been invested in the different assets (both current and fixed).
Types of Investment Decisions
Investment decisions can be long term (capital budgeting decision) or short-term (working capital decision) in nature.
I. Long Term Investment Decisions/Capital Budgeting Decisions
It refers to the amount of capital required for investment in fixed assets or long term projects which will yield return and influence the earning capacity of business over a period of time. It affects the amount of assets, competitiveness and profitability of business.
Importance of Long Term Investment Decisions/Capital Budgeting Decisions/Fixed Capital Decisions
A sound capital budgeting decision may have a profound impact on the financial fortune of a business.
This is primarily because of the following reasons:
(a) Long-term growth and effects
(b) Large amount of funds involved
(c) Risk involved
(d) Irreversible decisions
Factors Affecting Capital Budgeting Decisions
(a) Cash flows of the project
(b) The rate of return
(c) The investment criteria involved
II. Short Term Investment Decisions/Working Capital Decisions
A short-term investment decision is also called working capital decision. These decision relate to affect the day to day working of a business and seek to determine the levels of cash, inventories and debtors. These decisions affect the liquidity as well as profitability of a business as the current assets provide little or low return Net Working Capital ( NWC) = Current Assets – Current Liabilities i.e. CA – CL.
B. Financing Decision
Financing decision relates to determining the quantum (amount) of funds to be raised from different sources of finance. This decision determines the overall cost of capital and the financial risk of the enterprise.
While taking the financial decision it is important to understand that debt is considered to a cheaper source of finance primarily for two reasons :
Firstly, the amount of interest paid on debt is treated as a tax deductable expense for computation of tax liability.
Secondly, considering the fact that the risk presumed by the lender is lesser than that of a shareholder as the lenders earns an assured return and repayment of capital, consequently they should require a lower rate of return.
Financial risk refers to the inability of a business to meet its fixed financial obligations like payment of interest.
Factors Affecting Financing Decision
In practise, some of the important factors affecting the financing decisions stated below:
(a) Cost: The cost of each type of finance is estimated and the source which involves the least cost should be chosen by the financial manager.
(b) Risk: The associated risk is different for each source e.g. the risk involved in raising debt capital is higher than equity.
(c) Floatation Costs: A source of finance involving less floatation cost is considered to be more preferable.
(d) Cash Flow Position of the Business: If the cash flow position of a business is good it should opt for debt else equity.
(e) Level of Fixed Operating Costs: If the fixed operating cost of a business is low it should opt for debt else equity.
(f) Control Considerations: The issue of equity capital dilutes the control of existing shareholders over business whereas financing through debt does not lead to any such effect.
(g) State of Capital Markets: If there is boom in capital market it is easy for the company to raise equity capital else it may opt for debt.
C. Dividend Decision
Dividend decision relates to disposal of profit by deciding the proportion of profit which is to be distributed among shareholders and the proportion of profit which is to be retained in the business for meeting the investment requirements.
FACTORS AFFECTING DIVIDEND DECISION
Some of the important factors affecting the dividend decisions stated below:
(a) Earnings: If the earnings of the company are high it is likely to higher dividends or vice versa.
(b) Stability of Earnings: If the other actors are kept constant, a company whose earnings are stable over the years it is likely to declare higher dividends or vice versa.
(c) Stability of Dividends: The companies usually tend to adopt a policy of stabilising dividend per share as wide variations in dividend payouts may adversely affect its goodwill.
(.d) Growth Opportunities: If the company has lucrative forthcoming growth opportunities it is likely to retain greater portion of its their earnings for investment in these ventures and declare low dividends or vice versa.
(e) Cash Flow Position: Since, the dividends are paid in cash, a company is in a position to declare high dividends only when it enjoys high liquidity besides high profitability.
(f) Taxation Policy: If the tax rate is high, the company is likely to pay less dividend or vice versa.
(g) Stock Market Reaction: When a company declares high dividends it tends to create a positive impact on the investors because it leads to a surge in its market price as well. On contrary, declaration of low dividends is linked to poor performance of the company and may have a negative impact on the share prices in the stock market.
(h) Access to Capital Market: Since, the investors prefer to invest in the large and credit worthy they seem to have an easy access the capital market. Thus, the small companies are likely to pay lower dividends than the larger companies.
(i) Legal Constraints: The management of company needs to abide by the provisions of the Company’s Act place while declaring dividend.
(/) Contractual Constraints: The contractual constraints may also affect the dividend payment by a company.
The process of estimating the funds requirement of a business and specifying the sources of funds is called financial planning. It basically involves preparation of a financial blueprint of an organisation’s future operations.
The twin objectives of financial planning are described below:
(a) To ensure availability of funds whenever these are required
(b) To see that the firm does not raise resources unnecessarily
FEATURES OF FINANCIAL PLANNING
(a) Financial planning is the process that involves estimating the amount of funds required by a business enterprise and also determining the sources from where it will be raised.
(b) Financial planning is done by taking into consideration various aspects like growth, performance, investments and requirement of funds for a given period.
(c) Financial planning is done both on long term and short term basis.
(d) The long term financial planning relates to capital expenditure and facilitates to growth of the organisation through sound investments.
(e) A short-term financial plan is called budget which are a detailed plan of action for a period up to one year.
(f) Ideally, financial planning is done for three to five years as it may be difficult to anticipate situations beyond a certain time period.
IMPORTANCE OF FINANCIAL PLANNING
The importance of financial planning is stated as follows:
(a) Sound financial planning ensures smooth running of an enterprise.
(b) It helps to prepare backup plans to deal with all kinds of contingencies.
(c) It helps in anticipating future requirements of a funds and evading business shocks and surprises.
(d) It facilitates co-ordination among various departments of an enterprise.
(e) It helps to establish a link between the present and the future.
(f) It provides a continuous link between investment and financing decisions.
(g) It facilitates easy performance as evaluation standards are set in clear, specific and measurable terms.
CONCEPT OF CAPITAL STRUCTURE
Capital structure refers to the mix between owners and borrowed funds. In simple words, it refers to the debt to equity ratio. It is computed as ( Debt/Equity) or (Debt/Debt + Equity). Capital structure of a business affects both the profitability and the financial risk.
A capital structure will be said to be optimal when the ratio of debt and equity is such that it leads to an increase in the value of the equity share thereby increasing the wealth of the shareholders.
The proportion of debt in the overall capital is called financial leverage. It is computed as D/E or D/D+E when D is the Debt and E is the Equity.
Financial leverage = Debt/ Equity
A company is said to be highly levered when the proportion of debt in the total capital is high whereas when the proportion of debts in the total capital is less, then the company will be said to low levered.
When the return on investment (ROI) exceeds the rate of interest, the financial leverage is favourable, or the firm is said to be trading on equity.
Whereas, when the return on investment (ROI) is less than the rate of interest, the financial leverage is unfavourable. Consequently, the equity stockholders are not benefited from the use of debt in capital structure.
CONCEPT OF TRADING ON EQUITY
Trading on Equity refers to the increase in the earnings per share by employing the sources of finance carrying a fixed financial charges like debentures ( interest is paid at a fixed rate on preference shares (dividend is paid at fixed rate).
The two conditions necessary for trading on equity are as follows:
(a) The amount of interest paid on debt is treated as a tax deductable expense for computation of tax liability.
(b) The rate of return on investment should be more than the rate of interest.
(ROI > Rate of interest)
FACTORS AFFECTING THE CHOICE OF CAPITAL STRUCTURE
The capital structure decision depends upon multiple factors are stated below:
(a) Cash Flow Position: If the cash flow position of the business is good it may use debt. As against this, if the cash flow position of the business it may use equity.
(b) Interest Coverage Ratio (ICR): If the interest coverage ratio is high the business may use debt but if the interest coverage ratio low the business may use equity.
(c) Debt Service Coverage Ratio (DSCR): If the debt service coverage ratio is high the business may use debt but if the debt service coverage ratio is low the business should opt for equity.
(d) Return on Investment (Rol): If the return on investment is high the business may use debt on the other hand if the interest coverage ratio is low the business may use equity.
(e) Cost of debt: If cost of debt is low more debt can be employed. As against it, if the cost of debt is high more of equity may be used.
(f) Tax Rate: A higher tax rate further reduces the cost of debt and makes it a preferable source of finance.
(g) Cost of Equity: As the proportion of debt goes beyond a certain level in the capital structure, the risk of the shareholders increases further. In such a situation, the shareholders may expect a higher return for assuming greater risk.
(h) Floatation Costs: It is usually presumed that the cost of raising debt is less than that of equity.
(i) Risk Consideration: Financial risk refers to a situation under which a business is unable to meet its fixed financial charges. Business risk refers to the operating risk and is directly proportional to its fixed operating costs. Thus, if a firm’s business risk is high, its capacity to use debt is low and vice-versa.
(/) Flexibility: In order to maintain flexibility a firm should never use its debt potential to the full, and always keep provision to raise debt in unexpected situations.
(k) Control: Since, the equity shareholders have the right to control business, issue of further equity further dilutes the control of existing shareholders. As against this issue of debt does not dilute the control of the existing shareholders.
(Z) Regulatory Framework: It is essential for every company to operates within a regulatory framework to avoid any form of legal complications.
(m) Stock Market Conditions: If the stock market conditions are bullish, a company may use equity. On contrary, during bearish period it is preferable for the company to opt for debt as it offers surety of returns.
(n) Capital Structure of other Companies: For successful running of a business enterprise its management must take into consideration the capital structure of other companies in the same industry as it may provide useful guidance.
FACTORS AFFECTING THE WORKING CAPITAL REQUIREMENTS OF A BUSINESS ENTERPRISE
Some of the important factors affecting the fixed capital requirements are stated below:
(a) Nature of Business: The fixed capital requirements of a manufacturing business is higher than a trading business.
(b) Scale of Operations: A business operating on large scale will require higher investment in fixed assets as against a business operating on small scale.
(c) Choice of Technique: If capital intensive production technique is used the fixed capital requirement for such enterprises would be higher On contrary, if labour intensive production techniques are adopted it would require less investment in fixed assets.
(d) Technology Up gradation: In case a business operates on certain technology that makes the related assets obsolete quickly, its fixed capital requirements will be high as constant up gradations in terms of assets/technology may be essential.
(e) Growth Prospects: The fixed capital requirements of a business enterprise planning to pursue higher growth opportunities will be more. On contrary, if there are no forthcoming growth opportunities the fixed capital requirements of the business will not be altered.
(/) Diversification: If a business firm plans to diverse, its fixed capital requirements will increase as new investments in fixed assets may be needed. As against this, if a business has no diversification plans in near future its fixed capital requirements will not be affected.
(g) Financing Alternatives: The availability of investment options like leasing facilities as an alternative to outright purchase may reduce the fixed capital requirements of funds considerably.
(h) Level of Collaboration: If level of collaboration is high the fixed capital requirements of a business is low. On contrary, if level of collaboration of a business is low its fixed capital requirement is less.
FACTORS AFFECTING THE WORKING CAPITAL REQUIREMENT
Some of the important factors affecting the working capital requirements are stated below:
(a) Nature of Business: A trading business requires less working capital as compared to a manufacturing concern.
(b) Scale of Operations: If a business operates on a large scale its working capital requirements will be more or vice versa.
(c) Business Cycle: During boom period both the sales and production is more, consequently the requirement of working capital is high. However, during the time of depression the requirement of working capital is low. because there is fall in both sales and production levels.
(d) Seasonal Factors: During the peak season the demand for the product/service is high, therefore more working capital is required by the business concern. As against this, the requirement of working capital is less during lean season.
(e) Production Cycle: In case of business where the production cycle is shorter, less working capital is needed or vice versa.
(/) Credit Allowed: In case a business firm follows a liberal credit policy, its requirement of working capital is higher as compared to a business which follows a strict credit policy.
(g) Credit Availed: In case a business is able to avail the benefit of credit purchases its requirements of working capital will be less as compared to a business which has to make cash purchases.
(h) Operating Efficiency: An inefficiency in business operations is likely to increase the working capital requirements of a business or vice versa.
(i) Availability of Raw Material: If the raw materials needed by a firm is easily available and on regular basis it can operate efficiently on lower stock levels. But if there is procurement raw materials is difficult, the working capital requirements of the firm will more.
(j) Growth Prospects: If the growth potential of a concern is perceived to be higher, it will require higher amount of working capital so that is able to meet higher production and sales target whenever required.
(k) Level of Competition: Higher level of competitiveness increases the working capital requirement or vice versa. (Z) Inflation: The working capital requirement of a business will be higher with higher rate of inflation or vice versa.