Business Studies: Class 12 (Part 2) — Chapter 9: Financial Management

Financial Management is concerned with the optimal procurement as well as the usage of finance. It aims at reducing the cost of funds, keeping risk under control, and achieving effective deployment of funds.

The financial decisions of a firm directly affect its financial statements and overall health, specifically influencing:

• The size and composition of Fixed Assets.
• The quantum and break-up of Current Assets (cash, inventory, and receivables).
• The proportion of long-term and short-term funds used.
• The break-up of long-term financing into debt and equity.
• All items in the Profit and Loss Account (e.g., Interest, Depreciation).

The primary aim of financial management is to maximise shareholders' wealth, referred to as the Wealth Maximisation Concept. This is reflected in the market price of the company's equity shares.

Long-term investment decisions are also called Capital Budgeting Decisions. They are affected by:

• Cash flows of the project: The series of cash receipts and payments over the life of the investment.
• The rate of return: The expected return based on risk-return calculations.
• The investment criteria involved: Evaluation techniques (capital budgeting techniques) involving interest rates, cash flows, and rate of return.

• Cost: Choosing the cheapest source of finance.
• Risk: Evaluating the financial risk associated with debt.
• Floatation Costs: Costs incurred in raising funds (e.g., brokerage, underwriting).
• Cash Flow Position: A stronger cash flow makes debt financing more viable.
• Fixed Operating Costs: High fixed operating costs reduce the capacity to employ debt.
• Control Considerations: Avoiding dilution of management control by preferring debt over equity.
• State of Capital Market: Bullish markets favour equity; bearish markets make debt more viable.

• Amount of Earnings: Dividends are paid out of current and past earnings.
• Stability of Earnings: Stable earnings allow higher dividend payouts.
• Stability of Dividends: Companies prefer to stabilise dividend per share.
• Growth Opportunities: High-growth companies retain more earnings and pay lower dividends.
• Cash Flow Position: Availability of sufficient cash is necessary to declare dividends.
• Shareholders' Preference: Meeting expectations of regular income-seeking shareholders.
• Taxation Policy: Higher tax on dividends encourages retaining earnings.
• Stock Market Reaction: Dividend increases generally boost share prices.
• Access to Capital Market: Reputed companies with easy market access can pay higher dividends.
• Legal & Contractual Constraints: Adhering to provisions of the Companies Act and lender agreements.

1. To ensure availability of funds whenever required: Estimating the funds needed for long-term assets and day-to-day expenses.
2. To see that the firm does not raise resources unnecessarily: Avoiding idle finance which adds to costs.

• Helps in forecasting future business situations and preparing for shocks.
• Aids in co-ordinating various business functions (e.g., sales and production).
• Reduces waste, duplication of efforts, and gaps in planning.
• Provides a continuous link between investment and financing decisions.
• Makes evaluation of actual performance easier by setting detailed objectives.

Trading on Equity refers to the increase in profit earned by equity shareholders due to the presence of fixed financial charges like interest. This occurs when the Return on Investment (RoI) is higher than the cost of debt.

• Cash Flow Position, Interest Coverage Ratio (ICR), and Debt Service Coverage Ratio (DSCR).
• Return on Investment (RoI) and Cost of Debt.
• Tax Rate (higher tax rates make debt cheaper due to tax deductibility of interest).
• Cost of Equity and Floatation Costs.
• Risk Consideration (Business Risk vs. Financial Risk).
• Flexibility, Control, Regulatory Framework (SEBI guidelines), Stock Market Conditions, and Capital Structure of other companies.

• Nature of Business: Manufacturing concerns require more fixed capital than trading concerns.
• Scale of Operations: Larger organisations require higher investment in fixed assets.
• Choice of Technique: Capital-intensive techniques require more fixed capital than labour-intensive ones.
• Technology Upgradation: Industries with rapid obsolescence require frequent capital investments.
• Growth Prospects & Diversification: Higher growth and diversification increase fixed capital needs.
• Financing Alternatives: Availability of leasing reduces immediate fixed capital requirements.
• Level of Collaboration: Sharing facilities (e.g., joint ATMs) reduces fixed asset investment.

• Nature of Business: Service and trading businesses require less working capital than manufacturing.
• Scale of Operations: Larger scale requires larger inventory and debtors.
• Business Cycle: Boom periods require more working capital than depression periods.
• Seasonal Factors: Peak seasons require higher working capital.
• Production Cycle: Longer processing times increase working capital requirements.
• Credit Allowed & Credit Availed: Liberal credit terms to customers increase working capital, while credit from suppliers reduces it.
• Operating Efficiency: High inventory turnover and quick debtor realization reduce working capital needs.
• Availability of Raw Material: Easy availability reduces the need to maintain large stocks.
• Growth Prospects & Competition: High growth and intense competition increase working capital requirements.
• Inflation: Rising prices require larger funds to maintain the same volume of operations.