Revision Notes

Class - 12 Business Studies

Chapter 9 - Financial Management

Meaning of Business Finance

● The money required to carry out business activities is known as business
finance. Finances are needed to operate a business, as well as to carry out day to
day activities of the business.

Financial Management
● Financial Management is concerned with the proper procurement and usage of
finance. It includes business activities such as procuring funds, reducing the cost
of funds, keeping the risk under control and deployment of such funds.

● Financial management involves two dimensions, that is finance and

management. Hence, financial management can be said as the application of the
management functions, particularly planning and controlling functions in the
finance function of the business.

● Financial Management is very important as it has a direct emphasis on the

financial health of a business. Financial management decisions affect all the
items of the financial statement directly or indirectly.

Importance of Financial Management

● The size and composition of fixed assets of the business: Over investment in
fixed assets may block funds and increase the size of fixed assets which may not
be healthy for business whereas, little investment may hamper the growth of
business.

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● The quantum of current assets and its break up into cash, inventory and
receivables: The financial decisions about investments in fixed assets, the credit
policy, inventory management, etc., influence the amount of working capital
required by a business enterprise.

● Break-up of long-term financing into debt, equity etc: It is important for a

financial manager to decide the way by which the proportions of debt and/or
equity in a business have to be pumped in. The decisions of the finance
managers affect debt, equity share capital, preference share capital and are an
integral part of financing management.

● The amount of long term and short term financing to be used: Financing
decision decides the proportion of funds raised from long term and short term
sources.

● All items in the profit and loss account: Financing decisions affect the value
of items appearing in the profit and loss account.

All the financial decisions taken by the financial managers in the past largely affect
the current financial decisions as well as the future financial decisions. The overall
health of finance is determined by the quality of financial management.

Objective of Financial Management

● Profit maximization: This was the primary objective of firms which are
concerned with the increasing earning per share (EPS) of the company. It is also
the traditional objectives of the financial management that focuses on the fact
that all the financial efforts should be made to increase the overall profit of the
company,

● Wealth maximization: Financial management mainly aims to maximize

shareholders' wealth which is also referred to as wealth-maximization. This
objective focuses on increasing the overall shareholder wealth of the company,
by directing the financing efforts on increasing the share price of the company.
Higher the share price, higher is the wealth of the shareholders. The goal of
financial management in this is to optimize the current value of the company's

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 equity shares. The market price of the shares of the company is highly influenced
by the financial decisions of the company.

● Other objectives: There can be other objectives such as optimum utilisation of

financial resources, choosing the most appropriate source, ensuring easy
availability of funds at reasonable costs etc.

Financial Decisions
The financial decision is one of the most important decisions that the finance
managers of an organization exercise. The financial decisions of the company are
determined by and are concerned with the three important decisions taken:

● Investment decision

● Financing decision

● Dividend decision

A. Investment Decision
● Each and every organization has limited resources in comparison to the uses of
the resources. So it is very important for a firm to decide the source in which the
funds should be invested in so as to fetch the best returns.

● Investment decisions in an organization are taken in both long term and short
term.

● There are two types of decisions:

○ Long term investment decisions: These are also called capital budgeting
decisions. This also implies that the funds are invested in a resource for a
longer period of time. These decisions affect the profitability and size of
assets.

○ Short term investment decision: These are also known as working capital
decisions. This also implies that the funds are invested in a resource for a
shorter period of time. These decisions affect the day to day operations and

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 activities of the organization. It also affects the liquidity and profitability of
the business.

● The essential contents in a working capital are:

○ Inventory management,

○ Receivables management and

○ Efficient cash management.

Factors affecting Capital budgeting decisions.

There are a huge number of ventures and businesses available in the market for the
purpose of investment. It is important to evaluate each and every venture carefully
to assess the profitability and return on investment. The factors affecting the
decisions are:

1. Cash flow of the project: It is important to analyse the pattern of cash flows in
terms of inflows and outflows over a period of time.

2. Rate of return: This is one of the most important factors to be considered

before investing in any venture. These are based on expected returns and the risk
involved in each proposal.

3. The investment criteria involved: It is important to evaluate various

investment proposals by considering factors like interest rate, cash flows, etc.

B. Financing Decision
● Under this the Financial managers of the organization decide the sources from
which to raise long-term funds. The main source of funding is shareholders' fund
and borrowed funds.

○ Shareholders' funds include share capital, reserves and surpluses and retained
earnings.

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 ○ Borrowed funds refer to funds raised through issue of debentures and other
forms of debt.

● The decision of raising funds from various sources in appropriate proportion lies
in the hands of the financial managers.

● Interest on loan has to be paid regardless of the profitability of the project.

● Debt is considered to be the cheapest form of finance.

Factors affecting Financing Decision

1. Cost: Cost of raising funds influences the financing decisions. A prudent
financial manager selects the cheapest source of finance.

2. Risk: Each source of finance has a different degree of risk. For example,
borrowed funds have high financial risk as compared to equity capital.
3. Floatation cost: A finance manager estimates the flotation cost of various
sources and selects the source with least flotation cost.

4. Cash Flow position of the company: A business with a strong cash flow
position prefers to raise funds from debts as it can easily pay interest and the
principal.

5. Fixed operating costs: For a business with high operating cost, funds must be
raised from equity and lower debt financing would be better.
6. Control consideration: A company would prefer debt financing if it wants to
retain complete control of the business with the existing shareholders. On the
other hand if a company is ready to lose control, it can raise funds from equity.

7. State of capital markets: During boom periods investors are ready to invest in
equity but during depression investors look for second options for investment.

C. Dividend Decision
● Dividend is that part of profit which has to be distributed among the shareholders

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 of a company. This decision relates to the distribution of dividends among
various groups. In this decision, it must be decided that,

○ If all profits are to be dispersed,

○ Whether all earnings will be retained in the business, or

○ Whether a portion of profits will be retained in the business and the remainder
distributed among shareholders.

Factors affecting dividend decision

1. Amount of earning: Dividend represents the share of profits distributed
amongst shareholders. Thus, earning is a major determinant of dividend
decisions.

2. Stability Earnings: A company with stable earnings is not only in a position

to declare higher dividend but also maintain the rate of dividend in the long
run.

3. Stability of Dividends: In order to maintain dividend per share a company

prefers to declare the same rate of dividend to its shareholders.

4. Growth Opportunities: The growing companies prefer to retain a larger share

of profits to finance their investment requirements; hence they prefer
distributing less dividends.

5. Cash Flow position: A profitable company is in a position to declare dividend

but it may have liquidity problems as a result of which it may not be in a
position to pay dividends to its shareholders.

6. Shareholders' Preference: Management of a company takes into

consideration its shareholders expectations for dividend and try to take
dividend decisions accordingly.

7. Taxation policy: Dividends are a tax free income for shareholders but the
company has to pay tax on the share of profit distributed as dividend.

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8. Legal Constraints: Every company is required to adhere to the restrictions and
provisions laid by the companies Act regarding dividend payouts.

9. Contractual Constraints: Sometimes companies are required to enter into

contractual agreements with their lenders with respect to the payment of
dividend in future.

10. Stock Market: A bull or bear market, also affects the dividend decision of the
firm.

Financial Planning
Financial planning refers to the preparation of a plan to ensure the adequacy of
funds at the time of requirement. In case, the funds are not available on time the
company will not be able to fulfill its activities

Objectives of Financial Planning

1. It ensures that the funds are readily available at the time of need.

2. It also checks that the firm need not unnecessarily raise resources.

Importance of Financial Planning

1. Forecasting: It helps in forecasting the future under different circumstances.
This helps the firms and organizations in dealing with contingencies.

2. Prepares for uncertainties: It helps in preparing firms for various future

ventures by avoiding business shocks and surprises.

3. Coordination: It helps in better coordination of various business functions like

production, sales, etc.

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4. Building links: It builds a link between the present of the organization with its
future. It also provides a link between the financing and investment decisions on
a regular basis.

5. Easy Performance Evaluation: It makes the evaluation of the performance

easier and in a detailed way.

Capital Structure
● It is one of the most important decisions under financial management to decide
the pattern or the proportion of various sources that should be used for raising
the funds.

● Capital structure is a blend of debt and equity or borrowed funds and owners'
funds respectively. It is calculated as debt-equity ratio.

i.e. Debt 
Equity
 

Or

The proportion of debt out of total capital i.e. Debt 
Debt  Equity .
 

Classification of Sources of Business Finance: On the Basis of Ownership:

This can be classified into two categories:

● Owners' Funds: It consists of equity share capital, preference share capital,

reserves and surplus and retained earnings.

● Borrowed funds: It can be in the form of loans, debentures, various types of

public deposits, borrowed funds from banks and other financial institutions.

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Features
● The cost of debt and equity differ significantly.

● The risks involved in debt and equity financing are different.

● The cost of debt is lower than the cost of equity.

● The interest that is paid on the debt is a deductible expense while computing tax
liability whereas the dividend that is paid to the shareholders is paid out of after
tax profit.

● Debt is a cheaper source of finance as compared to that of equity but it is more

risky for a business because the payment of interest and the return of the
principal value is mandatory for the business.

● Default in payment of the interest on debt may result in liquidation of the

business whereas there is no such compulsion in case of equity.

Factors affecting the Choice of Capital Structure.

1. Cash Flow Position: Before raising finance business must consider the
projected flow to ensure that it has sufficient cash to pay fixed cash obligations.
A company with high liquidity and a good cash flow position can issue debt
capital, as the company will have less chances of facing financial risk than the
company with a low cash position.

2. Size of business: Small businesses generally go for retained earnings, and

equity capital, as if they go for debt or borrowed capital, the company has to
face a fixed interest burden. However in the case of large companies, issuing
debt is not a big issue, and they can raise long term finance from borrowed
sources cheaper than that of small firms.

3. Interest Coverage Ratio: It refers to the number of times a company can

cover its interest obligations from the profits and higher ICR reduces the risk of
failing to meet interest obligations.

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4. Debt Service Coverage Ratio: It indicates the company's ability to meet cash
commitments for interest and principal amount of debt.

5. Return on Investment: If a company earns high returns it has the capacity to

opt for death as a source of finance.

6. Cost of debt: A company may raise funds from debts if it has the capacity to
borrow funds at a lower interest rate.

7. Tax Rate: Higher the tax rate, more preference for debt capital in the capital
structure, as interest on debt capital being a tax deductible expense makes the
debt cheaper.

8. Cost of equity: If a company has high risk, its shareholder may expect a high
rate of return resulting in increased cost of capital.

9. Floatation cost: Choosing a source of fund depends on the flotation cost to be

incurred to raise such funds, flotation cost makes this show less attractive.

10. Risk Consideration: A company chooses debts as a source of finance

depending on its operating risk and overall business risk.

11. Flexibility: The choice of debts depends on the company's potential to borrow
and the level of flexibility it wants to retain for choosing a source of funds in
future.

12. Regulatory Framework: The guidelines norms for documentation procedures

influence the decision to choose a source of finance.

13. Stock Market Conditions: If the stock market is flourishing, and there is a
condition of boom then the companies may prefer more equity over debt in the
capital structure. However, in the case of a bear market, to avoid any more
risks, the companies will prefer more debt over equity in the capital structure.

14. Capital Structure of other companies: Capital structure of other companies

in the industry may be considered as a guideline while planning a firm’s capital
structure but the final decision must be based on company’s capacity to afford
financial risk.

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Fixed and Working Capital

a. Fixed Capital:
● Fixed capital is that amount of capital which is incurred in procurement or
buying the fixed assets for a business or an organization. The fixed assets of an
organization are those assets which remain with the business for more than one
year.

● For example: Plant and Machinery, land, furniture and fixtures vehicles, etc.

Importance of Management of Capital budgeting/ Fixed Capital

1. Long-term growth: Capital budgeting decisions have long term effects on
growth and profitability of the business in the future.

2. Large amount of funds involved: Capital budgeting decisions involving high

amounts of funds block for a long period of time.

3. Risk involved: Investment in fixed capital and the related financial risks affect
the overall business risk in the long term.

4. Irreversible decisions: The investment decision cannot be reversed without

incurring heavy losses and wasteful expenditure.

Factors affecting the requirement of Fixed Capital

1. Nature of Business: The requirement of fixed capital largely depends upon the
type and nature of the business a company or organization is involved in.
Trading requires less fixed capital, while manufacturing business requires more
fixed capital due to the involvement of heavy plant and machinery.

2. Scale of operations: Larger the business operation, bigger is the investment and
lower the level of business operation smaller is the investment.

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3. Choice of Technique: The requirement of fixed capital of an organization
largely depends upon the technique of operation in the organization. An
organization that is capital-intensive requires a huge amount of investment in
plant and machinery because it does not rely on manual labour whereas if an
organization is labour- intensive it requires a comparatively less amount of
investment in its fixed assets.

4. Technology Upgradation: The organizations whose assets become obsolete in

a very short duration need to upgrade their technology from time to time which
may result in a higher amount of investment in fixed assets.

5. Growth Prospects: If an organization aspires for higher growth, the investment

in fixed assets should be on a higher side.

6. Diversification: Diversification needs investment in fixed assets. If a jute textile

manufacturing company diversifies into FMCG it requires huge investment.
7. Financing Alternatives: There are many tools that act as alternatives to huge
investment in assets. For example: Plant and Machinery may be available on a
lease and the firm may use the asset for the required time and pay the rentals
thereby reducing huge capital investment.

8. Level of Collaboration: It has become a common practice to collaborate with

different organizations in the industry and use each other's resources for a
common good. For example: One single ATM machine can be used to withdraw
funds from accounts of different banks, this practice reduces the investment cost
at a large scale.

b. Working Capital:
● Working capital is that amount of capital which is used in the day-to-day
operations of the business this may be in cash or cash equivalents. The working
capital is utilized by the business within one year.

● For example: stocks and inventories, debtors, bills receivables, etc.

● Various type of Current assets that contribute to the working capital are:

○ Cash in hand/cash at Bank

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 ○ Marketable securities

○ Bills receivable

○ Debtors

○ Finished goods

○ Inventory

○ Work-in-progress

○ Raw material

○ Prepaid expenses

● Various sources of Current liabilities that contribute to the working capital are:

○ Bills payable

○ Creditors

● Outstanding expenses and advances received from customers.

Factors affecting the Working Capital requirements advances from customers.

● Nature of Business: Manufacturing business requires more working capital as
compared to trading business or service provider.

● Business Cycle: During boom period firms require a large amount of working
capital to manage the increased sales and production.
● Seasonal Factors: Seasonal businesses require more working capital during
their season time.

● Scale of Operations: Businesses operating on a large scale require larger

amounts of working capital as compared to small business firms.

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● Credit Allowed: A business extending a longer credit period to its buyers will
need more working capital as compared to a business doing cash business or
offering a lesser credit period.

● Production Cycle: Businesses with longer production cycles require more

working capital as compared to businesses with short-term production cycles.
● Credit Availed: A business organisation receiving longer credit period from
their supplier will require lesser working capital as compared to business
purchases goods for cash or receive short credit period.

● Operating Efficiency: A business operating efficiently is able to convert

current assets into cash easily and thus will require lesser working capital.

● Availability of Raw Material: A business having each and continuous

availability of raw material will not require large stock levels and thus, can
manage with lesser working capital.

● Growth Prospects: Firms with high growth rate targets need higher working
capital to meet increased sales target.

● Level of Competition: Tougher competition forces businesses to offer

discounts liberal credit and maintain high levels of stock requiring larger
amounts of working capital.

● Inflation: Inflation increases prices as a result firms require large amounts of

working capital to meet the same volume of purchase and operating expenses.

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