Chapter: 9

What Are Financial Management ?

Finance is needed by every organisation to establish a business, to run , to modernise, to expand, or diversify it. Financial Management is concerned with optimal procurement as well as the usage of finance. It also aims at reducing the cost of funds procured Almost all items in the financial statements of a business are affected
directly or indirectly through some financial management decisions like:

• 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

• Break-up of long-term financing into debt, equity etc

• All items in the Profit and Loss Account like commission, bad debts etc

The primary aim of financial management is to maximise shareholders’ wealth or wealth-maximisation.

Financial Decisions

Financial management is concerned with the solution of three major issues relating to investment, financing and dividend decision.

Investment Decision

Investment decision is related to investment of funds of an organisation in different assets. Investment  decision can be for long-term or short-term. Long-Term investment decision is called Capital Budgeting Decision and Short-term investment decisions are also called working capital decisions.

Factors affecting the Capital Budgeting Decisions

  • Cash Flows of the Project
  • The rate of return
  • The investment criteria involved

Financing Decision

The decision refers to the amount of finance to be raised from various long-term sources. The main sources of finance are: shareholder’s funds and borrowed funds.

Factors affecting Financing Decision

  • Cost
  • Risk
  • Floatation Cost
  • Cash Flow Position of the Company
  • Fixed operating Cost
  • Control Consideration
  • State of Capital Market

Dividend Decision

Dividend is that portion of profit which is being given to shareholders. The dividend decision refers to the how much amount of profit is to be given to the shareholders and how much should be retained in the business.

Factors affecting Financing Decision

  • Amount of Earnings
  • Stability Earnings
  • Stability of Dividends
  • Growth Opportunities
  • Cash flow positions
  • Shareholder’s Preference
  • Fixed operating Cost
  • Taxation policy
  • Stock Market Reaction
  • Access to capital market
  • Legal Constraints
  • Contractual Constraints

Financial Planning

It is the financial blueprint of an organisation’s future operations.

Objectives of Financial Planning

• To ensure availability of funds whenever required

• To make sure that the firm does not raise resources unnecessarily

Importance of Financial Planning

  • Forecasts what may happen in future under different business circumstances.
  • Avoids business shocks and surprises
  • Co-coordinates various business functions
  • Reduces waste and duplication of efforts
  • Link present and future
  • Linkage between investment and financing decisions

Capital Structure

It refers to proportion of owner’s funds and borrowed funds in an organisation. It can be calculated by Debt-Equity ratio. Capital structure of the company affects both profitability and financial risk.

Factors affecting the choice of Capital Structure

  • Cash flow Position
  • Interest Coverage Ratio
  • Debt Service Coverage Ratio
  • Return on Investment
  • Cost of Debt
  • Tax Rate
  • Cost of Equity
  • Risk Consideration
  • Flexibility
  • Control
  • Regulatory Framework
  • Stock Market Conditions
  • Capital Structure of other Companies

Fixed Capital

Fixed Capital refers to the capital which is being invested in long-term assets.

Factors affecting the Requirement of Fixed Capital

  • Nature of Business
  • Scale of Operations
  • Choice of Technique
  • Technology Up gradation
  • Growth Prospects
  • Diversification
  • Financial Alternative
  • Level of Collaboration

Working Capital

It refers to the capital which is being required for day to day expenses. It is calculated as Current Assets- Current Liabilities.

Factors affecting the Requirement of Working Capital

  • Nature of Business
  • Scale of Operations
  • Business Cycle
  • Seasonal Factors
  • Production Cycle
  • Credit Allowed
  • Credit Availed
  • Operating Efficiency
  • Availability of Raw Materials
  • Growth Prospects
  • Level of Competition
  • Inflation