Notes - Financial Management

11. Financial Management

 

11.1 Meaning of Financial Management

 

• Financial management is that managerial activity, which is concerned with the planning and controlling of the firm’s financial resources. It is an integrated decision-making process concerned with acquiring, financing and managing assets to accomplish the overall goal of a business organisation.
• According to JF Bradley, “Financial management is the area of business management devoted to the judicious use of capital and careful selection of sources of capital in order to enable a spending unit to move in the direction of reaching its goals.”
• According to Howard and Upton, “Financial management is the application of the planning and control functions of the finance functions.”

 

11.1.1 Scope of Financial Management

 

1. Investment Decision

The investment decision relates to how the firm’s funds are invested in different assets, so that the firm is able to earn the highest possible returns on investment. Investment decisions can be of two types:

(i) Short-term investment decisions (working capital decisions)

(ii) Long-term investment decisions (capital budgeting decisions)

 

2. Financing Decision

Financing decision relates to the quantum of finance to be raised from long-term sources. It involves identification of various alternative sources and deciding the proportion of funds to be raised from different sources. This decision determines the overall cost of capital and financial risk of the enterprise.

 

3. Dividend Decision

The dividend decision relates to the dividend policy of the company, in which a manager has to decide the quantum of profit to be distributed or retained in the business. Dividend is the portion of profit which is distributed among the shareholders. While dividend provides regular and present income to the shareholders, retained earnings aim to increase the future earnings of the shareholders.

 

11.1.2 Role/Importance of Financial Management

 

Financial management is the financial health of a business. It plays a vital role in the organisation by:

(i) Raising funds at minimum cost.

(ii) Generating adequate profits for expansion, modernisation and growth of business.

(iii) Determining the size and composition of fixed assets through optimum capital budgeting decision.

(iv) Determining the size and composition of current assets through optimum working capital decision.

(v) Determining the amount of debt and equity to make up the capital structure of the company.

(vi) Determining the amount of long-term and short-term funds through optimum financing decision.

 

11.1.3 Objectives of Financial Management

 

The main objective of financial management:

 

(i) Primary Objective

The primary objective of financial management is to maximise shareholders’ wealth. The return earned by the shareholders on the funds invested determines the market value of equity shares held by them. Any financial action or decision which leads to increase in market price of shares, results in wealth maximisation of the shareholders.

Thus, the benefits of financial actions are more than the cost involved in it, which is the objective of financial management.

 

(ii) Other Objectives

(a) It ensures availability of sufficient funds at a reasonable cost.

(b) It ensures effective utilisation of funds.

(c) It ensures safety of funds by creating reserves, reinvesting profits, etc.

 

11.2 Financial Planning

 

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

It aims at smooth operations by focusing on fund requirements and their availability at the right time.

Financial plans are made for both long-term as well as short-term

1. Long-term Plans: They focus on long-term growth and investment matters. They are made for 3-5 year time frames.
2. Short-term Plans: They are also known as budgets and are made for a period of one year or less.

 

11.2.1 Objectives of Financial Planning

 

The objectives of financial planning are

• To ensure availability of funds whenever these are required.
• To see that the firm does not raise resources unnecessarily.

 

11.2.2 Importance of Financial Planning

 

The importance of financial-planning can be explained as follow

• It helps in forecasting what may happen in future under different business situations.
• It helps in avoiding business shocks and surprises.
• It helps in coordinating various business functions.
• It tries to link the present with the future.
• It provides a link between investment and financing decisions.
• It helps to reduce wastages, duplication of efforts and gaps in planning.
• It acts as the basis of control, by spelling out the objectives of various business segments.

 

11.3 Capital Structure

 

The term capital structure refers to the composition of the amount of long-term financing. In other words, we can say that capital structure refers to the mix between owners’ fund and borrowed funds or it represents the proportion of debt capital and equity capital to make up the total capital of the firm. Capital structure of the business affects its profitability and financial risk.

 

11.3.1 Factors Affecting Capital Structure

 

The factors that affects the capital structure are as follows:

 

(i) Cash Flow Position: A company has cash payment obligation for normal business services, investment in fixed assets, payment of interest and repayment of principal. A company must have enough cash to cover fixed cash payment obligation and maintain a surplus also. Stronger the cash flow position of the company, it can make use of more debt in its capital structure.

 

(ii) Interest Coverage Ratio (ICR): It refers to the number of times earnings before interest and taxes of a company covers the interest obligation.

\[ICR=\frac{EBIT}{Interest}\]

            Higher the ICR, more debt can be used in the capital structure.

 

(iii) Debt Service Coverage Ratio (DSCR): The cash profits generated by the operations are compared with the total cash required for the service of the debt and preference share capital.

\[DSCR=\frac{Profit\text{ }After\text{ }Tax+Depreciation+Interest+Non-cash\,\,Expenses}{Preference\text{ }Dividend+Interest+Repayment\text{ }Obligation}\]

            Higher the DSCR, more debt can be used by the company in its capital structure.

 

(iv) Return on Investment (RoI): Higher the RoI, the company can make use of more debt to take the benefit of trading on equity to increase the return of equity shareholders.

 

(v) Cost of Debt: Higher the cost of debt, i.e. interest rate on borrowed funds, the company must use less of debt in its capital structure.

 

(vi) Cost of Equity: Stock owners expect a rate of return which commensurate with the risk they are assuming. If the company increases debt, financial risk faced by equity shareholders increases. Therefore, the company cannot use debt beyond a point where cost of equity may increase sharply and share prices may decline.

 

(vii) Tax Rate: As interest is a tax deductible expense, cost of debt is affected by tax rate. Higher the tax rate, the company can make use of more debt in its capital structure.

 

(viii) Floatation Costs: It refers to the costs involved in the process of raising resources. Higher the floatation cost, such source will be less preferred by the company.

 

(ix) Risk Consideration:  Use of debt increases the financial risk of the company. Financial risk refers to a position when a company is unable to meet its fixed financial charges. Business risk depends upon fixed operating costs of the business. If the business risk is lower, the company can make use of more debt in its capital structure.

 

(x) Flexibility: If a firm uses its debt potential to the full extent, it loses flexibility to issue further debt. To maintain flexibility, it must maintain some borrowing power for unforeseen situations.

 

(xi) Control: Debt does not cause a dilution of control. While issue of equity may reduce management’s holding in the company.

 

(xii) Regulatory Framework: Issue of debt and equity has to be made as per the SEBI guidelines. Raising funds from banks and other financial institutions also require fulfilment of such norms.

 

(xiii) Stock Market Conditions:  If the stock markets are bullish, equity shares are more easily sold. Use of equity shares is often not preferred during bearish phase.

 

(xiv) Capital Structures of Other Companies: A company may use the capital structures of other companies as a guideline to design their own capital structure.

 

11.3.1 Theories of Capital Structure

 

Various theories which help in deciding the optimum capital structure are

 

1. Net Income Approach In this method, following steps are undertaken to calculate cost of capital

(\[{{K}_{o}}\]).

Step 1 Determination of Earnings Before Interest and Tax (EBIT).

Step 2 Computation of net income or Earnings Before Tax (EBT).

Step 3 Computation of market value of equity

            \[\left( E \right)=EBT/Cost\text{ }of\text{ }equity\text{ }({{K}_{e}})\]

Step 4 Computation of market value of debt (D) = Interest/Cost of debt (\[{{K}_{d}}\]).

Step 5 Computation of market value of firm

            (V)=E+D

Step 6 Computation of cost of capital (\[{{K}_{o}}\])

                                    =EBIT/Value of firm

 

2. Net Operating Income Approach: This approach is similar to the net income approach except for the following three conditions:

 

• Market value of firm (V) is calculated as

               \[\frac{EBIT}{Weighted\text{ }Average\text{ }Cost\text{ }of\text{ }Capital\text{ }\left( WACC \right)}\]

• Value of Equity (E) = Value of Firm\[-\]Value of Debt
• Cost of equity capital (\[{{K}_{e}}\]) =\[\frac{EBT}{Value\,of\,Equity}\]

 

3. Modigliani and Miller Approach: This approach is a refinement of the net operating income approach and assumes that overall cost of capital is constant. In this method, the market capitalises the value of the firm as a whole. The market value of the firm is ascertained by capitalising the net operating income at the overall cost of capital which is constant. The market value is not affected by changes in debt-equity mix. So, weighted average cost of capital at 0% debt will be the same as WACC at any other percentage of debt.

 

11.4 Leverage Analysis

 

Leverage in general, refers to advantages gained for any purpose. It refers to a relationship between two interrelated variables. In financial analysis, there are three types of leverages:

1. Financial leverage: It involves the use of funds obtained at a fixed cost in the hope of increasing the return to common stockholders. It can be

\[computed\text{ }as\text{ }Financial\text{ }leverage=\frac{EBIT}{EBT}\]

 

2. Operating leverage: It is calculated to find out the income of the company at different levels of sale. It is a measure of effect on operating profit of the concern on change in sales. It can be computed as

\[Operating\text{ }leverage=\frac{Contribution}{EBIT}\]

 

3. Combined leverage: The combined effect of operating cost and interest charges is measured by combined leverage. It can be computed as

\[Combined\text{ }leverage=\frac{Contribution}{Profit\text{ }Before\text{ }Tax\,\,\left( PBT \right)}\]

 

11.5 Fixed Capital

 

It involves allocation of firm’s capital to long-term assets or projects. It is used on a long-term basic to generate revenues for the firm.

 

11.5.1 Factors Affecting the Requirement of Fixed Capital

 

The main factors affecting the requirement of fixed capital are discussed below

 

         (i) Nature of Business: If the business is manufacturing in nature, it requires more fixed capital for fixed assets like plant, machinery, etc. If the business is trading in nature, it requires less fixed capital.

 

(ii) Scale of Operations: If the organisation operates on a large scale, more fixed capital is required. If the organisation operates on small scale, it requires less fixed capital.

 

(iii) Choice of Technique: Organisations that use labour-intensive technique of production, require less fixed capital. Organisations that use capital-intensive technique of production, require more fixed capital.

 

(iv) Technology Upgradation: Organisations and industries where assets become obsolete sooner and require frequent upgradation require more fixed capital than industries where assets replacement is rare.

 

(v) Growth Prospects: Higher growth of an organisation generally requires higher investment in fixed assets.

 

(vi) Diversification: Organisations that may choose to diversify its operations, require larger fixed capital. For example, a textile company is diversifying and starting a cosmetic manufacturing unit consequently, its fixed capital investment will increase.

 

         (vii) Financing Alternatives: Industries which have the option of using fixed assets on lease, require less fixed capital than those industries where leasing alternative is not available.

 

         (viii) Level of Collaboration: Collaboration with other organisations reduces the level of fixed capital requirement by a business.

 

11.6 Working Capital

 

It means the portion of capital which is invested in current assets. Such as stock of materials, finished goods, bills receivable, cash in hand, cash at bank etc for meeting day to day expenses of the businesses called working capital or current capital. The term ‘working capital’ may mean gross working capital or net working capital.

(i) Gross Working Capital means current assets.

 

(ii) Net Working Capital means current assets less current liabilities. Thus,

\[Net\text{ }Working\text{ }Capital=Current\text{ }Assets-Current\text{ }Liabilities\]

Or

\[NWC=CA-CL\]

• Unless otherwise specified working capital means NWC.

 

11.6.1 Factors Affecting the Working Capital Requirements

 

The main factors affecting the working capital requirements are given below

 

(i) Nature of Business: A trading organisation usually requires less working capital. A manufacturing organisation requires more working capital for making payments such as wages, salaries, power, fuel, electricity, etc.

 

(ii) Scale of Operations: An organisation which operates on a large scale requires more working capital whereas, an organisation which operates on a small scale, requires less working capital.

 

(iii) Business Cycle: In case of boom, production and sales are likely to be larger and therefore, larger amount of working capital is required. Whereas, in case of depression, working capital requirements of the company reduces.

 

(iv) Seasonal Factors: During peak season, because of higher level of activity, working capital requirements of the industry increases. But, during lean season, working capital requirements reduce, as the level of activity lowers.

 

(v) Production Cycle (Operating cycle): Production cycle is the time span between production and sale of finished goods. Larger the production cycle, a firm requires larger working capital to keep its operations going on.

 

(vi) Credit Allowed:  Firms following a liberal credit policy and having higher amount of debtors, require more working capital.

 

(vii) Credit Availed: Firms that enjoy and avail credit from their suppliers, require lesser working capital.

 

(viii) Operating Efficiency: Firms that have a high level of efficiency in operations require less working capital.