Financial Management Class 12 Notes

Financial management is concerned with optimal procurement as well as the usage of finance. Here are the financial management class 12 notes.

Business Finance

The money required for carrying out business activities is called business finance. Finance is needed to establish a business, to run it, to modernise it, to expand, or diversify it.

Objective of Financial Management

The primary objective of financial management is “Shareholder Wealth Maximisation”. It refers to increasing the current price of the company’s equity shares so that the shareholders’ wealth would also increase.

Financial Decisions

Financial management majorly focuses on the three most important decisions for any business which are:

a) Investment Decision
b) Dividend Decision
c) Financing Decision

Investment Decision

This decision is related to choosing where to invest the firm’s resources so that they can earn the highest possible return for their investors.

Investment decisions can be long-term or short-term.

• Long-term Investment Decision: A long-term investment decision is also called a capital budgeting decision.
  It involves committing the finance on a long-term basis. For example, investing in a new machine, opening a new branch, etc.
• Short-term Investment Decision: Short-term investment decisions are also called working capital decisions.
  These decisions are concerned with the decisions about the levels of cash, inventory, and receivables. These decisions affect the day-to-day working of a business.

Factors Affecting Capital Budgeting Decision

There are several projects often available to a business to invest in. Factors that affect capital budgeting decisions are:

1. Cash flows of the project: When a company makes an investment decision involving a huge amount it expects to generate some cash flows over a period.
   The amount of these cash flows should be carefully analyzed before considering a capital budgeting decision.
2. The rate of return: The most important criterion is the rate of return of the project. These calculations are based on the expected returns from each proposal and the assessment of the risk involved.
3. The investment criteria involved: The decision to invest in a particular project involves several calculations regarding the amount of investment, interest rate, cash flows, and rate of return.
   There are different techniques to evaluate investment proposals which are known as capital budgeting techniques.

Financing Decision

This decision is about the quantum of finance to be raised from various long-term sources. The main sources of funds for a firm are shareholders’ funds and borrowed funds.

• Shareholders’ Funds: These refer to the equity capital and the retained earnings.
• Borrowed Funds: These refer to the finance raised through debentures or other forms of debt.

Factors Affecting Financing Decisions

1. Cost: The cost of raising funds through different sources is different. A prudent financing manager would normally opt for a source that is the cheapest.
2. Risk: The risk associated with each of the sources is different.
3. Floatation Costs: The higher the floatation cost, the less attractive the source.
4. Cash Flow Position of the Company: A stronger cash flow position may make debt financing more viable than funding through equity.
5. Fixed Operating Costs: If a business has high fixed operating costs(e.g., building rent, insurance premium, salaries, etc.).
   It must reduce fixed financing costs. Hence, lower debt financing is better. Similarly, if fixed operating costs are less, more debt financing may be preferred.
6. Control Considerations: Issues of more equity may lead to dilution of management’s control over the business. Debt financing has no such implication.
7. State of Capital Market: Health of the capital market may also affect the choice of source of funds.
   A depressed capital market may make an issue of equity shares difficult for any company.

Dividend Decision

This decision is related to how much of the profit earned by the company(after paying tax) is to be distributed to the shareholders and how much it should be retained in the business.

Factors Affecting Dividend Decision

1. Amount of Earnings: Dividends are paid out of current and past earnings.
2. Stability Earnings: Other things remain the same, a company having stable earnings is in a better position to declare higher dividends.
3. Stability of Dividends: Companies generally follow a policy of stabilizing dividends per share.
4. Growth Opportunities: Companies having good growth opportunities retain more money out of their earnings to finance the required investment.
5. Cash Flow Position: The payment of dividends involves an outflow of cash. A company may be earning profit but may be short on cash.
6. Shareholders’ Preference: While declaring dividends, management must keep in mind the preferences of the shareholders in this regard.
7. Taxation Policy: The choice between the payment of dividends and retaining the earnings is, to some extent, affected by the difference in the tax treatment of dividends and capital gains.
8. Access to Capital Market: Large and reputed companies generally have easy access to the capital market and therefore may depend less on retained earnings to finance their growth so they tend to pay higher dividends.
9. Legal Constraints: Certain provisions of the Companies Act, place restrictions on payouts and dividends which are known as legal constraints.
10. Contractual Constraints: While granting loans to a company, sometimes the lender may impose certain restrictions on the payment of dividends in the future which are known as contractual constraints.

Financial Planning

Financial planning is the preparation of a financial blueprint for an organization’s future operations.

Objectives of Financial Planning

Financial planning has two twin objectives:

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

Importance of Financial Planning

• It helps in forecasting what may happen in the future under different business situations.
• It helps in avoiding business shocks and surprises and helps the company in preparing for the future.
• It helps in coordinating various business functions, i.e., sales and production functions, by providing clear policies and procedures.
• Detailed plans of action prepared under financial planning reduce waste, duplication of efforts, and gaps in planning.
• It tries to link the present with the future.
• It provides a link between investment and financing decisions continuously.
• By spelling out detailed objectives for various business segments, evaluates actual performance more easily.

Consumer Protection Class 12 Notes

Capital Structure

Capital structure refers to the mix between owners and borrowed funds.

Capital Structure=Debt/Equity

• Financial Leverage: The proportion of debt in the overall capital is financial leverage.
• Financial Risk: It is the chance that a firm would fail to meet its payment obligations like interest payment, preference dividend, etc.
• Business Risk/Operating Risk: It is the chance that a firm would fail to meet its fixed operating costs like salaries of employees, rent, etc.
• Trade of Equity: Trading on equity refers to the increase in profit earned by the equity shareholders due to the presence of fixed charges like interest.

To understand trading on equity let’s take an example:

Example 1:

You can see that with the increased use of debt, the EPS is rising. This is because the cost of debt is lower than the return on investment.

Cost of Debt(Interest Rate)= 10%
Return on Investment= EBIT/Total Investment*100
ROI= 13.33%

Since, ROI>Cost of Debt(13.33%>10%), EPS is rising.

If the cost of debt is higher than ROI then instead of rising, the EPS will fall. This process of using debt to increase the EPS is known as trading on equity.

Factors Affecting the Choice of Capital Structure

1. Cash Flow Position: The cash position of an organization must be seen before taking borrowings as it includes fixed cash payments like interest.
2. Interest Coverage Ratio: IT refers to the number of times earnings before interest and taxes of a company cover the interest obligations.
   The higher the ratio, the lower the risk of the company defaulting on interest payments.
   Interest Coverage Ratio=EBIT/Interest
3. Debt Coverage Ratio: The cash profits generated by the operations are compared with the total cash required for the service of the debt and preference share capital.
   It is calculated as follows:
   Profit after tax+Dep.+Interest+Non Cash Exp./Pref. Div.+Interest+Repayment Obligation
4. Return on Investment(ROI): If the ROI of the company is higher, it can choose to use trading on equity to increase its EPS.
5. Cost of Debt: A firm’s ability to borrow at a lower rate increases its capacity to employ higher debt.
6. Tax Rate: A higher tax rate makes debt relatively cheaper and increases its attraction vis-a-vis equity.
7. Cost of Equity: If the debt is used beyond a point, the cost of equity may go up sharply and the share price may decrease despite increased EPS.
8. Floatation Costs: The process of raising resources involves some costs which are known as floatation costs like audit fees, stock exchange fees, etc.
9. Risk Consideration: An organization has to take a calculated risk. The use of debt increases the financial risk of a business.
10. Flexibility: If a firm uses its debt potential to the full, it loses the flexibility to issue further debt.

Importance of Capital Budgeting Decisions

Capital budgeting decisions are important for the following reasons:

1) Long-term growth

These decisions affect the organization on the long-term growth. The funds invested in machines, land, and acquisitions affect the prospects of the business.

2) Large amount of funds involved

These decisions result in a substantial portion of capital funds being blocked in long-term projects.

3) Risk Involved

Fixed capital involves investment in huge amounts. If affects the returns of the firm as a whole in the long term these decisions influence the whole business risk.

4) Irreversible decisions

These decisions once taken, are not reversible without incurring heavy losses. Abandoning a project after heavy investment is made is quite costly in terms of waste of funds.

Fixed Capital

Fixed capital refers to investment in long-term assets like the purchase of land, buildings, plants and machinery, etc. Management of fixed capital involves decisions known as capital budgeting decisions.

Factors Affecting the Requirement of Fixed Capital

1. Nature of Business: The types of business has a bearing upon the fixed capital requirements.
2. The Scale of Operations: A larger organization operating at a higher scale needs bigger plants, more space, etc. than a lower organization.
3. Choice of Technique: There are two types of techniques, capital intensive and labor intensive.
4. Technology Upgradation: Organisations that use assets prone to obsolescence require higher fixed capital to purchase such assets.
5. Growth Prospects: Higher growth of an organization generally requires higher investment in fixed assets and consequently larger fixed capital.
6. Diversification: A firm may choose to diversify its operations for various reasons that would demand more fixed capital.
7. Level of Collaboration: Collaboration with other organizations reduces the level of investment in fixed assets for each one of the participating organizations.

Working Capital

The investment made in current assets for smooth day-to-day operations of the business is called working capital.

Factors Affecting Working Capital Requirements

1. Nature of Business: The basic nature of business influences the amount of working capital required like manufacturing and trading business
2. The scale of Operations: Larger Organisations require higher working capital than smaller organizations.
3. Seasonal Factors: In peak season, with a higher level of activity, more working capital is required than in lean season.
4. Growth Prospects: If the growth potential of a concern is perceived to be higher, it will require a larger amount of working capital.
5. Inflation: With rising prices, larger amounts are required even to maintain a constant volume of production and sales. Thus, with inflation working capital requirement would be more and vice-versa.
6. Credit Allowed: A liberal credit policy results in a higher amount of debtors, increasing the requirement of working capital.
7. Credit Availed: Just as a firm allows credit to its customers it also may get credit from its suppliers. To the extent it avails the credit on purchases, the working capital requirement is reduced.