CBSE Class 12 Business Studies Financial Management Notes

 Introduction :-

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. Finanicial management is the activity concerned with the planning, raising controlling and  dministering of funds used in the business. It is concerned with optimal procurement as well as usuage of finance. It aims at ensuring availability of enough funds whenever required as well as avoiding idle finance.

The Main Objective of Financial Management : is to maximise shareholder’s wealth, for which achievement of optimum capital structure and proper utilisation of funds is a must. Every company is required to take three main financial decisions which are as follow

1. Investment Decision :-

It relates to how the firm’s funds are invested in different assets. Investment decision can be long-term or short term. A long term investment decision is called capital budgeting decisions which involve huge amounts of investments and are irreversible except at a huge cost while short term investment decisions are called working capital decisions which affect day to day working of a business.

2. Financing Decison :-

It relates to the amount of fincance to be raised from various long term sources. The main sources of funds are owner’s funds i.e. equity / share holder’s funds and the borrowed funds i.e. Debts. Borrowed funds have to be repaid at a fixed time and thus some amount of financial risk (i.e. risk of default on payment) is there in debt financing. Morever interest on borrowed funds have to be paid regardless of whether or not a firm has made a profit. On the other hand shareholder funds involve no commitment regarding payment of returns or repayment of capital. A firm mixes both debt and equity in making financing decisions.

3. Dividend Decision :-

Dividend refers to that part of the profit which is distributed to shareholders. A company is required to decide how much of the profit earned by it should be distributed among shareholders and how much should be retained. The decision regarding dividend should be taken keeping in view the overall objective of maximising shareholder’s wealth.

Financial Planning :-

The process of estimating the fund requirement of a business and specifying the sources of funds is called financial planning. It ensure that enough funds are available at right time so that a firm could honour its commitments and carry out, its plans.

Importance of Financial Planning

1. To ensure availbility of adequate funds at right time.

2. To see that the firm does not raise funds unnecessarily. 

Factors affecting Investment Decisions / Capital Budgeting decisions

1. Cash flows of the project : The series of cash receipts and payments over the life of an investment proposal should be considered and analysed for selecting the best proposal.
2. Rate of Return : The expected returns from each proposal and risk involved in them should be taken into account to select the best proposal.
3. Investment Criteria Involved : The various investment proposals are evaluated on the basis of capital budgeting techniques. Which involve calculation regarding investment amount, interest rate, cash flows, rate of return etc.

Factors Affecting Financing Decision

1. Cost :- The cost of raising funds from different sources are different. The cheapset source should be selected.
2. Risk :- The risk associated with different sources is different, More risk is associated with borrowed funds as compared to owner’s fund as interest is paid on it and it is rapaid also.
3. Floatation Cost :- The cost involved in issuing securities such as broker’s commission, underwriters fees, expenses on prospectus etc is called floatation cost. Higher the floatation cost, less attractive is the source of finance.
4. Cash flow position of the business :- In case the cash flow position of a company is good enough then it can easily use borrowed funds.
5. Control Considerations : In case the existing shareholders want to retain the complete control of business then finance can be raised through borrowed funds but when they are ready for dilution of control over business, equity can be used for raising finance.
6. State of Capital Markets : - During boom, finance can easily be raised by issuing shares but during depression period, raising finance by means of debt is easy.

Factors affecting Dividend Decision :

1. Earnings : - Company having high and stable earning could declare high rate of dividends are paid out of current and past earnings.
2. Stability od Dividends : Companies generally follow the policy of stable dividend. The dividend per share is not altered/changed in case earning changes by small proportion or increase in earning is temporary in nature.
3. Growth Prospects : In cse there are growth prospects for the company in the near future them it will retain its earning and thus, no or less dividend will be declared.
4. Cash Flow Positions : Dividends involve an outflow of cash and thus, availability of adequate cash is foremost requirement for declaration of dividends.
5. Preference of Shareholders : While deciding about divident the preference of shareholders is also taken into account. In case shareholders desire for dividend then company may go for declaring the same.
6. Taxation Policy : A company is required to pay tax on dividend declared by it. If tax on dividend is higher, company will prefer to pay less by way of dividends whereas if tax rates are lower then more dividends can be declared by the company.

Capital Structure

Capital structure refers to the mix between owner’s funds and borrowed funds. It will be said to be optimal when the proportion of debt and equity is such that it results in an increase in the value of the equity share.
The proportion of debt in the overall capital of a firm is called financial Leverage or capital gearing. When the proportion of debt in the total capital is high then the firm will be called highly levered firm but when the proportion of debts in the total capital is less then the firm will be called low levered firm.

Factors affecting Capital Structure.

1. Cash flow position : In case a company has strong cash flow position then it may raise finance by issuing debts.
2. Interest Coverage Ratio : If refers to the number of times earning before interest and taxes of a company covers the interest obligation. High Interest coverage ratio indicate that company can have more of borrowed funds.
3. Return on Investment : If return on investment is higher than the rate of interest on debt then it will be beneficial for a firm to raise finance through borrowed funds.
4. Floatation Cost : The cost involved in issuing securities such as brokers comission, under writers fees, cost of prospectus etc is called floatation cost. While selecting the source of finance floatation cost should be taken into account.
5. Control : When existing shareholders are ready to dilute their control over the firm then new equity shares can be issued for raising finance but in reverse sitation debts should be used.
6. Tax Rate : Interest on debt is allowed as a deduction, thus in case of high tax rate debts are prefered over equity but in case of low tax rate more preference is given to Equity.
In addition, cost of debt, cost of equity flexibility, risk consideration etc are other factors affecting capital structure.

Fixed Capital and Factors affecting Fixed Capital

Fixed capital refers to investment in long-term assets. Investment in fixed assets is for longer duration and they must be financed through long-term sources of capital. Decisions relating to fixed capital involve huge capital/ funds and are not reversible without incurring heavy losses. The factorsaffecting the requirement of fixed capital are the follows.

1. Nature of Business : Manufacturing concern require huge investment in fixed assets & thus huge fixed capital is required for them but trading concern needs less fixed capital as they doesn’t require to purchase plant and machinery etc.
2. Scale of Operations : An organisation operating on large scale require more fixedd capital as compare to an organisation operating on small scale.
3. Choice of Technique : An organisation using capital intensive techniques require more investment in plant & machinery as compare to organisation using labour intensive techniques.
4. Technology upgradation : Organisations using assets which become obsolete faster require more fixed capital as compare to other organisations.
5. Growth Prospects : Companies having higher growth plan require more fixed capital. In order to expand production capacity more plant & machinery are required.
6. Diversification : In case a company go for diversification then it will require more fixed capital to invest in fixed assets like plant and machinery.

Working Capital and Factors affecting working capital
Working Capital refers to the capital required for day to day working of an organisation. Apart from the investment in fixed assets every business organisation needs to invest in current assets, which can be converted into cash or cash equivalents within a period of one year. They provide liquidity to the business. Working capital is of two types : Gross working capital
and Net working capital Investment in all the current assets is called gross working capital whereas the excess of current assets over current liabilities is called net working capital. Following are the factors which affect working capital requirements of an organisation.

1. Nature of Business : A trading organisation needs a lower amount of working capital as compared to a manufacturing organisation as trading organisation undertake no processing work.
2. Scale of operations : - An organisation operating on large scale wille require more inventory and thus, its working requirement will be more as compared to small organisation.
3. Business Cycle ; In the time of boom more production will be undertaken and so more working capital will be required during that time as compared to depression.
4. Seasonal Factors : During peak season demand of a product will be high and thus high working capital will be required as compared to lean season.
5. Credit allowed : If credit is allowed by a concern to its customers than it will require more working capital but if goods are sold on cash basis than less working capital is required.
6. Credit availed : If a firm is able to purchase raw material on credit from its suppliers then less working capital will be required.
In addition to above growth prospects, operating efficiency, inflation, level of competition etc also affect working capital requirement.

Trading on Equity :
It refers to the increase in profit earned by the equity shareholders due to the presence of fixed financial charges like interest. Trading on equity happen when the rate of earning of an organisation is higher than the cost at which funds have been borrowed and a as result equity shareholders get higher rate of dividend per share.

Key Concepts in nutshell:

Meaning of Business Finance: Money required for carrying out business activities is called business finance.

Financial Management: It is concerned with optimal procurement as well as usage of finance.

Role of Financial Management: It cannot be over‐emphasized, since it has a direct bearing on the financial health of a business. The financial statements such as Profit and Loss A/C and B/S reflect a firm’s financial position and its financial health.

i) The size as well as the composition of fixed assets of the business

ii) The quantum of current assets as well as its break‐up into cash, inventories and receivables used.

iii) The amount of long‐term and short‐term financing to be used.

iv) Break‐ up of long‐term financing into debt, equity etc.

v) All items in the profit and loss account e.g., interest, expenses, depreciation etc. 

Objectives of Financial Management: Maximisation of owners’ wealth is sole objective of financial management. It means maximization of the market value of equity shares. Market price of equity share increases if the benefits from a decision exceed the cost involved. 

Investment Decision: It relates to how the firm’s funds are invested in different assets . Investment decision can be long‐term or short‐term. A long‐term investment decision is also called a Capital Budgeting decision.

Factors affecting Capital Bud geting Decision/Investment Decision:

1. Cash flows of the project: If anticipated cash flows are more than the cost involved then such projects are considered.

2. The rate of return: The investment proposal which ensures highest rate of return is finally selected.

3. The investment criteria involved: Through capital budgeting techniques, investment proposals are selected.

Financing Decision: It refers to the quantum of finance to be raised from various sources of long‐term of finance. It involves identification of various available sources. The main sources of funds for a firm are shareholders funds and borrowed funds. Shareholders funds refer to equity capital and retained earnings. Borrowed funds refer to finance raised as debentures or other forms of debt.

Factors Affecting Financing Decision:

a) Cost: The cost of raising funds through different sources is different. A prudent financial manager would normally opt for a source which is the cheapest. (b) Risk: The risk asso ciated with different sources is different.

(c) Floatation Costs: Higher the floatation cost, less attractive the source.

(d) Cash Flow Position of the Business: A stronger cash flow position may make debt financing more viable than funding through equity.

(e) Level of Fixed Operating Costs: If a business has high level of fixed operating costs (e.g., building rent, Insurance premium, Salaries etc.), It must opt for lower fixed financing costs. Hence, lower debt financing is better. Similarly, if fixed operating cost is less, more

f) Control Considerations: Issues of more equity may lead to dilution of management’s control over the business. Debt financing has no such implication. Companies afraid of a takeover bid may consequent ly prefer debt to equity.

g) State of Capital Markets: Health of the capital market may also affect the choice of source of fund. During the period when stock market is rising, more people are ready to invest in equity. However, depressed capital market may make issue of equity shares difficult for any company.

DIVIDEND DECISION:The decision involved here is how much of the profit earned by company (after paying tax) is to be distributed to the shareholders and how much of it should be retained in the business for meeting the investment requirements.

FACTORS AFFECTING DIVIDEND DECISION:

a) Earnings: Dividends are paid out of current and past earning. Therefore, earnings is a major determinant of the decision about dividend.

(b) Stability of Earnings: Other things remaining the same, a company having stable earning is in a position to declare higher dividends. As against this, a company having unstable earnings is likely to pay sma ller dividend.

c) Stability of Dividends: It has been found that the companies generally follow a policy of stabilising dividend per share.

(d) Growth Opportunities: Companies having good growth opportunities retain more money out of their earnings so as to finance the required investment.

(e) Cash Flow Position: Dividends involve an outflow of cash. A company may be profitable but short on cash. Availability of enough cash in the company is necessary for declaration of dividend by it.

(f) Shareholder Preference: While declaring dividends, managements usually keep in mind the preferences of the shareholders in this regard.

(g) Taxation Policy: The choice between payment of dividends and retaining the earnings is, to some extent, affected by difference in the tax treatment of dividends and capital gains.

(h) Stock Market Reaction: Investors, in general, view an increase in dividend as a good news and stock prices react positively to it. Similarly, a decrease in dividend may have a negative impact on the share prices in the stock market.

(i) 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. These companies tend to pay higher dividends than the smaller companies which have relatively low access to the market.

(j) Legal Constraints: Certain provisions of the Company’s Act place restrictions on payouts as dividend. Such provisions must be adhered to while declaring the dividends.

(k) Contractual Constraints: While granting loans to a company, sometimes the lender may impose certain restrictions on the payment of dividends in future.

FINANCIAL PLANNING 
Financial Planning is essentially preparation of financial blueprint of an organisations’s future operations. The objective of financial planning is to ensure that enough funds are available at right time.

OBJECTIVES

(a) To ensure availability of fundswhenever these are required: This include a proper estimation of the funds required for different purposes such as for the purchase of long‐term assets or to meet day‐ to‐ day expenses of business etc.

(b) To see that the firm does not raise resources unnecessarily: Excess funding is almost as bad as inadequate funding.

IMPORTANCE OFFINANCIAL PLANNING

(i) It tries to forecast what may happen in future under different business situations. By doing so, it helps the firms to face the eventual situation in a better way. In other words, it makes the firm better prepared to face the future.

(ii) It helps in avoiding business shocks and surprises and helps the company in preparing for the future.

(iii) If helps in co‐ordinating various business functions e.g., sales and production functions, by providing clear policies and procedures.

(iv) Detailed plans of action prepared under financial planning reduce waste, duplication of efforts, and gaps in planning.

(v) It tries to link the present with the future.

(vi) It provides a link between investment and financing decisions on a continuous basis.

(vii) By spelling out detailed objectives for various business segments, it makes the evaluation of actual performance easier.

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

FACTORS AFFECTING THE CHOICE OF CAPITAL STRUCTURE

1. Cash Flow Position: Size of projected cash flows must be considered before issuing debt.

2. Interest Coverage Ratio (ICR): The interest coverage ratio refers to the number of times earnings before interest and taxes of a compab ny covers the interest oligation.

3. Debt Service Coverage Ratio(DSCR): Debt Service Coverage Ratio takes care of the deficiencies referred to in the Interest Coverage Ratio (ICR).

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