Financial Management

Financial Management :
Financial management refers to efficient acquisition, allocation and usage of funds by a company for its smooth
working.
The main objectives of financial management are to reduce the expenses involved in procuring funds, to control risk
and to achieve effective deployment of funds.

Importance of Financial Management

 The role of financial management is as such that it has a direct impact on all the
financial aspects/activities of a company. Certain aspects affected by financial
management decisions are
1. Size and composition of fixed assets: The amount of money invested in fixed assets
is an outcome of investment decisions. So, if more amount of capital is decided to be
invested in fixed assets, then it will increase the value of the total share of fixed
assets by the amount invested.
2. Amount and composition of current assets: The quantum of current assets and its
constituents like cash, bills receivable, inventory etc. is also influenced by
management decisions. It is also dependent on the amount invested in fixed assets,
decisions about credit and inventory management etc.
3. Amount of long-term and short-term funds to be used: Financial management
determines the quantum of funds to be raised for the short term and long term. In
case a firm requires more liquid assets, then it will prefer to have more long-term
finance even when their profits will decrease due to payment of more interest in
comparison to short term debts.
4. Proportion of debt and equity in capital: Financial management also takes decisions
regarding the proportion of debt and/or equity.
5. All items in profit and loss account: All items in the profit and loss account are
affected by financial management decisions. For example, higher amount of debt will
lead to increase in the expense in the form of interest payment in the future.

Objectives of Financial Management

1. The basic objective of financial management is to maximise the wealth of shareholders.

2. It aims at taking financial decisions which prove beneficial for shareholders. Such financial decisions are taken
wherein the anticipated benefits exceed the cost incurred. This in turn implies an improvement in the market value
of shares.

3. An increase in the market value of shares is gainful for shareholders.

4. It focusses on taking those financial decisions which lead to value addition for the company, so the price of the
equity share rises.

5. As this basic objective gets fulfilled, other objectives such as optimum utilisation of funds, maintenance of liquidity
etc. are also fulfilled automatically. 6. It involves choosing the best alternative which will prove to be beneficial.

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.

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

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.

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.

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

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

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.

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]

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.

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 hai 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 companies
capacity to afford financial risk.

Fixed and Working Capital

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.

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.

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.

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 utilised by the business within one year.
  For example: stocks and inventories, debtors, bills receivables, etc.

Factors affecting the Working Capital requirements advances from customers.

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

2. Business Cycle: During boom period firms require a large amount of working capital to manage the increased
sales and production.

3. Seasonal Factors: Seasonal businesses require more working capital during their season time.

4. Scale of Operations: Businesses operating on a large scale require larger amounts of working capital as
compared to small business firms.

5. 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.

6. Production Cycle: Businesses with longer production cycles require more working capital as compared to
businesses with short-term production cycles.

7. 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.

8. Operating Efficiency: A business operating efficiently is able to convert current assets into cash easily and
thus will require lesser working capital.

9. 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.

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

11. Level of Competition: Tougher competition forces businesses to offer discounts liberal credit and maintain
high levels of stock requiring larger amounts of working capital.

12. Inflation: Inflation increases prices as a result firms require large amounts of working capital to meet the
same volume of purchase and operating expenses.