ASSISTANT
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Finance is the bloodstream of every business.
Kuchal S. C. has defined Financial Management as:
“Financial Management deals with procurement of funds and their effective utilization in the business.”
Efficient use of funds
Functions of Financial Management
1. Forecasting Monetary requirements
It is important for a company to decide the following:
1. Purpose of funds -
A company has to determine for what purposes funds are required, i.e., for franchise agreements, raw materials, salaries of employees, or all of the following.
2. Amount required -
3. When - Funds are required at the beginning or after a certain period of time.
4. Duration of Funds - Repayment Schedule
5. Kind of Funds - Own Funds or Borrowed Funds.
Functions of Financial Management
2. Sources of Funds:
Own Funds Borrowed Funds
Functions of Financial Management
3. Utilization of Funds
Once money is received
Functions of Financial Management
4. Dividend Policy
Once profits are earned, a company has to decide whether to distribute the profits as dividends or retain them in the business for future expansion.
This decision is taken in financial management.
Functions of Financial Management
5. Analysis of performance
Since financial resources are scarce, a company has to analyze the efficient utilization of funds and ensure the cost of raising funds is reasonable (dividend and interest is the cost).
Functions of Financial Management
6. Role of Advisor
Financial manager
Functions of Financial Management
7. Day to day functions
Financial Books
Financial Statements
Group of people: Debtors, Creditors, and Directors.
Financial Statement.
Objectives of Financial Management
Profit maximization
Wealth maximization
Social objective
Profit Maximization
Earning profit is the prime objective.
Financial management aims at efficient use of monetary funds. This leads to a reduction in finance cost.
Importance of profit maximization:
- Difficult for a business without profits
- Enables business to run smoothly
- Helps business to generate employment
- Helps in distributing higher dividend
- Creates good public image
Wealth Maximization
Wealth maximization is a broad concept and includes profit maximization.
Maximizing the wealth of shareholders
Maximizing the value or net worth of the business
The wealth of the shareholders is based on the market price of the shares of the company.
Market price of shares = wealth of shareholders
Social Objective
Need of social objective:
Business organization cannot operate in isolation.
Works in society and needs society to grow. Give and take relationship.
Particulars:
1. Employees - by providing adequate compensation, incentives, good work environment, etc.
2. Customers - offering good quality products, affordable prices, etc.
3. Suppliers - making proper payment on time
4. Government - Disclosing correct income and paying taxes on time
5. Society as a whole - by optimum utilization of resources, following fair trade practices, not causing pollution.
Financial Planning
J.H. Boneville defines financial planning as:
Capital Structure
Two-fold aspects of financial planning:
- Financial policies adopted or intended to be adopted
Importance of Financial Planning
1. Helps in achieving growth:
Because of financial planning, a business can determine how much funds are required and the source of raising the same. Thus financial planning helps in getting the funds on time as a result helping in the expansion of the business.
Importance of Financial Planning
2. Improving image:
With financial planning, funds are available when payments are to be made hence there are no defaults resulting in the improvement in the image of the business.
3. Team Spirit:
Financial plan is a master plan and considers requirements of all departments. Therefore, the process of financial planning requires information from all the departments which are interlinked with each other. This process helps them to think in the same direction and helps build team spirit throughout the organization.
Importance of Financial Planning
4. Cost of funds:
Loans / Debentures / Public Deposits
Equity and Preference Dividend
This cost fluctuates due to various changes in the economy like change in tax rates, monetary policy, economic conditions, etc. Financial planning takes into consideration such changes.
5. Improves coordination:
All the divisions of business such as production, purchase, sale, distribution, finance, etc., have to work together to create an effective and efficient Financial Plan.
Importance of Financial Planning
6. Decision making:
Financial plan helps to take the decision as to whether there is a need for funds and accordingly either borrow or use retained earnings.
Capital Structure
Equity Share Capital
Capital means Long Term Funds
Structure means Composition
Preference Share Capital
Borrowed Capital
Components of Capital Structure
Retained Earnings
According to R. H. Wessel, capital structure is:
1. Equity share capital:
Money raised by the issue of equity shares is called equity share capital. The equity shareholders are the owners of the company and, like everyone, they bear the risk and enjoy returns in the form of a dividend. The dividend earned by equity shareholders is not fixed and it depends on the profits earned by the company.
Components of Capital Structure
2. Preference share capital:
Money raised by the issue of preference shares is referred to as preference share capital. Preference shareholders are given preference over equity shareholders while distributing dividends and also in repayment of capital at the time of liquidation. Further, they enjoy a fixed dividend every year. They also get to vote on matters related to them.
3. Borrowings:
A company can raise long-term funds by way of debt. A company can borrow funds from outsiders in the following ways:
1. Bonds, debentures, and public deposits
2. Loans
Components of Capital Structure
4. Retained profits:
Retained profits = Net Profit - Dividend distributed to shareholders
Retained profits are the profits of the business that remain after the dividend is paid to shareholders.
Factors influencing Capital Structure
Internal Factors
1. Size of business:
Small Business Large Business
Limited Borrowing Capacity Huge Borrowing Capacity
Greater risk for investors Less risk for investors
As less asset base As more assets base
Opts for Own Funds Opts for Both own funds and borrowed funds
2. Future capital requirements:
A company will not require funds only once. It may require funds at various stages. If the company requires a large amount of funds in the future, it may opt for debt funds at present and later raise funds by the issue of equity shares.
Internal Factors
3. Ideology of management:
Risk involved with borrowed capital. If borrowed capital is not repaid, the assets of the company can be sold to repay the amount.
Risk appetite ↓ Borrowings ↑
Risk appetite ↑ Borrowings ↓
Internal Factors
4. Nature of business:
Manufacturing Company Trading Company
Needs more funds for plant Needs less funds for plant
and machinery and machinery
Opts for Own Funds Opts for Own Funds
and Borrowed Funds
Internal Factors
5. Trading on equity:
Profit occurs in the following situation:
Therefore, a company which adopts trading on equity may raise funds by the issue of debentures and loans.
Example on trading on equity
Particulars | Company A | Company B
Equity Capital (FV 10/-) | 100,000 | 500,000
10% loan | 900,000 | 500,000
Total capital | 1,000,000 | 1,000,000
Net profit before interest | 200,000 | 200,000
Less: Interest | 90,000 | 50,000
Net profit for shareholders | 110,000 | 150,000
Total shares | 10,000 | 50,000
Earning per share | 11 | 3
Company A has more debt funds than Company B. The rate of return on investment is 20 percent (200,000*100/1,000,000). The cost of debt is 10 percent. As long as the rate of return is more than the cost of debt, it will always be beneficial to have more debt than equity as can be seen from the above example. In the current scenario, the capital structure of company A is favorable. However, if the rate of return falls below the cost of debt, the capital structure of company B will be more favorable.
Internal Factors
6. Expected business risk:
Interest has to be paid when funds are borrowed irrespective of profit or loss. Payment of dividend is not mandatory and the company which suffers a loss may choose not to pay dividend.
Greater risk → Borrowings ↑
Lower risk → Borrowings ↓
Internal Factors
7. Requirement period:
Long Period - Regular basis
Short Period - Specific Purpose
Equity Share - Loans or Debentures
Internal Factors
8. Nature of cash flow:
Cash inflow from sales - Interest and principal on loan is to be paid periodically - Continuous fixed outflow of money.
Stable cash flow → Borrowings ↑
Unstable cash flow → Borrowings ↓
Internal Factors
9. Age of company:
New company - difficult to borrow funds from outsiders
Old companies - opt for mix of equity and debt - easier and cheaper
Internal Factors
10. Level of control:
If Equity shareholders do not want to dilute their holding they will opt for Debt Funds.
External Factors
1. Expected cost of capital:
The rate of return to be paid to the providers of capital is the “cost of capital”. Equity shareholders - higher risk - high rate of return. Preference shareholders and debenture holders - lower risk - lower rate of return.
External Factors
2. Extent of development of capital market:
Capital Market is the place where equity shares are traded. Good network of capital market → Investors willing to invest in equity shares ↑
3. Terms of lending:
Rate of interest for raising debt - Complex terms of lending - Issue of preference shares / equity shares
4. Economical conditions
Generally, when an economy is going through a recession, the investor sentiment is low and people stay away from equity shares as it involves high risk.
Practical example: In the early part of 2013, two IPOs were withdrawn due to poor investor response (Hindustan Times Report on 5th May, 2013).
External Factors
5. Risk appetite of investors:
Investor | Risk Taker | Conservative
Invest in equity shares | Invest in debentures
not get returns | Income
6. Need to consider taxes:
If tax rates are high, debt funds preferred as interest is deductible expenditure.
7. Attitude of rating agencies:
If the rating agencies give poor ratings to debentures of a company, then the company may have to source a major part of its funds by issue of equity shares.
Generally, if the competition is high, the profit margins are low. In such cases, the company would prefer equity funds over debt funds.
Government policies
The ratio of debt funds to equity funds of a company is called the “debt-equity” ratio. The Securities Exchange Board of India (SEBI) has prescribed a maximum debt-equity ratio of 2:1 i.e., the debt in a company’s balance sheet cannot exceed twice the amount of subscribed equity share capital. Thus, companies have to take into consideration rules and regulations of the government.
Fixed Capital
Fixed capital is that portion of total capital which is invested in fixed assets such as land, buildings, equipment, etc. It is real or physical assets that are not used directly in the production of goods.
National Accounts defines Fixed Capital as “The stock of tangible, durable goods or used by resident producers for more than one year.”
Factors that affect Fixed Capital Requirement
1. Size of business:
The bigger the business, the more is the fixed capital requirement. Size may be measured in terms of turnover, assets, number of employees, etc.
2. Use of technology:
Use of modern technology requires a large amount of fixed capital as such technology is very costly. On the other hand, labor-intensive or traditional technology does not require a very high fixed capital.
3. Nature of business:
Generally, large engineering companies, construction companies, hotels, public utility providing companies (electricity, railways, airways) etc. have large fixed capital requirements.
LARSEN & TOUBRO LIMITED JET AIRWAYS JW MARRIOTT
4. Scope of business activities:
If the scope of business is vast, then it requires large fixed capital. For example: Since “Jumbo King” manufactures, distributes, and sells vada pavs by itself, it requires huge capital for manufacturing, distribution, and setting up stalls.
5. Expansion plans:
If a business is planning to expand its operations by setting up a new manufacturing unit, its fixed capital requirement will be high.
More Fixed Capital Less Fixed Capital
requirement during requirement during
expansion consolidation
Working Capital
Current assets are short-term assets such as cash, short-term securities, amounts receivable, inventories, etc.
Current liabilities are short-term liabilities such as creditors, short-term loans, bills payable, etc.
Bead, Baker, and Mallot have defined the term ‘working capital’ as the excess of current assets over current liabilities.
Factors that affect Working Capital Requirement
1. Conditions of purchase and sale:
If the company enjoys a good credit from its suppliers (creditors), it requires less working capital. Similarly, if the company allows a longer credit period to its debtors, the working capital requirement will be more.
2. Affected by size of business:
A big company has a large number of operations, has to maintain a huge amount of stock, and may also have a large amount of debtors outstanding. Hence, it requires more Working Capital. For example, the working capital of Big Bazaar is more than the working capital of a local kirana store.
3. Production time cycle:
If the time taken to convert raw material to finished product is long, higher working capital is required because the business has to sustain expenses for a long period of time till the finished product is sold and converted to cash.
4. Intensity of competition:
In the case of a competitive market, a company has to maintain a large inventory as buyers may shift to a competitor's product if the goods are not available in the market. In such market conditions, the working capital requirement is high.
5. The nature of business:
A service sector company like bus transport requires less working capital. On the other hand, Big Bazaar has to stock a lot of goods and requires comparatively higher working capital.
6. Affected by seasonal fluctuations:
Seasonal businesses have fluctuating working capital. For example, a ceiling fan manufacturing company has peak sales during summer. Working capital needs increase in summer.
7. Liquidity requirement:
Large cash dealings require more liquid funds. Unpredictable payment cycles require more liquid funds. Therefore, such businesses have a high working capital requirement.
8. Business cycle:
Boom period - Sales increase — more working capital needed.
Recession - Sales decrease — less working capital needed.
9. Development plans:
If management becomes aggressive with expansion, large working capital is needed. If management expects modest growth, less working capital is required.
10. External factors:
If the company gets funds on short notice and at cheap rates from banks or financial institutions, it requires less capital. If financial institutions do not provide funds on easy terms, a higher working capital is needed.