Financial Management Class 12 Notes

Financial management is the management of the financial aspects of the enterprise, that is the raising of the funds and their use, and the chapter opens by stating the concept, the role it plays in the organisation and the objectives it pursues.

• In the narrow sense, financial management is the finance function, the corporate finance, and it consists only of the decisions about the raising of the funds and about their use.
• In the modern sense, financial management is concerned with the management of all the financial decisions of the firm, and it is not limited to the finance department, because the marketing manager, the production manager and the personnel manager all take financial decisions within their own department.
• The role of the financial management in the organisation has four parts. It arranges the funds, that is it decides how much is to be raised, from which source and at what cost. It allocates the funds to the various activities of the business. It takes the decisions of the investment, the financing and the dividend. And it keeps the whole business on a sound financial footing, so that the firm can meet its obligations to the creditors, to the workers and to the government.
• The objectives of the financial management are the wealth maximisation, the profit maximisation and the sales maximisation, and the wealth maximisation is regarded as the best of the three because it is the only one that looks at the long run.
• The wealth of the shareholders is the market value of their shares, and the financial management maximises it by taking the decisions that raise the long-run return and keep the risk of the business at an acceptable level, and the profit maximisation is rejected because the profit can be raised in the short run at the cost of the long run, and the sales maximisation is rejected because the sales can grow while the profit disappears.
• The three objectives differ in what they measure. The wealth maximisation measures the market value of the shares and it considers the long run, the risk and the returns to all the claimants. The profit maximisation measures the accounting profit of a period and it considers only the shareholder. And the sales maximisation measures the revenue of the sales and it considers the volume only.

The three financial decisions are the three answers to the three questions of the manager, what to do with the money, where to get the money from and what to do with the profit.

• The investment decision is the decision about the assets in which the funds of the firm will be invested, that is the allocation of the funds, and it is taken first because the money has to be put somewhere before anything else can be decided, and it is also called the capital budgeting decision.
• The financing decision is the decision about the mix of the capital, that is how much of the requirement is to be met by the owner's funds and how much by the borrowed funds, and it decides the capital structure of the firm, and it is taken after the investment because it is the investment that says how much is needed.
• The dividend decision is the decision about how much of the profit is to be distributed to the shareholders and how much is to be retained for the growth, and it is also the decision about the internal financing of the firm, and it is taken last because it is the residual that is left after the investment and the financing.
• The three decisions are inter-dependent, and a decision on one constrains the other two, so that a firm that raises a large debt to finance a long-term project has changed both its capital structure and its risk, and it may then be unable to pay a large dividend.
• The order of the three is the investment, the financing and the dividend, and the investment comes first because the amount and the risk of the investment decide the amount and the kind of the finance that is needed, and the dividend comes last because the profit that is to be distributed is what is left after the investment and the financing have been settled.

No financial decision is taken in the air, and the syllabus asks for the factors that bear on each of the three, so they are taken one at a time here.

• The factors affecting the investment decision are the return expected from the project against the cost of the funds that will be used for it, the risk that the project will not deliver what is expected, the time in which the return comes, the liquidity of the investment, and the strategic fit of the project with the existing business of the firm.
• The factors affecting the financing decision are the cost of the debt against the cost of the equity, the risk that the fixed interest has to be paid whether the firm earns or not, the control that the owners will retain after the finance is raised, the tax treatment of the interest, the flexibility that is left to raise further funds, and the period for which the funds are needed.
• The factors affecting the dividend decision are the cash position of the firm at the time, the growth opportunities that need the profit to be retained, the return that the shareholders are earning in the market, the tax position of the shareholder, the stability of the earnings of the firm, and the payout ratio that the company has been following in the past.
• There are also the factors that are common to all the three, the stage of the life cycle of the firm, the level of the interest rate in the economy, the conditions of the capital market at the time, the size of the firm, and the degree of the risk that the management is willing to take.
• The factors are stated in the form of questions in an examination, and the form of the answer is the same. For the investment, is the return worth the risk. For the financing, is the debt safe and is it cheap. For the dividend, should the shareholder be given the cash or should the firm keep it for the growth.

Financial planning is the process of translating the long-term objectives of the enterprise into a set of the short-term financial statements, the balance sheet and the income statement, so that the firm knows what it must earn, what it must spend and where the money is to come from.

• In the narrow sense, financial planning is the estimation of the funds required and the preparation of the financial statements of the firm.
• In the wider sense, financial planning is the whole process of the financial management, and it begins with the objectives of the firm, it goes through the financial forecasting, the deciding of the capital structure, the preparation of the financial statements, and it ends with the setting of the financial policies, so that every part of the business is planned in money terms.
• The objectives of the financial planning are to see that the funds are available in the right quantity and at the right time, to provide a basis for the control of the expenditure, to keep the cost of the capital at the minimum, to provide a means of the coordination between the departments, to make the best use of the retained earnings, and to ensure the survival of the firm in a competitive environment.
• The importance of the financial planning is that it removes the guesswork from the financing, because the firm knows in advance how much it will need and for how long, and it gives the basis of the control, because the actual performance can be compared with the budget, and it makes the coordination possible, because every department is given a target in money terms.
• The importance is also in the relationship with the taxation, because the tax is a charge on the profit and the planning is done after the tax, and in the flexibility, because the firm that has planned can meet an unexpected demand while the firm that has not must borrow at the last moment on disadvantageous terms.
• A financial plan is normally a financial budget, and the budget is expressed in the three statements, the cash budget, the budgeted income statement and the budgeted balance sheet, and these three together are called the financial plan of the firm.

The capital structure is the long-term financing of the firm, and it is decided by the proportion in which the long-term funds are raised from the owners and from the creditors.

• The capital structure is the mix of the long-term sources of the finance, and the sources are the owner's funds, the share capital and the reserves and the reserves, and the borrowed funds, the debentures and the long-term loans, and the proportion of the debt to the equity in the total long-term finance is the capital structure.
• The debt equity ratio is the measure of the capital structure, and it is the ratio of the borrowed funds to the owners' funds, and a firm that is financed wholly by the owners has a ratio of zero, and a firm financed wholly by the debt has an infinite ratio, and the capital structure theory asks what ratio is the ideal one.
• The cost of the debt is lower than the cost of the equity, because the interest is a deductible expense for the tax, so every rupee of the debt reduces the tax, and this is the reason why the firm is tempted to borrow, but the interest is a fixed charge that has to be paid whether the firm earns or not.
• The gearing refers to the proportion of the debt in the capital structure, and a highly geared firm has a large debt, and the leverage is the effect of the fixed interest on the earnings available to the owners, and the operating leverage is the effect of the fixed costs on the earnings and the financial leverage is the effect of the debt.
• The factors that determine the capital structure are the leverage, the risk, the cost, the control and the flexibility. The leverage says that a low gearing reduces the risk and a high gearing raises the return to the owners when the earnings rise. The risk is the chance of the loss, and it rises with the debt. The cost is lower for the debt but the compulsory interest must be paid. The control is diluted when the new shares are issued, and the creditors gain control over the assets. And the flexibility is the ability to raise further funds without disturbing the existing pattern, and a firm with a high debt has little of it left.
• There are two views on the ideal structure. The net income approach says that the firm should maximise the value of the market price of the shares, and it favours a moderate gearing. And the operating income approach says that the firm should not let the earning power of the assets fall, because the value of the shares then depends only on the operating income, and the income of the firm is then at its maximum when the interest is just equal to the earnings of the firm before the interest and the tax.

The capital of a firm is of two kinds, the fixed capital that is used to buy the long-lived assets, and the working capital that is used to run the business from day to day, and the two move in opposite directions in the life of the firm.

• The fixed capital, also called the permanent capital, is the capital that is invested in the long-term assets like the plant, the machinery, the land and the buildings, and it is financed by the owner's funds and the long-term loans, and its necessity does not arise at a fixed level but in blocks, since a machine is bought when it is needed and not in fractions of a rupee.
• The working capital, also called the current capital or the circulating capital, is the capital that is used to meet the day-to-day operating expenses, the purchase of the raw material, the wages of the workers, the rent, the power and the office expenses, and it is financed by the short-term sources like the bank overdraft, the cash credit, the trade credit and the accruals, and the need for it arises evenly through the year.
• The difference between the two is five, the period, the purpose, the source, the nature of the need and the risk. The fixed capital is invested for the long term and the working capital for the short term. The fixed capital is used to create the capacity to produce and the working capital to pay for the operations. The fixed capital comes from the owners and the long-term loans and the working capital from the short-term sources. The need for the fixed capital arises in blocks and the need for the working capital arises evenly. And the working capital is the more risky of the two, because the firm may be unable to meet the day-to-day claims even while the factory stands.
• The factors affecting the need for the working capital are the nature of the business and the operating cycle, and a firm that gives the credit sells slowly, so the operating cycle is long, and the working capital requirement is long, while a firm that sells for cash needs very little.
• The other factors are the rules of the stock exchange, the credit terms offered by the suppliers, the degree of the liquidity of the stock, the level of the current assets and the current liabilities, the conditions of the market and the growth of the firm, because a firm that is growing must hold more stock and more debtors, and a firm that has to pay the tax in a lump sum must hold cash for it.
• The ideal working capital is the amount that is just enough, and it is not the maximum, because the excess working capital is a waste, it earns nothing, and it carries an opportunity cost, while a working capital that is too little means that the firm cannot pay the wages on the due date and the creditors stop the supply, and the operations of the firm come to a standstill.