Financial Management and 3 important decisions.

Financial Management consider both long term and short term planning

Finance, as we all know, is essential for running a business.

Financial Management is essentially concerned with issues relating to how well the funds are deployed in assets and operations, and how timely and economically the finances are arranged from outside or from the business.

The success of a business depends on how well finance is invested in assets and operations and how timely and cheaply the finances are arranged, from outside or from within the business.

Don’t worry if you find some of above statements like very technical or not know when you will need them.

Give a chance to this post to help you make familiar with all you need to know about the basics of Financial Management.

What is Financial Management?

Financial Management is essentially concerned with issues relating to how well the funds are deployed in assets and operations, and how timely and economically the finances are arranged from outside or from the business.

Is Debt better than Equity?

For example, debt is considered to be the cheapest of all the sources, tax deductibility of interest makes it still cheaper.
Associated risk is also different for each source, e.g., it is necessary to pay interest on debt and redeem the principal amount on maturity.
There is no such compulsion to pay any dividend on equity shares.

What are 3 Important Financial Decisions?

Financial Management is concerned with the management of the flow of funds and involves decisions relating to the procurement of funds (financing decisions), investment of funds (investing decisions), and distribution of earnings to owners (dividend decisions).

What is Capital Structure?

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

Financial Management – The Introduction

Financial Management is concerned with procurement as well as the usage of finance.

For optimal procurement, different available sources of finance are identified and compared in terms of their costs and associated risks.

Similarly, the finance so procured needs to be invested in a manner that the returns from the investment exceed the cost at which procurement has taken place.

Why Financial Management is important?

Financial Management aims at reducing the cost of funds procured, keeping the risk under control, and achieving effective deployment of such funds.

It also aims at ensuring the availability of enough funds whenever required as well as avoiding idle finance. Needless to emphasize, the future of a business depends a great deal on the quality of its financial management.

The financial statements, such as Balance Sheet and Profit and Loss Account, reflect a firm’s financial position and financial health.

Almost all items in the financial statements of a business are affected directly or indirectly through some financial management decisions.

Some good examples might be:-

(a). The size and the composition of fixed assets of the business: For example, a capital budgeting decision to invest a sum of Rs. 100 crores in fixed assets would raise the size of the fixed assets block by this amount.

(b). The amount of long-term and short-term funds to be used: Financial management, among others, involves decisions about the proportion of long-term and short-term funds. An organization wanting to have more liquid assets would raise relatively more amount on a long-term basis.

You should think in both the long term and short term in Financial Management.
You should think of both the long term and short term in Financial Management.

There is a choice between liquidity and profitability. The underlying assumption here is that current liabilities cost less than long term liabilities.

(c). Break-up of long-term financing into debt, equity, etc: Of the total long-term finance, the proportions to be raised by way of debt and/or equity is also a financial management decision. The amounts of debt, equity share capital, preference share capital are affected by the financing decision, which is a part of financing management.

Thus, the overall financial health of a business is determined by the quality of its financial management.

Good financial management aims at mobilisation of financial resources at lower cost and deployment of these in most profitable activities.

Objectives of Financial Management

The primary objective of financial management is to maximize the shareholders’ wealth, which means the maximization of the current market price of equity shares of the company.

Shareholders’ wealth maximization is linked to the maximization of the market price of a company’s share because funds belong to the shareholders and the manner in which they are invested and the return earned by them determines their market value and price.

It means the maximization of the market value of equity shares.

The market price of equity share increases, if the benefit from a decision exceeds the cost involved.

Maximization of shareholders’ wealth is achieved by:-

(a). Ensuring availability of sufficient funds at reasonable cost.

(b). Ensuring effective utilization of resources – when a decision is taken about investment in a new machine, the aim of financial management is to ensure that benefits from the investment exceed the cost so that some value addition takes place.

(c). Ensuring the safety of funds – Financial Management must aim at ensuring the safety of funds procured by creating reserves, reinvesting profits, etc.

3 Important Financial Decisions

Financial Management is concerned with the management of the flow of funds and involves decisions relating to the procurement of funds (financing decisions), investment of funds (investing decisions), and distribution of earnings to owners (dividend decisions).

Investment Decisions in Financial Management

A firm’s resources are scarce in comparison to the uses to which they can be put.

A firm, therefore, has to choose where to invest these resources, so that they are able to earn the highest possible return for their investors.

The investment decision, therefore, relates to how the firm’s funds are invested in different assets.

Investment decision can be longterm or short-term.

A long-term investment decision is also called a Capital Budgeting decision. It involves committing the finance on a long-term basis.

3 Important Decisions in Financial Management
3 Important Decisions in Financial Management

For example, making an investment in a new machine to replace an existing one or acquiring a new fixed asset or opening a new branch, etc. These decisions are very crucial for any business since they affect its earning capacity in the long run.

The size of assets, profitability and competitiveness are all affected by capital budgeting decisions.

Moreover, these decisions normally involve huge amounts of investment and are irreversible except at a huge cost.

Therefore, once made, it is often almost impossible for a business to wriggle out of such decisions.

Therefore, they need to be taken with utmost care.

These decisions must be taken by those who understand them comprehensively.

A bad capital budgeting decision normally has the capacity to severely damage the financial fortune of a business.

Short-term investment decisions (also called working capital 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. These affect the liquidity as well as the profitability of a business in financial management.

Efficient cash management, inventory management and receivables management are essential ingredients of sound working capital management.

Factors affecting investment decisions:-

(a). Rate of return of the project ;- 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.

Suppose, there are two projects, A and B (with the same risk involved), with a rate of return of 10 per cent and 12 per cent, respectively, then under normal circumstance, project B should be selected.

(b). The cash flow of the project

(c). Investment criteria involved :- The decision to invest in a particular project involves a number of 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.

These techniques are applied to each proposal before selecting a particular project.

Financing Decisions in Financial Management

This decision is about the quantiy of finance to be raised from various long-term sources.

Short-term sources are studied under the ‘working capital management’.

It involves identification of various available sources. The main sources of funds for a firm are shareholders’ funds and borrowed funds.

The shareholders’ funds refer to the equity capital and the retained earnings.

Borrowed funds refer to the finance raised through debentures or other forms of debt.

A firm has to decide the proportion of funds to be raised from either sources, based on their basic characteristics.

Interest on borrowed funds have to be paid regardless of whether or not a firm has earned a profit.

Likewise, the borrowed funds have to be repaid at a fixed time.

The risk of default on payment is known as a financial risk which has to be considered by a firm likely to have insufficient shareholders to make these fixed payments in financial management.

Shareholders’ funds, on the other hand, involve no commitment regarding the payment of returns or the repayment of capital.

A firm, therefore, needs to have a judicious mix of both debt and equity in making financing decisions, which may be debt, equity, preference share capital, and retained earnings.

Is Debt better than Equity?

The cost of each type of finance has to be estimated. Some sources may be cheaper than others.

For example, debt is considered to be the cheapest of all the sources, tax deductibility of interest makes it still cheaper.

Associated risk is also different for each source, e.g., it is necessary to pay interest on debt and redeem the principal amount on maturity.

There is no such compulsion to pay any dividend on equity shares.

Thus, there is some amount of financial risk in debt financing.

The overall financial risk depends upon the proportion of debt in the total capital.

The fund raising exercise also costs something. This cost is called floatation cost. It also must be considered while evaluating different sources.

Financing decision is, thus, Financial Decisions concerned with the decisions about how much to be raised from which source.

This decision determines the overall cost of capital and the financial risk of the enterprise.

Factors affecting Financing decisions:-

(a). Cost: The cost of raising funds through different sources are different. A prudent financial manager would normally opt for a source which is the cheapest.

(b) Risk: The risk associated with each of the sources is different.

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

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

(e) 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 cost is less, more of debt financing may be preferred.

(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 would prefer debt to equity in financial management.

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

Dividend Decisions in Financial Management

The third important decision that every financial manager has to take relates to the distribution of dividend.

Dividend is that portion of profit which is distributed to shareholders.

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.

While the dividend constitutes the current income re-investment as retained earning increases the firm’s future earning capacity.

The extent of retained earnings also influences the financing decision of the firm.

Since the firm does not require funds to the extent of re-invested retained earnings, the decision regarding dividend should be taken keeping in view the overall objective of maximising shareholder’s wealth.

Factors affecting Dividend Decisions

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

(b) Stability Earnings: Other things remaining the same, a company having stable earning is in a better position to declare higher dividends.

As against this, a company having unstable earnings is likely to pay smaller dividend.

(c) Stability of Dividends: Companies generally follow a policy of stabilising dividend per share.

The increase in dividends is generally made when there is the confidence that their earning potential has gone up and not just the earnings of the current year in financial management.

In other words, dividend per share is not altered if the change in earnings is small or seen to be temporary in nature.

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

The dividend in growth companies is, therefore, smaller, than that in the non– growth companies.

(e) Cash Flow Position: The payment of dividend involves an outflow of cash. A company may be earning profit but may be short on cash. Availability of enough cash in the company is necessary for declaration of dividend.

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

If the shareholders in general desire that at least a certain amount is paid as dividend, the companies are likely to declare the same.

There are always some shareholders who depend upon a regular income from their investments.

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

If tax on dividend is higher, it is better to pay less by way of dividends. As compared to this, higher dividends may be declared if tax rates are relatively lower.

Though the dividends are free of tax in the hands of shareholders, a dividend distribution tax is levied on companies in financial management.

Thus, under the present tax policy, shareholders are likely to prefer higher dividends.

(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. Thus, the possible impact of dividend policy on the equity share price is one of the important factors considered by the management while taking a decision about it.

(i) Access to Capital Market: Large and reputed companies generally have easy access to the capital market and, therefore, may depend less on retained earning 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 Companies Act place restrictions on payouts as dividend. Such provisions must be adhered to while declaring the dividend.

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

The companies are required to ensure that the dividend does not violate the terms of the loan agreement in this regard.

Why do you need to know about Capital Structure?

On the basis of ownership, the sources of business finance can be broadly classified into two categories i.e are ‘owners’ funds’ and ‘borrowed funds’.

Owners’ funds consist of equity share capital, preference share capital and reserves and surpluses or retained earnings.

Borrowed funds can be in the form of loans, debentures, public deposits etc.

These may be borrowed from banks, other financial institutions, debenture holders and public.

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

It is one of the most overlooked aspects of Financial Management. If you are enjoying it so far, then the post on Financial Market can be a good read.

Capital Structure in Financial Management
Capital Structure in Financial Management

These shall be referred as equity and debt in the subsequent text.

It can be calculated as debt-equity ratio.

Debt and equity differ significantly in their cost and riskiness for the firm.

The cost of debt is lower than the cost of equity for a firm because the lender’s risk is lower than the equity shareholder’s risk, since the lender earns an assured return and repayment of capital and, therefore, they should require a lower rate of return.

Additionally, interest paid on debt is a deductible expense for computation of tax liability whereas dividends are paid out of after-tax profit.

Increased use of debt, therefore, is likely to lower the over-all cost of capital of the firm provided that the cost of equity remains unaffected.

Any default in meeting these commitments may force the business to go into liquidation.

There is no such compulsion in case of equity, which is therefore, considered riskless for the business.

Higher use of debt increases the fixed financial charges of a business.

As a result, increased use of debt increases the financial risk of a company.

Financial risk is the chance that a firm would fail to meet its payment obligations.

Capital structure of a company, thus, affects both the profitability and the financial management decisions.

A capital structure 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 in financial management.

In other words, all decisions relating to capital structure should emphasise on increasing the shareholders’ wealth. The proportion of debt in the overall capital is also called financial leverage.

Factors affecting Capital Structure:-

Deciding about the capital structure of a firm involves determining the relative proportion of various types of funds.

This depends on various factors. For example, debt requires regular servicing. Interest payment and repayment of principal are obligatory on a business.

In addition a company planning to raise debt must have sufficient cash to meet the increased outflows because of higher debt. Similarly, important factors which determine the choice of capital structure are as follows:

(a). Cash Flow Position: Size of projected cash flows must be considered before borrowing.

Cash flows must not only cover fixed cash payment obligations but there must be sufficient buffer also. It must be kept in mind that a company has cash payment obligations for

  • normal business operations;
  • for investment in fixed assets; and
  • for meeting the debt service commitments i.e., payment of interest and repayment of principal.

(b). Interest Coverage Ratio (ICR): The interest coverage ratio refers to the number of times earnings before interest and taxes of a company covers the interest obligation.

The higher the ratio, lower shall be the risk of company failing to meet its interest payment obligations.

However, this ratio is not an adequate measure.

A firm may have a high EBIT but low cash balance. Apart from interest, repayment obligations are also relevant.

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

The cash profits generated by the operations are compared with the total cash required for the service of the debt and the preference share capital.

A higher DSCR indicates better ability to meet cash commitments and consequently, the company’s potential to increase debt component in its capital structure.

(d). Return on Investment (RoI): If the ROI of the company is higher, it can choose to use trading on equity to increase its EPS, i.e., its ability to use debt is greater in financial management.

We have already observed that a firm can use more debt to increase its EPS. However, in Example II, use of higher debt is reducing the EPS.

It is because the firm is earning an RoI of only 6.67% which lower than its cost of debt. In example I the RoI is 13.33%, and trading on equity is profitable. It shows that, RoI is an important determinant of the company’s ability to use Trading on equity and thus the capital structure.

(e). Cost of debt: A firm’s ability to borrow at a lower rate increases its capacity to employ higher debt. Thus, more debt can be used if debt can be raised at a lower rate.

(f). Tax Rate: Since interest is a deductible expense, cost of debt is affected by the tax rate.

The firms in our examples are borrowing @ 10%. Since the tax rate is 30%, the after tax cost of debt is only 7%.

A higher tax rate, thus, makes debt relatively cheaper and increases its attraction vis-à-vis equity.

(g). Cost of Equity: Stock owners expect a rate of return from the equity which is commensurate with the risk they are assuming. When a company increases debt, the financial risk faced by the equity holders, increases.

Consequently, their desired rate of return may increase. It is for this reason that a company can not use debt beyond a point.

If debt is used beyond that point, cost of equity may go up sharply and share price may decrease inspite of increased EPS in financial management.

Consequently, for maximisation of shareholders’ wealth, debt can be used only upto a level.

(h). Floatation Costs: Process of raising resources also involves some cost. Public issue of shares and debentures requires considerable expenditure. Getting a loan from a financial institution may not cost so much. These considerations may also affect the choice between debt and equity and hence the capital structure.

(I). Risk Consideration: As discussed earlier, use of debt increases the financial risk of a business.

Financial risk refers to a position when a company is unable to meet its fixed financial charges namely interest payment, preference dividend and repayment obligations.

Apart from the financial risk, every business has some operating risk (also called business risk).

Business risk depends upon fixed operating costs. Higher fixed operating costs result in higher business risk and vice-versa.

The total risk depends upon both the business risk and the financial risk. If a firm’s business risk is lower, its capacity to use debt is higher and vice-versa.

(j). Flexibility: If a firm uses its debt potential to the full, it loses the flexibility to issue further debt in financial management.

To maintain flexibility, it must maintain some borrowing power to take care of unforeseen circumstances.

Now its your turn

I took massive references from the CBSE guide for writing this post and also my subject from Organisational Behaviour.

I hope that I am doing some good by writing this kind of post.

To be honest with you I am not gonna write any post that strictly follows the theme of 11 and 12 standard. You can check them also by going to the blog from the menu.

I wrote some posts in past that cover some important chapters from Business Studies.

But from now on I will be writing posts that will give insights from different perspectives and I will try to present the best view possible.

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At last I just want to finish by saying.

A very big thank you if you are reading this.

Take care and be healthy.

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