Big picture
Every business decision involves money: where to get it, where to put it, and what to do with the profit. Financial management is concerned with the optimal procurement and usage of finance.
The chapter is organised around three financial decisions: the investment decision (where to invest), the financing decision (where to raise funds from) and the dividend decision (how much profit to distribute). It then covers financial planning, capital structure and the fixed and working capital a business needs. Exam questions often describe a company's situation and ask which factor is influencing a decision.
Learning goals
Explain the meaning, role and objective of financial management.
Explain the investment, financing and dividend decisions and the factors affecting each.
Explain financial planning, its objectives and importance.
Explain capital structure, financial risk and trading on equity, with a worked EPS example.
Explain the factors affecting capital structure.
Explain the factors affecting fixed and working capital requirements.
Core ideas
1. Meaning and objective
Financial management means the efficient acquisition, allocation and use of funds. Its role is visible in the size and composition of fixed assets, the amount and composition of current assets, the mix of long-term and short-term finance, the mix of debt and equity, and every item in the profit and loss account.
Objective: wealth maximisation. The primary aim is to maximise shareholders' wealth, which is reflected in the market price of the company's equity shares. A decision that increases the share price (by earning returns above the cost of funds, with acceptable risk) is a good financial decision.
2. Investment decision
The investment decision decides how the firm's funds are invested in different assets.
Long-term investment decisions (capital budgeting): buying a new machine, opening a new plant, acquiring another business. They are crucial because they affect the firm's earning capacity for years, involve large amounts, are risky, and are irreversible except at a huge cost.
Short-term investment decisions (working capital decisions): how much to keep in cash, inventory and receivables. They affect day-to-day liquidity and profitability.
Factors affecting capital budgeting decisions
Cash flows of the project: the expected inflows and outflows over the project's life.
Rate of return: the expected return and risk of each project.
Investment criteria involved: techniques such as payback period and net present value that compare projects.
3. Financing decision
The financing decision is about the quantum of finance to be raised from various long-term sources: shareholders' funds (equity, retained earnings) and borrowed funds (debentures, loans).
Shareholders' funds | Borrowed funds |
|---|---|
No fixed commitment to pay; dividend depends on profit | Fixed commitment to pay interest and repay the principal |
No financial risk | Increases financial risk |
More costly (equity holders expect more because they bear more risk) | Cheaper; interest is tax-deductible |
New equity can dilute control | No dilution of control |
Factors affecting the financing decision
Cost: the cost of raising funds from each source; a prudent manager prefers the cheapest source.
Risk: each source carries a different degree of risk; debt is riskier for the company than equity.
Floatation costs: costs of issuing securities (brokerage, underwriting); higher floatation costs make a source less attractive.
Cash flow position: a strong cash flow makes debt financing more viable.
Fixed operating costs: if fixed operating costs are high (rent, salaries, insurance), the firm should avoid adding fixed financial costs.
Control considerations: issuing more equity dilutes the owners' control; debt does not.
State of the capital market: in a rising (bull) market, equity is easier to raise; in a depressed market, debt may be preferred.
4. Dividend decision
The dividend decision is about how much of the profit to distribute to shareholders and how much to retain for growth.
Factor | Effect |
|---|---|
Amount of earnings | Dividends are paid out of current and past earnings; higher earnings allow higher dividends |
Stability of earnings | A company with stable earnings can pay higher dividends |
Stability of dividends | Companies try to keep dividends per share steady and raise them only when earnings rise permanently |
Growth opportunities | Companies with good growth prospects retain more and pay less |
Cash flow position | Dividends need cash; a profitable company short of cash may pay less |
Shareholders' preference | Many shareholders expect regular dividends |
Taxation policy | If dividends are taxed more heavily than capital gains, companies may pay less |
Stock market reaction | An increase in dividend is generally taken as good news and lifts the share price |
Access to capital market | Large firms that can raise funds easily can pay higher dividends |
Legal constraints | The Companies Act restricts dividends (they must come from profits) |
Contractual constraints | Loan agreements may restrict dividends until loans are repaid |
5. Financial planning
Financial planning is preparing a financial blueprint of the organisation's future operations. It ensures that the right amount of funds is available at the right time, and that no funds are left idle.
Objectives: (1) to ensure availability of funds whenever required, including estimating the amount and timing and the sources; (2) to see that the firm does not raise resources unnecessarily, since surplus funds add cost.
Importance: it helps forecast what may happen and prepares the firm for shocks; avoids business shocks and surprises; coordinates the various business functions (sales, production) with finance; reduces waste and duplication; links the present with the future; links investment and financing decisions; and makes evaluation of actual performance easier.
6. Capital structure and trading on equity
Capital structure is the mix of owners' funds (equity, retained earnings) and borrowed funds (debt) in long-term finance. It is often expressed as the debt-equity ratio.
Financial leverage is the proportion of debt in total capital. Trading on equity means using fixed-cost debt to increase the return to equity shareholders (EPS). It works only when the return on investment (ROI) is higher than the rate of interest on debt.
Worked example. A company needs ₹30 lakh. Its expected EBIT is ₹6 lakh (ROI 20%). The tax rate is 30%. Option A: all equity, 3,00,000 shares of ₹10. Option B: ₹10 lakh equity (1,00,000 shares) and ₹20 lakh debt at 10%.
Particulars | Option A (all equity) | Option B (debt and equity) |
|---|---|---|
EBIT | 6,00,000 | 6,00,000 |
Less: Interest | Nil | 2,00,000 |
EBT | 6,00,000 | 4,00,000 |
Less: Tax at 30% | 1,80,000 | 1,20,000 |
EAT | 4,20,000 | 2,80,000 |
Number of shares | 3,00,000 | 1,00,000 |
EPS | ₹1.40 | ₹2.80 |
ROI (20%) is above the interest rate (10%), so using debt doubles the EPS.
Now suppose EBIT falls to ₹2,40,000 (ROI 8%, below the interest rate). Option A: EAT = 2,40,000 × 70% = ₹1,68,000, EPS ₹0.56. Option B: EBT = 2,40,000 − 2,00,000 = ₹40,000; EAT ₹28,000; EPS ₹0.28. Debt now reduces EPS. This is why debt increases financial risk.
7. Factors affecting the choice of capital structure
Factor | How it influences the choice |
|---|---|
Cash flow position | Strong, stable cash flows support more debt |
Interest coverage ratio (ICR) | EBIT ÷ interest; a higher ICR means more debt can be taken safely |
Debt service coverage ratio (DSCR) | Cash available ÷ (interest + principal repayment); a higher DSCR allows more debt |
Return on investment (ROI) | If ROI is higher than the cost of debt, trading on equity is profitable |
Cost of debt | Cheaper debt encourages more borrowing |
Tax rate | Interest is tax-deductible, so a higher tax rate makes debt cheaper after tax |
Cost of equity | Too much debt raises shareholders' risk, so they demand a higher return |
Floatation costs | Issuing equity usually costs more than borrowing from a bank |
Risk consideration | Total risk (business risk plus financial risk) must stay acceptable |
Flexibility | Keeping some borrowing capacity unused allows debt to be raised in emergencies |
Control | Debt does not dilute management's control; equity does |
Regulatory framework | SEBI and lending rules affect how funds can be raised |
Stock market conditions | Equity is easier to issue in a bull market |
Capital structure of other companies | Industry norms act as a guide |
8. Fixed capital
Fixed capital is invested in long-term assets (land, buildings, machinery). These decisions are important because they affect growth, profitability and risk over the long term, involve large sums, and are irreversible except at a big loss.
Factors affecting fixed capital requirements
Factor | Example |
|---|---|
Nature of business | A manufacturer needs more fixed capital than a trader |
Scale of operations | A large steel plant needs more fixed capital than a small foundry |
Choice of technique | Capital-intensive techniques need more fixed capital than labour-intensive ones |
Technology upgradation | Industries where technology becomes obsolete fast (computers) need more frequent fixed investment |
Growth prospects | Firms planning expansion need more fixed capital |
Diversification | Adding new product lines needs more fixed capital |
Financing alternatives | Leasing reduces the need for fixed capital |
Level of collaboration | Sharing facilities with other firms (such as a bank sharing ATMs) reduces it |
9. Working capital
Gross working capital = total current assets. Net working capital = current assets − current liabilities. Working capital is needed because of the operating cycle: cash → raw materials → work in progress → finished goods → receivables → cash.
Factors affecting working capital requirements
Factor | Effect |
|---|---|
Nature of business | A trading firm needs less than a manufacturer; a service firm needs little |
Scale of operations | Larger operations need more inventory and receivables |
Business cycle | More working capital is needed in a boom, less in a depression |
Seasonal factors | More is needed in the peak season (woollens in winter) |
Production cycle | A longer production cycle needs more working capital |
Credit allowed | Liberal credit to customers raises receivables and working capital |
Credit availed | More credit from suppliers reduces working capital needed |
Operating efficiency | Efficient inventory and receivables management reduces it |
Availability of raw material | Easy and continuous availability means lower stocks are needed |
Growth prospects | Higher growth needs more working capital |
Level of competition | Strong competition forces larger stocks and liberal credit |
Inflation | Rising prices increase the funds needed for the same quantities |
A reliable approach to case-based questions
Decide which decision the case is about: buying assets (investment), raising funds (financing), or distributing profit (dividend).
Look for the clue that names the factor: "fears losing control" (control), "share market is booming" (state of capital market), "plans to expand" (growth opportunities), "earnings fluctuate" (stability of earnings).
For trading on equity, compare ROI with the interest rate and compute EPS for each option.
For capital requirements, ask whether the case is about long-term assets (fixed capital) or day-to-day operations (working capital).
Connections that matter
Financial markets are where the funds chosen in the financing decision are raised.
Accountancy: share capital and debentures record the issue of these securities.
Accountancy: ratio analysis gives the interest coverage and debt-equity ratios used here.
Common mistakes
Saying the objective is profit maximisation. It is wealth maximisation, measured by the share price.
Assuming more debt always raises EPS. Only when ROI exceeds the cost of debt.
Confusing ICR and DSCR. DSCR includes principal repayment; ICR covers interest only.
Saying a firm offering liberal credit needs less working capital. It needs more.
Mixing up fixed and working capital factors, such as putting "seasonal factors" under fixed capital.
Revision checklist
I can explain wealth maximisation as the objective of financial management.
I can explain the three financial decisions and the factors affecting each.
I can explain the objectives and importance of financial planning.
I can calculate EPS under different capital structures and explain trading on equity.
I can explain the factors affecting capital structure, fixed capital and working capital.