Financial Management

Capital structure is the proportion of debt and equity used for financing business operations. It represents the proportion of debt capital and equity capital in the capital structure. It is not easy to define the best capital structure for a firm. It should increase the value of the equity share or maximize the wealth of the equity shareholders.

Capital structure= Debt/ Equity

Financial planning means designing a blueprint of the financial operations of the firm. It ensures the smooth functioning of the organisation by the right allocation of resources available at the right time. It helps the firms are able to forecast the requirement of find in the future.

The two objectives of financial planning are:

a. To ensure the availability of sufficient funds in the company for different purpose such as purchasing long term assets, to meet the day to day expenses, etc. Financial planning also aims at specifying the source of these finances.

b. To ensure that the firm does not raise the resources unnecessarily. Excess funding is as bad as a shortage of funds. An efficient financial planning system ensures that the funds are not raised unnecessarily to avoid unnecessary addition of cost. If there is any surplus money, it should be used e in the best possible manner to avoid any loss for the organisation.

The concept of financial management which increases the return to equity shareholders due to the presence of fixed financial charges is called trading on equity. When the rate of earning of the return on investment of a company is higher than the rate of interest on the borrowed funds only then a company should adopt for trading on equity.

Working capital is the amount of capital required for meeting the day-to-day operations of the business. In this case, Amrit runs a Transport Service. This business operates on a large scale of operation, with a higher amount of inventory. He would require a large amount to working capital.

Working capital is the amount of capital required for meeting the day-to-day operations of the business. In this case, Ramnath is purchasing the components of television on 3 months of credit, and selling the company's product in cash. His working capital requirement is reduced to the extent of credit availed by him.

Financial risk is a situation when a company is not able to meet its fixed financial charges. The fixed financial charges are the –

● Interest that is to be paid on borrowed capital and

● Rate of dividend to be paid on preference capital.

Current assets are those assets which can be converted into cash within a period of one year.

Examples of such assets are –

● Stock

● Debtors

● Bills receivable and

● Marketable securities

The objectives of financial management can be listed as –

● To ensure regular and adequate supply of funds

● To ensure adequate return to the shareholders

● To ensure optimum utilisation of funds

● To ensure safety of investment

● To plan sound capital structure that is to maintain of a balance between debt and equity

Financial management refers to the procurement, allocation and utilisation of funds. It deals with three main decisions –

a) Procurement decisions – To decide the source of capital that is from where the capital should be raised so as the overall cost of capital should be at its minimum.

b) Investment decisions (Allocation of funds) - Where the available funds should be invested so as to ensure maximum return.

c) Dividend decision – To decide the rate of dividend to be paid to the shareholders

A company can issue debenture for raising fund if the cost of the debt is less then cost of capital.

In this case, the cost of capital for sunrises limited is 10%, for the total capital of 80,00,000, cost of capital will be 8,00,000 INR.

As per the previous year earnings statement, the company had net earnings of 8,00,000 for the capital investment of 1,00,00,00 , so total ROI for that is mentioned below

ROI- RETURN / INVESTMENT

ROI = 8,00,000/1,00,00,000 = 8 Percent

Under the assumption that company will operate under the same efficiency, the additional investment of 80,00,000 will be having net ROI of 8% which will be 6,40,000 aganist the cost of debt 8,00,000.

As for the project the cost of debt is 10 % which is generating ROI of 8% , it would not be advisable decision for a company to issue debenture when cost of debt is higher than cost of capital.

Working capital is the difference between current assets and current liabilities. It affects both liquidity and profitability of the business.

● The increase in current assets increases the liquidity position of the business but affects the profitability adversely because the return on current assets is quite low.

● Low working capital will affect the liquidity of the business which may disturb the day to day operation

So the working capital should be maintained at such a level that a proper balance could be maintained between profitability and liquidity.

The financial concept discussed in this is called capital budgeting decision, it is decision-related to capital investment in the company which have long term effect on the profitability of the company.

As the company want to invest in new machinery which will require huge investment, and it will affect the operations of the organisation which will affect the profitability of the organisation.

The objective can be achieved by this are following

a. Cash flow – after this investment, new machinery will reduce the operational cost of the products, which will increase the profitability of the organisation. Cash flow needs to be analysed that how the Investment which affects cash inflow over the period.

b. The rate of return – as the company want to raise fund both from inside and outside the organisation, it is very important to know that the additional return generated from the investment is more than the cost of capital.

c. The investment criteria involved - as mentioned in the paragraph the company is planning to raise fund both from inside and outside the organisation and both have a different cost associated with it. Debt from outside will have a different interest rate associated with it, whereas internal cash can be used for other activity which may have more or less rate of return which needs to be analysed.

Companies pay part of their earning to the shareholders on a regular basis and it is called dividend. There are multiple factors which affect the pay-out of dividends

Legal constraint – certain provision of the company's actions put the constraint on the pay-out of dividends and those norms need to be followed while paying dividends.

Contractual constraints- Paying the dividend reduces companies' cash as cash is going outside the company, the company’s also raises money in the form of loan from other banks or investors, they can put a restriction of the company to pay dividends, loan agreements need to be analysed.

Working capital is that part of firms’ capital which is required for financing the short term or current asset. The working capital is also known as revolving capital or circulating capital or short term capital.

It is the amount of funds needed to meet the day to day operations of a business; it can be described as the excess of current assets over current liabilities.

Calculation of Working Capital

Working Capital = Current Assets – Current Liabilities

Determinants of working capital are stated below

1) Nature of business - It means that whether the firm is a trading firm or a manufacturing concern. The manufacturing concern has a lengthy operating cycle, so it needs more working capital as compared to a trading firm.

2) Volume of business - Big businesses need higher working capital than the small ones.

3) Credit period - It means the credit period allowed by creditors and allowed to debtors. If creditors allow more credit period then less working capital is required and vice a versa.

Capital structure may be defined as combination of debt and equity in capital.

The capital structure should be so designed that –

● It should minimise cost of capital

● It should reduce risk

● It should give required flexibility

● It should provide required control to owners

● It should enable the company to have adequate Finance

Risk is the variability in income. The risk may be of two types - business risk and financial risk.

● Business risk is the situation when EBIT may vary due to change in capital structure

● Financial risk is the variability in EPS due to change in financial structure.

The theory of optimal capital structure states that as the level of debt is raised the value of firm can be raised up to a certain extent so debt should be increased up to a particular level.

An optimal capital structure is when the proportion of debt and equity has been so maintained that it results in increase in the value of equity shares.

Capital budgeting decision means the firm's decision to invest its available funds in long term assets in most efficient and effective manner so as to earn benefits for a series of years.

The capital budgeting decisions include the decisions like -

● Expansion

● Acquisition

● Modernization

● Replacement

● New product development

● Obligatory and welfare investment

The features of capital budgeting decisions are that

● They have long term consequences

● They involve substantial outlays

● They are difficult or expensive to reverse

The capital budgeting decisions are very crucial because they affect the earning capacity of the firm for long run as well as it involves huge amount of investment, which is almost irreversible.

So the capital budgeting decision should be taken with utmost care as it can change the fortune of a business either positive or negative that means it may increase the profitability or decrease the profitability and attract financial burden

Dividend is that part of profit after tax which is divided among the shareholders. Dividend policy is concerned with determining the portion of firms earning into dividend and retained earnings, that is to decide the payout ratio and retention ratio.

The factors affecting dividend policy of a firm are stated below -

1) Legal requirements - For any company there is no legal compulsion to distribute dividend, however there are certain conditions regarding distribution of dividend -

a. A company can pay dividend only out of the profit during the year, in case of loss it cannot pay dividend.

b. If the total Assets of the firm are less than the total liabilities then it cannot pay dividend

c. The total profit after tax cannot be distributed as dividend rather a part of it shall be transferred to retained earnings before paying dividend

2) Liquidity position - The dividend payout is affected by the liquidity position of the firm because the dividends are to be paid in cash.

3) Repayment need - If the firm has to retain its profit for the purpose of the repayment of the debt then the payout ratio will be less.

4) Future investment - If firm is expecting any investment opportunities having higher rate of return then retention ratio will be more than the payout ratio.

5) Stability of earning - The firm having stable earnings are more likely to pay larger dividend than those having fluctuating earnings.

6) Desire of control - If the finance manager anticipates any investment need in future, then in order to concentrate the control it will retain more profit so that no further issue of equity shares is needed.

7) Access to capital market - The firms having easy access to capital market for arranging additional finance do not require more retained earnings so there payout ratio is high.

8) Tax liability - The dividend income is taxable for an individual under the head Income from Other Sources, so the stockholders in higher tax bracket prefer capital gain than cash dividend.

Trading on equity is the financial process of using debt (borrowed capital) to produce gain for the remaining owners. It is practiced because the equity shareholders have interest only in the business income.

The term trading on equity means that the creditors are willing to give loans on the strength of equity supplied by the owners which means if sufficient portion of equity is available then only the debts can be raised.

When the amount of borrowing is more than capital stock a company is said to be trading on equity but where the borrowed capital is comparatively small the company is said to be trading on thick equity.

The fluctuations in EBIT can be magnified on EPS by operating on trading on equity.

Impact on trading on equity can be explained with the help of following example –

The capital structure of P Limited is 10000 equity shares of Rs 100 each. The management wishes to raise another 10 lakh to finance a major project for which it has following four options -

A. All by equity issue

B. Rs 5 lakh by equity shares and Rs 5 lakh by 5% Debentures

The present EBIT is Rs 120000 and tax rate is 50%

The EPS of Option B his higher than Option A, because the company has taken benefit of trading on equity.

a. Financial management of a company is concerned with effective and efficient management of funds. In ‘S’ Ltd, the financial management will look into –

● Procurement of funds, the capital fund of Rs. 5000 crores to set up and short term fund of Rs 500 crores

● Minimising the risk associated with procured funds – Capital as well as short term.

● Utilisation of available funds in most productive and effective manner

● Deciding the ratio of debt and equity while procuring funds.

The financial management of company will try to maximise wealth of the shareholders and profit of the company both.

Manufacturing cycle - The business having larger manufacturing cycle need more working capital than those having smaller manufacturing cycle.

Other factors –

a. Degree of coordination between production and distribution policy

b. Specialisation in the field of distribution

c. Development of the means of transportation and communication

d. The hazards and contingency related to with the type of business

b. The importance of financial planning for this company are listed below –

a) The financial planning will ensure the availability of required funds so as to meet the working capital as well as fixed capital requirements.

b) It will maintain a balance between inflow and outflow of funds so as to ensure liquidity.

c) The problem of shortage or surplus of funds in present scenario will be effectively dealt with.

d) It will ensure increased profitability by proper cost and benefit analysis and by avoiding wasteful operations.

Example – In the given example of the company S limited, the fixed capital requirement of Rs 5000 crores will be met effectively with help of financial planning and the plan will not only help in deciding the sources available but will also decide the leverage. Suppose the financial management finds that the cost of debt is lower than cost of equity so it decided to raise more from debt than equity as it will result in tax saving too.

c. Capital structure means the proportion of debt and equity funds in the capital of the business. The factors that will affect the capital structure of the company are –

S Ltd will decide to raise more from equity if –

● The funds are required for long period

● Financial risk in stock market is less

● Debts are not easily available

S Ltd will decide to raise more from debt if –

● Sufficient cash flow is available to meet fixed financial charges

● To reduce tax liability

● It does not want to dilute control over management

d. The working and fixed capital requirement of S Limited will be high due to following reasons

● The business is capital intensive and scale of operation is large

● Heavy investment is required for building production based and Technology upgradation

● In case of steel industry the major inputs are iron and coal so the raw material cost will be high and that it will require a higher working capital

● Longer operating cycle and the terms of credit for buying and selling