Financial Management | Role | Objective | Financial Decision | Chapter 9 |
Meaning and Concept of Financial Management
Financial management refers to the part of management which helps in doing effective acquisition of fixed assets and utilisation of funds for day to day expenses. It is concerned with the optimal procurement as well as usage of funds which means doing all the functions of management in terms of financial activities in the organisation. The main aim of financial management is to reduce the cost during acquisition, keep the risk under control which is related with the funds, sufficient available of funds but avoiding idle funds etc.
Role of Financial Management
Financial Management plays an important role in a business organisation. A good financial system aims at mobilisation of funds at lower cost and deployment of these funds into most profitable activity. The roles played by financial management are as follow:
- Determining Fixed Assets: Under financial management, the best alternative is to choose for the acquisition of fixed assets which is done through capital budgeting.
- Determining Current Assets: Under this, the total amount that is to be invested in current assets along with the value of every separate current asset is determined.
- Determining Proportions: Under this, the proportion of various sources of long term as well as short term capital fund is determined on the basis of liquidity and cost analysis.
- Determining of items of Profit and Loss: Items of profit and loss are also determined in the financial management which may affect or influence the business.
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Objective of Financial Management
The priority of the financial management is to fulfill the interest of the owners. Therefore, the main objective of financial management is maximisation of wealth. Wealth maximisation refers to the increase in the capital invested by the shareholders or the owner of the company through optimal investing decision in which investment is done on activities which are more profitable, financing decision which includes the combination of both debt and equity in order to arrange the capital at minimum cost and dividend decision in which the total amount is divided in such a manner that shareholders get satisfied, called distribution of dividend as well as company has enough funds to invest for future called retained-earning.
- Investing Decision: It refers to the selection of type assets in which the company is going to invest. It is related to how the company’s fund is invested in different assets so that the company is able to earn highest possible return on investment.
Types of Investing Decisions
- Long-term Investment Decision: This type of decision is related with the selection of long term assets in which the company is going to invest. It is done through capital budgeting decision.
- Short-term Investment Decision: This type of decision is related with the selection of short term assets in which the company is going to invest. It is done through working capital management.
Factors Affecting Investing Decisions
- Long-term Investment Decision
Cash Flow of the Project: Under this, the cash receipt and payment of the proposed investment is considered over the life of the investment and the best proposal is analysed.
Rate of Return: The expected return and risk involved in each proposal is taken into account during a selection of best proposal.
Investment Criteria: Under this, various proposals are evaluated by calculating investment amount, interest rate, rate of return etc.
- Short-term Investment Decision: Under this, the liquidity and profitability is taken into account as a healthy amount required for the functioning of day to day activities is determined which should neither be less nor more.
2. Financing Decision: It refers to the decision which is related with the composition of fund from various long-term sources. It is related to the quantum, level, amount of finance which is to be raised from the long term source of funds.
A firm needs blend of both debt and equity source of funds. The debt funds involve financial risk as the repayment of principle amount and interest is necessary whereas there is no fixed commitment with the equity fund which is also known as shareholder’s fund for the payment of dividend and repayment of capital.
Factors Affecting Financing Decision
Cost: The cost which is required for raising funds from different sources. The cheapest source is selected.
Risk: The risk which is involved with the different source of funds. The borrowed funds are more risky than the shareholder’s fund.
Period of Finance: For permanent capital requirement in the business, equity shares must be issued whereas in case of long and medium term requirement, preference shares or debentures may be issued.
State of Capital Market: During boom period, finance should be raised by issuing shares whereas during depression period finance should be raised from debt.
Control Consideration: In case, the shareholders want to dilute their control over business, shares can be issued whereas if they don’t want to do so, that can be raised.
Cash Flow Position: If the cash flow position of the business is good, it can go for debt funds as company is able to make payment of interest on time whereas if the cash flow position is not good, then company should issue shares.
Fixed Operating Cost: If the fixed operating cost is in excess of the fixed financial cost, then shares should be issued. On the contrary, if the level of fixed operating cost is less than the debt capital can be used.
- Dividend Decision: It refers to the decision which is taken for determining the portion of the profit which should be distributed among the shareholders which results in increasing the current income of the shareholders and proportion of profit which should be kept in business in order to reinvest the amount in the business for future use.
Factors Affecting Dividend Decision
Earnings: If the company is having high and stable earning, the company should declare high rate of dividends as dividends are paid from current earnings.
Growth Prospect: If the growth prospect of the company is more in the near future, it should go with retained earnings otherwise the company should declare dividend.
Cash Flow Position: If the position of cash flow is good, in that case the company should declare dividends and if the position of the cash flow is not good, in that case the company should retain the profits.
Taxation Policy: If the tax paid during declaration of dividends is more, the company can go with retained earnings otherwise it should declare dividends.
Legal Constraints: Under Companies Act, every company has to declare a minimum amount in the form of dividend. Therefore, in that case the company has to declare dividend and can retain the surplus amount.
Issue of Bonus Shares: If the company has large reserves, it can go with the distribution of bonus shares in order to increase the capital base of the company and can enhance their reputation in the market.
Preference of Shareholders: At the time of deciding the dividend amount, the preference of the shareholders can also be taken for declaring dividend or retaining profit for future use.
Financial Planning- Meaning, Concept, Objective and Process
Financial Planning refers to the process of estimating future finance requirement of an organisation and specifying the source of funds. In other words, the financial need of the organisation is forecasted by preparing financial blueprints for future operations.
Objectives of Financial Planning
- Through financial planning an organisation can ensure the availability of finance on time.
- A proper balance is maintained through financial planning so that an organisation should not have shortage of funds or surplus funds.
Process of Financial Planning
- Determination of financial objectives
- Determination of financial policies
- Determination of financial processor
Capital structure- Meaning, Concept, Factors Affecting
It refers to the source of long term funds which are required in the business. In other words, it means proportion of borrowed funds and owned funds which are used for financing the different operations of the business. The different sources can be equity share capital, preference share capital, borrowed capital which is the combination of both i.e. debenture and long-term liability and retained earnings.
Both the sources of long-term and short-term capital which are shown on the liability side of the balance sheet are called financial structures and when the short-term capital sources are excluded from financial structure, then it is known as capitalisation and relative proportion of long-term capital source is called capital structure.
Factors Affecting Capital Structure
- Cash flow position: If the sufficient cash flow is available in the company, debt can be used because a company have lots of cash for the payment of interest and repayment of capital.
- Debt service coverage ratio: A higher debt service coverage ratio shows the generation of cash profit as compare to the cash required for debt service.
- Interest coverage ratio: In the higher interest coverage ratio, the company has low risk in order to make the payments of interest.
- Cost of debt: If the cost of debt is low, the company can use more debt.
- Cost of equity: If the company uses more debt than the financial risk faced by the shareholders increases which results in increasing the desire rate of return.
- Return on investment: If the return of investment of a company is greater, the company has the ability to use greater debt.
- Tax rates: If the tax rates are higher, debt can be available at cheaper source than the equity.
- Risk consideration: If the risk in the business is less, the company can go with debt and if the risk in the business is more, the company can go with equity.
Fixed capital refers to the capital which is invested in long-term assets of the business. The investment in long-term assets should be done with long-term capital source.
Factors Affecting the Requirement of Fixed Capital
- Nature of business: If the nature of business is of manufacturing, more fixed capital is required and if the nature of business is of trading, less fixed capital is required.
- Choice of technique: If an enterprise adopts capital intensive technique for production, more fixed capital is required and if an enterprise adopts labour intensive technique for production, less fixed capital is required.
- Upgradation of technology: If a business requires immediate change in technology, it requires more fixed capital and if a business do not require immediate change in technology, it requires less fixed capital.
- Diversification: If the diversification in the business is more, it requires more fixed capital and if the diversification in the business is less, it requires less fixed capital.
- Alternatives for financing: If more alternatives of finance are available, less fixed capital is required and if less alternatives of finance are available, more fixed capital is required.
Working capital refers to the capital which is required for day to day functioning of the business. Apart from investing in fixed assets, every business requires to invest in current assets also. Working capital is of two types i.e. is Gross Working Capital which includes all the current assets whereas Net Working Capital which is the excess of current assets over current liability.
Factors Affecting Requirement of Working Capital
- Nature of Business: If the nature of business is of manufacturing, more working capital is required and if the nature of business is of trading, less working capital is required.
- Business cycle: During the period of boom, more working capital is required whereas during the period of depression less working capital is required.
- Scale of operation: If the scale of business organisation is large, it requires more working capital and if the scale of business is small, it requires less working capital.
- Production cycle: If the time consumed for converting the raw material into finished goods is more, more working capital is required and if the time consumed for converting the raw material into finished goods is less, less working capital is required.
- Seasonal factor: During peak season more working capital is required whereas on the other season less working capital is required.
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