Chapter -9 Financial Management

Transcription

1 Chapter -9 Financial Management Business Studies (VKS) Definition Financial management is concerned with efficient acquisition and allocation of funds. In other words, financial management means estimating the required fund, arranging the required fund, utilising the required fund in the most productive manner and distributing the surplus generated by investment in the best possible way. Objectives of Financial management The main and foremost objectives of financial management are to maximise the wealth of equity shareholder. With the objective of wealth maximization of equity shareholder, following objectives automatically get achieved: 1. Profit maximisation 2. Maintenance of liquidity 3. Proper utilisation of funds 4. Meetings of financial commitments with creditors. Finance Functions or Financial Decisions The finance functions relate to three major decisions which every finance manager has to take: a) Investment decision b) Financing decision c) Dividend Decision Investment Decisions (Capital Budgeting Decision) Investment decision relates to how the firms funds are invested in different assets so that the firm is able to earn the highest possible returns on investment. Investment decisions can be further classified into following: 1. Long Term Investment Decision This decision involves allocation of funds to different projects or assets with longterm implications for the business. Examples: (i) purchase of new fixed assets like land, building, plant and machinery, etc. (ii) opening a new branch, (iii) launching a new product line, (iv) investing In advanced techniques of production, development programme, etc. Decision relating to investment in fixed assets are also known as 'Capital Budgeting' The capital budgeting decisions cannot be changed or reversed overnight. 2. Short-term Investment Decision Short-term investment decisions or working capital decisions are concerned with the decisions about the levels of cash, inventories and debtors. These decisions affect the day-to-day working of a business. These decisions affect the liquidity as well as profitability of a business because shortterm assets are more liquid but less profitable. Efficient cash management, inventory management and receivables management are the essential ingredients of sound working capital management. 1

2 Factors Affecting Investment/Capital Budgeting Decisions 1. Cash flow of the project. Company expects some regular amount of cash flow to meet day to day requirement. 2. Return on investment. The most important criteria to decide the investment proposal is rate of return it will be able to bring back for the company in the form of income. 3. Risk involved. The company should prefer the investment proposal with moderate degree of risk only. 4. Investment criteria. Availability of labour, technologies, input, machinery, etc. help in selecting an investment proposal along with return, risk, cash flow related factors.. The finance manager must compare all the available alternatives very carefully and then only decide where to invest the most scarce resources of the firm, i.e., finance. Financing Decision Financing Deciding how much to raise from which source is concern of financing decision. Mainly sources of finance can be divided into two categories: 1. Owners' fund, 2. Borrowed fund. Share capital and retained earnings constitute owners' fund and debentures, loans, bonds, etc. constitute borrowed fund. The main concern of finance manager is to decide how much to raise from owners' fund and how much to raise from borrowed fund. Under financing decision finance manager fixes a ratio of owner fund and borrowed fund in the capital structure of the company. Factors affecting financing decisions 1. Cost. Finance managers always prefer the source with minimum cost. 2. Risk. Finance manager prefers securities with moderate risk factor. 3. Cash flow position. With smooth and steady cash flow companies can easily afford borrowed fund securities but when companies have shortage of cash flow, then they must go for owner's fund securities only. 4. Control considerations. If existing shareholders want to retain the complete control of business then they prefer borrowed fund securities. On the other hand if they do not mind to lose the control then they may go for owner's fund securities. 2

3 5. Floatation cost. It refers to cost involved in issue of securities such as broker's commission, underwriters fees, expenses on prospectus, etc. Firm prefers securities which involve least floatation cost. 6. Fixed operating cost. If a company is having high fixed operating cost then they must prefer owner's fund because due to high fixed operational cost, the company may not be able to pay interest on debt securities which can cause serious troubles for company. 7. State of capital market. During boom period it is easy to sell equity shares as people are ready to take risk whereas during depression period there is more demand for debt securities in capital market. Dividend Decision This decision is concerned with distribution of surplus funds. The surplus profit is either distributed to equity shareholders in the form of dividend or kept aside in the form of retained earnings. Under dividend decision the finance manager decides how much to be distributed in the form of dividend and how much to keep aside as retained earnings. This decision is also called residual decision because it is concerned with distribution of residual or left over income Factors affecting Dividend Decision 1. Earning. If there are more earnings then company declares high rate of dividend whereas during low earning period the rate of dividend is also low. 2. Stability of earnings. Companies having stable or smooth earnings prefer to give high rate of dividend whereas companies with unstable earnings prefer to give low rate of earnings. 3. Cash flow position. Companies declare high rate of dividend only when they have surplus cash. In situation of shortage of cash companies declare no or very low dividend. 4. Growth opportunities. If companies have no investment or growth plans then it would be better to distribute more in the form of dividend. Generally mature companies declare more dividend whereas growing companies keep aside more retained earnings. 5. Stability of dividend. The stable dividend policy satisfies the investor. There are three types of stable dividend policies which a company may follow: (i) Constant dividend per share. In this case, the company decides a fixed rate of dividend and declares the same rate every year, e.g., 10% dividend on investment. 3

4 (ii) Constant pay out ratio. Under this system the company fixes up a fixed percentage of dividend on profit and not on investment, e.g., 10% on profit so dividend keeps on changing with change in profit rate. (iii) Constant dividend per share and extra dividend. Under this scheme a fixed rate of dividend on investment is given and if profit or earnings increase then some extra dividend in the form of bonus or interim dividend is also given. 6. Preference of shareholders. If a company is having large number of retired and middle class shareholders then it will declare more dividend and keep aside less in the form of retained earnings whereas if company is having large number of young and wealthy shareholders then it will prefer to keep aside more in the form of retained earnings and declare low rate of dividend. 7. Taxation policy If tax rate is higher, then company prefers to pay less in the form of dividend whereas if tax rate is low then company may declare higher dividend. 8. Access to capital market consideration. If capital market can easily be accesses or approached and there is enough demand for securities of the company then company can give more dividend and raise capital by approaching capital market, but if it is difficult for company to approach and access capital market then companies declare low rate of dividend and use reserves or retained earnings for reinvestment. 9. Legal Constraints Certain provisions of the Companies' Act place restrictions on payment of dividend out of profits. Sometimes restrictions can be applied by lenders who provide loans to the companies. So if the company has enough profit and liquidity and there are no restrictions on payment of dividend then it will declare dividend and keep aside less retained earnings. 10. Stock market reactions. The declaration of dividend has impact on stock market as increase in dividend is taken as good news in the stock market and prices of security rise. Whereas a decrease in dividend may have negative impact on the share price in the stock market. Financial Planning The process of estimating the funds requirements of a business and determining the sources of funds for current and fixed assets arid future expansion prospects is called financial planning. Financial planning means deciding in advance how much to spend, on what to spend according to the funds at your disposal. Following are the tasks which comes under financial planning: _ (i) Determination of Financial Objectives, 4

5 (ii) Formulation of Financial Policies and Rules, (iii) Forecasting the Need of Finance. (iv) Developing Alternative Sources of Finance. (v) Selection of Best Alternative. (vi) Implementing Financial Plans and Policies. Objectives of financial planning 1. Ensure Availability of Funds. Financial planning ensures availability of funds whenever these are required. This includes a proper estimation of funds required for different purposes such as for long-term assets or to meet day to day expenses of business, etc. If adequate funds are not available, the firm will not be able to honour its commitments and carry out its plans. 2. Prevent Excess Funding. Financial planning ensures that the firm does not raise resources unnecessarily. Excess funding is almost as bad as inadequate funding. If excess funds are available, it will unnecessary add to the cost and may encourage wasteful expenditure. Note- Financial planning includes both short term as well as the long term planning. Long-term planning focuses on capital expenditure plan whereas short term financial plans are called budgets. Budgets include detailed plan of action for a period of one year or less. Importances of Financial Planing 1. Facilitates Coordination. Financial planning helps in coordinating various business functions, such as, sales, production, etc. by providing clear policies and procedures. 2. Forecast About Future. Financial planning tries to forecast what may happen in future under different business situations. By doing so, it makes the firm better prepared to face the future. 3. Acquisition of Required Funds. Financial planning involves accurate forecasts of the present and future requirements of funds. It ensures acquisition of required funds from various sources. Uncertainty about the availability of funds is reduced. It ensures stability of business operations. 4. Integral Part of Planning. Financial planning is an integral part of planning of the business. Without financial planning, business plans are incomplete and useless. The success or failure of the production, distribution and other business activities depends on the financial decisions. Detailed plans of action prepared under financial planning reduce waste, duplication of efforts and gaps in planning.. 5

6 5. Base for Financial Control. Financial planning acts as bash for checking the financial activities by comparing the actual revenue with estimated revenue and actual cost with estimated cost. 6. Helps in Avoiding Shocks and Surprises. By anticipating the financial requirements financial planning helps to avoid shock or surprises which otherwise firms have to face in uncertain situations. It helps the company in preparing for the future. 7. Link Present with Future. Financial planning relates present financial requirement /with future requirement by anticipating the sales and growth plans of the company. 8. Link between Investment and Financing Decisions. Financial planning helps in deciding debt/equity ratio and by deciding where to invest this fund. It creates a link between both the decisions. Capital Structure Capital structure means the proportion of debt and equity used for financing the operations of business. Capital Structure refers to the mix between owner's funds (Equity) and borrowed funds (Debt.) Capital Structure = The capital structure should be such which increases the value of equity share or maximises the wealth of equity shareholders. Debt and equity differ in cost and risk Capital structure of the business affects the profitability and financial risk. Financial Leverage Proportion of debt in the total capital is also called financial leverage. Financial Leverage = Favourable Financial Leverage If a company's rate of return on investment (ROI) is more than the cost of debt, EPS of the Company will increase with increased use of debt. This is a situation of favourable financial leverage. Trading on equity is advised in such a situation Unfavourable Financial Leverage If a company's rate of return on investment (ROI) is less than the cost of debt, EPS of the Company will fall with increased use of debt. This is a situation of unfavourable financial leverage. Trading on equity is not advised in such a situation. 6

7 Question How are the shareholders likely to gain with loan components in capital employed? Explain with suitable example. HOTS All India 2011 Ans. With a debt component in the total capital, shareholders are likely to have the benefit of a higher rate of return on the share capital. This is because debt/loan carry a fixed charge and the amount of interest paid is deductible from the earnings before tax payment. The benefit to the shareholders will be realised only if the average rate of return on total capital invested is more than the rate of interest payable on loan/debt. For Example. Let us consider two public companies X Ltd and Y Ltd. The following calculation will show how trading on equity increases the return on equity shares (i) X Ltd. Total Capital Equity Capital (5,00,000 Rs. 10 each) Debt Earning Before Interest and Tax (EBIT) (-) 50% Earning after Tax (EAT) Earning Per Share (EPS) = Amount (Rs.) 50,00,000 50,00,000 Nil 10,00,000 (5,00,000) 5,00,000 = Rs. 1 (ii) Y Ltd. Total Capital Equity Capital (3,50,000 Rs. 10 each) Debt Capital at 12% Interest Earning Before Interest and Tax (EBIT) (-) Interest (12% of 15,00,000) Earning Before Tax (EBT) (-) 50% Earning after Tax (EAT) Earning Per Share (EPS) = Amount (Rs.) 50,00,000 35,00,000 15,00,000 10,00,000 (1,80,000) 8,20,000 (4,10,000) 4,10,000 = Rs Thus, it can be concluded that Y Ltd. using fixed cost sources, i.e. debentures, earn a relatively high rate of return on equity capital. Question- Viyo Ltd is a company manufacturing textiles. It has a share capital of Rs. 60 lakhs. The earning per share in the previous year was Rs For diversification, the company requires additional capital of Rs.40 lakhs. The company raised funds by issuing 10% debentures for the same. During the current year the company earned a profit of Rs. 8 lakhs on capital employed. It paid tax 40%. State whether the shareholders gained or lost, in respect of earning per share on 7

8 diversification, show your calculations clearly. Delhi 2016 Ans. Particulars Earning Before Interest & Tax (EBIT) (-) Debentures Interest (40,00,000 X ) Earning Before Tax (EBT) (-) Tax (4,00,000 X ) Earning After Tax (EAT) Earning Per Share (EPS) = Amount(Rs.) 8,00,000 4,00,000 4,00,000 1,60,000 2,40,000 = Rs Since earning per share has fallen from Rs to Rs. 0.40, therefore the shareholders stand to lose on diversification. Note- In the absence of any information, shares are assumed to be of Rs. 10 each. Factors Determining the Capital Structure 1. Cash flow position. A company employs more of debt securities in its capital structure if company issure of generating enough cash inflow. whereas if there is shortage of cash then it must employ more of equity in its capital structure as there is no liability of company to pay its equity shareholders. 2. Interest coverage ratio (ICR). ICR = High ICR means companies can have more of borrowed fund securities whereas lower ICR means less borrowed fund securities. 3. Debt service coverage ratio (DSCR). DSCR = If DSCR is high then company can have more debt in capital structure as high DSCR indicates ability of company to repay its debt but if DSCR is less then company must avoid debt and depend upon equity capital only. 4. Return on investment. If return on investment is less than rate of interest to be paid on debt, then company should avoid debt and rely on equity capital. 5. Cost of debt. If firm can arrange borrowed fund at low rate of interest then it will prefer more of debt as compared to equity. 6. Tax rate. High tax rate means prefer debt whereas at low tax rate we can prefer equity in capital 8

9 structure. 7. Cost of equity. As far as debt is increasing earning per share (EPS), then we can include it in capital structure but when EPS starts decreasing with inclusion of debt then we must depend upon equity share capital only. 8. Floatation costs. It is a major consideration for small companies but even large companies cannot ignore this factor because along with cost there are many legal formalities to be completed before entering into capital market. 9. Risk consideration. If firm's business risk is low then it can raise more capital by issue of debt securities Whereas at the time of high business risk it should depend upon equity. 10. Flexibility. Excess of debt may restrict the firm's capacity to borrow further. To maintain flexibility it must maintain some borrowing power to take care of unforeseen circumstances. 11. Control. If existing shareholders want complete control then they should prefer debt, loans of small amount, etc. If they don't mind sharing the control then they may go for equity shares also. 12. Regulatory framework. If SEBI guidelines are easy then companies may prefer issue of securities for additional capital whereas if monetary policies are more flexible then they may go for more of loans. 13. Stock market condition There are two main conditions of market, i.e. Boom condition or Depression condition. During depression period, it is advisable to issue borrowed fund. During Boom period, prefer to invest in equity shares to earn more in the form of dividend. 14. Capital structure of other companies. Some companies frame their capital structure according to Industrial norms If firm cannot afford high risk it should not raise more debt only because other firms are raising. Fixed Capital Fixed capital involves allocation of firm's capital to long term assets or projects. Managing fixed capital is related to investment decision and it is also called Capital Budgeting. The capital budgeting decisions include purchase of land, building, plant and 9

10 machinery, change of technology, expenditure of advertising campaign, research and development etc. Factors Affecting Requirement of Fixed Capital 1. Nature of business A manufacturing company needs more fixed capital as compared to a trading company, as trading company does not need plant, machinery, etc. 2. Scale of operation. The companies which are operating at large scale require more fixed capital whereas small scale enterprises need less amount of fixed capital. 3. Technique of production. Companies using capital-intensive techniques require more fixed capital whereas companies using labour intensive techniques require less capital. 4.Technology upgradation. Industries in which technology upgradation is fast need more amount of fixed capital whereas companies where technological upgradation is slow they require less fixed capital as they can manage with old machines. 5. Growth prospects. Companies which are expanding and have higher growth plan require more fixed capital. 6. Diversification. Companies which have plans to diversify their activities by including more range of products require more fixed capital. 7. Availability of finance and leasing facility. If companies can arrange financial and leasing facilities easily then they require less fixed capital. On the other hand if easy loan and leasing facilities are not available then more fixed capital is needed. 8. Level of collaboration/joint ventures. If companies are preferring collaborations, joint venture then companies will neeed less fixed capital. Working Capital Working capital refers to excess of current assets over current liabilities. Gross Working Capital. This refers to the investment in all the current assets such as cash, bills receivables, prepaid expenses, inventories, etc. These current assets get converted into cash within an accounting year. Net Working Capital This refers to excess of current assets over current liabilities. 10

11 Current liabilities are to be paid within an accounting year, e.g., bills payable, creditors, etc. Current liabilities are sources of funds for acquiring current assets. The net working capital can be negative also, when current liabilities exceed current assets. The net working capital indicates the liquidity position of the company. Factors Affecting the Working Capital 1. Length of operating cycle. If operating cycle is long then more working capital is required whereas for companies having short operating cycle, the working capital requirement is less. 2. Nature of business. In case of trading concern or retail shop the requirement of working capital is less because length of operating cycle is small. The wholesalers & manufacturing company requires huge amount of working capital because they have to convert raw material into finished goods, sell on credit, maintain the inventory of raw material as well as finished goods. 3. Scale of operation The firms operating at large scale require large working capital whereas firms operating at small scale require less working capital. 4. Business cycle fluctuation. During boom period more amount of working capital is required. Whereas during depression period less working capital will be required. 5. Seasonal factors. The working capital requirement is constant for the companies which are selling goods throughout the season whereas the companies which are selling seasonal goods require huge amount during. 6. Technology and production cycle. If a company, is using labour intensive technique of production then more working capital is required whereas if company is using machine:intensive techhique of production then less working capital is required. In case of production cycle, if production cycle is long then more working capital will be required whereas when production cycle is small less working capital is required. 7. Credit allowed. If company is following liberal credit policy then it will require more working capital whereas if company is following strict or short term credit policy, then it can manage with less working capital also. 8. Credit avail. If suppliers of raw materials are giving long term credit then company can manage with less amount of working capital whereas if suppliers are giving only short period credit then company will require more working capital to make payments to creditors. 11

12 9. Operating efficiency. The firm having high degree of operating efficiency requires less amount of working capital as compared to firm having low degree of efficiency which requires more working capital 10. Availability of raw materials. If raw materials are easily available and there is ready supply of raw materials and inputs then firms can manage with less amount of working capital. Whereas if the supply of raw materials is not smooth, Companies require more working capital. 11. Level of competition. If the market is competitive then company require more working capital. A business with less competition or with monopoly position will require less working capital. 12. Inflation If there is increase or rise in prices, then it will increase in working capital requirement. But if company is able to increase the price of its own goods as well, then there will be less problem of working capital. 13. Growth prospects. Firms planning to expand their activities will require more amount of working capital. 12