Financial Management

Written and reviewed by Rohit Singh, Computer Science & Commerce faculty at UniDrill (MCA, Osmania University · 6 years teaching). Based on NCERT Business Studies Class XII, Chapter 9.

Why does a profitable bakery still run out of cash?

Anand Bakers has had a good year. Orders are rising, the books show a profit, and the owner wants a second outlet. Then the flour supplier calls for payment and the account is empty: the cash is stuck in unsold cakes and in bills that customers have not paid yet. The owner now faces three questions at once. Which assets should the money go into? Where should the new money come from, a bank loan or new partners? And of the profit that is left, how much should be paid out and how much kept?

Those three questions are the three financial decisions that this chapter is built on: investment, financing and dividend. Everything else, such as capital structure, fixed capital and working capital, is a detail inside one of them.

Business finance and financial management

Business finance is the money needed to carry out business activities: to establish a business, run it day to day, modernise it, expand it or diversify it. Money is needed for tangible assets such as machinery and factories, for intangible assets such as patents and trademarks, and for daily operations.

Financial management is about the best way to procure finance and the best way to use it. Funds are compared on cost and risk, and whatever is raised must earn a return higher than what it cost. The aim is to keep the cost of funds low, keep risk under control, deploy funds well, keep enough funds available and avoid idle money.

It matters because almost every line of the financial statements is shaped by a financial decision, as the table shows.

The real objective: wealth maximisation

A business could aim for the biggest possible profit this year. Financial management aims higher: it aims to maximise the current market price of the company's equity shares, which is the wealth of the shareholders. The share price goes up only when the benefit of a decision is greater than its cost, so a decision that lowers the share price is a poor financial decision, even if it shows a quick profit.

Beyond the textbook. For the exam: the objective is wealth maximisation, meaning the market price of equity shares. In reality: the market price reflects what investors expect about future earnings and risk, not just this year's profit. A firm that boosts this year's profit by cutting maintenance or training may see its share price fall, because buyers can see that future earnings are weaker. Why it matters: it explains why "maximise profit" is the tempting wrong option in so many MCQs.

The three financial decisions

Remember that the investment decision has two parts. CUET likes to show only one of them and call it "the investment decision".

Investment decision: capital budgeting

Capital budgeting is the long-term investment decision: committing funds to something like a new machine, a new branch or a new product line. These decisions involve large amounts, cannot easily be reversed and decide the firm's earning capacity for years. A wrong choice is costly to undo.

Three factors affect the decision.

Working capital decisions are the short-term side of the investment decision: how much cash, stock and credit to customers the business should carry. They decide liquidity and profitability in day-to-day operations.

Financing decision

The financing decision is about the quantum of long-term finance to raise from shareholders' funds (equity and retained earnings) and from borrowed funds (debentures and loans). Debt is usually the cheapest source, and the tax saving on interest makes it cheaper still. But interest must be paid whether or not the firm earns a profit, so debt carries financial risk. Dividends are not compulsory, so equity carries no such burden, but it costs more.

Pause and predict: a firm with high fixed operating costs and weak cash flows wants Rs 50 lakh. A banker offers a loan at a low rate. Why might the firm still hesitate?

Check your answer: a loan adds fixed interest on top of fixed operating costs, and weak cash flows may not cover both. The low rate looks attractive, but the risk of failing to pay is what the firm is weighing.

Dividend decision

A company must decide how much of its profit after tax to distribute to shareholders as dividend and how much to keep as retained earnings to fund growth. Paying more makes shareholders happy now, but leaves less for expansion.

Beyond the textbook. For the exam: taxation policy is a factor in the dividend decision, because the way dividends are taxed can make a payout more or less attractive. In reality: the tax on dividends used to be paid by the company as a Dividend Distribution Tax. Since 2020 that tax has been removed, and dividends are taxed in the hands of the shareholder who receives them. Why it matters: the factor still exists, only the person who pays the tax has changed.

Financial planning

Financial planning is a blueprint of the firm's future operations in money terms. It has two aims: to make sure funds are available whenever they are needed, and to make sure the firm does not raise more than it needs. Both shortage and excess are costly, because a shortage disrupts work and idle surplus funds cost interest or earn nothing.

Plans usually look three to five years ahead. A plan for one year or less is a budget. The process starts with a sales forecast, since everything else, from stock to staff, follows from expected sales. Financial planning is not a substitute for financial management: planning is about how much money is needed and when, while management is about choosing the best way to get and use it.

Capital structure

Capital structure is the mix of owners' funds (equity) and borrowed funds (debt) that a firm uses. The proportion of debt is the financial leverage, shown as a ratio of debt to equity or of debt to total capital.

$$\text{Debt-equity ratio} = \dfrac{D}{E} \qquad \text{or} \qquad \dfrac{D}{D+E}$$

Debt is cheaper than equity for two reasons: the lender's risk is lower because interest is paid before dividends and is backed by a legal claim, and interest is deductible from taxable profit. More debt therefore lowers the overall cost of capital, but it raises financial risk, the chance that the firm fails to meet its payment obligations. The optimum capital structure is the mix that balances risk and return so that shareholders' wealth is as high as possible.

Trading on Equity means that equity shareholders gain extra earnings per share because the firm uses debt at a fixed interest rate. It works only when the return on investment is higher than the cost of debt.

$$\text{RoI} = \dfrac{\text{EBIT}}{\text{Total investment}} \times 100 \qquad \text{EPS} = \dfrac{\text{Profit after tax}}{\text{Number of equity shares}}$$

Worked example: when debt helps and when it hurts. A company has Rs 20 lakh of funds. Shares have a face value of Rs 10, the tax rate is 30 percent, and borrowed money carries 10 percent interest. Plan A raises everything from equity (2 lakh shares). Plan B raises Rs 10 lakh from equity (1 lakh shares) and Rs 10 lakh as debt. Compare EPS when EBIT is Rs 3 lakh (RoI 15 percent) and when EBIT is Rs 1 lakh (RoI 5 percent).

When RoI (15 percent) is above the cost of debt (10 percent), debt lifts EPS from Rs 1.05 to Rs 1.40. When RoI (5 percent) is below the cost of debt, debt wipes out the profit and EPS falls from Rs 0.35 to nil. The common wrong step is to apply tax on EBIT instead of on profit after interest, which hides the tax saving that makes debt cheaper.

Pause and predict: in the example, what happens to Plan B's EPS if EBIT is exactly Rs 2 lakh, which gives RoI equal to the 10 percent cost of debt?

Check your answer: Plan A gives profit after tax of Rs 1.40 lakh over 2 lakh shares, so EPS is Rs 0.70. Plan B has interest of Rs 1 lakh, profit before tax of Rs 1 lakh, profit after tax of Rs 0.70 lakh over 1 lakh shares, so EPS is also Rs 0.70. At RoI equal to the cost of debt, debt neither helps nor hurts.

Beyond the textbook. For the exam: debt is cheaper than equity, so more debt lowers the overall cost of capital. In reality: lenders ask for higher interest from a firm that is already heavily borrowed, and shareholders ask for a higher return as the firm becomes riskier. Beyond a point, extra debt stops being cheap. Why it matters: this is why the chapter talks about an optimum mix rather than "as much debt as possible".

Factors affecting the choice of capital structure

The two coverage ratios are the ones students forget to define.

$$\text{ICR} = \dfrac{\text{EBIT}}{\text{Interest}}$$

$$\text{DSCR} = \dfrac{\text{PAT} + \text{Depreciation} + \text{Interest} + \text{Non-cash expenses}}{\text{Preference dividend} + \text{Interest} + \text{Repayment obligation}}$$

ICR looks only at interest. DSCR is wider: it adds repayment of the loan and preference dividend to the obligations, and adds back depreciation and other non-cash items to the cash available.

Fixed capital

Fixed capital is the money invested in long-term assets that stay in the business for more than one year: land, building, plant, machinery and vehicles. It must be financed from long-term sources such as equity, preference shares, debentures, long-term loans and retained earnings. Decisions here are capital budgeting decisions: large funds, long-term effect, high risk and hard to reverse.

Working capital

Working capital is the money invested in current assets: cash, marketable securities, bills receivable, debtors, stock and prepaid expenses. Current assets are more liquid than fixed assets but earn less. Net working capital is the excess of current assets over current liabilities.

$$\text{Net working capital} = \text{Current assets} - \text{Current liabilities}$$

A firm with current assets of Rs 8 lakh and current liabilities of Rs 5 lakh has net working capital of Rs 3 lakh. In order of liquidity, the main current assets run: cash, marketable securities, bills receivable, debtors, finished goods, work in progress, raw materials and prepaid expenses.

Why it matters. Anand Bakers in the opening was profitable but short of cash because its working capital was locked in stock and debtors. Profit is an accounting figure; working capital is what keeps the shop open this week.

Exam traps

60-second revision

Where this chapter connects

The sources that supply the funds discussed here, equity, debentures and loans, are described in Sources of Business Finance. The sales forecast and budgets that start financial planning belong to the planning function in Planning. The coverage and turnover ratios used to judge capital structure and working capital are worked out in Accounting Ratios, and the movement of cash that decides dividend capacity is covered in Cash Flow Statement.