NCERT Class 12 Business Studies Chapter 9 PDF

chapter 9 Financial Management Learning Objectives When Tata Steel Acquired Corus...

chapter 9 Financial Management Learning Objectives When Tata Steel Acquired Corus After studying this chapter, you Tata Steel, the biggest steel producer in should be able to: the Indian private sector has acquired Corus, (formerly known as British Steel) in a deal worth $8.6 billion in ¾¾ explain the meaning of 2007. This makes Tata Steel the fifth business finance; largest steel producer in the world. A financial decision of this magnitude ¾¾ d e s c r i b e f i n a n c i a l has significant implicitness for both management; Tata Steel and Corus as well as their employees and shareholders. To mention some of them: ¾¾ explain the role of financial management in our yyTata Steel raised a debt of over $8 billion to finance the transaction. enterprise; The deal will be paid for by Tata Steel UK, a special purpose vehicle (SPV) ¾¾ d i s c u s s o b j e c t i v e s o f set up for the purpose. This SPV financial management and received funds from Tata Steel routed how they could be achieved; through a Singapore subsidiary. Another company of the Tata group, ¾¾ explain the meaning and Tata Sons Ltd., invested $ 1 billion dollars for preference shares along importance of financial with Tata Steel which will invest an planning; equal amount. yyTata Steel, the acquirer company, ¾¾ state the meaning of capital arranged about 36,500 crores of structure; rupees to finance the take-over. yyTata Steel raised this amount through ¾¾ analyse the factors affecting debt or equity or a combination the choice of an appropriate of both. Some amount came from capital structure; internal accruals also. This financing decision affected the capital structure ¾¾ state meaning of fixed capital of Tata Steel. and working capital; and yyNeedless to emphasise, decisions like this affect the future of the organisation. These decisions are ¾¾ analyse the factors affecting almost irrevocable after they have been the requirement of fixed and formalised. working capital. Source: The Economic Times 2020-21 Ch_9.indd 225 10/1/2019 10:13:39 AM  BUSINESS  STUDIES 226 Introduction thus, very crucial for the survival and growth of a business. In the above case, these decisions require careful financial planning, Financial Management an understanding of the resultant capital structure and the riskiness All finance comes at some cost. It and profitability of the enterprise. All is quite imperative that it needs to these have a bearing on shareholders be carefully managed. Financial as well as employees. They require Management is concerned with optimal an understanding of business procurement as well as the usage of finance, major financial decision finance. For optimal procurement, areas, financial risk, and working different available sources of finance capital requirements of the business. are identified and compared in terms Finance, as we all know, is essential of their costs and associated risks. for running a business. Success of Similarly, the finance so procured business depends on how well finance needs to be invested in a manner that is invested in assets and operations the returns from the investment exceed and how timely and cheaply the the cost at which procurement has finances are arranged, from outside taken place. Financial Management or from within the business. aims at reducing the cost of funds procured, keeping the risk under Meaning of Business Finance control and achieving effective deployment of such funds. It also Money required for carrying out aims at ensuring availability of enough business activities is called business funds whenever required as well as finance. Almost all business activities avoiding idle finance. Needless to require some finance. Finance is emphasise, the future of a business needed to establish a business, to depends a great deal on the quality of run it, to modernise it, to expand, or its financial management. diversify it. It is required for buying Importance : The role of financial a variety of assets, which may be management cannot be over- tangible like machinery, factories, emphasised, since it has a direct buildings, offices; or intangible such bearing on the financial health of a as trademarks, patents, technical business. The financial statements, expertise, etc. Also, finance is central such as Balance Sheet and Profit to running the day-to-day operations and Loss Account, reflect a firm’s of business, like buying material, financial position and its financial paying bills, salaries, collecting cash health. Almost all items in the financial from customers, etc. needed at every statements of a business are affected stage in the life of a business entity. directly or indirectly through some Availability of adequate finance is, financial management decisions. Some 2020-21 Ch_9.indd 226 10/1/2019 10:13:39 AM  Financial Managements 227 prominent examples of the aspects raised by way of debt and/or equity being affected could be as under: is also a financial management (i) The size and the composition of decision. The amounts of debt, fixed assets of the business: For equity share capital, preference example, a capital budgeting share capital are affected by the financing decision, which is a part decision to invest a sum of Rs. 100 of financing management. crores in fixed assets would raise the size of fixed assets block by this (v) All items in the Profit and Loss amount. Account, e.g., Interest, Expense, Depreciation, etc. : Higher amount (ii) The quantum of current assets and of debt means higher interest its break-up into cash, inventory expense in future. Similarly, use and receivables: With an increase of higher equity may entail higher in the investment in fixed assets, payment of dividends. Similarly, an there is a commensurate increase expansion of business which is a in the working capital requirement. result of capital budgeting decision The quantum of current assets is likely to affect virtually all items is also influenced by financial in the profit and loss account of the management decisions. In addition, business. decisions about credit and inventory It can, thus, be stated that the management affect the amount of financial statements of a business debtors and inventory which in are largely determined by financial turn affect the total current assets as well as their composition. management decisions taken earlier. Similarly, the future financial (iii) The amount of long-ter m and statements would depend upon past short- ter m funds to be used: as well as current financial decisions. Financial management, among Thus, the overall financial health others, involves decision about of a business is determined by the the proportion of long-term and quality of its financial management. short-term funds. An organisation Good financial management aims at wanting to have more liquid assets mobilisation of financial resources at would raise relatively more amount a lower cost and deployment of these on a long-term basis. There is in most lucrative activities. a choice between liquidity and profitability. The underlying assumption here is that current Objectives liabilities cost less than long term The primary aim of financial liabilities. management is to maximise (iv) Break-up of long-term financing into shareholders’ wealth, which is referred debt, equity etc: Of the total long- to as the wealth-maximisation concept. term finance, the proportions to be The market price of a company’s shares 2020-21 Ch_9.indd 227 10/1/2019 10:13:39 AM  BUSINESS  STUDIES 228 is linked to the three basic financial some value addition should take place. decisions which you will study a little All those avenues of investment, modes later. This is because a company funds of financing, ways of handling various belong to the shareholders and the components of working capital must manner in which they are invested and be identified which will ultimately lead the return earned by them determines to an increase in the price of equity their market value and price. It means share. It can happen through efficient maximisation of the market value of decision-making. Decision-making is equity shares. The market price of efficient if, out of the various available equity share increases, if the benefit alternatives, the best is selected. from a decision exceeds the cost involved. All financial decisions aim at Financial Decisions ensuring that each decision is efficient Financial management is concerned and adds some value. Such value with the solution of three major issues additions tend to increase the market relating to the financial operations price of shares. Therefore, those of a firm corresponding to the three financial decisions are taken which questions of investment, financing will ultimately prove gainful from and divident decision. In a financial the point of view of the shareholders. context, it means the selection of The shareholders gain if the value of best financing alternative or best shares in the market increases. Those investment alternative. The finance decisions which result in decline in function, therefore, is concerned the share price are poor financial with three broad decisions which are decisions. Thus, we can say, the explained below: objective of financial management is to maximise the current price of equity Investment Decision shares of the company or to maximise the wealth of owners of the company, A firm’s resources are scarce in that is, the shareholders. comparison to the uses to which Therefore, when a decision is taken they can be put. A firm, therefore, about investment in a new machine, has to choose where to invest these the aim of financial management resources, so that they are able to earn is to ensure that benefits from the the highest possible return for their investment exceed the cost so that investors. The investment decision, some value addition takes place. therefore, relates to how the firm’s Similarly, when finance is procured, funds are invested in different assets. the aim is to reduce the cost so that Investment decision can be long- the value addition is even higher. term or short-term. A long-term In fact, in all financial decisions, investment decision is also called a major or minor, the ultimate objective Capital Budgeting decision. It involves that guides the decision-maker is that committing the finance on a long- 2020-21 Ch_9.indd 228 10/1/2019 10:13:39 AM  Financial Managements 229 term basis. For example, making decisions) are concerned with the investment in a new machine to decisions about the levels of cash, replace an existing one or acquiring inventory and receivables. These a new fixed asset or opening a new decisions affect the day-to-day branch, etc. These decisions are very working of a business. These affect crucial for any business since they the liquidity as well as profitability of a affect its earning capacity in the long business. Efficient cash management, run. The size of assets, profitability inventory management and receivables and competitiveness are all affected by management are essential ingredients capital budgeting decisions. Moreover, of sound working capital management. these decisions normally involve huge amounts of investment and are Factors affecting Capital irreversible except at a huge cost. Budgeting Decision Therefore, once made, it is often almost A number of projects are often available impossible for a business to wriggle out to a business to invest in. But each of such decisions. Therefore, they need project has to be evaluated carefully to be taken with utmost care. These and, depending upon the returns, a particular project is either selected or rejected. If there is only one project, its viability in terms of the rate of return, viz., investment and its comparability with the industry’s average is seen. There are certain factors which affect capital budgeting decisions. (a) Cash flows of the project: When a company takes an investment decision involving huge amount it expects to generate some cash flows over a period. These cash flows are in the form of a series Wealth Maximisation Concept of cash receipts and payments over the life of an investment. The amount of these cash flows decisions must be taken by those who should be carefully analysed before understand them comprehensively. considering a capital budgeting A bad capital budgeting decision decision. normally has the capacity to severely (b) The rate of retur n: The most damage the financial fortune of a important criterion is the rate business. Short-ter m investment of return of the project. These decisions (also called working capital calculations are based on the 2020-21 Ch_9.indd 229 10/1/2019 10:13:40 AM  BUSINESS  STUDIES 230 expected returns from each whether or not a firm has earned a proposal and the assessment of profit. Likewise, the borrowed funds the risk involved. Suppose, there have to be repaid at a fixed time. The are two projects, A and B (with the risk of default on payment is known same risk involved), with a rate as financial risk which has to be of return of 10 per cent and 12 considered by a firm likely to have per cent, respectively, then under insufficient shareholders to make normal circumstance, project B these fixed payments. Shareholders’ should be selected. funds, on the other hand, involve no (c) The investment criteria involved: commitment regarding the payment The decision to invest in a particular of returns or the repayment of capital. project involves a number of A firm, therefore, needs to have a calculations regarding the amount judicious mix of both debt and equity of investment, interest rate, cash in making financing decisions, which flows and rate of return. There are may be debt, equity, preference share different techniques to evaluate capital, and retained earnings. inv e s t m ent p ro p o sals which The cost of each type of finance has are known as capital budgeting to be estimated. Some sources may techniques. These techniques are be cheaper than others. For example, applied to each proposal before debt is considered to be the cheapest selecting a particular project. of all the sources, tax deductibility of interest makes it still cheaper. Financing Decision Associated risk is also different for This decision is about the quantum each source, e.g., it is necessary to of finance to be raised from various pay interest on debt and redeem the long-term sources. Short-term sources principal amount on maturity. There are studied under the ‘working capital is no such compulsion to pay any management’. dividend on equity shares. Thus, there It involves identification of various is some amount of financial risk in available sources. The main sources debt financing. The overall financial of funds for a firm are shareholders’ risk depends upon the proportion of funds and borrowed funds. The debt in the total capital. The fund shareholders’ funds refer to the equity raising exercise also costs something. capital and the retained earnings. This cost is called floatation cost. Borrowed funds refer to the finance It also must be considered while raised through debentures or other evaluating different sources. Financing forms of debt. A firm has to decide the decision is, thus, concerned with the proportion of funds to be raised from decisions about how much to be raised either sources, based on their basic from which source. This decision characteristics. Interest on borrowed determines the overall cost of capital funds have to be paid regardless of and the financial risk of the enterprise. 2020-21 Ch_9.indd 230 10/1/2019 10:13:40 AM  Financial Managements 231 Financial Decisions Factors Affecting Financing different. A prudent financial Decisions manager would normally opt for a The financing decisions are affected source which is the cheapest. by various factors. Important among (b) Risk: The risk associated with each them are as follows: of the sources is different. (a) Cost: The cost of raising funds (c) Floatation Costs: Higher the floatation through different sources are cost, less attractive the source. 2020-21 Ch_9.indd 231 10/1/2019 10:13:40 AM  BUSINESS  STUDIES 232 (d) Cash Flow Position of the Company: the choice of source of fund. During A stronger cash flow position may the period when stock market is make debt financing more viable rising, more people invest in equity. than funding through equity. However, depressed capital market (e) Fixed Operating Costs: If a business may make issue of equity shares has high fixed operating costs (e.g., difficult for any company. building rent, Insurance premium, Salaries, etc.), It must reduce fixed Dividend Decision financing costs. Hence, lower debt financing is better. Similarly, if The third important decision that every financial manager has to fixed operating cost is less, more take relates to the distribution of of debt financing may be preferred. dividend. Dividend is that portion (f) Control Considerations: Issues of of profit which is distributed to more equity may lead to dilution shareholders. The decision involved of management’s control over here is how much of the profit earned the business. Debt financing has by company (after paying tax) is to be no such implication. Companies distributed to the shareholders and afraid of a takeover bid would how much of it should be retained prefer debt to equity. in the business. While the dividend (g) State of Capital Market: Health of constitutes the current income the capital market may also affect re-investment as retained earning India Inc. Issues Bonus Shares and Dividends Corporate India has opened its purse strings to shareholders with interim dividends and bonus shares. At least 60 companies have declared interim dividend or announced plans to do so in the first three weeks of January. In addition, around 12 companies have announced bonus share issues this month, about three times more than January 2006. There are range of things that a company can do for maximising shareholder value and dividend is the most direct and simple form of it. Ideally companies need to balance it up between paying cash and building value of the stock for total shareholder returns. This trend of dividends and bonuses is in synchronisation with the good profits being posted by companies. It’s a way of rewarding shareholders. A number of companies have also announced plans of bonus shares for their shareholders. Most of the companies who have already declared bonus issues or announced that they would be taking it up in their next board meeting are small or mid-sized companies. Source: The Economic Times 2020-21 Ch_9.indd 232 10/1/2019 10:13:40 AM  Financial Managements 233 increases the firm’s future earning the change in earnings is small or capacity. The extent of retained seen to be temporary in nature. earnings also influences the financing (d) Growth Opportunities: Companies decision of the firm. Since the firm having good growth opportunities does not require funds to the extent retain more money out of their of re-invested retained earnings, the earnings so as to finance the decision regarding dividend should required investment. The dividend be taken keeping in view the overall in growth companies is, therefore, objective of maximising shareholder’s smaller, than that in the non– wealth. growth companies. Factors Affecting Dividend (e) Cash Flow Position: The payment Decision of dividend involves an outflow of cash. A company may be earning How much of the profits earned by a profit but may be short on cash. company will be distributed as profit Availability of enough cash in and how much will be retained in the the company is necessary for business is affected by many factors. declaration of dividend. Some of the important factors are (f) Shareholders’ Preference: While discussed as follows: declaring dividends, managements (a) Amount of Earnings: Dividends must keep in mind the preferences are paid out of current and past of the shareholders in this regard. If earning. Therefore, earnings is a the shareholders in general desire major determinant of the decision that at least a certain amount is about dividend. paid as dividend, the companies (b) Stability Earnings: Other things are likely to declare the same. There remaining the same, a company are always some shareholders who having stable earning is in a better depend upon a regular income position to declare higher dividends. from their investments. As against this, a company having (g) Taxation Policy: The choice between unstable earnings is likely to pay the payment of dividend and smaller dividend. retaining the earnings is, to some (c) Stability of Dividends: Companies extent, affected by the difference in generally follow a policy of the tax treatment of dividends and stabilising dividend per share. The capital gains. If tax on dividend is increase in dividends is generally higher, it is better to pay less by made when there is confidence that way of dividends. As compared their earning potential has gone to this, higher dividends may be up and not just the earnings of declared if tax rates are relatively the current year. In other words, lower. Though the dividends are free dividend per share is not altered if of tax in the hands of shareholders, 2020-21 Ch_9.indd 233 10/1/2019 10:13:40 AM  BUSINESS  STUDIES 234 a dividend distribution tax is levied Financial Planning on companies. Thus, under the present tax policy, shareholders Financial planning is essentially the are likely to prefer higher dividends. preparation of a financial blueprint of an organisation’s future operations. (h) Stock Market Reaction: Investors, The objective of financial planning in general, view an increase in is to ensure that enough funds are dividend as a good news and stock prices react positively to it. available at right time. If adequate Similarly, a decrease in dividend funds are not available the firm will may have a negative impact on the not be able to honour its commitments share prices in the stock market. and carry out its plans. On the other Thus, the possible impact of hand, if excess funds are available, it dividend policy on the equity share will unnecessarily add to the cost and price is one of the important factors may encourage wasteful expenditure. considered by the management It must be kept in mind that financial while taking a decision about it. planning is not equivalent to, or a (i) Access to Capital Market: Large and substitute for, financial management. reputed companies generally have Financial management aims at easy access to the capital market choosing the best investment and and, therefore, may depend less financing alternatives by focusing on on retained earning to finance their costs and benefits. Its objective their growth. These companies is to increase the shareholders’ wealth. tend to pay higher dividends than Financial planning on the other the smaller companies which have hand aims at smooth operations relatively low access to the market. by focusing on fund requirements (j) Legal Constraints: Certain and their availability in the light of provisions of the Companies Act financial decisions. For example, if a place restrictions on payouts as capital budgeting decisions is taken, dividend. Such provisions must the operations are likely to be at a be adhered to while declaring the higher scale. The amount of expenses dividend. and revenues are likely to increase. (k) Contractual Constraints: While Financial planning process tries to granting loans to a company, forecast all the items which are likely sometimes the lender may impose to undergo changes. It enables the certain restrictions on the payment management to foresee the fund of dividends in future. The requirements both the quantum as companies are required to ensure well as the timing. Likely shortage that the dividend does not violate and surpluses are forecast so that the terms of the loan agreement in necessary activities are taken in this regard. advance to meet those situations. 2020-21 Ch_9.indd 234 10/1/2019 10:13:40 AM  Financial Managements 235 Thus, financial planning strives to programmes. Short-term planning achieve the following twin objectives. covers short-term financial plan called (a) To ensure availability of funds budget. whenever required: This include Typically, financial planning is a proper estimation of the funds done for three to five years. For longer required for different purposes periods it becomes more difficult and such as for the purchase of long- less useful. Plans made for periods of term assets or to meet day-to- one year or less are termed as budgets. day expenses of business etc. Budgets are example of financial Apart from this, there is a need to planning exercise in greater details. estimate the time at which these They include detailed plan of action funds are to be made available. for a period of one year or less. Financial planning also tries to Financial planning usually begins specify possible sources of these with the preparation of a sales forecast. funds. Let us suppose a company is making (b) To see that the firm does not a financial plan for the next five years. raise resources unnecessarily: It will start with an estimate of the Excess funding is almost as bad sales which are likely to happen in as inadequate funding. Even if the next five years. Based on these, there is some surplus money, good the financial statements are prepared financial planning would put it to keeping in mind the requirement the best possible use so that the of funds for investment in the fixed financial resources are not left idle capital and working capital. Then the and don’t unnecessarily add to the expected profits during the period are cost. estimated so that an idea can be made of how much of the fund requirements Thus, a proper matching of funds can be met internally i.e., through requirements and their availability retained earnings (after dividend is sought to be achieved by financial payouts). This results in an estimation planning. This process of estimating of the requirement for external funds. the fund requirement of a business Further, the sources from which the and specifying the sources of funds external funds requirement can be is called financial planning. Financial met are identified and cash budgets planning takes into consideration the are made, incorporating these factors. growth, performance, investments and requirement of funds for a given period. Financial planning includes Importance both short-term as well as long-term Financial planning is an important planning. Long-term planning relates part of overall planning of any business to long term growth and investment. enterprise. It aims at enabling the It focuses on capital expenditure company to tackle the uncertainty in 2020-21 Ch_9.indd 235 10/1/2019 10:13:40 AM  BUSINESS  STUDIES 236 respect of the availability and timing sales is predicted. However, it of the funds and helps in smooth may happen that the growth rate functioning of an organisation. The eventually turns out to be 10% importance of financial planning can or 30%. Many items of expenses be explained as follows: shall be different in these three (i) It helps in forecasting what may situations. By preparing a happen in future under different blueprint of these three situations business situations. By doing the management may decide what so, it helps the firms to face the eventual situation in a better way. must be done in each of these In other words, it makes the firm situations. This preparation of better prepared to face the future. alternative financial plans to meet For example, a growth of 20% in different situations is clearly of Cutting Back on Debt Even successful businesses have debt, but how much is too much? Learning how to manage debt is what can put you ahead. Taking on the right amount of debt can mean the difference between a business struggling to survive and one that can respond nimbly to changing economic or market conditions. A number of circumstances may justify acquiring debt. As a general rule, borrowing makes the most sense when you need to bolster cash flow or finance growth or expansion. But while debt can provide the leverage you need to grow, too much debt can strangle your business. So the question is: How much debt is too much? The answer, experts say, lies in a careful analysis of your cash flow as well as your industry. A business that doesn’t grow dies. You’ve got to grow, but you’ve got to grow within the financial constraints of your business. What is the ideal capital structure a business needs in its industry to remain viable? The higher the volatility (in your industry), the less debt you should have. The smaller the volatility, the more debt you can afford. Although banks and other financial institutions look for a satisfactory debt-to- equity ratio before agreeing to make a loan, don’t assume a creditor’s willingness to extend funds is evidence that your business is in a strong debt position. Some financial institutions are overzealous lenders, particularly when trying to lure or hold on to promising business customers. “The bank may be looking more at collateral than whether the (business’s) earnings are going to come in to justify the debt service. To avoid these and other credit pitfalls, it’s up to you to get the financial facts on your business and make sound borrowing decisions. Unfortunately, many entrepreneurs fail to recognise how important financial analysis is to running a successful business. Even business owners who receive detailed financial statements from their accountants often do not take advantage of the valuable information contained in the documents. 2020-21 Ch_9.indd 236 10/1/2019 10:13:40 AM  Financial Managements 237 immense help in running the public deposits etc. These may be business smoothly. borrowed from banks, other financial (ii) It helps in avoiding business institutions, debentureholders and shocks and surprises and helps public. the company in preparing for the Capital structure refers to the mix future. between owners and borrowed funds. These shall be referred as equity and (iii) If helps in co-ordinating various debt in the subsequent text. It can business functions, e.g., sales be calculated as debt-equity ratio and production functions, by providing clear policies and  Debt  i.e.,  or as the proportion procedures.  Equity  (iv) Detailed plans of action prepared of debt out of the total capital i.e., under financial planning reduce waste, duplication of efforts, and  Debt  gaps in planning.  Debt + Equity . (v) It tries to link the present with the Debt and equity differ significantly future. in their cost and riskiness for the (vi) It provid es a lin k between firm. The cost of debt is lower than investment and financing decisions the cost of equity for a firm because on a continuous basis. the lender’s risk is lower than the (vii) By spelling out detailed objectives equity shareholder’s risk, since the for various business segments, it lender earns an assured return and makes the evaluation of actual repayment of capital and, therefore, performance easier. they should require a lower rate of return. Additionally, interest paid Capital Structure on debt is a deductible expense for computation of tax liability whereas One of the important decisions under dividends are paid out of after-tax financial management relates to the profit. Increased use of debt, therefore, financing pattern or the proportion of is likely to lower the over-all cost of the use of different sources in raising capital of the firm provided that the funds. On the basis of ownership, the cost of equity remains unaffected. sources of business finance can be Impact of a change in the debt-equity broadly classified into two categories ratio upon the earning per share viz., ‘owners’ funds’ and ‘borrowed is dealt with in detail later in this funds’. Owners’ funds consist of chapter. equity share capital, preference share Debt is cheaper but is more risky capital and reserves and surpluses or for a business because the payment of retained earnings. Borrowed funds can interest and the return of principal is be in the form of loans, debentures, obligatory for the business. Any default 2020-21 Ch_9.indd 237 10/1/2019 10:13:41 AM  BUSINESS  STUDIES 238 in meeting these commitments may Capital structure of a company, force the business to go into liquidation. thus, affects both the profitability and There is no such compulsion in case of the financial risk. A capital structure equity, which is therefore, considered will be said to be optimal when the riskless for the business. Higher use proportion of debt and equity is of debt increases the fixed financial such that it results in an increase charges of a business. As a result, in the value of the equity share. In increased use of debt increases the other words, all decisions relating to financial risk of a company. capital structure should emphasise on Financial risk is the chance that increasing the shareholders’ wealth. a firm would fail to meet its payment The proportion of debt in the overall obligations. capital is also called financial leverage. Example I Company X Ltd. Total Funds used Rs. 30 Lakh Interest rate 10% p.a. Tax rate 30% EBIT Rs. 4 Lakh Debt Situation I Nil Situation II Rs. 10 Lakh Situation III Rs. 20 Lakh EBIT-EPS Analysis Situation I Situation II Situation III EBIT 4,00,000 4,00,000 4,00,000 Interest NIL 1,00,000 2,00,000 EBT 4,00,000 3,00,000 2,00,000 (Earnings before taxes) Tax 1,20,000 90,000 60,000 EAT 2,80,000 2,10,000 1,40,000 (Earnings after taxes) No. of shares of Rs.10 3,00,000 2,00,000 1,00,000 EPS 0.93 1.05 1.40 (Earnings per share) 2020-21 Ch_9.indd 238 10/1/2019 10:13:41 AM  Financial Managements 239 D that company is earning on funds Financial leverage is computed as employed. The company is earning a E D return on investment (RoI) or D + E when D is the Debt and E is  EBIT  of 13.33%   100  the Equity. As the financial leverage  Total Investment , increases, the cost of funds declines  4Lakh    100 . This is higher than because of increased use of cheaper 30Lakh  debt but the financial risk increases. the 10% interest it is paying on debt The impact of financial leverage on the funds. With higher use of debt, this profitability of a business can be seen difference between RoI and cost of debt through EBIT-EPS (Earning before Interest and Taxes-Earning per Share) increases the EPS. This is a situation analysis as in the following example. of favourable financial leverage. In Three situations are considered. such cases, companies often employ There is no debt in situation-I i.e. more of cheaper debt to enhance the (unlevered business). Debt of Rs. 10 EPS. Such practice is called Trading lakh and 20 lakh are assumed in on Equity. situations-II and III, respectively. All Trading on Equity refers to the debt is at 10% p.a. increase in profit earned by the equity The company earns Rs. 0.93 per shareholders due to the presence of share if it is unlevered. With debt of fixed financial charges like interest. Rs. 10 lakh its EPS is Rs. 1.05. With Now consider the following case of a still higher debt of Rs. 20 lakh, its, Company Y. All details are the same EPS rises to Rs. 1.40. Why is the EPS except that the company is earning rising with higher debt? It is because a profit before interest and taxes of the cost of debt is lower than the return Rs. 2 lakh. Example II Company Y Ltd. Situation I Situation II Situation III EBIT 2,00,000 2,00,000 2,00,000 Interest NIL 1,00,000 2,00,000 EBT 2,00,000 1,00,000 NIL Tax 60,000 30,000 NIL EAT 1,40,000 70,000 NIL No. of shares of Rs.10 3,00,000 2,00,000 1,00,000 EPS 0.47 0.35 NIL 2020-21 Ch_9.indd 239 10/1/2019 10:13:41 AM  BUSINESS  STUDIES 240 In this example, the EPS of the borrowing. Cash flows must not only company is falling with increased use cover fixed cash payment obligations of debt. It is because the Company’s but there must be sufficient buffer rate of return on investment (RoI) is also. It must be kept in mind that a less than the cost of debt. The RoI company has cash payment obligations 2Lakh for (i) normal business operations; for company Y is × 100 , i.e., 30Lakh (ii) for investment in fixed assets; 6.67%, whereas the interest rate on and (iii) for meeting the debt service debt is 10%. In such cases, the use commitments i.e., payment of interest of debt reduces the EPS. This is a and repayment of principal. situation of unfavourable financial 2. Interest Coverage Ratio (ICR): leverage. Trading on Equity is clearly The interest coverage ratio refers to unadvisable in such a situation. the number of times earnings before Even in case of Company X, interest and taxes of a company covers reckless use of Trading on Equity is the interest obligation. This may be not recommended. An increase in debt calculated as follows: may enhance the EPS but as pointed EBIT out earlier, it also raises the financial ICR = Interest risk. Ideally, a company must choose that risk-return combination which The higher the ratio, lower shall maximises shareholders’ wealth. The be the risk of company failing to debt-equity mix that achieves it, is the meet its interest payment obligations. optimum capital structure. However, this ratio is not an adequate measure. A firm may have a high EBIT Factors affecting the Choice of but low cash balance. Apart from Capital Structure interest, repayment obligations are Deciding about the capital structure also relevant. of a firm involves determining the 3. Debt Service Coverage Ratio relative proportion of various types (DSCR): Debt Service Coverage Ratio of funds. This depends on various takes care of the deficiencies referred factors. For example, debt requires to in the Interest Coverage Ratio (ICR). regular servicing. Interest payment The cash profits generated by the and repayment of principal are obligatory on a business. In addition operations are compared with the total a company planning to raise debt cash required for the service of the must have sufficient cash to meet the debt and the preference share capital. increased outflows because of higher It is calculated as follows: debt. Similarly, important factors Profit after tax + Depreciation + Interest + Non Cash exp. which determine the choice of capital Pref. Div + Interest + Repayment obligation structure are as follows: A higher DSCR indicates better 1. Cash Flow Position: Size of projected ability to meet cash commitments cash flows must be considered before and consequently, the company’s 2020-21 Ch_9.indd 240 10/1/2019 10:13:41 AM  Financial Managements 241 potential to increase debt component reason that a company can not use in its capital structure. debt beyond a point. If debt is used 4. Return on Investment (RoI): If beyond that point, cost of equity may the RoI of the company is higher, it go up sharply and share price may can choose to use trading on equity decrease inspite of increased EPS. to increase its EPS, i.e., its ability to Consequently, for maximisation of use debt is greater. We have already shareholders’ wealth, debt can be used observed in Example I that a firm only upto a level. can use more debt to increase its 8. Floatation Costs: Process of EPS. However, in Example II, use of raising resources also involves some higher debt is reducing the EPS. It is cost. Public issue of shares and because the firm is earning an RoI of debentures requires considerable only 6.67% which lower than its cost expenditure. Getting a loan from a of debt. In example I the RoI is 13.33%, financial institution may not cost so and trading on equity is profitable. much. These considerations may also It shows that, RoI is an important affect the choice between debt and determinant of the company’s ability equity and hence the capital structure. to use Trading on equity and thus the 9. Risk Consideration: As discussed capital structure. earlier, use of debt increases the 5. Cost of debt: A firm’s ability to financial risk of a business. Financial borrow at a lower rate increases its risk refers to a position when a capacity to employ higher debt. Thus, company is unable to meet its fixed more debt can be used if debt can be financial charges namely interest raised at a lower rate. payment, preference dividend and 6. Tax Rate: Since interest is a repayment obligations. Apart from deductible expense, cost of debt is the financial risk, every business affected by the tax rate. The firms in has some operating risk (also called our examples are borrowing @ 10%. business risk). Business risk depends Since the tax rate is 30%, the after upon fixed operating costs. Higher tax cost of debt is only 7%. A higher fixed operating costs result in higher tax rate, thus, makes debt relatively business risk and vice-versa. The total cheaper and increases its attraction risk depends upon both the business vis-à-vis equity. risk and the financial risk. If a firm’s 7. Cost of Equity: Stock owners business risk is lower, its capacity to expect a rate of return from the equity use debt is higher and vice-versa. which is commensurate with the risk 10. Flexibility: If a firm uses its they are assuming. When a company debt potential to the full, it loses increases debt, the financial risk flexibility to issue further debt. To faced by the equity holders, increases. maintain flexibility, it must maintain Consequently, their desired rate of some borrowing power to take care of return may increase. It is for this unforeseen circumstances. 2020-21 Ch_9.indd 241 10/1/2019 10:13:41 AM  BUSINESS  STUDIES 242 11. Control: Debt normally does business risk of a firm is higher, it can not cause a dilution of control. A not afford the same financial risk. It public issue of equity may reduce the should go in for low debt. Thus, the managements’ holding in the company management must know what the and make it vulnerable to takeover. industry norms are, whether they are This factor also influences the choice following them or deviating from them between debt and equity especially in and adequate justification must be companies in which the current holding there in both cases. of management is on a lower side. 12. Regulatory Framework: Every Fixed and Working Capital company operates within a regulatory Meaning framework provided by the law e.g., Every company needs funds to finance public issue of shares and debentures its assets and activities. Investment have to be made under SEBI is required to be made in fixed assets guidelines. Raising funds from banks and current assets. Fixed assets are and other financial institutions require fulfillment of other norms. The relative those which remains in the business ease with which these norms can, be for more than one year, usually met or the procedures completed may for much longer, e.g., plant and also have a bearing upon the choice of machinery, furniture and fixture, land the source of finance. and building, vehicles, etc. Decision to invest in fixed assets 13. Stock Market Conditions: If the must be taken very carefully as the stock markets are bullish, equity investment is usually quite large. Such shares are more easily sold even at decisions once taken are irrevocable a higher price. Use of equity is often except at a huge loss. Such decisions preferred by companies in such a are called capital budgeting decisions. situation. However, during a bearish Current assets are those assets phase, a company, may find raising which, in the normal routine of the of equity capital more difficult and it business, get converted into cash or may opt for debt. Thus, stock market cash equivalents within one year, e.g., conditions often affect the choice inventories, debtors, bills receivables, between the two. etc. 14. Capital Structure of other Companies: A useful guideline in the Management of Fixed Capital capital structure planning is the debt- Fixed capital refers to investment in equity ratios of other companies in long-term assets. Management of fixed the same industry. There are usually capital involves allocation of firm’s some industry norms which may help. capital to different projects or assets with Care however must be taken that the long-term implications for the business. company does not follow the industry These decisions are called investment norms blindly. For example, if the decisions or capital budgeting decisions 2020-21 Ch_9.indd 242 10/1/2019 10:13:41 AM  Financial Managements 243 and affect the growth, profitability and is undertaken. This may involve risk of the business in the long run. decisions like where to procure These long-term assets last for more funds from and at what rate of than one year. interest. It must be financed through (iii) Risk involved: Fixed capital involves long-term sources of capital such investment of huge amounts. It as equity or preference shares, affects the returns of the firm as a debentures, long-term loans and whole in the long-term. Therefore, retained earnings of the business. investment decisions involving Fixed Assets should never be financed fixed capital influence the overall through short-term sources. business risk complexion of the Investment in these assets firm. would also include expenditure on acquisition, expansion, modernisation (iv) Irreversible decisions: These and their replacement. These decisions decisions once taken, are not include purchase of land, building, reversible without incurring heavy plant and machinery, launching losses. Abandoning a project after a new product line or investing in heavy investment is made is quite advanced techniques of production. costly in terms of waste of funds. Major expenditures such as those Therefore, these decisions should on advertising campaign or research be taken only after carefully and development programme having evaluating each detail or else the long term implications for the firm adverse financial consequences are also examples of capital budgeting may be very heavy. decisions. The management of fixed Factors affecting the Requirement capital or investment or capital of Fixed Capital budgeting decisions are important for the following reasons: 1. Nature of Business: The type (i) Long-term growth: These decisions of business has a bearing upon have bearing on the long-term the fixed capital requirements. For growth. The funds invested in example, a trading concern needs long-term assets are likely to yield lower investment in fixed assets returns in the future. These will compared with a manufacturing affect the future prospects of the organisation; since it does not require business. to purchase plant and machinery, etc. (ii) Large amount of funds involved: 2. Scale of Operations: A larger These decisions result in a organisation operating at a higher substantial portion of capital funds scale needs bigger plant, more space being blocked in long-term projects. etc. and therefore, requires higher Therefore, these investments are investment in fixed assets when planned after a detailed analysis compared with the small organisation. 2020-21 Ch_9.indd 243 10/1/2019 10:13:41 AM  BUSINESS  STUDIES 244 3. Choice of Technique: Some textile company is diversifying and organisations are capital intensive starting a cement manufacturing whereas others are labour intensive. plant. Obviously, its investment in A capital-intensive organisation fixed capital will increase. requires higher investment in plant 7. Financing Alternatives: A developed and machinery as it relies less on financial market may provide leasing manual labour. The requirement of facilities as an alternative to outright fixed capital for such organisations purchase. When an asset is taken on would be higher. Labour intensive lease, the firm pays lease rentals and organisations on the other hand uses it. By doing so, it avoids huge sums require less investment in fixed assets. required to purchase it. Availability of Hence, their fixed capital requirement leasing facilities, thus, may reduce the is lower. funds required to be invested in fixed 4. Technology Upgradation: In certain assets, thereby reducing the fixed industries, assets become obsolete capital requirements. Such a strategy sooner. Consequently, their replace- is specially suitable in high risk lines ments become due faster. Higher of business. investment in fixed assets may, 8. Level of Collaboration: At times, therefore, be required in such cases. certain business organisations share For example, computers become each other’s facilities. For example, obsolete faster and are replaced much a bank may use another’s ATM or sooner than say, furniture. Thus, such some of them may jointly establish a organisations which use assets which particular facility. This is feasible if the are prone to obsolescence require scale of operations of each one of them higher fixed capital to purchase such is not sufficient to make full use of the assets. facility. Such collaboration reduces 5. Growth Prospects: Higher growth the level of investment in fixed assets of an organisation generally requires for each one of the participating higher investment in fixed assets. organisations. Even when such growth is expected, a company may choose to create Working Capital higher capacity in order to meet the Apart from the investment in fixed anticipated higher demand quicker. assets every business organisation This entails larger investment in fixed needs to invest in current assets. This assets and consequently larger fixed investment facilitates smooth day-to- capital. day operations of the business. Current 6. Diversification: A firm may choose assets are usually more liquid but to diversify its operations for various contribute less to the profits than fixed reasons, With diversification, fixed assets. Examples of current assets, in capital requirements increase e.g., a order of their liquidity, are as under. 2020-21 Ch_9.indd 244 10/1/2019 10:13:41 AM  Financial Managements 245 1. Cash in hand/Cash at Bank if it can be converted into cash quicker 2. Marketable securities and without reduction in value. Insufficient investment in current 3. Bills receivable assets may make it more difficult for 4. Debtors an organisation to meet its payment 5. Finished goods inventory obligations. However, these assets provide little or low return. Hence, a 6. Work in progress balance needs to be struck between 7. Raw materials liquidity and profitability. 8. Prepaid expenses Current liabilities are those These assets, as noted earlier, are payment obligations which are due expected to get converted into cash for payment within one year; such as or cash equivalents within a period bills payable, creditors, outstanding of one year. These provide liquidity to expenses and advances received from the business. An asset is more liquid customers, etc. Working Capital Position “Its been a rather glamorous 18 months, with sales just huge,” says, CFO of PT Astra International, the US $4 billion in sales Indonesian automaker. Indonesia was on the growth path again, and a new breed of consumer was eager for a first vehicle – motorcycles – as well as Astra’s more premium brands of Hondas and Toyotas. And one of the most beautiful parts of the proposition was that working capital management seems to be taking care of itself. “Depending on the business, and counting trade receivables only, we had between eight and 19 days working capital,” which was manageable given the company’s steady growth. One of the reasons that working capital had not expanded at the rate of the business was inventory, or rather the dearth of it. “We were in a market that responded very strongly to new products,” said the manager “and the presales of products were very high. We had advanced orders form four to six months, with deposits paid, and this helped our cash position.” Best of all, as soon as a vehicle was off the assembly line, it was out to the dealer. “We had low inventory costs and the product lines were very easy to move.” The salutary role of banks in working capital management was a result reason that cashflow had improved in his business. Better management was a result of banking competition that had allowed the company to move from traditional bankers, the state-owned Indian institutions, to more competitive private institutions and teh foreign banks that partner with them. These banks had invested in technology, allowing a visibility over cashflow unheard of few years ago. http://www.cfoasia.com/archives/200503-02.html 2020-21 Ch_9.indd 245 10/1/2019 10:13:41 AM  BUSINESS  STUDIES 246 Some part of current assets is to the organisations which operate on a usually financed through short-term lower scale. sources, i.e., current liabilities. The 3. Business Cycle: Different phases of rest is financed through long-term business cycles affect the requirement sources and is called net working of working capital by a firm. In capital. Thus, NWC = CA – CL (i.e. case of a boom, the sales as well as Current Assets - Current Liabilities.) production are likely to be larger and, Thus, net working capital may be therefore, larger amount of working defined as the excess of current assets capital is required. As against this, over current liabilities. the requirement for working capital will be lower during the period of Factors Affecting the Working depression as the sales as well as Capital Requirements production will be small. 1. Nature of Business: The basic 4. Seasonal Factors: Most business nature of a business influences the have some seasonality in their amount of working capital required. operations. In peak season, because of A trading organisation usually higher level of activity, larger amount needs a smaller amount of working of working capital is required. As capital compared to a manufacturing against this, the level of activity as well organisation. This is because there as the requirement for working capital is usually no processing. Therefore, will be lower during the lean season. there is no distinction between raw 5. Production Cycle: Production materials and finished goods. Sales cycle is the time span between the can be effected immediately upon receipt of raw material and their the receipt of materials, sometimes conversion into finished goods. Some even before that. In a manufacturing businesses have a longer production business, however, raw material needs cycle while some have a shorter to be converted into finished goods one. Duration and the length of before any sales become possible. production cycle, affects the amount Other factors remaining the same, a of funds required for raw materials trading business requires less working and expenses. Consequently, working capital. Similarly, service industries capital requirement is higher in firms which usually do not have to maintain with longer processing cycle and lower inventory require less working capital. in firms with shorter processing cycle. 2. Scale of Operations: For organisations 6. Credit Allowed: Different firms which operate on a higher scale of allow different credit terms to their operation, the quantum of inventory and customers. These depend upon the debtors required is generally high. Such level of competition that a firm faces organisations, therefore, require large as well as the credit worthiness of their amount of working capital as compared clientele. A liberal credit policy results 2020-21 Ch_9.indd 246 10/1/2019 10:13:41 AM  Financial Managements 247 in higher amount of debtors, increasing the lead time, larger the quantity of the requirement of working capital. material to be stored and larger shall 7. Credit Availed: Just as a firm be the amount of working capital allows credit to its customers it also required. may get credit from its suppliers. 10. Growth Prospects: If the growth To the extent it avails the credit potential of a concern is perceived to on purchases, the working capital be higher, it will require larger amount requirement is reduced. of working capital so that it is able 8. Operating Efficiency: Firms to meet higher production and sales manage their operations with varied target whenever required. degrees of efficiency. For example, 11. Level of Competition: Higher level a firm managing its raw materials of competitiveness may necessitate efficiently may be able to manage with larger stocks of finished goods to a smaller balance. This is reflected meet urgent orders from customers. in a higher inventory turnover ratio. This increases the working capital Similarly, a better debtors turnover requirement. Competition may also ratio may be achieved reducing the force the firm to extend liberal credit amount tied up in receivables. Better terms discussed earlier. sales effort may reduce the average time for which finished goods inventory 12. Inflation: With rising prices, is held. Such efficiencies may reduce larger amounts are required even the level of raw materials, finished to maintain a constant volume of goods and debtors resulting in lower production and sales. The working requirement of working capital. capital requirement of a business 9. Availability of Raw Material: If thus, become higher with higher rate the raw materials and other required of inflation. It must, however, be noted materials are available freely and that an inflation rate of 5%, does not continuously, lower stock levels may mean that every component of working suffice. If, however, raw materials do capital will change by the same not have a record of un-interrupted percentage. The actual requirement availability, higher stock levels may shall depend upon the rates of price be required. In addition, the time lag change of different components (e.g., between the placement of order and raw material, finished goods, labour the actual receipt of the materials (also cost,) Finished goods as well as their called lead time) is also relevant. Larger proportion in the total requirement. 2020-21 Ch_9.indd 247 10/1/2019 10:13:41 AM  BUSINESS  STUDIES 248 Key Terms Financial Management Wealth Maximisation Investment Decision Financing Decision Dividend Decision Capital Budgeting Working Capital Financial Planning Capital Structure Trading on Equity Summary Business finance: The money required for carrying out business activities is called business finance. Almost all business activities require some finance. Finance is needed to establish a business, to run it, to modernise it, to expand, and diversify it. Financial Management: Financial Management is concerned with optimal procurement as well as usage of finance. For optimal procurement, different available sources of finance are identified and compared in terms of their costs and associated risks. Objectives and Financial Decisions The primary aim of financial management is to maximise shareholders’ wealth which is referred to as the wealth maximisation concept. The market price of a company’s shares are linked to the three basic financial decisions Financial decision-making is concerned with three broad decisions which are Investment Decision, Financing Decision, Dividend Decision Financial Planning and Importance Financial planning is essentially preparation of a financial blueprint of an organisation’s future operations. The objective of financial planning is to ensure that enough funds are available at right time. Financial planning strives to achieve the following twin objectives. (a) To ensure availability of funds whenever these are required: (b) To see that the firm does not raise resources unnecessarily: Financial planning is an important part of overall planning of any business enterprise. It aims at enabling the company to tackle the uncertainty in respect of the availability and timing of the funds and helps in smooth functioning of an organisation. Capital Structure and Factors One of the important decisions under financial management relates to the financing pattern or the proportion of the use of different sources in raising funds. On the basis of ownership, the sources 2020-21 Ch_9.indd 248 10/1/2019 10:13:41 AM  Financial Managements 249 of business finance can be broadly classified into two categories viz., ‘owners funds’ and ‘borrowed funds’. Capital structure refers to the mix between owners and borrowed funds. Deciding about the capital structure of a firm involves determining the relative proportion of various types of funds. This depends on various factors which are: Cash Flow Position, Interest Coverage Ratio (ICR), Debt Service Coverage Ratio (DSCR), Return on Investment (RoI), Cost of debt, Tax Rate, Cost of Equity, Floatation Costs, Risk Consideration, Flexibility, Control, Regulatory Framework, Stock Market Conditions, and Capital Structure of other Companies. Fixed and Working Capital Fixed capital refers to investment in long-term assets. Management of fixed capital involves around allocation of firm’s capital to different projects or assets with long-term implications for the business. These decisions are called investment decisions or capital budgeting decisions. They affect the growth, profitability and risk of the business in the long run. Factors affecting the Requirement of Fixed Capital are: Nature of Business, Scale of Operations, Choice of Technique, Technology Upgradation, Growth Prospects, Diversification, Financing Alternatives and Level of Collaboration. Apart from the investment in fixed assets, every business organisation needs to invest in current assets. This investment facilitates smooth day-to- day operations of the organisation. Current assets are usually more liquid but contribute less to the profits than fixed assets. Factors affecting the working capital requirement are: Nature of Business, Scale of Operations, Business Cycle, Seasonal Factor, Production Cycle, Credit Allowed, Credit Availed, Operating Efficiency, Availability of Raw Material, Growth Prospects, Level of competition, and rate of Inflation. exercises Very Short Answer Type 1. What is meant by capital structure? 2. Sate the two objectives of financial planning. 3. Name the concept of financial management which increases the return to equity shareholders due to the presence of fixed financial charges. 4. Amrit is running a ‘transport service’ and earning good returns by providing this service to industries. Giving reason, state whether the working capital requirement of the firm will be ‘less’ or ‘more’. 2020-21 Ch_9.indd 249 10/1/2019 10:13:42 AM  BUSINESS  STUDIES 250 5. Ramnath is into the business of assembling and selling of televisions. Recently he has adopted a new policy of purchasing the components on three months credit and selling the complete product in cash. Will it affect the requirement of working capital? Give reason in support of your answer. Short Answer Type 1. What is financial risk? Why does it arise? 2. Define current assets? Give four examples of such assets. 3. What are the main objectives of financial management? Briefly explain. 4. Financial management is based on three broad financial decisions. What are these? 5. Sunrises Ltd. dealing in readymade garments, is planning to expand its business operations in order to cater to international market. For this purpose the company needs additional `80,00,000 for replacing machines with modern machinery of higher production capacity. The company wishes to raise the required funds by issuing debentures. The debt can be issued at an estimated cost of 10%. The EBIT for the previous year of the company was `8,00,000 and total capital investment was `1,00,00,000. Suggest whether issue of debenture would be considered a rational decision by the company. Give reason to justify your answer. (Ans. No, Cost of Debt (10%) is more than ROI which is 8%). 6. How does working capital affect both the liquidity as well as profitability of a business? 7. Aval Ltd. is engaged in the business of export of canvas goods and bags. In the past, the performance of the company had been upto the expectations. In line with the latest demand in the market, the company decided to venture into leather goods for which it required specialised machinery. For this, the Finance Manager Prabhu prepared a financial blueprint of the organisation’s future operations to estimate the amount of funds required and the timings with the objective to ensure that enough funds are available at right time. He also collected the relevant data about the profit estimates in the coming years. By doing this, he wanted to be sure about the availability of funds from the internal sources of the business. For the remaining funds, he is trying to find out alternative sources from outside. a. Identify the financial concept discussed in the above paragraph. Also, state the objectives to be achieved by the use of financial concept so identified. ( Financial Planning). b. ‘There is no restriction on payment of dividend by a company’. Comment. ( Legal & Contractual Constraints) 2020-21 Ch_9.indd 250 10/1/2019 10:13:42 AM  Financial Managements 251 Long Answer Type 1. What is working capital? Discuss five important determinants of working capital requirement? 2. “Capital structure decision is essentially optimisation of risk-return relationship.” Comment.