CLASS XII CHAPTER 9
: FINANCIAL MANAGEMENT-STUDY NOTES
Business Finance: Business finance is the money needed for various business activities. This includes starting, running, modernizing, expanding, or diversifying a business. Finance is required for purchasing machinery, factories, and intangible assets like patents. It is also crucial for daily operations such as buying materials, paying bills, and collecting cash from customers.
Role of Financial Management
- Sources of Finance: Identify and compare different finance sources based on their costs and risks.
- Investment: Invest funds in a way that the returns exceed the procurement cost.
- Cost Control: Aim to reduce the cost of funds and keep risks under control.
- Availability: Ensure enough funds are available when needed and avoid idle finance.
Impact on Financial Health
- Fixed Assets: Decisions like investing Rs. 100 crores in fixed assets increases the size of the fixed asset block by this amount.
- Current Assets: An increase in investment in fixed assets requires more working capital. Decisions on credit and inventory management affect current assets.
- Long-term and Short-term Funds: Balancing liquidity with profitability through the right mix of funds.
- P&L Account: Higher debt increases interest expenses. Capital budgeting decisions affect depreciation and interest items.
Primary Objective: The main goal is to maximize shareholders' wealth (Wealth-Maximization Concept). Shareholders’ wealth is linked to the Market Price of a company’s shares. How well funds are invested determines the market value of these shares.
Efficiency in Decision Making
- Investment: Benefits must outweigh costs to add value.
- Financing: Minimize procurement costs to maximize value addition.
- Outcome: Efficient decisions lead to an increase in equity share prices.
I. Investment Decision
How resources are allocated among assets to earn highest returns.
- Capital Budgeting (Long-term): Irreversible, large fund commitment (e.g., new machinery, new branches).
Factors: Cash Flows of the project, Rate of Return, and Investment Criteria (NPV/IRR). - Working Capital (Short-term): Day-to-day liquidity management (Cash, Inventory, Debtors).
II. Financing Decision
Determining the amount to be raised from long-term sources (Equity vs. Debt).
- Debt: Cheaper due to tax deductibility of interest; higher financial risk.
- Equity: Costlier; lower financial risk (no fixed repayment).
Factors: Cost, Risk, Floatation Costs, Cash Flow Position, Fixed Operating Costs, Control Considerations, and Capital Market State.
III. Dividend Decision
Distribution of profits to shareholders vs. retention for reinvestment.
Factors: Amount/Stability of Earnings, Stability of Dividends, Growth Opportunities, Cash Flow Position, Shareholders’ Preferences, Taxation Policy, Stock Market Reaction, Access to Capital Market, Legal and Contractual Constraints.
Meaning: Preparing a comprehensive financial blueprint for future operations to ensure fund availability and prevent wasteful excess funding.
Objectives & Process
- Objectives: Ensure availability of funds; Avoid unnecessary resource raising.
- Process: Sales Forecast → Financial Statements → Profit Estimation → External Funds Identification → Cash Budgets.
- Importance: Forecasting, avoiding shocks, coordination, efficiency, and linking present with future.
Essential Formulas for Board Exams
(Profit After Tax + Depreciation + Interest + Non-cash Exp.) /
(Interest + Repayment Obligations)
Capital Structure: The mix of Owners' Funds and Borrowed Funds. Optimal Structure is the mix that maximizes shareholder wealth.
Numerical Illustration: Trading on Equity
Use of debt to increase EPS is only beneficial if RoI > Cost of Debt.
Investment: ₹30 Lakh | Tax: 30% | EBIT: ₹4 Lakh.
| Particulars | No Debt | ₹10L Debt | ₹20L Debt |
|---|---|---|---|
| EBIT | 4,00,000 | 4,00,000 | 4,00,000 |
| Less: Interest (10%) | - | 1,00,000 | 2,00,000 |
| EBT (Profit after Int.) | 4,00,000 | 3,00,000 | 2,00,000 |
| Less: Tax (30%) | 1,20,000 | 90,000 | 60,000 |
| Profit for Equity | 2,80,000 | 2,10,000 | 1,40,000 |
| No. of Shares (₹10) | 3,00,000 | 2,00,000 | 1,00,000 |
| EPS | 0.93 | 1.05 | 1.40 |
Conclusion: Since RoI > Cost of Debt, EPS increases with Debt. This is Favorable Leverage.
EBIT drops to ₹2 Lakh.
| Particulars | No Debt | ₹10L Debt | ₹20L Debt |
|---|---|---|---|
| EBIT | 2,00,000 | 2,00,000 | 2,00,000 |
| Less: Interest (10%) | - | 1,00,000 | 2,00,000 |
| EBT | 2,00,000 | 1,00,000 | 0 |
| Less: Tax (30%) | 60,000 | 30,000 | 0 |
| Profit for Equity | 1,40,000 | 70,000 | 0 |
| No. of Shares | 3,00,000 | 2,00,000 | 1,00,000 |
| EPS | 0.47 | 0.35 | 0.00 |
Conclusion: Since RoI < Cost of Debt, EPS decreases with Debt. This is Unfavorable Leverage.
Factors Affecting Fixed Capital
- Nature of Business: Manufacturing > Trading.
- Scale of Operations: Larger scale needs more assets.
- Choice of Technique: Capital-Intensive > Labor-Intensive.
- Technology Upgradation: Faster obsolescence needs more capital.
- Growth Prospects: High growth requires capacity expansion.
- Diversification: Entering new lines increases needs.
- Financing Alternatives & Collaboration: Leasing and sharing reduce capital requirement.
Factors Affecting Working Capital
- Nature of Business & Scale: Service/Trading needs less than Manufacturing.
- Business & Seasonal Cycle: Peak seasons/Booms require more capital.
- Production Cycle: Longer conversion time needs more funds.
- Credit Terms: Liberal credit given increases need; credit received from suppliers reduces it.
- Operating Efficiency: Better turnover ratios lower requirements.
- Availability of Raw Materials: Uncertain availability requires higher stocks.
- Growth, Competition & Inflation: High growth, high competition, and rising prices increase the need for working capital.
No comments:
Post a Comment