Meaning: Business finance is the money needed for various business activities. This includes starting, running, modernizing, expanding, or diversifying a business.
Examples: 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.
Importance: Adequate finance is vital for a business's survival and growth.
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.
- Examples: Choosing between loans or equity financing, and investing in profitable projects.
- Cost Control: Aim to reduce the cost of funds and keep risks under control.
- Availability of Funds: Ensure enough funds are available when needed and avoid idle finance.
Financial management directly affects the financial health of a business, reflected in financial statements like the Balance Sheet and Profit and Loss Account.
Detailed Examples of Impact
- Fixed Assets: Example: Investing Rs. 100 crores in fixed assets increases the size of the fixed asset block by this amount.
- Current Assets: Impact: An increase in investment in fixed assets requires more working capital. Decisions on credit and inventory management affect current assets and their composition.
- Long-term and Short-term Funds: Example: An organization that prefers more liquid assets might use more long-term funds. This decision balances liquidity with profitability.
- Break-up of Long-term Financing: Impact: Deciding the proportions of debt and equity affects the amounts of each in the financing structure.
- Profit and Loss Account: Example: Higher debt increases interest expenses. Expanding the business due to capital budgeting decisions affects all Profit and Loss Account items, like interest and depreciation.
Primary Aim: The main goal of financial management is to maximize shareholders' wealth. This is known as the wealth-maximization concept.
Explanation: Shareholders’ wealth is linked to the market price of a company’s shares. How well company funds are invested and the returns earned determine the market value and price of these shares.
Market Price and Financial Decisions
- Shareholder Benefit: The market price of equity shares increases if the benefits from a decision exceed the associated costs.
- Value Addition: Financial decisions aim to ensure efficiency and add value, leading to an increase in share price. Poor financial decisions that decrease share price are considered ineffective.
Decision-Making Logic
- Investment Decisions: Ensure benefits outweigh costs, adding value to the company.
- Financing Decisions: Minimize costs to maximize value addition.
- Efficiency: Achieved by selecting the best alternative from available options to increase equity share price.
I. Investment Decision
Relates to how a firm's resources are allocated among various assets to earn the highest possible returns.
- Long-term Investment (Capital Budgeting): Committing funds for extended periods.
Importance: Affects earning capacity, asset size, profitability, and competitiveness. Usually significant and irreversible without loss.
Examples: Purchasing machinery, opening new branches. - Short-term Investment (Working Capital): Decisions about cash, inventory, and receivables. Impacts day-to-day liquidity and operations.
Factors Affecting Capital Budgeting
- Cash Flows: Series of receipts and payments. Analysis ensures they cover cost and provide return.
- Rate of Return: Measure of profitability. Higher rates are preferred for same risk.
- Investment Criteria: Involves interest rates and techniques like NPV, IRR, and Payback Period.
II. Financing Decision
Determining the amount to raise from long-term sources and deciding the proportion of each.
- Shareholders' Funds: Equity Capital and Retained Earnings.
- Borrowed Funds: Debentures, loans, and bonds.
Factors Affecting Financing Decisions
- Cost: Different sources have varying costs; cheaper sources are preferred. Debt is typically cheaper due to tax benefits.
- Risk: Debt increases financial risk due to mandatory interest and principal repayments.
- Floatation Costs: Legal, underwriting, and registration fees. Higher costs reduce attractiveness.
- Cash Flow Position: Strong flows favor debt; weak flows favor equity.
- Fixed Operating Costs: High fixed costs (Rent/Salary) suggest using less debt to reduce risk.
- Control Considerations: Issuing more equity dilutes management control; debt does not.
- Capital Market State: Rising markets favor equity; depressed markets may require debt.
III. Dividend Decision
Distributing profits to shareholders vs. retaining for reinvestment.
Factors Affecting Dividend Decisions
- Amount of Earnings: Higher current/past earnings lead to higher dividends.
- Stability of Earnings: Stable earnings allow higher and more consistent payouts.
- Stability of Dividends: Companies adjust gradually to long-term trends to keep confidence.
- Growth Opportunities: High-growth firms retain more earnings and pay lower dividends.
- Cash Flow: Adequate cash is needed to pay physical dividends.
- Shareholders’ Preferences: Management considers those who rely on dividend income.
- Taxation Policy: Higher taxes on dividends encourage retaining more profit.
- Stock Market Reaction: Dividend changes impact share prices; increases are viewed positively.
- Access to Capital Market: Easy access allows for higher payouts; smaller firms rely on retention.
- Legal & Contractual Constraints: Adherence to Companies Act and loan agreement restrictions.
Introduction: Preparing a comprehensive financial blueprint for future operations to ensure fund availability and prevent wasteful excess funding.
Objectives
- Ensure Availability of Funds: Estimate requirements and specify timing and potential sources.
- Avoid Unnecessary Resource Raising: Prevent waste and utilize surplus funds effectively.
The Process
- Sales Forecast (e.g., for 5 years).
- Prepare Financial Statements based on forecasts.
- Estimate Profits (Retained earnings).
- Identify External Funds needed and their sources.
- Prepare Cash Budgets incorporating funds and sources.
Importance
- Forecasting: Preparing for future growth or variations.
- Avoiding Shocks: Reducing surprises in future uncertainties.
- Coordination: Aligning functions like sales and production.
- Efficiency: Reducing waste, duplication, and planning gaps.
- Linking: Connecting present operations with future goals and linking investment with financing.
Capital Structure: The mix of ownership (Equity) and borrowed (Debt) funds. Owners' Funds: Equity, Preference, Retained Earnings. Borrowed Funds: Loans, Debentures, Public Deposits.
Numerical Illustration: Trading on Equity
Trading on Equity refers to using fixed interest-bearing debt to increase return for equity shareholders. Favorable Leverage occurs when RoI > Cost of Debt. Unfavorable Leverage occurs when RoI < Cost of Debt.
Total Investment = ₹30 Lakh. Interest on Debt = 10%. Tax Rate = 30%. EBIT = ₹4 Lakh.
RoI = (4,00,000 / 30,00,000) × 100 = 13.33%. (Since 13.33% > 10%, it is Favorable).
| Particulars | Situation I (No Debt) | Situation II (₹10L Debt) | Situation III (₹20L Debt) |
|---|---|---|---|
| EBIT | ₹4,00,000 | ₹4,00,000 | ₹4,00,000 |
| Less: Interest (10%) | Nil | ₹1,00,000 | ₹2,00,000 |
| EBT | ₹4,00,000 | ₹3,00,000 | ₹2,00,000 |
| Less: Tax (30%) | ₹1,20,000 | ₹90,000 | ₹60,000 |
| EAT (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 (EAT / Shares) | ₹0.93 | ₹1.05 | ₹1.40 |
Impact: EPS increases from ₹0.93 to ₹1.40 as Debt portion is increased. This maximizes shareholder wealth.
Suppose EBIT drops to ₹2 Lakh.
RoI = (2,00,000 / 30,00,000) × 100 = 6.67%. (Since 6.67% < 10%, it is Unfavorable).
| Particulars | Situation I (No Debt) | Situation II (₹10L Debt) | Situation III (₹20L Debt) |
|---|---|---|---|
| EBIT | ₹2,00,000 | ₹2,00,000 | ₹2,00,000 |
| Less: Interest (10%) | Nil | ₹1,00,000 | ₹2,00,000 |
| EBT | ₹2,00,000 | ₹1,00,000 | ₹0 |
| Less: Tax (30%) | ₹60,000 | ₹30,000 | ₹0 |
| EAT | ₹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 |
Impact: EPS decreases as Debt portion is increased. This destroys shareholder wealth.
Factors Affecting Capital Structure
- Cash Flow Position: Ensure cash covers operations, fixed assets, and debt (e.g., if ops need ₹5L, fixed ₹2L, debt ₹1L, at least ₹8L cash is needed).
- Interest Coverage Ratio (ICR): Measures how well EBIT covers interest payments.
- Debt Service Coverage Ratio (DSCR): Measures cash profits against total debt obligations.
- RoI: Higher RoI allows for more profitable debt usage.
- Cost of Debt: Cheaper interest/Tax benefits. (Ex: 10% int with 30% tax = 7% effective cost).
- Cost of Equity: High debt increases risk for equity holders, raising their required return.
- Floatation Costs: Fees for issuing new securities.
- Risk & Flexibility: Balance financial/business risk and maintain borrowing capacity for unforeseen needs.
- Control: Debt doesn't dilute management control.
- Industry Norms & Regulatory Framework: Guidelines based on sector and legal compliance.
Meaning: Funds invested in long-term assets (Plant, Building, Vehicles). These decisions (Capital Budgeting) affect long-term growth and are usually irrevocable.
Factors Affecting Requirement
- Nature of Business: Manufacturing needs more than trading.
- Scale of Operations: Larger scale requires bigger plants/more space.
- Choice of Technique: Capital-Intensive (machines) needs more than Labor-Intensive.
- Technology Upgradation: Industries with rapid obsolescence (Computers) need higher fixed capital.
- Growth Prospects: Higher anticipated demand requires capacity expansion.
- Diversification: Moving into new industries (e.g., textile to cement) increases requirements.
- Financing Alternatives: Leasing reduces the need for outright purchase.
- Level of Collaboration: Sharing facilities reduces individual investment.
Meaning: Funds for day-to-day operations. Current Assets: Convert to cash within one year (Cash, Debtors, Finished Goods). Net Working Capital = CA – CL.
Liquidity vs. Profitability: Balance is crucial as current assets provide low returns but ensure meeting obligations.
Factors Affecting Requirement
- Nature of Business: Trading/Service needs less than Manufacturing.
- Scale of Operations: Larger scale requires more inventory and debtors.
- Business Cycle: Booms increase needs; depressions decrease them.
- Seasonal Factors: Peak seasons require higher working capital.
- Production Cycle: Longer cycles (receiving raw material to finished goods) increase needs.
- Credit Allowed: Liberal credit to customers increases debtors and funding needs.
- Credit Availed: Credit from suppliers reduces the firm's requirement.
- Operating Efficiency: Better turnover ratios (inventory/debtors) lower requirements.
- Availability of Raw Material: Readily available materials mean lower stock levels are sufficient.
- Growth Prospects & Competition: Higher growth and high competition increase the need for stock.
- Inflation: Rising prices require more funds to maintain same production volume.
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