Financial Management

Financial Management: • Financial management is the process of planning, organising, directing, and controlling the financial activities of an enterprise — including procurement and utilisation of funds to achieve the organisation's financial goals. • It deals with three fundamental decisions: (1) investment decisions (where to invest funds), (2) financing decisions (how to raise funds), and (3) dividend decisions (how much profit to distribute). Objectives of Financial Management: 1. Profit Maximisation (Traditional Objective): • Maximising the firm's accounting profit. • Criticism: Ignores the timing of cash flows (a rupee today is worth more than a rupee next year), ignores risk, and does not account for shareholder wealth. 2. Wealth Maximisation (Modern/Accepted Objective): • Maximising the market value of shareholders' wealth (the share price × number of shares). • This is the universally accepted objective because it: - Accounts for the time value of money (future cash flows are discounted). - Accounts for risk - Considers long-term cash flows, not just accounting profit - Aligns management decisions with shareholder interests. Financial Planning: • Financial planning is the process of estimating future financial needs and determining the best sources to meet those needs. • It involves forecasting sales and profits, estimating required investment, and deciding how to fund that investment. Objectives of financial planning: 1. Ensure availability of funds when needed — no shortage that disrupts operations, no surplus that wastes money. 2. Maintain a balance between inflow and outflow of funds (liquidity management). 3. Minimise the cost of capital and maximise returns. Importance of financial planning: • Avoids financial surprises and crises. • Provides a basis for decision-making. • Coordinates the financial activities of different departments. • Links financial planning to overall business strategy.

Capital Structure: • Capital structure refers to the mix of different types of long-term finance (equity and debt) used by a firm to fund its operations and assets. • It determines how the firm's assets are financed — the proportion of equity (shareholders' funds) to debt (borrowed funds). • Leverage / Gearing = Proportion of debt in the capital structure. Components of capital structure: • Equity: Share capital (equity + preference), retained earnings — does not need to be repaid; dividends are optional. • Debt: Debentures, long-term loans, bonds — must be repaid; interest is compulsory (a fixed charge). Optimal capital structure: • The ideal mix that minimises the firm's cost of capital and maximises shareholder wealth (market value of the firm). Factors Affecting Capital Structure Decisions: 1. Cash Flow Position: • A firm with strong, stable cash flows can afford higher debt (can reliably service interest and principal). A firm with uncertain cash flows should rely more on equity. 2. Interest Coverage Ratio: • ICR = EBIT / Interest. A higher ICR means the firm can comfortably service more debt. A low ICR signals risk of financial distress → less debt. 3. Debt Service Coverage Ratio (DSCR): • Measures the firm's ability to service total debt obligations — principal + interest. Higher DSCR → more capacity for debt. 4. Return on Investment (ROI) vs. Cost of Debt: • If ROI > cost of debt, using debt is beneficial (financial leverage amplifies returns to equity). • If ROI < cost of debt, debt is harmful — equity is preferred. 5. Tax Rate: • Interest on debt is tax-deductible → debt provides a tax shield. Higher tax rates make debt relatively more attractive. 6. Cost of Equity vs. Cost of Debt: • Debt is typically cheaper than equity (interest < required equity return + tax shield). But excessive debt increases financial risk. 7. Flotation Costs: • The cost of issuing new shares is high (underwriting, legal fees) → may favour retained earnings or debt. 8. Risk Appetite of Management: • Risk-averse management prefers equity; risk-tolerant management may use more debt. 9. Control: • Issuing new equity dilutes ownership and voting control. Debt does not dilute ownership — management may prefer debt to maintain control.

Fixed Capital: • Fixed capital refers to funds invested in long-term assets — assets that are used in the business over many years and are not converted into cash quickly. • Examples: Land and buildings, plant and machinery, vehicles, furniture, computers. • Characteristics: Long-term investment, non-liquid, provides productive capacity, recovered over many years through depreciation. Working Capital: • Working capital refers to the funds needed to finance day-to-day business operations — the short-term funds needed to keep the business running. • Gross Working Capital = Total current assets (inventory + debtors + cash + short-term investments). • Net Working Capital = Current Assets − Current Liabilities. • Characteristics: Short-term, recycles quickly through the operating cycle (cash → raw materials → work-in-process → finished goods → debtors → cash). Factors Determining Working Capital Requirements: 1. Nature of Business: • Manufacturing companies need more working capital (large inventories of raw materials, WIP, finished goods, debtors). • Service companies (consulting, software) need less working capital (no physical inventory). • Trading companies need moderate working capital (mainly inventory and debtors). 2. Scale of Operations: • Larger firms (higher sales volume) require more working capital — more inventory, more debtors. 3. Business Cycle / Seasonality: • During boom periods, more working capital is needed. Seasonal businesses (ice cream, umbrellas) need extra working capital before the peak season. 4. Production Cycle Length: • The longer the production cycle (time from raw material to finished goods), the more WIP held at any time → more working capital needed. E.g., shipbuilding has a very long production cycle. 5. Credit Policy: • A liberal credit policy (long credit period offered to customers) increases debtors and requires more working capital. • If suppliers give long credit (long accounts payable), less working capital is needed. 6. Growth and Expansion: • Growing firms need more working capital — they need to support increasing sales volume. 7. Availability of Raw Materials: • If raw materials are scarce or available only seasonally, the firm must hold larger inventories → more working capital.