Introduction and Role & Objectives of Financial Management


  • Financial Decisions: investment, financing and dividend- Meaning and factors affecting.
  • Financial Planning- concept and importance.
  • Capital Structure - Concept.
  • Fixed and Working Capital - Concept and factors affecting their requirements.
  • Factors affecting capital budgeting decisions- cash flows of the project, the rate of return, investment criteria involved.
  • Factors affecting financing decision- cash flow position of the company, cost, risk, floatation costs, fixed operating costs, control considerations, state of the capital market, Return on investment, tax rate, flexibility, regulatory framework.
  • Factors affecting dividend decision- the number of earnings, stability of earnings, stability of dividends, growth opportunities, cash flow position, shareholder's preference, taxation policy, stock market reaction, access to the capital market, legal constraints, contractual constraints.
  • Factors affecting fixed capital requirement- Nature of business, the scale of operations, choice of technique, technology up-gradation, growth prospects, diversification, financing alternatives, level of collaboration.
  • Working capital- the concept of the operating cycle,
  • Factors affecting working capital requirement- Nature of business, the scale of operations, business cycle, seasonal factors, production cycle, and credit allowed, the credit availed, availability of raw material.

Business Finance

Money required for carrying out business activities is called business finance. Required for

  • Long term fixed assets , expansion, modernization and growth
  • Short term working capital for meeting day to day working

Financial Management

Study of obtaining funds and their effective and careful utilization, to maximize the benefits to the owners of the funds

Objectives of financial management are as follows:-

Primary objective: To maximize the wealth of owners in the long run – Wealth Maximization concept.

  • Owners‟ of a company are the shareholders.
  • The term wealth refers to the wealth of owners as reflected by the market price of their shares.
  1. The goal of a firm should be to maximize the wealth of owners in the long run.
  2. An increase in the market price of shares is an indicator of the financial health of a firm.

Wealth of shareholders= number of shares * market price per share.

Other objectives that help a firm achieve the primary objective are:

  1. Ensure availability of funds at reasonable costs:
  2. Ensure effective utilization of funds:
  3. Ensure the safety of funds through the creation of reserves:
  4. Maintain liquidity and solvency:

Role of Financial Management:

Financial Management has a direct bearing on the financial health of a company.

Financial Decisions


  1. Investment Decisions:
    1. Involves decision regarding short term (working capital) required for operational and day-to-day activities
    2. Long term (capital budgeting) investment in assets require funds for the setting up a new project or for expansion and modernization, machinery, building, etc
  2. Financing decisions:-
    1. Decision relates to various sources of finance i.e. equity shares, preference and debenture
    2. And relative proportion between them to form a capital structure
  3. Dividend decision: -
    1. Profit may either reinvest in the business for growth and expansion or it may distribute as dividends to the shareholder.
    2. Manager has to maintain the balance between the two.


Investment Decisions


  1. Involves decision regarding short term (working capital) required for operational and day-to-day activities
  2. Long-term (capital budgeting) investment in assets requires funds for the setting of new projects or expansion and modernization.

Capital budgeting:

Refers to investment in long-term assets e.g. plant and machinery, furniture and fixture, land and building, expenditure on acquisition, expansion, modernization.

  • Capital budgeting affects the growth, and profitability of the business in the long run.
  • Must be financed through long-term sources of capital such as equity debentures, and long-term loans.

Why capital budgeting decision is considered a risky decision?

Capital budgeting decisions are important for the following reasons:

  1. Funds involved are large:
  • Involves a large portion of  funds
  • Requires a lot of financial planning
  1. Irreversible decisions:
    • Decisions once taken are not reversible without incurring heavy losses.
    • Cancellation of a project is quite costly in terms of waste of funds.
  2. Returns/profits come in long run:
    • The fixed assets are invested for the long term and earnings come after a long duration.
    • It is difficult to measure the benefits as the future is uncertain due to political, legal, and technological changes.
  3. Effects on Long-term growth and profitability:
  • The direction of growth depends on capital expenditure.
  • If the decision goes in the right direction profitability increases.
  • If goes wrong, it is harmful to growth and profitability.

Factors affecting capital budgeting decisions:

  1. Rate of return:-
    • Expected rate of returns from each proposal should be compared with the risks associated with the projects before taking an investment decision.
    • E.g If there are two investment proposals A and B with a rate of return of 10% and 12%, the project B should be selected. 
  2. Investment criteria involved:
  • All projects are to be considered based on the amount of investment, interest rate, cash flows and rate of return
  • Ranking the projects, according to their profitability by using various capital budgeting techniques like;-Net Present Value (NPV), Internal Rate of Return (IRR), Payback Period
  1. Cash Flows Of The Project:
  • Cash is likely to generate when invest in fixed assets
  • Company must analyze the duration in which the cash is likely to generate
  • Projects like hydro-power, telecom longer time
  • Eatables generate quick cash

Financing Decisions

  • This decision is about the amount of finance to be raised from various long-term sources
  • Main sources of funds are shareholder's funds and borrowed funds
  • A firm needs to have a careful mix of both debt and equity in making a capital structure

Factors Affecting Financing Decision:

  1. Cash Flow Position of the Business: a company having a stronger cash flow position may choose debt financing
  2. Higher Fixed Operating Costs:  Already higher fixed operating costs (e.g., building rent, Insurance premium, Salaries, etc.), discourages the  debt  over equity
  3. Other Floatation Costs: Equity have a higher  flotation cost in comparison to debts like prospectus, underwriter commission
  4. Issue of Cost: The costs of raising funds through different sources are different.  The financial manager should have a cheaper source of finance.
  5. Control Considerations: Issues of more equity may lead to dilution of management’s control over the business. Debt does not let control dilution may be preferred
  6. Extent of Risk: Debts have more risk in comparison to equity.
  7. State of Capital Markets: During the boom period when the stock market is rising, more people invest in equity as a growing business will give more chances of higher-earning than investing in debts.

Dividend Decisions


The dividend is that portion of the profit that is distributed to shareholders. Involved

  • How much of the profit earned by the company (after paying tax) is to be distributed to the shareholders
  • How much of it should be retained in the business for meeting the investment requirements

​​​​​​​Explain Factors Affecting The Dividend Decision.

  1. Earnings: Dividends are paid out of the current and past earnings. Therefore, earnings are high then only the company can pay the dividend
  2. Stability of Earnings:  Company having stable earnings is in a position to declare higher dividends than a company having unstable earnings.
  3. Stability of Dividends: some companies may pay a fixed rate of dividend irrespective of profit like the company may pay a dividend of Rs 3 per share for every share
  4. Growth Opportunities: Companies having good growth opportunities keep more money out of their earnings so as to invest in future projects. The dividend in growth companies is, therefore, smaller than that in the non–growth companies.
  5. Cash Flow Position: Dividends involve an outflow of cash. A company may be profitable but short on cash. The availability of enough cash in the company is necessary for the declaration of dividends by it.
  6. Shareholder Preference: If the shareholders, in general, want that at least a certain amount is paid as a dividend, the companies are likely to declare the same or vice -versa
  7. Taxation Policy. If the tax on dividends is higher it would be better to pay less by way of dividends. As compared to this, higher dividends may be declared if tax rates are relatively lower.
  8. Stock Market Reaction: Investors, in general, view an increase in dividends as good news and stock prices react positively to it. Similarly, a decrease in dividends may have a negative impact on the share prices in the stock market.
  9. Access to Capital Market: Large and reputed companies have easy access to the capital market and depend less on retained earnings growth to pay higher dividends.
  10. Legal Constraints: Certain provisions of the Company’s Act place restrictions on payouts as dividends. Such provisions must be adhered to while declaring the dividends.
  11.  Contractual Constraints: While granting loans to a company, sometimes the lender may impose certain restrictions on the payment of dividends in the future. The companies are required to ensure that the dividends do not violate the terms of the loan agreement in this regard

Factors Affecting Dividend Decision:

Financial Planning


Meaning - It involves the preparation of a financial blueprint for an organization. It is the process of estimating the fund requirement of a business and determining the possible sources from which it can be raised.

Objectives of Financial Planning:

  1. To ensure the availability of funds whenever they are required:
  • Includes estimation of the funds required for different purposes (long term assets/wk cap requirement)
  • Estimate the time at which these funds need to be made available.
  • Specify sources of these funds.
  1. To see that the firm does not raise resources unnecessarily
  • Shortage of funds => firm cannot meet its payment obligations. o
  • Surplus funds => do not earn returns but add to costs.

Importance of Financial Planning:

  1. Co-coordinating different functions: Financial Planning helps to coordinate the activities of the financial departments and other departments. Helps in co-coordinating various business functions e.g., sales and production functions, by providing clear policies and procedures.
  2. Avoiding business shocks and surprises: Financial Planning aims at studying various factors that have an impact on the business and helps in predicting the probability of their occurrence. Thus, Financial Planning helps to avoid shocks and surprises by predicting them in advance and developing plans to meet them.
  3. Makes the firm better prepared for the future: Financial Planning tries to forecast what may happen in the future and prepares alternative plans to meet different eventualities. Financial Planning would help to identify the sources from which funds can be raised to finance such a programm.
  4. Evaluation of performance easier: Financial Plans set standards against which actual performance is compared. The deviations that are identified can be corrected and necessary steps can be taken to prevent their re-occurrence.
  5. Links the present with the future: Financial Planning helps to estimate future requirements and prepares plans in the present to balance requirements of funds with the availability of funds.

Capital Structure


Financial risk?

  • The risk of default on the payment of debt.
  • Higher  use of debt increases the financial risk of a business

Capital Structure

  • Refers to the mix  of debt and equity

Optimum Capital Structure

  • Proportion of debt and equity that results in an increase in the  value of shareholders (higher E.P.S)

Factors affecting the Choice of Capital Structure:

  1. Cash Flow Position: Cash flows must not only cover fixed cash payment obligations but there must be sufficient safeguards also. It must be kept in mind that a company has cash payment obligations for normal business operations.
  2. Interest Coverage Ratio: refers to the number of times earnings before interest and taxes of a company cover the interest obligation. The higher the ratio, the lower is the risk of the company failing to meet its interest payment obligations.    
  3. Formula for calculating ICR = EBIT/interest.
  4. Return on Investment: If the ROI of the company is higher, it can choose to use trading on equity to increase its EPS, i.e., its ability to use debt is greater.
  5. Cost of debt: A firm’s ability to borrow at a lower rate increases its capacity to employ higher debt. Thus, more debt can be used if the debt can be raised at a lower rate.
  6. Tax Rate: Since interest is a deductible expense, the cost of debt is affected by the tax rate makes debt relatively cheaper.
  7. Floatation Costs: Public issue of shares and debentures requires large expenditure. Getting a loan from a financial institution may not cost so much.
  8. Risk Consideration: Debt increases the financial risk to meet fixed interest payments and repayment obligations. If a firm’s business risk is lower, its capacity to use debt is higher and vice-versa.
  9. Flexibility: If a firm uses its debt potential to the full, it loses the flexibility to issue further debt. To maintain flexibility, it must maintain some borrowing power to take care of unforeseen circumstances.
  10. Control: A company that wants to retain control can use debts( up to a certain extent) . A public issue of equity may reduce the management holding in the company and may cause a takeover threat
  11. Regulatory Framework: Every company operates within a regulatory framework provided by the law e.g., public issues of shares and debentures have to be made under SEBI guidelines.
  12. Stock Market Conditions: If the stock markets are bullish, equity shares are more easily sold even at a higher price. During a bearish phase, a company may find rising equity capital more difficult and it may opt for debt.
  13. Capital Structure of other Companies: A useful guideline in capital structure planning is the debt-equity ratios of other companies in the same industry


Financial Leverage

Trading On Equity /Financial Leverage

How are the shareholders of a company likely to gain with a debt component in the capital employed?

Explain with the help of an example.

What do you mean by Trading on equity/financial leverage?

Financial leverage = proportion of debt in the overall capital structure. Also called - Trading on Equity or

Capital Gearing.

  • Cost of funds = cost of debt + cost of equity.
  • As financial leverage increases, the cost of funds declines as debt is a cheaper source of funds.

The reasons for higher EPS with debt are:

  • Rate of return on investment  is more than the cost of debt
  • Interest paid on debt is tax-deductible and so there is a saving on the amount of income tax that the company will be required to pay.
  • Number of shares is lesser when funds are raised as debt and so divisible profits (EAT) will have to be distributed among a lesser number of shares.

Use of Financial Leverage, however, involves a risk to equity holders because even a small change in EBIT will cause a great change in EPS and return on Equity as we can see in example II. Thus, the benefits of trading on Equity are available only when the following conditions are satisfied:

  • The rate of earning is higher than the rate of interest on the debt.
  • The company‘s earnings are stable and are regular to pay at least the interest on debentures.
  • There are sufficient fixed assets to offer as security to lenders.



Example I: A company requires Rs 30, 00,000 to finance its operations. The expected rate of return is 15% and the tax rate is 30%. Financing options are:

  • Equity shares @ Rs 10 per share OR
  • Equity @ Rs 10 per share and debt @ 10% per annum.

The calculations of EBT (Earnings before Tax), EAT (Earnings after taxes), and EPS (Earning per

Share) under the above three alternatives can be given as:

In the above example, we see that Plan C has a higher EPS as:

  1. Tax paid is least in Plan C as compared with tax paid in Plans A and B.
  2. The rate of return on investment (=15%) is more than the cost of debt (10%)
  3. The number of shareholders under Plan C = 1, 00,000 which is much lesser than that under plan A (3, 00,000) or B (2, 00,000).

Que. Sahil Industries needs to raise funds of Rs.30,00,000. Its expected earnings before interest and taxes (EBIT) are Rs. 2,00,000. The company wishes to use more debt content as compared to equity to raise earnings per share (EPS) of equity shareholders. The debt is available at an interest of 10%. As finance Manager, advise whether the company should prefer more debt or more equity to have higher EPS. Give reasons to support your answer.

Ans. Sahil Industries should use less debt (preferably no debt) to have higher EPS because the current return on investment (ROI) is less than the cost of debt. The prevailing ROI is only 6.66% (=2,00,000/30,00,000 * 100) against the interest rate of 10%. When ROI is less than the interest rate on debt, then EPS falls with rising in use of debt. So, the company should prefer more equity to have higher EPS.

Que. Viyo Ltd.’ is a company manufacturing textiles. It has a share capital of ` 60 lakhs. The earnings per share in the previous year was ` 0.50. For diversification, the company required additional capital of ` 40 lakhs. The company raised funds by issuing 10% debentures for the same. During the current year, the company earned a profit of ` 8 lakhs on capital employed. It paid tax @40%.

(a) State whether the shareholders gained or lost, in respect of earning per share on diversification. Show your calculations clearly.

(b) Also, state any three factors that favor the issue of debentures by the company as part of its capital structure.

Answer:- Statement showing the calculation of earnings for shareholders

Thus the shareholders have lost wealth as earnings per share have decreased. Assuming the face value of a share is Rs 10.

Cost of Debt: As external sources of finance are always cheaper than internal sources of finance, debt helps in producing the overall cost.

  1. Tax Rate: Interest paid on debt is tax-deductible expenses. Due to this real cost of debt is much lower than the nominal one.
  2. Control: By rising debt, the control of shareholders is not diluted

Capital structure decision is essentially optimization of risk-return relationship


i. Capital structure decision is related to the proportion of debt (risk) and equity (return).

ii. Debt is cheaper but is riskier for a business because payment of interest and the return of principal is obligatory for the business. Any default in meeting these commitments may force the business to go into liquidation. There is no such compulsion in the case of equity, which is, therefore, considered riskless for the business.

iii. Debt component in the total capital generates a higher return for equity shareholders as interest payable on debt is deductible from earning before tax payment.

iv. Thus, capital structure decision affects risk as well as return. So, it is true capital structure decision is essentially an optimization of the risk-return relationship.

Fixed Capital

FIXED CAPITAL            

Factors affecting the Requirement of Fixed Capital:

  1. Collaboration Level:

If business organizations share each other’s facilities such collaboration reduces the level of investment in fixed assets. For example, a bank may use another’s ATM, or telecom companies share a common TOWER.

  1. Upgrading Of Technique:
    • If assets become obsolete sooner. For example, computers become obsolete faster and are replaced much sooner. Require higher fixed capital.
    • Other business like steel and textile has stable assets and can be used for a longer period.
  2. Prospectus Of Growth:
    • An organization generally aiming for higher growth requires higher investment in fixed assets in order to meet the expected order quickly.
  3. Scale Of Business:
    • A larger organization operating at a higher scale needs a bigger plant, more space, etc. and therefore, requires higher investment in fixed assets when compared with a small organization.
  4. Technology Choice:
    • A capital-intensive organization requires higher investment in plants and machinery as it relies less on manual labor. Labor-intensive organizations on the other hand require less investment in fixed assets.
  5. Alternatives of Finance:
    • Availability of leasing facilities may reduce the funds required to be invested in fixed assets, thereby reducing the fixed capital requirements.
  6. Nature of Business:
    • A trading concern needs lower investment in fixed assets compared with a manufacturing organization; since it does not require purchasing plant and machinery etc.
  7. Diversification:
    • A firm chooses to enter into other sectors/businesses With diversification, fixed capital requirements increase e.g., a textile company is diversifying

Factors affecting fixed assets requirements are:

Working Capital


Those funds needed for meeting day-to-day operations affect the liquidity and profitability of the business.

Formulae = current assets – current liability

Current Assets

  • Converted into cash within a period of one year without a reduction in value.
  • EXAMPLE Cash at Bank  Marketable securities, Debtors

Current Liability

  • The payment which is due for payment within one year; \
  • Example bills payable, creditors, bank overdraft.

Types Working Capital

  • Gross working capital: - total fund invested in the current assets.
  • Gross working capital = current assets
  • Networking capital: excess of current assets over current liabilities.= current assets – current liability

Major ingredients of working capital

  • Cash management
  • Inventories management
  • Debtors management

Factors affecting the working capital requirements:

  1. Nature of Business:        
    • In trading concerns, there is no processing that requires less working capital. Etc wholesale business
    • Service industries do not have to maintain inventory and require less working capital. Example transportation, tourism, education, etc
    • In manufacturing concern raw material is to convert into finished good requires more working capital. Steel, car manufacturing, cement, etc.
  2. Scale of Operations: Organizations operate on a higher scale of operation, the amount of inventory and debtors required is generally high and requires a large amount of working capital.
  3. Business Cycle: In case of a boom, the sales, as well as production, are higher and therefore, a higher  amount of working capital is required and vice-versa
  4. Seasonal Factors: In peak season, a higher level of activity, and a higher amount of working capital are required. As against this, the level of activity, as well as the requirement for working capital, will be lower during the thin season.
  5. Production Cycle. Some businesses have a longer production cycle while some have a shorter one. Therefore, the working capital requirement is higher in firms with longer processing cycles and lower in firms with shorter processing cycles.
  6. Credit Allowed: Different firms allow different credit terms to their customers. A liberal credit policy results in a higher amount of debtors, increasing the requirement for working capital.
  7. Credit Availed: Just as a firm allows credit to its customers it also may get credit from its suppliers. To the extent, it avails the credit on its purchases; the working capital requirement is reduced.
  8. Operating Efficiency: Firms manage their operations with varying degrees of efficiency. Such efficiencies may reduce the level of raw materials, finished goods and debtors resulting in lower requirements for working capital.
  9. Availability of Raw Material: If the raw materials and other required materials are available freely and continuously, lower stock levels may be sufficient or vice-versa.
  10. Growth Prospects: For a firm with a growth prospect of concern is perceived to be higher, it will require a higher amount of working capital so that is able to meet higher production and sales target whenever required.
  11. Level of Competition: A higher level of competitiveness and liberal credit terms require a higher amount of working capital in a stock of finished goods, credit sales, advertisement
  12. Inflation: rising prices of input cost like labor, raw material, rent, and interest higher amounts of working capital is required to meet higher cost or vice-versa.

Factors affecting the working capital requirements: