Financial management

• Business finance


  Money required for carrying out business activities
• Almost all business activities require some finance
• Finance is needed to establish a business, to run it, to modernise it, to expand, or diversify it
• Finance is required for

  • Buying tangible assets like machinery, factories, buildings, offices
  • Buying intangible assets such as trademarks, patents, technical expertise
  • Running day-to-day operations like buying material, paying bills, salaries, collecting cash from customers
• Availability of adequate finance is thus, very crucial for the survival and growth of a business
• Financial management


  Concerned with optimal procurement as well as the usage of finance
• Objectives of financial management

  • Reducing the cost of funds procured
  • Keeping the risk under control
  • Achieving effective deployment of such funds
  • Ensuring availability of enough funds whenever required
  • Avoiding idle finance
• Wealth maximisation concept


  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 is linked to the three basic financial decisions: investment decision, financing decision, and dividend decision
• Investment decision


  Relates to how the firm's funds are invested in different assets
• Investment decisions


  • Can be long-term (capital budgeting) or short-term (working capital management)
  • Long-term decisions involve committing finance on a long-term basis, e.g. investing in a new machine, acquiring a new fixed asset, opening a new branch
  • These decisions are very crucial as they affect the earning capacity in the long run
• Factors affecting capital budgeting decisions

  • Cash flows of the project
  • Rate of return
  • Investment criteria involved
• Financing decision


  About the quantum of finance to be raised from various long-term sources
• The main sources of funds for a firm are shareholders' funds and borrowed funds
• A firm has to decide the proportion of funds to be raised from either sources, based on their basic characteristics
• Financial risk


  The risk of default on payment of interest and repayment of borrowed funds
• Capital budgeting techniques


  Techniques applied to each proposal before selecting a particular project
• Financing decision


  Decision about the quantum of finance to be raised from various long-term sources
• Main sources of funds for a firm

  • Shareholders' funds
  • Borrowed funds
• Shareholders' funds


  Equity capital and retained earnings
• Borrowed funds


  Finance raised through debentures or other forms of debt
• Financial risk


  Risk of default on payment
• Cost of each type of finance

  Debt is considered the cheapest due to tax deductibility of interest
• Floatation cost


  Cost of the fund raising exercise
• Factors affecting financing decisions

  • Cost
  • Risk
  • Floatation costs
  • Cash flow position
  • Fixed operating costs
  • Control considerations
  • State of capital market
• Dividend


  Portion of profit distributed to shareholders
• Factors affecting dividend decision

  • Amount of earnings
  • Stability of earnings
  • Stability of dividends
  • Growth opportunities
  • Cash flow position
  • Shareholders' preference
  • Taxation policy
  • Stock market reaction
  • Access to capital market
  • Legal constraints
  • Contractual constraints
• Financial planning


  Preparation of a financial blueprint of an organisation's future operations
• Objectives of financial planning

  • Ensure availability of funds whenever required
  • Ensure the firm does not raise resources unnecessarily
• Financial planning is not equivalent to or a substitute for financial management
• Financial planning includes both short-term and long-term planning
• Financial planning usually begins with the preparation of a sales forecast
• Importance of financial planning

  • Helps in forecasting future business situations
  • Helps the firm face the eventual situation in a better way
  • Helps in coordination and control
  • Helps in optimum utilisation of financial resources
  • Helps in minimising uncertainty
• External funds requirement


  The funds needed by a business that cannot be met from internal sources
• Cash budgets


  Budgets that incorporate factors affecting the availability and timing of funds
• Capital structure


  The mix between owners' funds (equity) and borrowed funds (debt)
• Debt-equity ratio


  Debt / Equity
• Proportion of debt


  Debt / (Debt + Equity)
• Cost of debt


  Lower than cost of equity because lender's risk is lower
• Financial risk


  The chance that a firm would fail to meet its payment obligations