Meaning of Business Finance

Business finance refers to the money required for carrying out all business activities. It is the lifeblood of any enterprise. Almost all business activities, from the initial establishment of a business to its day-to-day operations, and its long-term growth through expansion and modernisation, require some form of finance. Finance is needed to establish a business, to run it, to modernise it, and to diversify it.

This requirement for funds is primarily for acquiring a variety of assets, which may be:

• Tangible Assets: These are physical assets such as machinery, factories, buildings, land, and offices, which are essential for production and operations.

• Intangible Assets: These are non-physical assets that have value, such as trademarks, patents, copyrights, and technical expertise.

Furthermore, finance is central to running the day-to-day operations of a business. This includes activities like buying raw materials, paying utility bills, paying salaries and wages to employees, and managing the cash flow from collecting money from customers. The availability of adequate finance at every stage of a business's life is, thus, a crucial and indispensable factor for its survival and growth.

Financial Management

All finance comes at some cost and carries some degree of risk. Therefore, it is imperative that these funds be carefully and efficiently managed. Financial Management is concerned with the optimal procurement as well as the effective usage of finance. It involves applying general management principles to the financial resources of an enterprise.

The two key aspects of Financial Management are:

1. Optimal Procurement of Funds: This involves identifying the different available sources of finance and comparing them in terms of their costs and associated risks. The aim is to procure the required funds at the lowest possible cost while keeping the financial risk under control. As seen in the case of Tata Steel's acquisition of Corus, the company had to decide on a mix of sources, including debt, equity from its parent company Tata Sons, and its own internal funds.

2. Effective Usage of Funds: This involves investing the procured funds in a manner that the returns generated from the investment exceed the cost at which the procurement has taken place. This ensures that the firm is creating value and not just covering its costs.

Financial Management also aims at ensuring the availability of enough funds whenever required for operations or investment, while also avoiding idle finance, which unnecessarily adds to the cost without generating any return. The long-term future of a business depends a great deal on the quality of its financial management.

Importance of Financial Management

The role of financial management is of paramount importance as it has a direct bearing on the financial health and overall success of a business. The financial statements of a firm, such as the Balance Sheet and the Profit and Loss Account, are a reflection of its financial position. Almost all items in these statements are affected directly or indirectly by some financial management decisions. Key aspects affected by financial management include:

• The size and composition of fixed assets: A major capital budgeting decision, such as Tata Steel's acquisition of Corus, directly increases the size of the company's fixed assets block on its Balance Sheet.

• The quantum and composition of current assets: Decisions about how much credit to extend to customers affect the amount of debtors, and decisions on inventory management affect the amount of stock. Both debtors and stock are key components of current assets.

• The amount of long-term and short-term funds: Financial management involves deciding the proportion of long-term funds (like shares and debentures) and short-term funds (like bank overdrafts and creditors) to be used to finance the assets.

• Break-up of long-term financing into debt, equity, etc.: The financing decision determines the proportion of debt (borrowed funds) and equity (owners' funds) in the capital structure, which appears on the liabilities side of the Balance Sheet.

• All items in the Profit and Loss Account: Financial decisions have a direct impact on profitability. For example, using more debt leads to higher interest expenses. An expansion of business, which is a capital budgeting decision, affects virtually all items in the profit and loss account, from sales to depreciation.

Thus, the overall financial health and performance of a business are determined by the quality of its financial management. Good financial management aims at the mobilisation of financial resources at a lower cost and the deployment of these resources in the most lucrative and productive activities.

Objectives of Financial Management

The primary and overriding objective of financial management is to maximise shareholders’ wealth. This is often referred to as the wealth-maximisation concept. In practical terms, this means maximising the market value of the company's equity shares. This objective automatically takes care of all other objectives, such as profit maximisation and social welfare, as a company cannot create wealth for its shareholders in the long run without being profitable and socially responsible.

The market price of a company’s shares is directly linked to the three basic financial decisions: the investment decision, the financing decision, and the dividend decision. The company's funds ultimately belong to the shareholders, and the manner in which these funds are invested and the return earned by them determines the market value and price of their shares. The market price of an equity share increases if the benefit derived from a financial decision exceeds the cost involved. All financial decisions must, therefore, aim at ensuring that each decision is efficient and adds some value to the firm. Such value additions tend to increase the market price of the shares.

Therefore, when a decision is taken about investing in a new machine, the aim of financial management is to ensure that the benefits from the investment (in the form of future cash flows) exceed the cost of the investment, so that some value addition takes place. Similarly, when finance is procured, the aim is to reduce the cost as much as possible so that the value addition is even higher. In all financial decisions, the ultimate objective that guides the decision-maker is that some value addition should take place, which will ultimately lead to an increase in the price of the equity share and, thus, the wealth of the shareholders.

Financial Decisions

Financial management is concerned with the solution of three major issues relating to the financial operations of a firm. These correspond to three broad and interrelated decisions that every financial manager has to take: the investment decision, the financing decision, and the dividend decision.

1. Investment Decision

A firm’s resources are scarce and have alternative uses. Therefore, a firm has to choose where to invest these resources to earn the highest possible return for its investors. The investment decision relates to how the firm’s funds are invested in different assets. Investment decisions can be long-term or short-term.

• Long-term Investment Decision (Capital Budgeting): This involves committing finance on a long-term basis into projects and assets. Examples include investing in a new machine, acquiring a new fixed asset, opening a new branch, or acquiring another company (like Tata Steel's acquisition of Corus). These decisions are very crucial as they affect the firm's earning capacity, growth, and risk profile in the long run. They normally involve huge amounts of investment and are largely irreversible except at a very high cost.

• Short-term Investment Decision (Working Capital Management): These decisions are concerned with the management of current assets, such as the levels of cash, inventory (stock), and receivables (debtors). They affect the day-to-day working of the business and have a significant impact on its liquidity and profitability.

Factors affecting Capital Budgeting Decisions:

1. Cash flows of the project: A project involves a series of cash outflows (investment) and cash inflows (returns) over its life. These cash flows should be carefully estimated and analysed.

2. The rate of return: The expected returns from each proposal and the assessment of the risk involved are the most important criteria. A project is selected only if its rate of return is higher than a certain minimum acceptable rate.

3. The investment criteria involved: There are various scientific capital budgeting techniques (like Net Present Value, Internal Rate of Return) that are used to evaluate and compare investment proposals based on calculations involving the amount of investment, interest rate, cash flows, and rate of return.

2. Financing Decision

This decision is about the quantum of finance to be raised from various long-term sources. The main sources of funds for a firm are shareholders’ funds (equity) and borrowed funds (debt). A firm has to decide the proportion of funds to be raised from these sources. This decision determines the firm's capital structure, its overall cost of capital, and its financial risk.

Factors affecting Financing Decisions:

1. Cost: The cost of raising funds from different sources varies. A prudent financial manager would normally opt for the source that is the cheapest.

2. Risk: The risk associated with each source is different. Debt is more risky for the firm as the payment of interest and the repayment of the principal are obligatory, regardless of profits.

3. Floatation Costs: These are the costs involved in raising funds (e.g., brokerage and underwriting fees for a public issue). Higher floatation costs make a source less attractive.

4. Cash Flow Position: A company with a strong and stable cash flow position is better able to meet its fixed payment obligations and can, therefore, opt for more debt financing.

5. Fixed Operating Costs: If a business has high fixed operating costs (like rent and salaries), it should reduce its fixed financing costs by opting for lower debt to manage its overall risk.

6. Control Considerations: Issuing more equity shares can lead to a dilution of the existing shareholders' control over the business, whereas debt financing does not have this implication.

7. State of Capital Market: The health and condition of the capital market (whether it is bullish or bearish) affects the choice between debt and equity. It is easier to raise equity in a booming market.

3. Dividend Decision

This decision relates to the distribution of the profits earned by the company. The financial manager has to decide how much of the profit earned by the company (after paying tax) is to be distributed to the shareholders as a dividend and how much of it should be retained in the business for future investment needs (retained earnings). While dividends constitute the current income for shareholders, their re-investment as retained earnings increases the firm’s future earning capacity and the value of its shares. The decision regarding dividends should, therefore, be taken keeping in view the overall objective of maximising shareholders’ wealth.

Factors affecting Dividend Decisions:

1. Amount of Earnings: Dividends are paid out of a company's current and past earnings, so the level of earnings is a major determinant of the dividend decision.

2. Stability of Earnings: A company with stable and consistent earnings is in a better position to declare higher and more regular dividends.

3. Stability of Dividends: Companies generally follow a policy of maintaining a stable dividend per share, as investors value consistency.

4. Growth Opportunities: Companies that have good growth and investment opportunities tend to retain a larger portion of their earnings to finance these investments.

5. Cash Flow Position: The payment of dividends involves an outflow of cash. Therefore, a company must have sufficient cash available to be able to pay the declared dividends.

6. Shareholders’ Preference: The management must keep in mind the preferences of the shareholders. If shareholders generally desire a regular income, the company is likely to declare a dividend.

7. Taxation Policy: The tax treatment of dividends in the hands of the shareholders and the dividend distribution tax levied on companies can affect the dividend decision.

8. Stock Market Reaction: An increase in dividend is generally viewed as good news by investors, and stock prices tend to react positively to it. The management considers this potential market reaction.

9. Access to Capital Market: Large and reputed companies that have easy access to the capital market for raising funds may depend less on retained earnings and can, therefore, afford to pay higher dividends.

10. Legal and Contractual Constraints: The provisions of the Companies Act and the terms of any loan agreements may place certain restrictions on the payment of dividends.

Financial Planning

Financial planning is a crucial process that is concerned with anticipating the future financial needs of an organisation. It is essentially the preparation of a financial blueprint of an organisation’s future operations. The objective of financial planning is to ensure that enough funds are available at the right time for various purposes, from long-term investments to day-to-day expenses.

It is important to understand that financial planning is not a substitute for financial management. While financial management aims at choosing the best investment and financing alternatives by focusing on their costs and benefits, financial planning aims at ensuring smooth operations by focusing on fund requirements and their availability in light of the financial decisions that have been made.

Financial planning typically begins with the preparation of a sales forecast. Based on this, financial statements are prepared to estimate the requirement of funds for investment in fixed and working capital. The process also forecasts shortages and surpluses so that necessary actions can be taken in advance.

Objectives of Financial Planning

Financial planning strives to achieve the following twin objectives, which are two sides of the same coin:

1. To ensure the availability of funds whenever required: This is the primary objective. It includes a proper estimation of the funds required for different purposes (long-term assets, day-to-day expenses) and the exact time at which these funds are to be made available. Financial planning also tries to specify the possible sources from which these funds can be raised.

2. To see that the firm does not raise resources unnecessarily: Excess funding is almost as bad as inadequate funding. If a firm has surplus funds, it will remain idle and will unnecessarily add to the cost without generating any return. Good financial planning ensures that surplus money is put to the best possible use.

Thus, a proper matching of fund requirements and their availability is sought to be achieved by financial planning.

Importance of Financial Planning

Financial planning is an important part of the overall planning of any business enterprise. Its importance can be explained by the following points:

• Prepares for the Future: It helps in forecasting what may happen in the future under different business situations. By preparing a blueprint for alternative scenarios, it makes the firm better prepared to face eventual situations.

• Avoids Shocks and Surprises: By anticipating future financial requirements and potential problems, it helps the company in avoiding business shocks and surprises.

• Facilitates Coordination: It helps in coordinating various business functions, such as sales and production, by providing clear financial policies and procedures.

• Reduces Waste: Detailed plans of action prepared under financial planning help in reducing waste, duplication of efforts, and gaps in planning.

• Links the Present with the Future: It serves as a crucial link between the company's present operations and its future growth plans.

• Links Investment and Financing Decisions: It provides a continuous link between the investment and financing decisions of the company.

• Aids in Control: By spelling out detailed objectives and standards for various business segments, it makes the evaluation of actual performance easier and serves as a basis for financial control.

Capital Structure

One of the most important decisions under financial management relates to the financing pattern of the firm, which is the proportion of the use of different sources in raising the required funds. Capital structure refers to the mix between owners' funds (equity) and borrowed funds (debt) used to finance the assets of a company.

Owners' funds consist of equity share capital, preference share capital, and reserves and surpluses (retained earnings). Borrowed funds can be in the form of loans, debentures, and public deposits. Capital structure can be expressed as a debt-equity ratio, i.e., $ \frac{Debt}{Equity} $, or as the proportion of debt out of the total capital, i.e., $ \frac{Debt}{Debt+Equity} $.

Debt and equity differ significantly in their cost and riskiness. Debt is generally cheaper than equity because lenders' risk is lower than that of equity shareholders (as lenders get an assured return and repayment). Additionally, the interest paid on debt is a tax-deductible expense. However, debt is more risky for a business because the payment of interest and the return of principal are obligatory. Any default in these commitments can force the business into liquidation. This risk is known as financial risk. Equity, on the other hand, is considered riskless for the business as there is no legal compulsion to pay dividends or repay the capital.

A capital structure is said to be optimal when the proportion of debt and equity is such that it results in an increase in the value of the equity share, thereby maximising the wealth of the shareholders. The proportion of debt in the overall capital is also called financial leverage.

Trading on Equity

Trading on Equity is a financial practice that refers to the increase in the profit earned by the equity shareholders due to the presence of fixed financial charges like interest. The concept works on the principle that if a company can earn a higher rate of return on its investments than the interest rate it pays on its borrowed funds, the surplus will go to the equity shareholders, thus increasing their Earning Per Share (EPS).

• When the company's Return on Investment (RoI) is higher than the cost of debt (interest rate), the use of debt magnifies the EPS of the equity shareholders. This is a situation of favourable financial leverage.

• However, if the RoI is less than the cost of debt, the use of debt reduces the EPS. This is a situation of unfavourable financial leverage.

While trading on equity can enhance the EPS, a reckless use of it is not recommended as it also significantly increases the financial risk of the company.

Factors Affecting the Choice of Capital Structure

The choice of an appropriate capital structure that balances risk and return is a complex decision that depends on various factors. The key factors are:

1. Cash Flow Position: A company must have a sufficiently large and stable cash flow to be able to meet its fixed payment obligations associated with debt (interest and principal repayment).

2. Interest Coverage Ratio (ICR): This ratio, calculated as $ \frac{EBIT}{Interest} $, indicates the number of times the company's earnings before interest and taxes can cover its interest obligation. A higher ratio indicates a lower risk of default and a greater capacity to borrow.

3. Debt Service Coverage Ratio (DSCR): This ratio is a more comprehensive measure of a company's ability to service its debt as it considers both interest and principal repayment obligations.

4. Return on Investment (RoI): If the RoI of the company is higher than the cost of debt, the company can effectively use trading on equity to increase its EPS.

5. Cost of Debt and Equity: A firm’s ability to borrow at a lower rate of interest increases its capacity to employ higher debt. The cost of equity also changes with the level of debt.

6. Tax Rate: Since the interest paid on debt is a tax-deductible expense, a higher corporate tax rate makes debt a relatively cheaper source of finance.

7. Floatation Costs: These are the costs involved in raising funds (e.g., brokerage and underwriting fees for a public issue). Raising funds through loans may involve lower floatation costs than a public issue of shares or debentures.

8. Risk Consideration: The total risk of a business depends on both its business risk (which is related to its fixed operating costs) and its financial risk (which is related to its fixed financial charges).

9. Flexibility: A firm should not use its debt potential to the full in normal times. It should maintain some borrowing power (flexibility) to be able to take care of unforeseen circumstances.

10. Control: Debt financing does not dilute the control of the existing equity shareholders over the company, whereas issuing new equity shares to the public does.

11. Regulatory Framework: Every company operates within a regulatory framework provided by the law (e.g., Companies Act, SEBI guidelines), which can influence the choice of financing.

12. Stock Market Conditions: The condition of the stock market (whether it is bullish or bearish) affects the ease and cost of raising funds through equity.

13. Capital Structure of Other Companies: The debt-equity ratios of other companies in the same industry can serve as a useful guideline, but they should not be followed blindly.

Fixed and Working Capital

Every company needs funds to finance its assets and activities. An investment is required in two types of assets: fixed assets and current assets.

• Fixed Assets are those assets that are intended to be used in the business for more than one year. Examples include plant and machinery, furniture and fixtures, land, and buildings.

• Current Assets are those assets which, in the normal course of business, are expected to be converted into cash or cash equivalents within a period of one year. Examples include inventories (raw materials, work-in-progress, finished goods), debtors, and bills receivable.

Management of Fixed Capital

Fixed capital refers to the investment that a company makes in its long-term assets. The management of fixed capital involves the allocation of the firm’s capital to different projects or assets that have long-term implications for the business. These decisions are known as investment decisions or capital budgeting decisions, and they are crucial as they affect the growth, profitability, and risk of the business in the long run. These decisions are of great importance for the following reasons:

• Long-term Growth: These decisions have a direct bearing on the long-term growth and prospects of the business.

• Large Amount of Funds Involved: They typically result in a substantial portion of the company's capital funds being blocked in long-term projects.

• High Risk Involved: They influence the overall business risk complexion of the firm, as a wrong decision can have severe consequences.

• Irreversible Decisions: These decisions, once taken, are not easily reversible without incurring heavy losses.

Factors affecting the Requirement of Fixed Capital:

1. Nature of Business: A manufacturing concern requires more fixed capital than a trading concern because it needs to invest in plant and machinery.

2. Scale of Operations: A larger organisation operating at a higher scale requires a higher investment in fixed assets than a smaller one.

3. Choice of Technique: A capital-intensive organisation (that uses more machinery) requires more fixed capital than a labour-intensive one.

4. Technology Upgradation: In industries where assets become obsolete sooner due to rapid technological changes, a higher investment in fixed assets is required for frequent replacements.

5. Growth Prospects: A company with higher growth prospects generally requires a higher investment in fixed assets to build capacity in anticipation of higher demand.

6. Diversification: When a firm chooses to diversify its operations by entering new product lines, its fixed capital requirements increase.

7. Financing Alternatives: The availability of financing alternatives like leasing facilities can reduce the need to purchase assets outright, thus lowering the immediate fixed capital requirement.

8. Level of Collaboration: If business organisations can share each other’s facilities (like a bank sharing another bank's ATM), it can reduce the level of investment in fixed assets for each organisation.

Working Capital

Apart from the investment in fixed assets, every business needs to invest in current assets to facilitate its smooth day-to-day operations. Working capital refers to the firm's investment in its current assets. While current assets are usually more liquid, they contribute less to the profits of the business than fixed assets. A key challenge is to strike a balance between liquidity and profitability.

Net working capital is a key metric in working capital management. It is defined as the excess of current assets over current liabilities (NWC = CA – CL). It represents the portion of current assets that is financed through long-term sources of funds.

Factors affecting the Working Capital Requirements:

1. Nature of Business: A trading organisation or a service industry usually needs a smaller amount of working capital compared to a manufacturing organisation.

2. Scale of Operations: Organisations that operate on a higher scale of operation generally require a larger amount of working capital to maintain higher levels of inventory and debtors.

3. Business Cycle: In the case of a boom (upward phase of the business cycle), the sales and production are likely to be larger, and therefore, a larger amount of working capital is required. The opposite is true during a depression.

4. Seasonal Factors: In the peak season for a business, a larger amount of working capital is required due to a higher level of activity. In the lean season, the requirement is lower.

5. Production Cycle: The production cycle is the time span between the receipt of raw material and its conversion into finished goods. A business with a longer production cycle requires more working capital.

6. Credit Allowed: A company that follows a liberal credit policy (allowing customers more time to pay) will have a higher amount of debtors, which increases its working capital requirement.

7. Credit Availed: Just as a firm allows credit to its customers, it may also get credit from its suppliers. The more credit a firm avails on its purchases, the lower is its working capital requirement.

8. Operating Efficiency: Firms that can manage their operations with a higher degree of efficiency (e.g., by maintaining a higher inventory turnover ratio or a better debtors turnover ratio) require a lower level of working capital.

9. Availability of Raw Material: If raw materials are not freely and continuously available, a company may need to maintain higher stock levels, which increases its working capital.

10. Growth Prospects: If the growth potential of a concern is perceived to be higher, it will require a larger amount of working capital to be able to meet the higher production and sales targets.

11. Level of Competition: A higher level of competition may necessitate maintaining larger stocks of finished goods to meet urgent orders from customers. It may also force the firm to extend liberal credit terms.

12. Inflation: With rising prices, larger amounts of funds are required even to maintain a constant volume of production and sales. Therefore, the working capital requirement of a business becomes higher with a higher rate of inflation.

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