Financial Management Concepts and Decisions
Introduction
Every business needs finance for its establishment, survival, and growth. However, simply having access to funds is not enough. These funds must be managed effectively to achieve the organisational goals. This is where Financial Management comes into play.
Financial management is a critical part of overall management. It deals with decisions related to how funds are procured, how they are invested, and how the profits earned are distributed.
Meaning Of Business Finance
As discussed previously, Business Finance refers to the money required for carrying out business activities. This includes funds for both fixed assets and day-to-day operations.
Financial management is concerned with the efficient acquisition and use of this business finance.
Financial Management
Financial Management is concerned with efficient acquisition, allocation, and control of financial resources of a business. It involves making decisions regarding how to raise funds, where to invest them, and how to distribute the income generated.
In simple terms, it is about managing the financial affairs of an organisation.
Key activities of financial management include:
1. Financial planning (estimating fund requirements)
2. Raising funds from various sources
3. Investing funds in assets
4. Managing cash flow
5. Managing working capital
6. Distributing profits
Importance
Effective financial management is crucial for the success and survival of a business. Its importance lies in:
1. Estimation of Financial Requirements: Helps in determining the amount of fixed and working capital required.
2. Deciding the Capital Structure: Helps in deciding the proportion of owner's funds (equity) and borrowed funds (debt) in the total capital.
3. Financial Planning: Assists in forecasting future financial needs and planning for their procurement.
4. Sound Utilisation of Funds: Ensures that funds are invested in the most profitable avenues, leading to efficient use of resources.
5. Proper Cash Management: Manages cash flows to ensure sufficient liquidity for meeting obligations while avoiding idle cash.
6. Improved Creditworthiness: Efficient financial management leads to better financial performance, enhancing the company's reputation and making it easier to raise funds in the future.
7. Profit Maximisation and Wealth Maximisation: Ultimately aims at increasing the profitability and shareholder wealth.
Objectives
The primary objective of financial management is to ensure that the business is financially healthy and sustainable. The main objectives are:
1. Profit Maximisation: Traditionally, profit maximisation was considered the main objective. It means maximising the total profit of the business.
Limitations of Profit Maximisation: It is a narrow objective as it ignores risk, the time value of money, and social considerations. Maximising profit in the short term might require actions (like delaying maintenance, cutting quality) that are detrimental in the long run.
2. Wealth Maximisation: The generally accepted objective of financial management in modern times is Wealth Maximisation. It means maximising the market value of the company's shares. This objective is also known as shareholder wealth maximisation.
Why Wealth Maximisation is Preferred:
a) Considers Risk: The market value of shares reflects the risk associated with the company's operations and financial structure. Decisions that increase expected returns must also consider the associated risk.
b) Considers Time Value of Money: The market value considers the timing of returns. Future returns are discounted to their present value. $$ \text{Present Value} = \frac{\text{Future Value}}{(1+r)^n} $$, where $$ r $$ is the discount rate and $$ n $$ is the number of periods.
c) Long-term Perspective: Wealth maximisation is a long-term objective. Decisions are evaluated based on their impact on the future value of the company.
d) Reflects Stakeholder Interests: In the long run, maximising shareholder wealth requires satisfying other stakeholders (employees, customers, suppliers, society), as neglecting them would negatively impact the company's future prospects and share value.
Therefore, financial management aims to make decisions that increase the net present value of the wealth of equity shareholders.
Example 1. A company has two investment proposals. Proposal A is expected to give a profit of ₹10 Lakhs next year with high risk. Proposal B is expected to give a profit of ₹8 Lakhs next year with moderate risk. If the company follows the objective of profit maximisation, which proposal would it choose? If it follows wealth maximisation, which might it choose?
Answer:
If the company follows Profit Maximisation, it would likely choose Proposal A as it promises a higher profit (₹10 Lakhs > ₹8 Lakhs).
If it follows Wealth Maximisation, it would consider both the expected profit and the associated risk. Proposal B has lower profit but also lower risk. The wealth maximisation objective would lead to choosing the proposal that adds more to the market value of shares, which depends on the balance between expected return and risk. It might choose B if A's high risk significantly outweighs its higher expected profit.
Financial Decisions
The finance function involves making three main decisions that are interconnected and crucial for creating wealth for the organisation:
1. Investment Decision
2. Financing Decision
3. Dividend Decision
Investment Decision
The Investment Decision (also known as Capital Budgeting Decision) relates to deciding where the funds are to be invested in various assets. A firm's profitability and growth depend on the effectiveness of this decision.
Investment decisions can be classified into two types:
a) Long-term Investment Decision: Decisions related to investing funds in fixed assets such as land, building, plant and machinery, etc. These decisions are irreversible (or reversible only at a high cost), involve large amounts of funds, and affect the earning capacity of the business for a long period. Therefore, they are critical and require careful evaluation.
b) Short-term Investment Decision: Decisions related to investing funds in current assets such as cash, inventory, receivables. These decisions, also known as working capital management decisions, affect the liquidity and profitability of the firm.
Factors Affecting Investment Decision:
1. Capital Budgeting Criteria: Various techniques are used to evaluate investment proposals, such as Net Present Value (NPV), Internal Rate of Return (IRR), Payback Period. These techniques help in assessing the profitability and viability of the investment.
2. The Investment Criteria: The choice of investment criteria (e.g., focus on short payback or high NPV) influences the selection of projects.
3. Cash Flows of the Project: The stream of cash inflows and outflows expected from the investment over its lifetime is crucial for evaluation.
4. The Rate of Return: The expected rate of return from an investment. Projects with higher expected returns are generally preferred, considering the risk.
5. The Investment Criterion Involved: Different evaluation techniques (NPV, IRR, Payback Period) might rank projects differently, influencing the final decision.
6. Risk Involved: Every investment has some risk. Projects with higher risk are generally expected to provide higher returns to compensate for the risk. The financial manager must consider the risk-return trade-off.
7. Funds Available: The amount of funds available for investment is a constraint.
8. Taxation Policy: Government tax policies regarding depreciation, investment allowances, etc., affect the profitability of investment projects.
Example 2. A company is considering investing ₹50 Lakhs in a new machine that is expected to increase annual revenue by ₹10 Lakhs and reduce costs by ₹2 Lakhs for the next 8 years. This machine has a certain level of risk associated with its performance and the market demand for the increased output. What type of financial decision is the company making, and what factors should the financial manager consider?
Answer:
This is a Long-term Investment Decision (Capital Budgeting Decision). The financial manager should consider factors such as:
- The Cash Flows of the Project (annual revenue increase + cost reduction - initial cost).
- The Rate of Return expected from this investment.
- The Risk Involved with the project.
- Use of Capital Budgeting Techniques like NPV or IRR to evaluate the project's profitability.
Financing Decision
The Financing Decision is concerned with deciding the proportion of funds to be raised from various long-term sources, especially the mix of owner's funds (equity) and borrowed funds (debt). This mix is known as the capital structure of the company.
This decision determines the overall cost of capital and the financial risk of the enterprise. A prudent financing decision aims at striking a balance between risk and return.
$$ \text{Capital Structure} = \text{Equity} + \text{Debt} $$
Factors Affecting Financing Decision:
1. Cost: The cost of raising funds from different sources varies. Debt is usually cheaper than equity because interest is tax-deductible, but it involves fixed payments.
2. Risk: Financial risk (risk of not being able to meet fixed financial obligations like interest payments) is associated with debt. Higher debt means higher financial risk. Equity does not carry financial risk for the company (dividend payment is discretionary).
3. Cash Flow Position: A company with a strong and stable cash flow position can afford to take on more debt as it is confident of meeting the fixed interest payments.
4. Fixed Operating Costs: If a company has high fixed operating costs (like rent, salaries), it should ideally use less debt to keep the total fixed burden manageable.
5. Control Considerations: Issuing equity can dilute the control of existing shareholders. Companies wishing to retain control may prefer debt.
6. State of Capital Market: Conditions in the stock market influence the ability to raise funds. During buoyant markets, equity issues are easier. During recessionary periods, debt might be preferred.
7. Period of Finance: Long-term needs require long-term financing sources.
8. Regulatory Framework: Rules by SEBI, RBI, etc., affect financing options.
9. Tax Rate: A higher corporate tax rate makes the tax shield on interest payments more valuable, favouring debt financing.
Example 3. A well-established manufacturing company with stable profits and strong cash flow needs to raise ₹100 Crore for expansion. The promoters want to retain control of the company. They are considering raising the funds either through issuing new equity shares or issuing debentures. Which financing option would be more suitable for them, considering their objectives?
Answer:
Considering the desire to retain control and stable financial position, issuing Debentures would likely be more suitable. Debentures do not dilute ownership or control (unlike equity shares) and the company's stable cash flow suggests it can manage the fixed interest payments associated with debt.
Dividend Decision
The Dividend Decision relates to deciding how much of the profit earned by the company is to be distributed to the shareholders (as dividend) and how much is to be retained in the business (as retained earnings) for future investment.
This decision affects shareholder wealth and the company's future growth prospects. A balance needs to be struck between paying dividends (which satisfy shareholders immediately) and retaining earnings (which can fuel future growth and potentially increase share value in the long run).
$$ \text{Profit After Tax} = \text{Dividends Paid} + \text{Retained Earnings} $$
Factors Affecting Dividend Decision:
1. Earnings: Dividends are paid out of current and past earnings. Higher earnings generally lead to higher dividends, but it is the earnings capacity that matters for dividend policy.
2. Stability of Earnings: A company with stable earnings can afford to pay higher dividends compared to a company with fluctuating earnings, which might need to retain funds to cover future losses or unstable periods.
3. Stability of Dividends: Companies usually try to maintain a stable dividend per share, even if earnings fluctuate. A stable dividend policy is preferred by investors as it reduces uncertainty.
4. Growth Opportunities: If a company has promising investment opportunities, it may retain a larger portion of earnings to finance these projects, reducing the amount paid out as dividends. Growth companies often pay lower or no dividends.
5. Cash Flow Position: Payment of dividends involves outflow of cash. The company must have sufficient cash to pay dividends, even if it has profits.
6. Shareholder Preference: Preferences of shareholders regarding dividends vs. capital gains (increase in share price from retained earnings) can influence policy. Elderly or retired investors may prefer regular income (dividends), while younger investors seeking growth may prefer retained earnings.
7. Taxation Policy: Tax on dividends for shareholders and tax on retained earnings for the company can influence the dividend policy.
8. Stock Market Reaction: A change in dividend policy can affect the company's share price. A dividend cut might be seen negatively by the market.
9. Access to Capital Market: Companies with easy access to external sources of finance might be more willing to pay dividends, relying on external markets for future funding needs.
10. Legal Provisions: The Companies Act, 2013, and SEBI guidelines have provisions regarding dividend payment.
Example 4. A technology startup in India has generated its first significant profit of ₹5 Crore. It has identified several promising new projects requiring substantial investment that are expected to generate high future returns. The founders believe that reinvesting the profits will significantly increase the company's value and stock price in the coming years. What dividend decision might they make, and what factors are influencing it?
Answer:
The founders are likely to make a dividend decision to retain most or all of the profit (pay low or no dividends). This decision is influenced by factors such as:
1. Growth Opportunities: The availability of promising new projects requiring investment.
2. Shareholder Preference (implicit/long-term): The belief that reinvesting will lead to higher future returns and increased share value (capital gains), which may align with the long-term growth expectations of startup investors.
3. Future Cash Flow Needs: The requirement for funds to finance the new projects.