Financial Management: Raising and Using Money Wisely

Meaning, role and objectives of financial management

Business finance means the money a business needs. Financial management means planning, getting and using this money in the best way, at the lowest cost.

Role of financial management

It affects almost every money figure of the firm:

• the size and type of fixed assets (machines, buildings);
• the amount of current assets (cash, stock, debtors);
• the mix of long-term and short-term funds;
• the split between debt and equity;
• all items in the profit and loss statement, such as interest and dividend.

Objective

The main objective is wealth maximisation: to increase the wealth of shareholders. This shows up as a higher market price of the share. A decision is good if it adds more value than it costs. Other aims follow from this: make sure funds are available when needed, at low cost, and used well.

Financial decisions: investment, financing and dividend

1. Investment decision

Where to put the money. Long-term investment is called capital budgeting (buying a new machine, opening a new branch). Short-term investment is about working capital (cash, stock, debtors).

Factors: cash flows of the project, rate of return, investment criteria used (like payback or net present value) and the amount of risk.

2. Financing decision

From where to raise the money: owners' funds (equity shares, retained earnings) or borrowed funds (debentures, loans). Borrowed funds have a fixed interest cost and risk; owners' funds have no fixed cost but cost more overall.

Factors: cost, risk, floatation costs (cost of raising the funds), cash flow position, fixed operating costs, control considerations and state of the capital market.

3. Dividend decision

How much of the profit to pay to shareholders as dividend and how much to keep as retained earnings for growth.

Factors: 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 limits and contract limits (loan agreements).

Financial planning

Financial planning means preparing a money plan (financial blueprint) in advance. It estimates how much money is needed, when it is needed, and from where it will come.

Objectives

• Make sure enough funds are available at the right time.
• Make sure the firm does not raise extra money that lies idle.

Importance

• It helps prepare for surprises by planning for different situations.
• It avoids business shocks and sudden shortages.
• It helps coordinate different departments (sales, production).
• It reduces waste and duplication.
• It links the present with the future.
• It links investment decisions with financing decisions.
• It sets clear standards to check performance later.

It usually covers 3 to 5 years (long term) and one year (short term, the budget).

Capital structure and trading on equity

Capital structure is the mix of owners' funds (equity) and borrowed funds (debt). Debt ÷ equity is one way to show it.

Debt is cheaper, because interest is lower than what shareholders expect and interest is tax-deductible. But it is risky: interest and repayment must be paid even in a bad year. This is called financial risk.

Trading on equity (financial leverage)

Using more debt to increase earnings per share (EPS). It works only when the return on investment (ROI) is higher than the rate of interest. If ROI is lower, more debt reduces EPS.

Factors affecting capital structure

• Cash flow position
• Interest coverage ratio (EBIT ÷ interest): higher = safer to borrow
• Debt service coverage ratio
• Return on investment
• Cost of debt and cost of equity
• Tax rate
• Floatation costs
• Risk consideration (business risk)
• Flexibility (keep some borrowing power)
• Control (new shares may reduce owners' control)
• Regulatory framework
• Stock market conditions
• Capital structure of other firms in the industry

Fixed capital and working capital

Fixed capital

Money put into long-life assets like land, buildings and machines. These decisions are big, hard to reverse and affect growth and risk for years.

Factors affecting fixed capital: nature of business (a factory needs more than a shop), scale of operations, choice of technique (machine-based vs labour-based), technology upgrades, growth prospects, diversification, financing alternatives (leasing reduces need) and level of collaboration (sharing or joint ventures).

Working capital

Money needed for day-to-day work. Gross working capital = current assets. Net working capital = current assets − current liabilities.

Factors affecting working capital: nature of business, scale of operations, business cycle (boom needs more), seasonal factors, production cycle, credit allowed to customers, credit taken from suppliers, operating efficiency, availability of raw material, growth prospects, level of competition and inflation.

Key formulas and definitions

• Objective: wealth maximisation = higher market price of the share.
• Three decisions: investment, financing, dividend.
• EBIT − Interest = EBT; EBT − Tax = EAT; EPS = EAT ÷ number of equity shares.
• Trading on equity helps only if ROI > rate of interest.
• Interest coverage ratio = EBIT ÷ Interest.
• Net working capital = Current assets − Current liabilities.

Worked examples

Common mistakes

• Saying the objective is profit maximisation. In Class 12 it is wealth maximisation (higher share price).
• Thinking more debt always raises EPS. It helps only when ROI is higher than the interest rate.
• Mixing up financing and investment decisions. Financing = from where; investment = where to use.
• Treating gross and net working capital as the same. Net = current assets minus current liabilities.