NCERT Business Studies Class 12 |Financial Management chapter 9|cbse class 12|PUC/CBSE notes class 12
cbse class 12 business studies notes
Important Questions and Answers
Money required for carrying out business activities is called business finance. All business requires some finance for its activities .Finance is required for running a business, or for expanding or diversifying it. For buying assets also, finance is required.Assets can tangible or intangible assets.
Finance is needed to establish a business, to run it, to modernise it, to expand, or diversify it. It is required for buying a variety of assets, which may be tangible like machinery, factories, buildings, offices or intangible such as trademarks, patents, etc
2.Explain the concept of financial management.
Financial Management is concerned with optimal procurement as well as the usage of finance. For optimal procurement, different available sources of finance are identified and compared in terms of their costs and associated risks. Similarly, the finance so procured needs to be invested in a manner that the returns from the investment exceed the cost at which procurement has taken place.Financial
Management aims at reducing the cost of funds procured, keeping the risk under control and achieving effective deployment of such funds. It also aims at ensuring availability of enough funds whenever required as well as avoiding idle finance.
cbse class 12 business studies notes
Financial management has a direct bearing on the financial health of a business. The financial statements, such as balance sheet and profit and loss account, reflect a firm’s financial position and its financial health. Almost all items in the financial statements of a business are affected directly or indirectly through some financial management decisions.
The financial statements of a business are largely determined by financial management decisions taken earlier. Similarly, the future financial statements would depend upon past as well as present financial decisions. Thus, the overall financial health of a business is determined by the quality of its financial management.
Good financial management aims at mobilisation of financial resources at a lower cost and deployment of these in most lucrative activities.Almost all items in the financial statements of a business are affected directly or indirectly through some financial management decisions.Few examples of the aspects being affected could be:
(i) The size and the composition of fixed assets of the business:
(ii)The quantum of current assets and its break-up into cash, inventory and receivables: With an increase in the investment in fixed assets, there is a commensurate increase in the working capital requirement.
(iii) The amount of long-term and short- term funds to be used: Financial management,involves decision about the proportion of long-term and short-term funds
(iv)Break-up of long-term financing into debt, equity etc: Of the total long term finance, the proportions to be raised by way of debt and/or equity is also a financial management decision. The amounts of debt, equity share capital, preference share capital are affected by the financing decision, which is a part of financing management.
(v) All items in the Profit and Loss Account, e.g., Interest, Expense, Depreciation, etc. : Higher amount of debt means higher interest expense in future.
4.Discuss the objectives of financial management
The primary aim of financial management is to maximise shareholders’ wealth. All financial decisions aim at ensuring that each decision is efficient and adds some value which tend to increase the market price of shares. Therefore, those financial decisions are taken which will be gainful from the point of view of the shareholders.
The shareholders gain increases if the value of shares in the market increases. The decisions which result in decline in the share price are poor financial decisions. Thus, the objective of financial management is to maximise the current price of equity shares of the company or to maximise the wealth of owners of the company, which are the shareholders .
Therefore, when a decision is taken about investment, the aim of financial management is to ensure that benefits from the investment exceed the cost so that some value addition takes place. Similarly, when finance is procured, the aim is to reduce the cost so that the value addition is even higher.All those avenues of investment, modes of financing, ways of handling various components of working capital must be identified which will ultimately lead to an increase in the price of equity share.
5.Discuss the three financial decisions and the factors affecting them.
Financial management is concerned with the solution of three major issues relating to the financial operations of a firm corresponding to the three questions of investment, financing and dividend decision. The finance function, is concerned with three broad decisions which are explained below:
1.Financing decisions
- It involves identification of various available sources.
- The main sources of funds for a firm are shareholders’ funds and borrowed funds.
- The shareholders’ funds refer to the equity capital and the retained earnings.
- Borrowed funds refer to the finance raised through debentures or other forms of debt.
- A firm has to decide the proportion of funds to be raised from either sources, based on their basic characteristics.
- Interest on borrowed funds have to be paid regardless of whether or not a firm has earned a profit.The borrowed funds have to be repaid at a fixed time.
A firm, needs to have a judicious mix of both debt and equity in making financing decisions, which may be debt, equity, preference share capital, and retained earnings.The overall financial risk depends upon the proportion of debt in the total capital.Financing decision is, thus, the decisions about how much to be raised from which source. This decision determines the overall cost of capital and the financial risk of the enterprise.
Factors Affecting Financing Decisions
The financing decisions are affected by various factors which are as follows:
(a) Cost: The cost of raising funds through different sources are different. An efficient financial manager would opt for a source which is the cheapest.
(b) Risk: The risk associated with each of the sources is different.
(c) Floatation Costs: Higher the flotation cost, less attractive the source.
(d) Cash Flow Position of the Company: A stronger cash flow position may make debt financing more viable than funding through equity.
(e) Fixed Operating Costs: If a business has high fixed operating costs (e.g., building rent, Insurance premium, Salaries, etc.), it must reduce fixed financing costs. Hence, lower debt financing is better. Similarly, if fixed operating cost is less, more of debt financing may be preferred.
(f) Control Considerations: Issues of more equity may lead to dilution of management’s control over the business. Debt financing has no such implication. Companies afraid of a takeover bid would prefer debt to equity.
(g) State of Capital Market: Health of the capital market may also affect the choice of source of fund. During the period when stock market is rising, more people invest in equity. However, depressed capital market may make issue of equity shares difficult for any company
2.Investment Decision
An investment decision, relates to how the firm’s funds are invested in different assets. Investment decision can be long-term or short-term. A long-term investment decision is also called a Capital Budgeting decision. It involves committing the finance on a long term basis.The size of assets, profitability and competitiveness are all affected by capital budgeting decisions.
Factors affecting capital budgeting decisions
(a) Cash flows of the project: When a company takes an investment decision involving huge amount it expects to generate some cash flows over a period. These cash flows are in the form of a series of cash receipts and payments over the life of an investment. The amount of these cash flows should be carefully analysed before considering a capital budgeting decision.
b) The rate of return: The most important criterion is the rate of return of the project.A bad capital budgeting decision normally can damage the financial fortune of a business.
(c) The investment criteria involved: The decision to invest in a particular project involves a number of calculations regarding the amount of investment, interest rate, cash flows and rate of return. There are different techniques to evaluate investment proposals which are known as capital budgeting techniques. These are applied to each proposal before selecting a particular project.
3.Dividend Decision
The third important decision that every financial manager has to take relates to the distribution of dividend. Dividend is that portion of profit which is distributed to shareholders. The decision involved here is how much of the profit earned by company (after paying tax) is to be distributed to the shareholders and how much of it should be retained in the business
Factors Affecting Dividend Decision
Some of the important factors affecting dividend are as follows:
(a) Amount of Earnings: Dividends are paid out of current and past earning. Therefore, earnings is a major determinant of the decision about dividend.
(b) Stability Earnings: Other things remaining the same, a company having stable earning is in a better position to declare higher dividends. As against this, a company having unstable earnings is likely to pay smaller dividend.
(c) Stability of Dividends: Companies generally follow a policy of stabilising dividend per share. The dividend per share is not altered if the change in earnings is small or seen to be temporary in nature.
(d) Growth Opportunities: Companies having good growth opportunities retain more money out of their earnings so as to finance the required investment.Hence the dividend in growth companies is, smaller, compared to non– growth companies.
(e) Cash Flow Position: A company may be earning profit but may be short on cash. Availability of enough cash in the company is necessary for declaration of dividend, as it involves on out flow of cash.
(f) Shareholders’ Preference: While declaring dividends, managements must keep in mind the preferences of the shareholders in this regard. If the shareholders desire that at least a certain amount is paid as dividend, the companies are likely to declare the same.
(g) Taxation Policy: If tax on dividend is higher, it is better to pay less by way of dividends. As compared to this, higher dividends may be declared if tax rates are relatively lower. The dividends are free of tax for shareholders, but a dividend distribution tax is levied on companies. Thus, under the present tax policy, shareholders are likely to prefer higher dividends.
(h) Stock Market Reaction: Investors, consider an increase in dividend as a good news and stock prices react positively to it. Similarly, a decrease in dividend may have a negative impact on the share prices in the stock market. Thus, the possible impact of dividend policy on the equity share price is one of the important factors considered by the management while taking a decision about it.
(i) Access to Capital Market: Large and reputed companies generally have easy access to the capital market . These companies tend to pay higher dividends than the smaller companies which have relatively low access to the market.
(j) Legal Constraints: Certain provisions of the Companies Act place restrictions on payouts as dividend. Such provisions must be strictly followed while declaring the dividend.
(k) Contractual Constraints: While granting loans to a company, sometimes the lender may impose certain restrictions on the payment of dividends in future. The companies are required to ensure that the dividend does not violate the terms of the loan agreement in this regard.
6.Describe the concept of financial planning and its objectives.
The process of estimating the fund requirement of a business and specifying the sources of funds is called financial planning.Financial planning includes both short-term as well as long-term planning. Long-term planning relates to long term growth and investment .Short-term planning covers short-term financial plan called budget
The objective of financial planning is to ensure that enough funds are available at right time.
Financial planning strives to achieve the following two objectives.
(a) To ensure availability of funds whenever required:
This include a proper estimation of the funds required for the purchase of long-term assets or to meet day-to-day expenses of business etc. The time at which these funds are to be made available must be estimated. Financial planning also specifies possible sources of these funds.
(b) To see that the firm does not raise resources unnecessarily:
Excess funding is as bad as inadequate funding. A good financial planning must make use of surplus money to the best use so that financial resources are not left idle and add to the cost
7.Explain the importance of financial planning.
Financial planning is an important part of overall planning of any business enterprise. It aims at enabling the company to tackle the uncertainty in respect of the availability and timing of the funds and helps in smooth functioning of an organisation.
The importance of financial planning can be explained as follows:
(i) It helps in forecasting what may happen in future under different business situations.It helps the firms to face the eventual situation in a better way. In other words, it makes the firm better prepared to face the future. It prepares alternative financial plans to meet different situations and thus helps in running the business smoothly.
ii) It helps in avoiding business shocks and surprises and helps the company in preparing for the future.
(iii) If helps in co-coordinating various business functions, e.g., sales and production functions, by providing clear policies and procedures.
(iv) Detailed plans of action prepared under financial planning reduce waste, duplication of efforts, and gaps in planning.
(v) It tries to link the present with the future.
(vi) It provides a link between investment and financing decisions on a continuous basis.
(vii)It gives detailed objectives for various business segments, which makes the evaluation of actual performance easier.
8.Explain the concept of capital structure.
Capital structure refers to the mix between owners and borrowed funds.
On the basis of ownership, the sources of business finance can be broadly classified into two categories viz., ‘owners’ funds’ and ‘borrowed funds’.
Owners’ funds consist of equity share capital, preference share capital and reserves and surpluses or retained earnings.
Borrowed funds can be in the form of loans, debentures, public deposits etc. These may be borrowed from banks, other financial institutions, debenture holders and public.
Capital structure refers to the mix between owners and borrowed funds.These shall be referred as equity and debt It can be calculated as debt-equity ratio . Debt and equity differ significantly in their cost and riskiness for the firm.
The cost of debt is lower than the cost of equity for a firm because the lender’s risk is lower than the equity shareholder’s risk, since the lender earns an assured return and repayment of capital and, therefore, they should require a lower rate of return.Capital structure of a company, thus, affects both the profitability and the financial risk.
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.All decisions relating to capital structure should emphasise on increasing the shareholders’ wealth.
9.Describe the factors determining the choice of an appropriate capital structure of a company.
The important factors which determine the choice of capital structure are as follows:
1. Cash Flow Position: Size of projected cash flows must be considered before borrowing. Cash flows must not only cover fixed cash payment obligations but there must be sufficient buffer also. A company has cash payment obligations for (i) normal business operations; (ii) for investment in fixed assets; and (iii) for meeting the debt service commitments.
2. Interest Coverage Ratio (ICR): The interest coverage ratio refers to the number of times earnings before interest and taxes of a company covers the interest obligation. It is calculated as :
ICR = EBIT /Interest .
The higher the ratio, lower the risk of company failing to meet its interest payment obligations.
3. Debt Service Coverage Ratio (DSCR): In DSCR the cash profits generated by the operations are compared with the total cash required for the service of the debt and the preference share capital. It is calculated as follows: A higher DSCR indicates better ability to meet cash commitments and consequently, the company’s Profit after tax + Depreciation + Interest + Non Cash exp. Pref. Div + Interest + Repayment obligation potential to increase debt component in its capital structure.
4. Return on Investment (RoI): 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. RoI is an important determinant of the company’s ability to use trading on equity and thus the capital structure.
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 debt can be raised at a lower rate.
6. Tax Rate: Since interest is a deductible expense, cost of debt is affected by the tax rate. A higher tax rate, thus, makes debt relatively cheaper and increases its attraction vis-Ã -vis equity.
7. Cost of Equity: When a company increases debt, the financial risk faced by the equity holders, increases. Consequently, their desired rate of return may increase. It is for this reason that a company can not use debt beyond a point, beyond which cost of equity may go up sharply and share price may decrease in spite of increased EPS. So for maximisation of shareholders’ wealth, debt can be used only up to a level.
8. Floatation Costs: Public issue of shares and debentures requires considerable expenditure. Getting a loan from a financial institution may not cost so much. These considerations may also affect the choice between debt and equity and hence the capital structure.
9. Risk Consideration: A Financial risk refers to a position when a company is unable to meet its fixed financial charges namely interest payment, preference dividend and repayment obligations. Additionally, every business has some operating risk (also called business risk)which depends upon fixed operating costs. Higher fixed operating costs result in higher business risk and vice-versa. The total risk depends upon both the business risk and the financial risk.
10. Flexibility: If a firm uses its debt potential to the full, it loses flexibility to issue further debt. To maintain flexibility, it must maintain some borrowing power to take care of unforeseen circumstances.
11. Control: Debt normally does not cause a dilution of control. A public issue of equity may reduce the managements’ holding in the company and make it vulnerable to takeover. This influences the choice between debt and equity in companies in which the current holding of management is on a lower side.
12. Regulatory Framework: Every company operates within a regulatory framework provided by the law e.g., public issue of shares and debentures have to be made under SEBI guidelines. Raising funds from banks and other financial institutions require fulfilment of other norms. The ease with which the procedures completed may have a bearing upon the choice of the source of finance.
13. Stock Market Conditions: If the stock markets are bullish, equity shares are more easily sold even at a higher price. Use of equity is preferred by companies in such a situation. However, during a bearish phase, a company, may find raising of equity capital more difficult and it may opt for debt. Thus, stock market conditions often affect the choice between the two.
14. Capital Structure of other Companies: A guideline in the capital structure planning is the debt equity ratios of other companies in the same industry. There are usually some industry norms which may help. The management must know what the industry norms are, whether they are following them or deviating from them and adequate justification must be there in both cases.
10.Explain the concept of fixed and working capital.
Every company needs funds to finance its assets and activities. Investment is required to be made in fixed assets and current assets. Fixed assets are those which remains in the business for more than one year, for e.g., plant and machinery, furniture and fixture, land and building, vehicles, etc. Decision to invest in fixed assets must be taken very carefully as the investment is usually quite large. Such decisions once taken are cannot be changed except at a huge loss. Such decisions are called capital budgeting decisions.
Every business organisation needs to invest in current assets apart from fixed assets. This investment facilitates smooth day-today operations of the business. Current assets are those assets which, in the normal routine of the business, get converted into cash or cash equivalents within one year, e.g., inventories, debtors, bills receivables, etc
11.Describe the factors determining the requirements of fixed and working capital.
Factors affecting the Requirement of Fixed Capital
1. Nature of Business: The type of business has a bearing upon the fixed capital requirements. For example, a trading concern needs lower investment in fixed assets compared with a manufacturing organisation; since it does not require to purchase plant and machinery, etc.
2. Scale of Operations: A larger organisation operating at a higher scale needs bigger plant, more space etc. and therefore, requires higher investment in fixed assets when compared with the small organisation.
3. Choice of Technique:Organisations are either capital intensive or labour intensive. A capital-intensive organisation requires higher investment in plant and machinery as it relies less on manual labour. The requirement of fixed capital for such organisations would be higher. Labour intensive organisations require less investment in fixed assets. Hence, their fixed capital requirement is lower.
4. Technology Up gradation: In certain industries, assets become obsolete sooner and their replacements become due faster. Higher investment in fixed assets must be required in such cases. For example, computers become obsolete faster and are replaced much sooner than say, furniture. Thus, such organisations which use assets which are prone to obsolescence require higher fixed capital to purchase such assets.
5. Growth Prospects: Higher growth of an organisation requires higher investment in fixed assets. Even when such growth is expected, a company may choose to create higher capacity in order to meet the anticipated higher demand quicker. This needs larger investment in fixed assets and consequently larger fixed capital.
6. Diversification: A firm may choose to diversify its operations for various reasons.With diversification, fixed capital requirements increase e.g. a textile company is diversifying and starting a cement manufacturing plant. So, its investment in fixed capital will naturally increase.
7. Financing Alternatives: A developed financial market may provide leasing facilities as an alternative to outright purchase. When an asset is taken on lease, the firm pays lease rentals and uses it. By doing so, it avoids huge sums required to purchase it.
8. Level of Collaboration: At times, certain business organisations share each other’s facilities. For example, a bank may use another’s ATM or some of them may jointly establish a particular facility. Such collaboration reduces the level of investment in fixed assets for each one of the participating organisations.
Factors Affecting the Working Capital Requirements
1. Nature of Business: The nature of a business influences the amount of working capital required. A trading organisation needs a smaller amount of working capital compared to a manufacturing organisation. This is because there is no processing hence no distinction between raw materials and finished goods. Sales can be effected immediately upon the receipt of materials.
In a manufacturing business, raw material needs to be converted into finished goods before any sales is possible. Other factors remaining the same, a trading business requires less working capital.
2. Scale of Operations: For organisations which operate on a higher scale of operation, the quantum of inventory and debtors required is generally high. Such organisations, require large amount of working capital as compared to those operating on lower scale.
3. Business Cycle: Different phases of business cycles affect the requirement of working capital by a firm. In case of a boom, the sales as well as production are likely to be larger and, therefore, larger amount of working capital is required. But, the requirement for working capital will be lower during the period of depression, as the sales as well as production will be small.
4. Seasonal Factors: Most business have some seasonality in their operations. In peak season, because of higher level of activity, larger amount of working capital is required. As against this, the level of activity as well as the requirement for working capital will be lower during the lean season.
5. Production Cycle: Production cycle is the time span between the receipt of raw material and their conversion into finished goods. Some businesses have a longer production cycle while some have a shorter one. Duration and the length of production cycle, affects the amount of funds required for raw materials and expenses. As a result, working capital requirement is higher in firms with longer processing cycle and lower in firms with shorter processing cycle.
6. Credit Allowed: Different firms allow different credit terms to their customers depending upon the level of competition that a firm faces as well as the credit worthiness of their clientele. A liberal credit policy results in higher amount of debtors, increasing the requirement of working capital.
7. Credit Availed: A firm may also get credit from its suppliers. To the extent it avails the credit on purchases, the working capital requirement is reduced.
8. Operating Efficiency: Firms manage their operations with varied degrees of efficiency. Better sales effort may reduce the average time for which finished goods inventory is held. Such efficiencies may reduce the level of raw materials, finished goods and debtors resulting in lower requirement of working capital.
9. Availability of Raw Material: If the raw materials are available freely and continuously, lower stock levels may suffice. If, raw materials do not have uninterrupted availability, higher stock levels may be required. The time lag between the placement of order and the actual receipt of the materials ( called lead time) is important. Larger the lead time, larger the quantity of material to be stored and larger will be the amount of working capital required.
10. Growth Prospects: If the growth potential of a concern is perceived to be higher, it will require larger amount of working capital so that it is able to meet higher production and sales target when required.
11. Level of Competition: Higher level of competitiveness may necessitate larger stocks of finished goods to meet urgent orders from customers. This increases the working capital requirement. Competition may also force the firm to extend liberal credit terms .
12. Inflation: With rising prices, larger amounts are required even to maintain a constant volume of production and sales. The working capital requirement of a business thus, become higher with higher rate of inflation. An inflation rate of 5%, does not mean that every component of working capital will change by the same percentage. The actual requirement shall depend upon the rates of price change of different components (e.g., raw material, finished goods, labour cost) .
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