CBSE Class 12 Business Studies Chapter 9: Financial Management - Lecture, Revision, Notes, Explanation

Hello friends, I am Sanjay. In this series, I am covering the Business Studies subject from the CBSE Class XII syllabus. We will be following the standard NCERT textbook for the topics that we will discuss. This is the ninth video of the series, and we will cover the ninth chapter—Financial Management from Part B of the subject.

Introduction

This chapter comes under Business Finance in Part B. So, we first have to understand, what is the meaning of Business Finance.

In simple words, business finance refers to the money required to carry out business activities. If you wish to start a business, almost all business activities need finance:

Establishing a business: Purchasing assets like machinery, factories, buildings, offices (tangible assets), or trademarks, patents, technical expertise (intangible assets).
Running daily operations: Buying materials, paying bills and salaries.
Modernizing and Expanding: Upgrading machinery, expanding operations, or diversifying into new areas.

Which means that adequate finance is essential for the survival and growth of a business. The process of managing all the financial aspects of businesses is a part of business finance.

Business finance includes the planning, procuring, management, and allocation of funds and resources to support a company’s operations, investments, and growth.

What is Financial Management?

Managing the finances of a business is called financial management. It involves careful handling of the finances since all finance comes with a cost.

Aims of Financial Management

Optimal Procurement: Identifying and getting funds from the best possible sources at the lowest cost.
Optimal Usage: Using the funds in such a way that they generate the best possible returns.
Reducing the Cost of Funds: Minimizing expenses associated with financing.
Keeping Risks Under Control: Managing financial risks effectively.
Ensuring Efficient Use of Funds: Allocating resources where they are most productive.
Ensuring Availability of Funds: Making sure enough funds are available when needed and avoiding idle funds.

Financial management directly affects the financial health of a business. For example, even a well-funded business like Byju’s, which raised billions of dollars, is undergoing severe problems because of improper financial management.

Importance of Financial Statements

The financial statements of a business like the balance sheet, profit and loss account, cash flow statement, etc., reflect the financial position of a business. Accurate financial statements enable management, investors, the public, and the government to understand what is happening inside the business without having to look into the actual operations.

This is the reason why there are accounting standards that need to be followed while preparing the reports, and they have to be audited and certified by professional chartered accountants.

Areas Affected by Financial Management

Size and Composition of Fixed Assets: Decisions to invest in fixed assets directly increase the company’s asset base.
Quantum of Current Assets: Decisions on credit and inventory affect debtors, inventory, and current assets.
Amount of Long-term and Short-term Funds: Deciding the proportion of long-term versus short-term funds impacts liquidity and financing costs.
Break-up of Long-term Financing (Debt vs. Equity): Decisions on financing sources affect the company’s leverage and financial risk.
Profit and Loss Account Items: Interest expenses, depreciation, and dividend payments are all influenced by financial management decisions.

In short, financial management affects almost all aspects of a business directly or indirectly.

Objectives of Financial Management

Good financial management ensures:

Mobilization of Finance at Lower Costs: Sourcing funds from the cheapest possible sources.
Investment in the Most Profitable Activities: Allocating funds to projects or activities that generate the highest returns.
Maximizing Shareholders’ Wealth: Increasing the earning per share and the market value of shares.

To summarize the wealth-maximization concept: The objective of financial management is to source funds from the cheapest source, use the funds for activities that generate the maximum returns, which will directly increase the profits or the earning per share for the shareholders, and the increased earning per share will also increase the market value of the shares, maximizing the shareholders’ wealth.

Financial Decisions in Financial Management

When it comes to finance for a business, there are three key questions:

Investment Decision: Why does the business need money? What is the purpose?
Financing Decision: What should be the source of the money?
Dividend Decision: Should the profits generated by the business be retained or distributed to shareholders as dividends?

These three decisions are called financial decisions and are the focus of financial management.

1. Investment Decisions

Investment decisions determine where to allocate funds to earn the highest possible returns. They can be:

Long-term Investments (Capital Budgeting): Investing in land, buildings, machinery, and other fixed assets.
Short-term Investments (Working Capital): Managing levels of cash, inventory, and receivables.

Factors affecting investment decisions include:

Expected Return on Investment (ROI): Assessing the profitability of potential investments.
Risk Assessment: Evaluating the risks associated with the investment.
Cost of Capital: Considering the cost of funds used for financing the investment.
Cash Flows: Timing and amount of expected cash flows from the investment.
Other Investment Criteria: Amount of investment, build-or-buy options, diversification risks.

2. Financing Decisions

Financing decisions involve determining the source of funds:

Shareholder Funds (Equity): Equity capital, share capital, or retained earnings. Advantages include no interest payments and no obligation to return the money.
Borrowed Funds (Debt): Loans, debentures, and other debts. Obligations include timely repayment of principal and interest payments. This introduces financial risk.

Factors to consider before making financing decisions:

Cost: Different sources have different costs; choose the cheapest source.
Risk: Debt has higher risk due to obligatory payments; equity has lower risk.
Floatation Costs: Higher processing and transaction fees make a source less attractive.
Cash Flow Position: Strong cash flow may make debt financing more viable.
Fixed Operating Costs: High fixed costs may necessitate lower debt financing.
Control Considerations: Issuing more equity may dilute control; debt does not.
State of Capital Market: Bull markets favor equity issuance; bear markets make it difficult.

3. Dividend Decisions

Dividend decisions involve determining what to do with the profits:

Distribute as Dividends: Paying out profits to shareholders.
Retain Earnings: Reinvesting profits for growth or as reserves.

Factors Affecting Dividend Decisions

Amount of Earnings: Higher earnings allow for higher dividends.
Stability of Earnings: Stable earnings support consistent dividends.
Stability of Dividends: Companies may aim to maintain a steady dividend per share.
Growth Opportunities: Companies with growth prospects may retain earnings.
Cash Flow Position: Adequate cash is essential for dividend payments.
Shareholders’ Preference: Considering shareholders’ desire for dividends vs. growth.
Taxation Policy: Tax rates on dividends can influence payout decisions.
Stock Market Reaction: Dividend changes can affect stock prices.
Capital Market Access: Large companies may pay higher dividends due to easier access to capital.
Legal Constraints: Adherence to laws governing dividend payouts.
Contractual Constraints: Loan agreements may restrict dividend payments.

Financial Planning

Financial planning is the creation of financial plans or blueprints for an organization’s future operations, ensuring that funds are available when needed.

Objectives of Financial Planning

Ensure Availability of Funds: Estimating the amount and timing of funds required and identifying possible sources.
Avoid Raising Unnecessary Resources: Efficiently using surplus funds to prevent idle financial resources.

The Process of Financial Planning

Financial planning aligns fund requirements with availability and includes both short-term (budgets) and long-term planning (growth and capital expenditure). Plans typically cover 3-5 years, with budgets providing detailed one-year plans.

The process starts with a sales forecast, followed by preparing financial statements, estimating internal fund generation, and determining the need for external funds and their sources.

Importance of Financial Planning

Tackles Uncertainty: Manages uncertainty regarding fund availability and timing, ensuring smooth operations.
Forecasting Future Scenarios: Prepares firms for different business situations by predicting various outcomes and creating alternative plans.
Avoiding Surprises: Reduces business shocks by preparing for potential future challenges.
Coordinates Functions: Aligns different business areas with clear policies and procedures.
Reduces Waste: Minimizes waste and eliminates effort duplication.
Connects Present and Future: Links current operations with future goals.
Aligns Investment and Financing: Ensures continuous coordination between investment and financing decisions.
Performance Evaluation: Simplifies performance assessment by setting clear objectives.

Concepts of Equity, Debt, and Leverage

Equity: Money invested in the business by the owners or shareholders.

Debt: Money borrowed by the business, such as bank loans, overdrafts, or amounts received from creditors.

Financial Leverage: The proportion of debt in the overall capital. Using debt can sometimes be advantageous and increase profits.

Example:

Suppose there is a business opportunity that gives 10% per annum returns.

Company A: Invests ₹1 lakh (equity). Profit: ₹10,000.
Company B: Invests ₹1 lakh (equity) and borrows ₹2 lakhs at 8% interest. Total investment: ₹3 lakhs. Returns: ₹30,000. Interest: ₹16,000. Profit: ₹14,000.
Company C: Invests ₹1 lakh (equity) and borrows ₹2 lakhs at 11% interest. Total investment: ₹3 lakhs. Returns: ₹30,000. Interest: ₹22,000. Profit: ₹8,000.

Funding through equity alone may not maximize profits. Leveraging, i.e., using a mix of debt and equity, can increase profits if the rate of return is higher than the cost of debt.

Capital Structure

Capital structure refers to the mix of owners’ funds (equity) and borrowed funds (debt). A business can have two sources of finance:

Owners’ Funds: Equity share capital, preference share capital, reserves, and retained earnings.
Borrowed Funds: Loans, debentures, deposits from banks or financial institutions.

Financial Leverage: Calculated as the ratio of debt to equity or debt to total capital (debt plus equity).

Financial Risk

The risk that the business may not be able to meet its financial obligations. Debt is riskier because interest and principal repayments are obligatory. Equity is considered less risky for the business.

An optimal capital structure is the best mix of debt and equity that maximizes profits and shareholders’ wealth.

Example of Leverage and Its Effect on Profitability

Suppose there are three businesses A, B, and C, each with a total capital of ₹30 lakhs.

Business A: ₹30 lakhs equity, no debt. Earnings per share (EPS): ₹0.93.
Business B: ₹20 lakhs equity, ₹10 lakhs debt. EPS: ₹1.05.
Business C: ₹10 lakhs equity, ₹20 lakhs debt. EPS: ₹1.40.

By increasing debt and leverage, the EPS has increased. However, this works only if the cost of debt (interest rate) is lower than the returns generated through the business.

Impact of High Debt When Return on Investment is Low

If the rate of return is lower than the cost of debt, increasing debt decreases profitability. Higher amounts of debt can lead to higher losses.

Factors Affecting the Choice of Capital Structure

Cash Flow Position: Adequate cash flow is essential for meeting obligations.
Interest Coverage Ratio (ICR): Measures how many times earnings cover interest obligations.
Debt Service Coverage Ratio (DSCR): Evaluates the firm’s ability to service debt, considering both interest and principal repayments.
Return on Investment (RoI): Higher RoI allows for effective use of debt to increase EPS.
Cost of Debt: Lower interest rates make debt more attractive.
Tax Rate: Interest on debt is tax-deductible, reducing the effective cost of debt.
Cost of Equity: Higher financial risk increases the cost of equity.
Floatation Costs: Expenses incurred when raising new funds.
Risk Considerations: Total risk includes financial and business risks.
Flexibility: Preserving borrowing capacity for unforeseen expenses.
Control: Issuing new equity may dilute existing control.
Regulatory Framework: Compliance with laws governing capital raising.
Stock Market Conditions: Market sentiment affects the attractiveness of equity financing.
Capital Structure of Other Companies: Benchmarking against industry norms.

Management of Fixed Capital and Working Capital

Fixed Capital

Fixed capital refers to long-term assets and investments that a company uses to generate revenue.

Examples: Plant and machinery, land and buildings, vehicles, furniture, and fixtures.

Fixed assets are not consumed or sold during normal business but are essential for production. They require large initial investments and are not liquid.

Working Capital

Working capital refers to short-term assets and liabilities used in day-to-day operations.

Examples: Cash, inventories, bills receivable, and debtors.

Working Capital = Current Assets – Current Liabilities

It ensures liquidity to pay bills and continue operations smoothly.

Management of Fixed Capital

Managing fixed capital involves making strategic long-term investments in the business. These decisions impact growth, profitability, and risk profile.

Importance of Fixed Capital Management

Long-term Growth: Assets invested today shape future growth.
Large Capital Requirement: Significant funds are involved, requiring thorough planning.
Substantial Risk: Poor decisions can affect overall risk profile.
Irreversibility: Fixed capital decisions are often irreversible without heavy financial losses.

Factors Affecting Fixed Capital Requirements

Nature of Business: Trading firms need less fixed capital than manufacturing firms.
Scale of Operations: Larger businesses require more fixed capital.
Choice of Technique: Capital-intensive businesses need higher investment in machinery.
Technology Upgradation: Rapid obsolescence increases fixed capital needs.
Growth Prospects: Expansion plans require more fixed capital.
Diversification: Entering new industries increases fixed capital requirements.
Financing Alternatives: Leasing can reduce upfront investments.
Level of Collaboration: Sharing facilities reduces individual fixed capital needs.

Management of Working Capital

Working capital management involves managing current assets and liabilities to ensure smooth day-to-day operations.

Net Working Capital (NWC) = Current Assets – Current Liabilities

Current assets are more liquid but contribute less to profits compared to fixed assets. Firms need to balance liquidity and profitability.

Factors Affecting Working Capital Requirements

Nature of Business: Manufacturing firms need more working capital than service firms.
Scale of Operations: Larger businesses require more working capital.
Business Cycle: Booms increase working capital needs; recessions decrease them.
Seasonal Factors: Peak seasons require more working capital.
Production Cycle: Longer cycles increase working capital needs.
Credit Allowed: More credit to customers increases working capital needs.
Credit Availed: Delayed payments to suppliers reduce working capital needs.
Operating Efficiency: Efficient management reduces working capital needs.
Availability of Raw Materials: Easily available materials reduce stock levels.
Growth Prospects: High growth requires more working capital.
Level of Competition: Competitive markets may require higher stock and flexible credit terms.
Inflation: Rising prices increase working capital needs.

Conclusion

And with that, we have come to the end of this chapter. If you have any questions or feedback, post a comment below. I will see you again in the next part of this series, where we will cover the next chapter.

CBSE Class 12 Business Studies Chapter 9: Financial Management – Lecture, Revision, Notes, Explanation

Financial Management