Chapter_1 Busineess Studies

LEARNING OBJECTIVESLEARNING OBJECTIVESLEARNING OBJECTIVESLEARNING OBJECTIVESLEARNING OBJECTIVES

After studying this chapter, youshould be able to:

Ø explain the meaning of businessfinance;

Ø describe financial management;

Ø explain the role of financialmanagement in our enterprise;

Ø discuss objectives of financialmanagement and how theycould be achieved;

Ø explain the meaning andimportance of financialplanning;

Ø state the meaning of capitalstructure;

Ø analyse the factors affecting thechoice of an appropriate capitalstructure;

Ø state meaning of fixed capitaland working capital; and

Ø analyse the factors affecting therequirement of fixed andworking capital.

CHAPTER

9FFFFFINANCIALINANCIALINANCIALINANCIALINANCIAL M M M M MANAGEMENTANAGEMENTANAGEMENTANAGEMENTANAGEMENT

TTTTTATAATAATAATAATA S S S S STEELTEELTEELTEELTEEL A A A A ACQUIRESCQUIRESCQUIRESCQUIRESCQUIRES C C C C CORUSORUSORUSORUSORUS

Tata Steel, the biggest steel producerin the Indian private sector has acquiredCorus, (formerly known as British Steel)in a deal worth $8.6 billion. This makesTata Steel the fifth largest steelproducer in the world. A financialdecision of this magnitude hassignificant implicitness for both TataSteel and Corus as well as theiremployees and shareholders. Tomention some of them:

l Tata Steel will become the fifthlargest producer of steel in the world.

l Tata Steel will raise a debt of over$ 8 billion to finance the transaction.The deal will be paid for by Tata SteelUK, a special purpose vehicle (SPV)set up for the purpose. This SPV willget funds from Tata Steel routedthrough a Singapore subsidiary.Another company of the Tata group,Tata Sons Ltd., will invest $ 1 billiondollars for preference shares alongwith Tata Steel which will invest anequal amount.

l Tata Steel, the acquirer company, shallhave to arrange about 36,500 croresof rupees to finance the take-over.

l Tata Steel will have to raise thisamount through debt or equity or acombination of both. Some amountmay come from internal accruals also.This financing decision will affect thecapital structure of Tata Steel.

l Tata Steel hopes to increase theproduction to 40 million tonnes andrevenue to 32 billion US dollars by2012.

2015-16(21/01/2015)

BUSINESS STUDIES

238

tangible like machinery, factories,buildings, offices; or intangible suchas trademarks, patents, technicalexpertise, etc. Also, finance is centralto running the day-to-day operationsof business, like buying material,paying bills, salaries, collecting cashfrom customers, etc. needed at everystage in the life of a business entity.Availability of adequate finance is,thus, very crucial for the survival andgrowth of a business.

FFFFFINANCIALINANCIALINANCIALINANCIALINANCIAL M M M M MANAGEMENTANAGEMENTANAGEMENTANAGEMENTANAGEMENT

All finance comes at some cost. It isquite imperative that it needs to becarefully managed. FinancialManagement is concerned with optimalprocurement as well as the usage offinance. For optimal procurement,different available sources of financeare identified and compared in termsof their costs and associated risks.Similarly, the finance so procuredneeds to be invested in a manner thatthe returns from the investment exceedthe cost at which procurement hastaken place. Financial Managementaims at reducing the cost of fundsprocured, keeping the risk under

IIIIINTRODUCTIONNTRODUCTIONNTRODUCTIONNTRODUCTIONNTRODUCTION

In the above case, these decisionsrequire careful financial planning, anunderstanding of the resultant capitalstructure and the riskiness andprofitability of the enterprise. All thesehave a bearing on shareholders as wellas employees. They require anunderstanding of business finance,major financial decision areas,financial risk, and working capitalrequirements of the business. Finance,as we all know, is essential for runninga business. Success of businessdepends on how well finance isinvested in assets and operations andhow timely and cheaply the financesare arranged, from outside or fromwithin the business.

MMMMMEANINGEANINGEANINGEANINGEANING OFOFOFOFOF B B B B BUSINESSUSINESSUSINESSUSINESSUSINESS F F F F FINANCEINANCEINANCEINANCEINANCE

Money required for carrying outbusiness activities is called businessfinance. Almost all business activitiesrequire some finance. Finance isneeded to establish a business, to runit, to modernise it, to expand, ordiversify it. It is required for buying avariety of assets, which may be

l It may affect the competitiveness of Tata Steel because the cost of production ofsteel in all probability, will change.

l The dividend paying capacity of Tata Steel may be affected because of this hugecash outflow and because of a significantly higher debt which would need to beserviced before paying any dividends to shareholders.

l The degree of risk shall also be affected. Needless to emphasise, decisions likethis affect the future of the organisation. These decisions are almost irrevocableafter they have been formalised.

Source: The Economic TimesSource: The Economic TimesSource: The Economic TimesSource: The Economic TimesSource: The Economic Times

2015-16(21/01/2015)

FINANCIAL MANAGEMENT

239

control and achieving effectivedeployment of such funds. It also aimsat ensuring availability of enough fundswhenever required as well as avoidingidle finance. Needless to emphasise, thefuture of a business depends a greatdeal on the quality of its financialmanagement.

Importance : The role of financialmanagement cannot be over-emphasised, since it has a directbearing on the financial health of abusiness. The financial statements,such as Balance Sheet and Profit andLoss Account, reflect a firm’s financialposition and its financial health.Almost all items in the financialstatements of a business are affecteddirectly or indirectly through somefinancial management decisions. Someprominent examples of the aspectsbeing affected could be as under:

(i) The size and the composition offixed assets of the business: Forexample, a capital budgetingdecision to invest a sum of Rs. 100crores in fixed assets would raisethe size of fixed assets block by thisamount.

(ii) The quantum of current assets andits break-up into cash, inventory and

receivables: With an increase in theinvestment in fixed assets, there isa commensurate increase in theworking capital requirement. Thequantum of current assets is alsoinfluenced by financialmanagement decisions. In addition,decisions about credit andinventory management affect the

amount of debtors and inventorywhich in turn affect the totalcurrent assets as well as theircomposition.

(iii)The amount of long-term and short-term funds to be used: Financialmanagement, among others,involves decision about theproportion of long-term and short-term funds. An organisationwanting to have more liquid assetswould raise relatively more amounton a long-term basis. There is achoice between liquidity andprofitability. The underlying ass-umption here is that currentliabilities cost less than long termliabilities.

(iv) Break-up of long-term financing intodebt, equity etc: Of the total long-term finance, the proportions to beraised by way of debt and/or equityis also a financial managementdecision. The amounts of debt,equity share capital, preferenceshare capital are affected by thefinancing decision, which is a partof financing management.

(v) All items in the Profit and LossAccount, e.g., Interest, Expense,Depreciation, etc. : Higher amountof debt means higher interestexpense in future. Similarly, useof higher equity may entail higherpayment of dividends. Similarly, anexpansion of business which is aresult of capital budgeting decisionis likely to affect virtually all itemsin the profit and loss account ofthe business.

It can, thus, be stated that thefinancial statements of a business are

2015-16(21/01/2015)

BUSINESS STUDIES

240

largely determined by financialmanagement decisions taken earlier.Similarly, the future financialstatements would depend upon pastas well as current financial decisions.Thus, the overall financial health of abusiness is determined by the qualityof its financial management. Goodfinancial management aims atmobilisation of financial resources ata lower cost and deployment of thesein most lucrative activities.

OOOOOBJECTIVESBJECTIVESBJECTIVESBJECTIVESBJECTIVES

The primary aim of financialmanagement is to maximiseshareholders’ wealth, which is referredto as the wealth-maximisationconcept. The market price of acompany’s shares is linked to the threebasic financial decisions which you willstudy a little later. This is because acompany funds belong to theshareholders and the manner in whichthey are invested and the returnearned by them determines theirmarket value and price. It meansmaximisation of the market value ofequity shares. The market price ofequity share increases, if the benefitfrom a decision exceeds the costinvolved. All financial decisions aim atensuring that each decision is efficientand adds some value. Such valueadditions tend to increase the marketprice of shares. Therefore, thosefinancial decisions are taken which willultimately prove gainful from the pointof view of the shareholders. Theshareholders gain if the value of shares

in the market increases. Thosedecisions which result in decline in theshare price are poor financialdecisions. Thus, we can say, theobjective of financial management isto maximise the current price of equityshares of the company or to maximisethe wealth of owners of the company,that is, the shareholders.

Therefore, when a decision is takenabout investment in a new machine,the aim of financial management is toensure that benefits from theinvestment exceed the cost so thatsome value addition takes place.Similarly, when finance is procured,the aim is to reduce the cost so thatthe value addition is even higher.

In fact, in all financial decisions,major or minor, the ultimate objectivethat guides the decision-maker is thatsome value addition should take place.All those avenues of investment,modes of financing, ways of handlingvarious components of working capitalmust be identified which willultimately lead to an increase in theprice of equity share. It can happenthrough efficient decision-making.Decision-making is efficient if, out ofthe various available alternatives, thebest is selected.

FFFFFINANCIALINANCIALINANCIALINANCIALINANCIAL D D D D DECISIONSECISIONSECISIONSECISIONSECISIONS

Financial management is concernedwith the solution of three major issuesrelating to the financial operations ofa firm corresponding to the threequestions of investment, financing and

2015-16(21/01/2015)


241

divident decision. In a financialcontext, it means the selection of bestfinancing alternative or bestinvestment alternative. The financefunction, therefore, is concerned withthree broad decisions which areexplained below:

Investment DecisionInvestment DecisionInvestment DecisionInvestment DecisionInvestment Decision

A firm’s resources are scarce incomparison to the uses to which theycan be put. A firm, therefore, has tochoose where to invest theseresources, so that they are able to earnthe highest possible return for theirinvestors. The investment decision,therefore, relates to how the firm’sfunds are invested in different assets.

Investment decision can be long-term or short-term. A long-terminvestment decision is also called aCapital Budgeting decision. It involvescommitting the finance on a long-termbasis. For example, makinginvestment in a new machine toreplace an existing one or acquiring anew fixed asset or opening a newbranch, etc. These decisions are verycrucial for any business since theyaffect its earning capacity in the longrun. The size of assets, profitability andcompetitiveness are all affected bycapital budgeting decisions. Moreover,these decisions normally involve hugeamounts of investment and areirreversible except at a huge cost.Therefore, once made, it is often almostimpossible for a business to wriggle outof such decisions. Therefore, they needto be taken with utmost care. These

decisions must be taken by those whounderstand them comprehensively. Abad capital budgeting decisionnormally has the capacity to severelydamage the financial fortune of abusiness.Short-term investmentdecisions (also called working capitaldecisions) are concerned with thedecisions about the levels of cash,inventory and receivables. Thesedecisions affect the day-to-day workingof a business. These affect the liquidityas well as profitability of a business.Efficient cash management, inventorymanagement and receivablesmanagement are essential ingredientsof sound working capital management.

Factors affecting CapitalFactors affecting CapitalFactors affecting CapitalFactors affecting CapitalFactors affecting CapitalBudgeting DecisionBudgeting DecisionBudgeting DecisionBudgeting DecisionBudgeting Decision

A number of projects are oftenavailable to a business to invest in. Buteach project has to be evaluatedcarefully and, depending upon thereturns, a particular project is either

Wealth Maximisation Concept

2015-16(21/01/2015)

BUSINESS STUDIES

242

selected or rejected. If there is only oneproject, its viability in terms of the rateof return, viz., investment and itscomparability with the industry’saverage is seen. There are certainfactors which affect capital budgetingdecisions.

(a) Cash flows of the project: When acompany takes an investmentdecision involving huge amount itexpects to generate some cashflows over a period. These cashflows are in the form of a series ofcash receipts and payments overthe life of an investment. Theamount of these cash flows shouldbe carefully analysed beforeconsidering a capital budgetingdecision.

(b) The rate of return: The mostimportant criterion is the rate ofreturn of the project. Thesecalculations are based on theexpected returns from eachproposal and the assessment of therisk involved. Suppose, there aretwo projects, A and B (with thesame risk involved), with a rate ofreturn of 10 per cent and 12 percent, respectively, then undernormal circumstance, project Bshould be selected.

(c) The investment criteria involved:

The decision to invest in aparticular project involves anumber of calculations regardingthe amount of investment, interestrate, cash flows and rate of return.There are different techniques toevaluate investment proposals

which are known as capitalbudgeting techniques. Thesetechniques are applied to eachproposal before selecting aparticular project.

Financing DecisionFinancing DecisionFinancing DecisionFinancing DecisionFinancing Decision

This decision is about the quantum offinance to be raised from variouslong-term sources. Short-term sourcesare studied under the ‘working capitalmanagement’.

It involves identification of variousavailable sources. The main sourcesof funds for a firm are shareholders’funds and borrowed funds. Theshareholders’ funds refer to the equitycapital and the retained earnings.Borrowed funds refer to the financeraised through debentures or otherforms of debt. A firm has to decidethe proportion of funds to be raisedfrom either sources, based on theirbasic characteristics. Interest onborrowed funds have to be paidregardless of whether or not a firmhas earned a profit. Likewise, theborrowed funds have to be repaidat a fixed time. The risk of defaulton payment is known as financialrisk which has to be considered bya firm likely to have insufficientshareholders to make these fixedpayments. Shareholders’ funds, on theother hand, involve no commitmentregarding the payment of returns orthe repayment of capital. A firm,therefore, needs to have a judiciousmix of both debt and equity in makingfinancing decisions, which may bedebt, equity, preference share capital,and retained earnings.

2015-16(21/01/2015)


243

The cost of each type of finance hasto be estimated. Some sources may becheaper than others. For example, debtis considered to be the cheapest of allthe sources, tax deductibility of interestmakes it still cheaper. Associated riskis also different for each source, e.g., itis necessary to pay interest on debt andredeem the principal amount onmaturity. There is no such compulsion

to pay any dividend on equity shares.Thus, there is some amount of financialrisk in debt financing. The overallfinancial risk depends upon theproportion of debt in the total capital.The fund raising exercise also costssomething. This cost is calledfloatation cost. It also must beconsidered while evaluating differentsources. Financing decision is, thus,

Financial Decisions

2015-16(21/01/2015)

BUSINESS STUDIES

244

concerned with the decisions abouthow much to be raised from whichsource. This decision determines theoverall cost of capital and the financialrisk of the enterprise.

Factors Affecting FinancingFactors Affecting FinancingFactors Affecting FinancingFactors Affecting FinancingFactors Affecting Financing

DecisionsDecisionsDecisionsDecisionsDecisions

The financing decisions are affected byvarious factors. Important amongthem are as follows:

(a) Cost: The cost of raising fundsthrough different sources aredifferent. A prudent financialmanager would normally opt for asource which is the cheapest.

(b) Risk: The risk associated with eachof the sources is different.

(c) Floatation Costs: Higher the floatationcost, less attractive the source.

(d) Cash Flow Position of the Company:

A stronger cash flow position maymake debt financing more viablethan funding through equity.

(e) Fixed Operating Costs: If abusiness has high fixed operatingcosts (e.g., building rent,Insurance premium, Salaries,etc.), It must reduce f ixedfinancing costs. Hence, lower debtfinancing is better. Similarly, iffixed operating cost is less, moreof debt f inancing may bepreferred.

(f) Control Considerations: Issues ofmore equity may lead to dilutionof management’s control over thebusiness. Debt financing has nosuch implication. Companiesafraid of a takeover bid wouldprefer debt to equity.

India Inc. Issues Bonus Shares and DividendsIndia Inc. Issues Bonus Shares and DividendsIndia Inc. Issues Bonus Shares and DividendsIndia Inc. Issues Bonus Shares and DividendsIndia Inc. Issues Bonus Shares and Dividends

Corporate India has opened its purse strings to shareholders with interimdividends and bonus shares. At least 60 companies have declared interim dividendor announced plans to do so in the first three weeks of January. In addition, around12 companies have announced bonus share issues this month, about three timesmore than January 2006.

There are range of things that a company can do for maximising shareholdervalue and dividend is the most direct and simple form of it. Ideally companies needto balance it up between paying cash and building value of the stock for totalshareholder returns.

This trend of dividends and bonuses is in synchronisation with the good profitsbeing posted by companies. It’s a way of rewarding shareholders.

A number of companies have also announced plans of bonus shares for theirshareholders. Most of the companies who have already declared bonus issues orannounced that they would be taking it up in their next board meeting are small ormid-sized companies.

Source: The Economic TimesSource: The Economic TimesSource: The Economic TimesSource: The Economic TimesSource: The Economic Times

2015-16(21/01/2015)


245

(g) State of Capital Market: Health of

the capital market may also affectthe choice of source of fund. During

the period when stock market isrising, more people invest in equity.

However, depressed capital marketmay make issue of equity shares

difficult for any company.

Dividend DecisionDividend DecisionDividend DecisionDividend DecisionDividend Decision

The third important decision thatevery 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 ofit should be retained in the business.

While the dividend constitutes thecurrent income re-investment as

retained earning increases the firm’sfuture earning capacity. The extent of

retained earnings also influences thefinancing decision of the firm. Since

the firm does not require funds to theextent of re-invested retained

earnings, the decision regardingdividend should be taken keeping in

view the overall objective ofmaximising shareholder’s wealth.

Factors Affecting Dividend DecisionFactors Affecting Dividend DecisionFactors Affecting Dividend DecisionFactors Affecting Dividend DecisionFactors Affecting Dividend Decision

How much of the profits earned by a

company will be distributed as profitand how much will be retained in the

business is affected by many factors.

Some of the important factors arediscussed as follows:

(a) Amount of Earnings: Dividends arepaid out of current and pastearning. Therefore, earnings is amajor determinant of the decisionabout dividend.

(b) Stability Earnings: Other thingsremaining the same, a companyhaving stable earning is in a betterposition to declare higherdividends. As against this, acompany having unstable earningsis likely to pay smaller dividend.

(c) Stability of Dividends: Companiesgenerally follow a policy ofstabilising dividend per share.The increase in dividends isgenerally made when there isconfidence that their earningpotential has gone up and notjust the earnings of the currentyear. In other words, dividend pershare is not altered if the changein earnings is small or seen to betemporary in nature.

(d) Growth Opportunities: Companieshaving good growth opportunitiesretain more money out of theirearnings so as to finance therequired investment. The dividendin growth companies is, therefore,smaller, than that in the non–growth companies.

(e) Cash Flow Position: The paymentof dividend involves an outflow ofcash. A company may be earningprofit but may be short on cash.Availability of enough cash in the

2015-16(21/01/2015)

BUSINESS STUDIES

246

company is necessary fordeclaration of dividend.

(f) Shareholders’ Preference: Whiledeclaring dividends, managementsmust keep in mind the preferencesof the shareholders in this regard.If the shareholders in generaldesire that at least a certainamount is paid as dividend, thecompanies are likely to declare thesame. There are always someshareholders who depend upon aregular income from theirinvestments.

(g) Taxation Policy: The choice betweenthe payment of dividend andretaining the earnings is, to someextent, affected by the differencein the tax treatment of dividendsand capital gains. If tax on dividendis higher, it is better to pay less byway of dividends. As compared tothis, higher dividends may bedeclared if tax rates are relativelylower. Though the dividends are freeof tax in the hands of shareholders,a dividend distribution tax is leviedon companies. Thus, under thepresent tax policy, shareholders arelikely to prefer higher dividends.

(h) Stock Market Reaction: Investors,in general, view an increase individend as a good news and stockprices react positively to it.Similarly, a decrease in dividendmay have a negative impact on theshare prices in the stock market.Thus, the possible impact ofdividend policy on the equity shareprice is one of the important factors

considered by the managementwhile taking a decision about it.

(i) Access to Capital Market: Large andreputed companies generally haveeasy access to the capital marketand, therefore, may depend less onretained earning to finance theirgrowth. These companies tend topay higher dividends than thesmaller companies which haverelatively low access to the market.

(j) Legal Constraints: Certainprovisions of the Companies Actplace restrictions on payouts asdividend. Such provisions must beadhered to while declaring thedividend.

(k) Contractual Constraints: Whilegranting loans to a company,sometimes the lender may imposecertain restrictions on the paymentof dividends in future. Thecompanies are required to ensurethat the dividend does not violatethe terms of the loan agreement inthis regard.

FFFFFINANCIALINANCIALINANCIALINANCIALINANCIAL P P P P PLANNINGLANNINGLANNINGLANNINGLANNING

Financial planning is essentially thepreparation of a financial blueprint ofan organisation’s future operations.The objective of financial planning isto ensure that enough funds areavailable at right time. If adequatefunds are not available the firm willnot be able to honour its commitmentsand carry out its plans. On the otherhand, if excess funds are available, itwill unnecessarily add to the cost and

2015-16(21/01/2015)


247

may encourage wasteful expenditure.It must be kept in mind that financialplanning is not equivalent to, or asubstitute for, financial management.Financial management aims atchoosing the best investment andfinancing alternatives by focusing ontheir costs and benefits. Its objectiveis to increase the shareholders’ wealth.Financial planning on the other handaims at smooth operations by focusingon fund requirements and their

availability in the light of financialdecisions. For example, if a capitalbudgeting decisions is taken, theoperations are likely to be at a higherscale. The amount of expenses andrevenues are likely to increase.Financial planning process tries toforecast all the items which are likelyto undergo changes. It enables themanagement to foresee the fundrequirements both the quantum aswell as the timing. Likely shortage and

Rising Dividends can Support ValuationsRising Dividends can Support ValuationsRising Dividends can Support ValuationsRising Dividends can Support ValuationsRising Dividends can Support Valuations

Over the next few years, companies cannot afford to ignore dividends. Investors arelooking for higher payouts and need the assurance of a stated dividend policy.In India, though, there are few companies that are as consistent in dividendpayments, even over the past five years.

The dividend yield, though, has steadily declined and is now at an average of 1.1per cent for a set of 800 companies. These companies form part of the various BSEand NSE indices. Not only has the dividend yield gone down, there is not one companyin this list that has increased dividends in line with profit growth in each of the pastfive years.

Among companies in the set, those that have steadily increased the payout overthe years include a number of multinational companies that also earn a high returnon net worth. Companies such as Astrazeneca Pharma, Nestle India, HindustanLever, Clariant, Pfizer, GlaxoSmithKline Consumer and Cummins India haveenhanced dividends to deliver value to shareholders. These companies do not seemto be constrained for growth, either. Some Indian companies that have also shownthe way forward include Automotive Axles, Ranbaxy Labs, Hero Honda Motors,Asian Paints, Thermax and a number of banking and non-banking financecompanies. These companies, too, are growing fast, and the declaration of dividendshas not dampened prospects.

Companies that have held on to profits and not declared dividends include e-Serve, Cranes Software, Sesa Goa, Tata Motors, Moser Baer, ABB, MICO, AztecSoftware, Havells India, Amtek India and Sterlite Industries. This is only an indicativelist and includes many more. The dividend payout ratio in the case of the indicatedcompanies is less than 20 per cent. Investors, however, need dividends to rise andthey also need a stated dividend policy. The earnings yield (inverse of PE ratio) isnow at about 6 per cent. If the payout ratio were stepped up to 40 per cent then thedividend yield would rise to about 2.5 per cent.

http://www.thehindubusinessline.com/iw/2005/07/24http://www.thehindubusinessline.com/iw/2005/07/24http://www.thehindubusinessline.com/iw/2005/07/24http://www.thehindubusinessline.com/iw/2005/07/24http://www.thehindubusinessline.com/iw/2005/07/24

2015-16(21/01/2015)

BUSINESS STUDIES

248

surpluses are forecast so thatnecessary activities are taken inadvance to meet those situations.Thus, financial planning strives toachieve the following twin objectives.

(a) To ensure availability of funds

whenever required: This include aproper estimation of the fundsrequired for different purposessuch as for the purchase of long-term assets or to meet day-to-dayexpenses of business etc. Apartfrom this, there is a need toestimate the time at which thesefunds are to be made available.Financial planning also tries tospecify possible sources of thesefunds.

(b) To see that the firm does not raise

resources unnecessarily: Excessfunding is almost as bad asinadequate funding. Even if thereis some surplus money, goodfinancial planning would put it tothe best possible use so that thefinancial resources are not leftidle and don’t unnecessarily addto the cost.

Thus, a proper matching of fundsrequirements and their availability issought to be achieved by financialplanning. This process of estimatingthe fund requirement of a businessand specifying the sources of funds iscalled financial planning. Financialplanning takes into consideration thegrowth, performance, investments andrequirement of funds for a given

period. Financial planning includesboth short-term as well as long-termplanning. Long-term planning relatesto long term growth and investment.It focuses on capital expenditureprogrammes. Short-term planningcovers short-term financial plan calledbudget.

Typically, financial planning isdone for three to five years. For longerperiods it becomes more difficult andless useful. Plans made for periods ofone year or less are termed as budgets.Budgets are example of financialplanning exercise in greater details.They include detailed plan of actionfor a period of one year or less.

Financial planning usually beginswith the preparation of a salesforecast. Let us suppose a company ismaking a financial plan for the nextfive years. It will start with an estimateof the sales which are likely to happenin the next five years. Based on these,the financial statements are preparedkeeping in mind the requirement offunds for investment in the fixedcapital and working capital. Then theexpected profits during the period areestimated so that an idea can be madeof how much of the fund requirementscan be met internally i.e., throughretained earnings (after dividendpayouts). This results in an estimationof the requirement for external funds.Further, the sources from which theexternal funds requirement can be metare identified and cash budgets aremade, incorporating these factors.

2015-16(21/01/2015)


249

IIIIIMPORTANCEMPORTANCEMPORTANCEMPORTANCEMPORTANCE

Financial planning is an important partof overall planning of any businessenterprise. It aims at enabling thecompany to tackle the uncertainty inrespect of the availability and timing ofthe funds and helps in smoothfunctioning of an organisation. Theimportance of financial planning canbe explained as follows:

(i) It helps in forecasting what mayhappen in future under different

business situations. By doing so,it helps the firms to face theeventual situation in a better way.In other words, it makes the firmbetter prepared to face the future.For example, a growth of 20% insales is predicted. However, it mayhappen that the growth rateeventually turns out to be 10% or30%. Many items of expensesshall be different in these threesituations. By preparing ablueprint of these three situations

Cutting Back on DebtCutting Back on DebtCutting Back on DebtCutting Back on DebtCutting Back on Debt

Even successful businesses have debt, but how much is too much? Learning howto manage debt is what can put you ahead.

Taking on the right amount of debt can mean the difference between a businessstruggling to survive and one that can respond nimbly to changing economic ormarket conditions. A number of circumstances may justify acquiring debt. As ageneral rule, borrowing makes the most sense when you need to bolster cash flowor finance growth or expansion. But while debt can provide the leverage you need togrow, too much debt can strangle your business. So the question is: How muchdebt is too much?

The answer, experts say, lies in a careful analysis of your cash flow as well asyour industry. A business that doesn’t grow dies. You’ve got to grow, but you’ve gotto grow within the financial constraints of your business. What is the ideal capital. What is the ideal capital. What is the ideal capital. What is the ideal capital. What is the ideal capitalstructure a business needs in its industry to remain viable?structure a business needs in its industry to remain viable?structure a business needs in its industry to remain viable?structure a business needs in its industry to remain viable?structure a business needs in its industry to remain viable? The higher thevolatility (in your industry), the less debt you should have. The smaller the volatility,the more debt you can afford.

Although banks and other financial institutions look for a satisfactory debt-to-equity ratio before agreeing to make a loan, don’t assume a creditor’s willingness toextend funds is evidence that your business is in a strong debt position. Some financialinstitutions are overzealous lenders, particularly when trying to lure or hold on topromising business customers. “The bank may be looking more at collateral thanwhether the (business’s) earnings are going to come in to justify the debt service.

To avoid these and other credit pitfalls, it’s up to you to get the financial factson your business and make sound borrowing decisions. Unfortunately, manyentrepreneurs fail to recognise how important financial analysis is to running asuccessful business. Even business owners who receive detailed financial statementsfrom their accountants often do not take advantage of the valuable informationcontained in the documents.

http://www.entrepreneur.com/magazine/entrepreneur/2006/Decemberhttp://www.entrepreneur.com/magazine/entrepreneur/2006/Decemberhttp://www.entrepreneur.com/magazine/entrepreneur/2006/Decemberhttp://www.entrepreneur.com/magazine/entrepreneur/2006/Decemberhttp://www.entrepreneur.com/magazine/entrepreneur/2006/December

2015-16(21/01/2015)

BUSINESS STUDIES

250

the management may decide whatmust be done in each of thesesituations. This preparation ofalternative financial plans to meetdifferent situations is clearly ofimmense help in running thebusiness smoothly.

(ii) It helps in avoiding businessshocks and surprises and helpsthe company in preparing for thefuture.

(iii) If helps in co-ordinating variousbusiness functions, e.g., sales andproduction functions, by providingclear policies and procedures.

(iv) Detailed plans of action preparedunder financial planning reducewaste, duplication of efforts, andgaps in planning.

(v) It tries to link the present with thefuture.

(vi) It provides a link betweeninvestment and financing decisionson a continuous basis.

(vii) By spelling out detailed objectivesfor various business segments, itmakes the evaluation of actualperformance easier.

CCCCCAPITALAPITALAPITALAPITALAPITAL S S S S STRUCTURETRUCTURETRUCTURETRUCTURETRUCTURE

One of the important decisions underfinancial management relates to thefinancing pattern or the proportion ofthe use of different sources in raisingfunds. On the basis of ownership, thesources of business finance can bebroadly classified into two categoriesviz., ‘owners’ funds’ and ‘borrowedfunds’. Owners’ funds consist of equity

share capital, preference share capitaland reserves and surpluses or retainedearnings. Borrowed funds can be in theform of loans, debentures, publicdeposits etc. These may be borrowedfrom banks, other financial institutions,debentureholders and public.

Capital structure refers to the mixbetween owners and borrowed funds.These shall be referred as equity anddebt in the subsequent text. It can becalculated as debt-equity ratio

i.e.,Debt

Equity

or as the proportion of

debt out of the total capital i.e.,

Debt

Debt+ Equity

.

Debt and equity differ significantlyin their cost and riskiness for the firm.The cost of debt is lower than the cost ofequity for a firm because the lender’s riskis lower than the equity shareholder’srisk, since the lender earns an assuredreturn and repayment of capital and,therefore, they should require a lowerrate of return. Additionally, interest paidon debt is a deductible expense forcomputation of tax liability whereasdividends are paid out of after-taxprofit. Increased use of debt, therefore,is likely to lower the over-all cost ofcapital of the firm provided that the costof equity remains unaffected. Impactof a change in the debt-equity ratioupon the earning per share is dealt within detail later in this chapter.

Debt is cheaper but is more riskyfor a business because the payment ofinterest and the return of principal is

2015-16(21/01/2015)


251

obligatory for the business. Any defaultin meeting these commitments mayforce the business to go into liquidation.There is no such compulsion in case ofequity, which is therefore, consideredriskless for the business. Higher use ofdebt increases the fixed financialcharges of a business. As a result,increased use of debt increases thefinancial risk of a company.

Financial risk is the chance that afirm would fail to meet its paymentobligations.

Capital structure of a company,thus, affects both the profitabilityand the financial risk. A capitalstructure will be said to be optimalwhen the proportion of debt andequity is such that it results in anincrease in the value of the equityshare. In other words, all decisionsrelating to capital structure shouldemphasise on increasing theshareholders’ wealth.

The proportion of debt in theoverall capital is also called financial

Example IExample IExample IExample IExample I

Company X Ltd.Company X Ltd.Company X Ltd.Company X Ltd.Company X Ltd.

Total Funds used Rs. 30 Lakh

Interest rate 10% p.a.

Tax rate 30%

EBIT Rs. 4 Lakh

DebtDebtDebtDebtDebt

Situation I Nil

Situation II Rs. 10 Lakh

Situation III Rs. 20 Lakh

EBIT-EPS AnalysisEBIT-EPS AnalysisEBIT-EPS AnalysisEBIT-EPS AnalysisEBIT-EPS Analysis

Situation ISituation ISituation ISituation ISituation I Situation IISituation IISituation IISituation IISituation II Situation IIISituation IIISituation IIISituation IIISituation III

EBIT 4,00,000 4,00,000 4,00,000

Interest NIL 1,00,000 2,00,000

EBT 4,00,000 3,00,000 2,00,000

(Earnings before taxes)

Tax 1,20,000 90,000 60,000

EAT 2,80,000 2,10,000 1,40,000

(Earnings after taxes)

No. of shares of Rs.10 3,00,000 2,00,000 1,00,000

EPS 0.93 1.05 1.40

(Earnings per share)

2015-16(21/01/2015)

BUSINESS STUDIES

252

leverage. Financial leverage is

computed asD

E or

D

D + E when D is

the Debt and E is the Equity. As thefinancial leverage increases, the costof funds declines because ofincreased use of cheaper debt but thefinancial risk increases. The impactof f inancial leverage on theprofitability of a business can be seenthrough EBIT-EPS (Earning beforeInterest and Taxes-Earning perShare) analysis as in the followingexample.

Three situations are considered.There is no debt in situation-I i.e.(unlevered business). Debt of Rs. 10lakh and 20 lakh are assumed insituations-II and III, respectively. Alldebt is at 10% p.a.

The company earns Rs. 0.93 pershare if it is unlevered. With debt of Rs.10 lakh its EPS is Rs. 1.05. With a stillhigher debt of Rs. 20 lakh, its, EPS risesto Rs. 1.40. Why is the EPS rising withhigher debt? It is because the cost of

debt is lower than the return thatcompany is earning on funds employed.The company is earning a return oninvestment (RoI)

of 13.33%EBIT

Total Investment× 100

,

4Lakh

30Lakh× 100

. This is higher than

the 10% interest it is paying on debtfunds. With higher use of debt, thisdifference between RoI and cost of debtincreases the EPS. This is a situationof favourable financial leverage. In suchcases, companies often employ more ofcheaper debt to enhance the EPS. Suchpractice is called Trading on Equity.

Trading on Equity refers to theincrease in profit earned by the equityshareholders due to the presence offixed financial charges like interest.

Now consider the following case ofCompany Y. All details are the sameexcept that the company is earning aprofit before interest and taxes ofRs. 2 lakh.

Example IIExample IIExample IIExample IIExample II

Company Y Ltd.Company Y Ltd.Company Y Ltd.Company Y Ltd.Company Y Ltd.

Situation I Situation II Situation III

EBIT 2,00,000 2,00,000 2,00,000

Interest NIL 1,00,000 2,00,000

EBT 2,00,000 1,00,000 NIL

Tax 60,000 30,000 NIL

EAT 1,40,000 70,000 NIL

No. of shares of Rs.10 3,00,000 2,00,000 1,00,000

EPS 0.47 0.35 NIL

2015-16(21/01/2015)


253

In this example, the EPS of thecompany is falling with increased useof debt. It is because the Company’s rateof return on investment (RoI) is less thanthe cost of debt. The RoI for company Y

is 2Lakh

30Lakh× 100, i.e., 6.67%, whereas

the interest rate on debt is 10%. In suchcases, the use of debt reduces the EPS.This is a situation of unfavourablefinancial leverage. Trading on Equity isclearly unadvisable in such a situation.

Even in case of Company X,reckless use of Trading on Equity isnot recommended. An increase in debtmay enhance the EPS but as pointedout earlier, it also raises the financialrisk. Ideally, a company must choosethat risk-return combination whichmaximises shareholders’ wealth. Thedebt-equity mix that achieves it, is theoptimum capital structure.

Factors affecting the Choice ofFactors affecting the Choice ofFactors affecting the Choice ofFactors affecting the Choice ofFactors affecting the Choice ofCapital StructureCapital StructureCapital StructureCapital StructureCapital Structure

Deciding about the capital structureof a firm involves determining therelative proportion of various types offunds. This depends on variousfactors. For example, debt requiresregular servicing. Interest paymentand repayment of principal areobligatory on a business. In additiona company planning to raise debt musthave sufficient cash to meet theincreased outflows because of higherdebt. Similarly, important factorswhich determine the choice of capitalstructure are as follows:

1. Cash Flow Position: 1. Cash Flow Position: 1. Cash Flow Position: 1. Cash Flow Position: 1. Cash Flow Position: Size ofprojected cash flows must beconsidered before borrowing. Cash

flows must not only cover fixed cashpayment obligations but there must besufficient buffer also. It must be keptin mind that a company has cashpayment obligations for (i) normalbusiness operations; (ii) for investmentin fixed assets; and (iii) for meeting thedebt service commitments i.e., paymentof interest and repayment of principal.

2. Interest Coverage Ratio (ICR): 2. Interest Coverage Ratio (ICR): 2. Interest Coverage Ratio (ICR): 2. Interest Coverage Ratio (ICR): 2. Interest Coverage Ratio (ICR): Theinterest coverage ratio refers to thenumber of times earnings beforeinterest and taxes of a company coversthe interest obligation. This may becalculated as follows:

ICR = EBIT

Interest

The higher the ratio, lower shall bethe risk of company failing to meet itsinterest payment obligations. However,this ratio is not an adequate measure.A firm may have a high EBIT but lowcash balance. Apart from interest,repayment obligations are also relevant.

3. Debt Service Coverage Ratio3. Debt Service Coverage Ratio3. Debt Service Coverage Ratio3. Debt Service Coverage Ratio3. Debt Service Coverage Ratio(DSCR): (DSCR): (DSCR): (DSCR): (DSCR): Debt Service Coverage Ratiotakes care of the deficiencies referredto in the Interest Coverage Ratio (ICR).The cash profits generated by theoperations are compared with the totalcash required for the service of the debtand the preference share capital. It iscalculated as follows:

Profit after tax + Depreciation + Interest + Non Cash exp.

Pref. Div + Interest + Repayment obligation

A higher DSCR indicates better abilityto meet cash commitments andconsequently, the company’s potentialto increase debt component in itscapital structure.

2015-16(21/01/2015)

BUSINESS STUDIES

254

Who funds Indian industry, why it matters?Who funds Indian industry, why it matters?Who funds Indian industry, why it matters?Who funds Indian industry, why it matters?Who funds Indian industry, why it matters?

Using data on listed Indian firms from the mid-1980s to the 1990s, severalissues relating to Indian industry were investigated. One aspect then was theextremely limited extent to which promoters and entrepreneurs actually ownedshares in the various companies they had control of

Proportions of the total capital of the firmProportions of the total capital of the firmProportions of the total capital of the firmProportions of the total capital of the firmProportions of the total capital of the firm

Percentage Share

Where did the borrowing come from?Where did the borrowing come from?Where did the borrowing come from?Where did the borrowing come from?Where did the borrowing come from?

Borrowing from Commercial Bank 26.69

Borrowings from Financial Institutions 19.89

Debentures 7.78

Fixed deposits 3.86

Other borrowings 8.78

Who owned the shares?Who owned the shares?Who owned the shares?Who owned the shares?Who owned the shares?

Shares held by the public at large 10.88

Foreign shareholding 3.54

Government shareholding 5.49

Institutional shareholding 8.44

Directors’ shareholding 2.81

Top 50 shareholders shareholding 1.85

Total Debt and Equity Capital of a CompanyTotal Debt and Equity Capital of a CompanyTotal Debt and Equity Capital of a CompanyTotal Debt and Equity Capital of a CompanyTotal Debt and Equity Capital of a Company 100100100100100

Nevertheless, in spite of the relative lack of ownership, the majority of listedentities, mostly private sector companies, were managed by these founders, theirsuccessive family members and other promoters as if they were fiefdoms.

By and large, Indian companies were essentially financed by debt. This wasunlike in the West. If the total debt plus nominal equity capital in the average.Indian company was 100, then 67 per cent of that amount came in the form of debtcapital while equity capital contributed only 33 per cent.

If the share of government ownership in corporate equity and the share offinancial institutions’ equity was added, then over 60 per cent (26.69 + 19.89 +5.49 + 8.44) of firms’ finances were funded by the state in one form or another.

Foreign shareholders, in spite of a lot a clamour about their role in India’scorporate economy, hardly owned more than 4 per cent (3.54) of the shares inIndia’s listed companies. While the public at large provided about 11 per cent of thefinances of an average Indian listed company, the share of the Top 50 shareholderswas less than 2 (1.85) per cent.

It is within this particular shareholding category that promoters, entrepreneurs andthe other large shareholders’ equity stakes fall under for the purposes of classification.

The public at large provides five times as much money for the company as theentrepreneurs. Yet, a group of individuals, whose financial contributions towards acompany are exceedingly small in magnitude, effectively control the company.

http://www.thehindubusinessline.com/2005/10/07http://www.thehindubusinessline.com/2005/10/07http://www.thehindubusinessline.com/2005/10/07http://www.thehindubusinessline.com/2005/10/07http://www.thehindubusinessline.com/2005/10/07

2015-16(21/01/2015)


255

4. Return on Investment (RoI): 4. Return on Investment (RoI): 4. Return on Investment (RoI): 4. Return on Investment (RoI): 4. Return on Investment (RoI): If theRoI of the company is higher, it canchoose to use trading on equity toincrease its EPS, i.e., its ability to usedebt is greater. We have alreadyobserved in Example I that a firm canuse more debt to increase its EPS.However, in Example II, use of higherdebt is reducing the EPS. It is becausethe firm is earning an RoI of only6.67% which lower than its cost ofdebt. In example I the RoI is 13.33%,and trading on equity is profitable. Itshows that, RoI is an importantdeterminant of the company’s abilityto use Trading on equity and thus thecapital structure.

5. Cost of debt: 5. Cost of debt: 5. Cost of debt: 5. Cost of debt: 5. Cost of debt: A firm’s ability toborrow at a lower rate increases itscapacity to employ higher debt. Thus,more debt can be used if debt can beraised at a lower rate.

6. Tax Rate: 6. Tax Rate: 6. Tax Rate: 6. Tax Rate: 6. Tax Rate: Since interest is adeductible expense, cost of debt isaffected by the tax rate. The firms inour examples are borrowing @ 10%.Since the tax rate is 30%, the after taxcost of debt is only 7%. A higher taxrate, thus, makes debt relativelycheaper and increases its attractionvis-à-vis equity.

7. Cost of Equity: 7. Cost of Equity: 7. Cost of Equity: 7. Cost of Equity: 7. Cost of Equity: Stock ownersexpect a rate of return from the equitywhich is commensurate with the riskthey are assuming. When a companyincreases debt, the financial risk facedby the equity holders, increases.Consequently, their desired rate ofreturn may increase. It is for thisreason that a company can not usedebt beyond a point. If debt is used

beyond that point, cost of equity maygo up sharply and share price maydecrease inspite of increased EPS.Consequently, for maximisation ofshareholders’ wealth, debt can be usedonly upto a level.

8. Floatation Costs: 8. Floatation Costs: 8. Floatation Costs: 8. Floatation Costs: 8. Floatation Costs: Process of raisingresources also involves some cost.Public issue of shares and debenturesrequires considerable expenditure.Getting a loan from a financialinstitution may not cost so much.These considerations may also affectthe choice between debt and equityand hence the capital structure.

9. Risk Consideration:9. Risk Consideration:9. Risk Consideration:9. Risk Consideration:9. Risk Consideration: As discussedearlier, use of debt increases thefinancial risk of a business. Financialrisk refers to a position when acompany is unable to meet its fixedfinancial charges namely interestpayment, preference dividend andrepayment obligations. Apart from thefinancial risk, every business has someoperating risk (also called businessrisk). Business risk depends uponfixed operating costs. Higher fixedoperating costs result in higherbusiness risk and vice-versa. The totalrisk depends upon both the businessrisk and the financial risk. If a firm’sbusiness risk is lower, its capacity touse debt is higher and vice-versa.

10. Flexibility:10. Flexibility:10. Flexibility:10. Flexibility:10. Flexibility: If a firm uses its debtpotential to the full, it loses flexibilityto issue further debt. To maintainflexibility, it must maintain someborrowing power to take care ofunforeseen circumstances.

11. Control:11. Control:11. Control:11. Control:11. Control: Debt normally does notcause a dilution of control. A public

2015-16(21/01/2015)

BUSINESS STUDIES

256

issue of equity may reduce themanagements’ holding in the companyand make it vulnerable to takeover. Thisfactor also influences the choicebetween debt and equity especially incompanies in which the current holdingof management is on a lower side.

12. Regulatory Framework:12. Regulatory Framework:12. Regulatory Framework:12. Regulatory Framework:12. Regulatory Framework: Everycompany operates within a regulatoryframework provided by the law e.g.,public issue of shares and debentureshave to be made under SEBIguidelines. Raising funds from banksand other financial institutions requirefulfillment of other norms. The relativeease with which these norms can, bemet or the procedures completed mayalso have a bearing upon the choice ofthe source of finance.

13. Stock Market Conditions: 13. Stock Market Conditions: 13. Stock Market Conditions: 13. Stock Market Conditions: 13. Stock Market Conditions: If thestock markets are bullish, equity sharesare more easily sold even at a higherprice. Use of equity is often preferredby companies in such a situation.However, during a bearish phase, acompany, may find raising of equitycapital more difficult and it may opt fordebt. Thus, stock market conditionsoften affect the choice between the two.

14. Capital Structure of other14. Capital Structure of other14. Capital Structure of other14. Capital Structure of other14. Capital Structure of otherCompanies: Companies: Companies: Companies: Companies: A useful guideline in thecapital structure planning is the debt-equity ratios of other companies in thesame industry. There are usually someindustry norms which may help. Carehowever must be taken that thecompany does not follow the industrynorms blindly. For example, if thebusiness risk of a firm is higher, it cannot afford the same financial risk. It

should go in for low debt. Thus, themanagement must know what theindustry norms are, whether they arefollowing them or deviating from themand adequate justification must bethere in both cases.

FFFFFIXEDIXEDIXEDIXEDIXED ANDANDANDANDAND W W W W WORKINGORKINGORKINGORKINGORKING C C C C CAPITALAPITALAPITALAPITALAPITAL

MeaningMeaningMeaningMeaningMeaning

Every company needs funds to financeits assets and activities. Investment isrequired to be made in fixed assets andcurrent assets. Fixed assets are thosewhich remains in the business formore than one year, usually for muchlonger, e.g., plant and machinery,furniture and fixture, land andbuilding, vehicles, etc.

Decision to invest in fixed assetsmust be taken very carefully as theinvestment is usually quite large.Such decisions once taken areirrevocable except at a huge loss.Such decisions are called capitalbudgeting decisions.

Current assets are those assetswhich, in the normal routine of thebusiness, get converted into cash orcash equivalents within one year, e.g.,inventories, debtors, bills receivables,etc.

Management of Fixed CapitalManagement of Fixed CapitalManagement of Fixed CapitalManagement of Fixed CapitalManagement of Fixed Capital

Fixed capital refers to investment inlong-term assets. Management of fixedcapital involves allocation of firm’scapital to different projectsor assets with long-term implications forthe business. These decisions are calledinvestment decisions or capital

2015-16(21/01/2015)


257

budgeting decisions and affect thegrowth, profitability and risk ofthe business in the long run. These long-term assets last for more than one year.

It must be financed throughlong-term sources of capital such asequity or preference shares,debentures, long-term loans andretained earnings of the business.Fixed Assets should never be financedthrough short-term sources.

Investment in these assets wouldalso include expenditure onacquisition, expansion, modernisationand their replacement. These decisionsinclude purchase of land, building,plant and machinery, launching a newproduct line or investing in advancedtechniques of production. Majorexpenditures such as those onadvertising campaign or research anddevelopment programme having longterm implications for the firm are alsoexamples of capital budgetingdecisions. The management of fixedcapital or investment or capitalbudgeting decisions are important forthe following reasons:

(i) Long-term growth: These decisionshave bearing on the long-termgrowth. The funds invested in long-term assets are likely to yieldreturns in the future. These willaffect the future prospects of thebusiness.

(ii) Large amount of funds involved:These decisions result in asubstantial portion of capital fundsbeing blocked in long-term projects.Therefore, these investments areplanned after a detailed analysis is

undertaken. This may involvedecisions like where to procurefunds from and at what rate ofinterest.

(iii) Risk involved: Fixed capitalinvolves investment of hugeamounts. It affects the returns ofthe firm as a whole in the long-term. Therefore, investmentdecisions involving fixed capitalinfluence the overall business riskcomplexion of the firm.

(iv) Irreversible decisions: Thesedecisions once taken, are notreversible without incurring heavylosses. Abandoning a project afterheavy investment is made is quitecostly in terms of waste of funds.Therefore, these decisions shouldbe taken only after carefullyevaluating each detail or else theadverse financial consequencesmay be very heavy.

Factors affecting the RequirementFactors affecting the RequirementFactors affecting the RequirementFactors affecting the RequirementFactors affecting the Requirementof Fixed Capitalof Fixed Capitalof Fixed Capitalof Fixed Capitalof Fixed Capital

1.1.1.1.1. Nature of Business: Nature of Business: Nature of Business: Nature of Business: Nature of Business: The type ofbusiness has a bearing upon the fixedcapital requirements. For example, atrading concern needs lowerinvestment in fixed assets comparedwith a manufacturing organisation;since it does not require to purchaseplant and machinery, etc.

2.2.2.2.2. Scale of Operations: Scale of Operations: Scale of Operations: Scale of Operations: Scale of Operations: A largerorganisation operating at a higherscale needs bigger plant, more spaceetc. and therefore, requires higherinvestment in fixed assets whencompared with the small organisation.

2015-16(21/01/2015)

BUSINESS STUDIES

258

and starting a cement manufacturingplant. Obviously, its investment infixed capital will increase.

7. Financing Alternatives: 7. Financing Alternatives: 7. Financing Alternatives: 7. Financing Alternatives: 7. Financing Alternatives: Adeveloped financial market may provideleasing facilities as an alternative tooutright purchase. When an asset istaken on lease, the firm pays leaserentals and uses it. By doing so, itavoids huge sums required to purchaseit. Availability of leasing facilities, thus,may reduce the funds required to beinvested in fixed assets, therebyreducing the fixed capital requirements.Such a strategy is specially suitable inhigh risk lines of business.

8. Level of Collaboration: 8. Level of Collaboration: 8. Level of Collaboration: 8. Level of Collaboration: 8. Level of Collaboration: At times,certain business organisations shareeach other’s facilities. For example, abank may use another’s ATM or someof them may jointly establish aparticular facility. This is feasible if thescale of operations of each one of themis not sufficient to make full use of thefacility. Such collaboration reduces thelevel of investment in fixed assetsfor each one of the participatingorganisations.

WWWWWORKINGORKINGORKINGORKINGORKING C C C C CAPITALAPITALAPITALAPITALAPITAL

Apart from the investment in fixedassets every business organisationneeds to invest in current assets. Thisinvestment facilitates smooth day-to-day operations of the business. Currentassets are usually more liquid butcontribute less to the profits than fixedassets. Examples of current assets, inorder of their liquidity, are as under.

3.3.3.3.3. Choice of Technique: Choice of Technique: Choice of Technique: Choice of Technique: Choice of Technique: Someorganisations are capital intensivewhereas others are labour intensive. Acapital-intensive organisation requires

higher investment in plant andmachinery as it relies less on manuallabour. The requirement of fixed capitalfor such organisations would be higher.Labour intensive organisations on the

other hand require less investment infixed assets. Hence, their fixed capitalrequirement is lower.

4. Technology Upgradation: 4. Technology Upgradation: 4. Technology Upgradation: 4. Technology Upgradation: 4. Technology Upgradation: In certainindustries, assets become obsolete

sooner. Consequently, their replace-ments become due faster. Higherinvestment in fixed assets may,therefore, be required in such cases. Forexample, computers become obsolete

faster and are replaced much soonerthan say, furniture. Thus, suchorganisations which use assets whichare prone to obsolescence require higherfixed capital to purchase such assets.

5. Growth Prospects: 5. Growth Prospects: 5. Growth Prospects: 5. Growth Prospects: 5. Growth Prospects: Higher growth ofan organisation generally requireshigher investment in fixed assets. Evenwhen such growth is expected, acompany may choose to create higher

capacity in order to meet the anticipatedhigher demand quicker. This entailslarger investment in fixed assets andconsequently larger fixed capital.

6. Diversification: 6. Diversification: 6. Diversification: 6. Diversification: 6. Diversification: A firm may

choose to diversify its operations forvarious reasons, With diversification,fixed capital requirements increasee.g., a textile company is diversifying

2015-16(21/01/2015)


259

1. Cash in hand/Cash at Bank

2. Marketable securities

3. Bills receivable

4. Debtors

5. Finished goods inventory

6. Work in progress

7. Raw materials

8. Prepaid expenses

These assets, as noted earlier, areexpected to get converted into cash orcash equivalents within a period of oneyear. These provide liquidity to thebusiness. An asset is more liquid if itcan be converted into cash quicker andwithout reduction in value. Insufficientinvestment in current assets may

make it more difficult for anorganisation to meet its paymentobligations. However, these assetsprovide little or low return. Hence, abalance needs to be struck betweenliquidity and profitability.

Current liabilities are thosepayment obligations which are due forpayment within one year; such as billspayable, creditors, outstandingexpenses and advances received fromcustomers, etc.

Some part of current assets isusually financed through short-termsources, i.e., current liabilities. Therest is financed through long-termsources and is called net workingcapital. Thus, NWC = CA – CL (i.e.Current Assets - Current Liabilities.)

Working Capital PositionWorking Capital PositionWorking Capital PositionWorking Capital PositionWorking Capital Position

”Its been a rather glamorous 18 months, with sales just huge,” says, CFO of PT AstraInternational, the US $4 billion in sales Indonesian automaker. Indonesia is on thegrowth path again, and a new breed of consumer is eager for a first vehicle – motorcycles– as well as Astra’s more premium brands of Hondas and Toyotas. And one of themost beautiful parts of the proposition is that working capital management seems tobe taking care of itself. “Depending on the business, and counting trade receivablesonly, we have between eight and 19 days working capital,” which is manageable giventhe company’s steady growth. One of the reasons that working capital has not expandedat the rate of the business is inventory, or rather the dearth of it. “We’re in a marketthat responds very strongly to new products,” says the manager “and the presales ofproducts are very high. We have advanced orders from four to six months, withdeposits paid, and this helps our cash position.” Best of all, as soon as a vehicle is offthe assembly line, it’s out to the dealer. “We have low inventory costs and the productlines are very easy to move.” The salutary role of banks in working capital managementis one reason that cashflow has improved in his business. Better management is aresult of banking competition that has allowed the company to move from traditionalbankers, the state-owned Indian institutions, to more competitive private institutionsand the foreign banks that partner with them. These banks have invested in technology,allowing a visibility over cashflow unheard of five years ago.

http://www.cfoasia.com/archives/200503-02.htmhttp://www.cfoasia.com/archives/200503-02.htmhttp://www.cfoasia.com/archives/200503-02.htmhttp://www.cfoasia.com/archives/200503-02.htmhttp://www.cfoasia.com/archives/200503-02.htm

2015-16(21/01/2015)

BUSINESS STUDIES

260

Thus, net working capital may bedefined as the excess of current assetsover current liabilities.

FFFFFACTORSACTORSACTORSACTORSACTORS A A A A AFFECTINGFFECTINGFFECTINGFFECTINGFFECTING THETHETHETHETHE W W W W WORKINGORKINGORKINGORKINGORKING

CCCCCAPITALAPITALAPITALAPITALAPITAL R R R R REQUIREMENTSEQUIREMENTSEQUIREMENTSEQUIREMENTSEQUIREMENTS

1. Nature of Business: 1. Nature of Business: 1. Nature of Business: 1. Nature of Business: 1. Nature of Business: The basicnature of a business influences theamount of working capital required. Atrading organisation usually needs asmaller amount of working capitalcompared to a manufacturingorganisation. This is because there isusually no processing. Therefore, thereis no distinction between raw materialsand finished goods. Sales can beeffected immediately upon the receiptof materials, sometimes even beforethat. In a manufacturing business,however, raw material needs to beconverted into finished goods beforeany sales become possible. Otherfactors remaining the same, a tradingbusiness requires less working capital.Similarly, service industries whichusually do not have to maintaininventory require less working capital.

2. Scale of Operations: 2. Scale of Operations: 2. Scale of Operations: 2. Scale of Operations: 2. Scale of Operations: For organisationswhich operate on a higher scale ofoperation, the quantum of inventory anddebtors required is generally high. Suchorganisations, therefore, require largeamount of working capital as comparedto the organisations which operate on alower scale.

3. Business Cycle: 3. Business Cycle: 3. Business Cycle: 3. Business Cycle: 3. Business Cycle: Different phasesof business cycles affect therequirement of working capital by afirm. In case of a boom, the sales aswell as production are likely to be

larger and, therefore, larger amount ofworking capital is required. As againstthis, the requirement for workingcapital will be lower during the periodof depression as the sales as well asproduction will be small.

4. Seasonal Factors: 4. Seasonal Factors: 4. Seasonal Factors: 4. Seasonal Factors: 4. Seasonal Factors: Most businesshave some seasonality in theiroperations. In peak season, because ofhigher level of activity, larger amountof working capital is required. Asagainst this, the level of activity as wellas the requirement for working capitalwill be lower during the lean season.

5. Production Cycle: 5. Production Cycle: 5. Production Cycle: 5. Production Cycle: 5. Production Cycle: Production cycleis the time span between the receipt ofraw material and their conversion intofinished goods. Some businesses havea longer production cycle while somehave a shorter one. Duration and thelength of production cycle, affects theamount of funds required for rawmaterials and expenses. Consequently,working capital requirement is higherin firms with longer processing cycleand lower in firms with shorterprocessing cycle.

6. Credit Allowed: 6. Credit Allowed: 6. Credit Allowed: 6. Credit Allowed: 6. Credit Allowed: Different firms allowdifferent credit terms to theircustomers. These depend upon the levelof competition that a firm faces as wellas the credit worthiness of theirclientele. A liberal credit policy resultsin higher amount of debtors, increasingthe requirement of working capital.

7. Credit Availed: 7. Credit Availed: 7. Credit Availed: 7. Credit Availed: 7. Credit Availed: Just as a firmallows credit to its customers it alsomay get credit from its suppliers. Tothe extent it avails the credit onpurchases, the working capitalrequirement is reduced.

2015-16(21/01/2015)


261

8. Operating Efficiency: 8. Operating Efficiency: 8. Operating Efficiency: 8. Operating Efficiency: 8. Operating Efficiency: Firmsmanage their operations with varieddegrees of efficiency. For example, afirm managing its raw materialsefficiently may be able to manage witha smaller balance. This is reflected ina higher inventory turnover ratio.Similarly, a better debtors turnoverratio may be achieved reducing theamount tied up in receivables. Bettersales effort may reduce the averagetime for which finished goods inventoryis held. Such efficiencies may reducethe level of raw materials, finishedgoods and debtors resulting in lowerrequirement of working capital.

9. Availability of Raw Material: 9. Availability of Raw Material: 9. Availability of Raw Material: 9. Availability of Raw Material: 9. Availability of Raw Material: If theraw materials and other requiredmaterials are available freely andcontinuously, lower stock levels maysuffice. If, however, raw materials donot have a record of un-interruptedavailability, higher stock levels may berequired. In addition, the time lagbetween the placement of order andthe actual receipt of the materials (alsocalled lead time) is also relevant. Largerthe lead time, larger the quantity ofmaterial to be stored and larger shallbe the amount of working capitalrequired.

10. Growth Prospects: 10. Growth Prospects: 10. Growth Prospects: 10. Growth Prospects: 10. Growth Prospects: If the growthpotential of a concern is perceived tobe higher, it will require larger amountof working capital so that it is able tomeet higher production and salestarget whenever required.

11. Level of Competition:11. Level of Competition:11. Level of Competition:11. Level of Competition:11. Level of Competition: Higherlevel of competitiveness maynecessitate larger stocks of finishedgoods to meet urgent orders fromcustomers. This increases the workingcapital requirement. Competition mayalso force the firm to extend liberalcredit terms discussed earlier.

12. Inflation:12. Inflation:12. Inflation:12. Inflation:12. Inflation: With rising prices,larger amounts are required even tomaintain a constant volume ofproduction and sales. The workingcapital requirement of a businessthus, become higher with higher rateof inflation. It must, however, be notedthat an inflation rate of 5%, does notmean that every component ofworking capital will change by thesame percentage. The actualrequirement shall depend upon therates of price change of differentcomponents (e.g., raw material,finished goods, labour cost,) Finishedgoods as well as their proportion inthe total requirement.

KKKKKEYEYEYEYEY T T T T TERMSERMSERMSERMSERMS

Financial Management Wealth Maximisation Investment Decision

Financing Decision Dividend Decision Capital Budgeting

Working Capital Financial Planning Capital Structure

Trading on Equity

2015-16(21/01/2015)

BUSINESS STUDIES

262

SUMMARYSUMMARYSUMMARYSUMMARYSUMMARY

Business finance:Business finance:Business finance:Business finance:Business finance: The money required for carrying out business activities iscalled business finance. Almost all business activities require some finance.

Finance is needed to establish a business, to run it, to modernise it, to expand,

and diversify it.

Financial Management:Financial Management:Financial Management:Financial Management:Financial Management: Financial Management is concerned with optimalprocurement as well as usage of finance. For optimal procurement, differentavailable sources of finance are identified and compared in terms of their costsand associated risks.

Objectives and Financial DecisionsObjectives and Financial DecisionsObjectives and Financial DecisionsObjectives and Financial DecisionsObjectives and Financial Decisions The primary aim of financial managementis to maximise shareholders’ wealth which is referred to as the wealthmaximisation concept. The market price of a company’s shares are linked tothe three basic financial decisions

Financial decision-making is concerned with three broad decisions which areInvestment Decision, Financing Decision, Dividend Decision

Financial Planning and ImportanceFinancial Planning and ImportanceFinancial Planning and ImportanceFinancial Planning and ImportanceFinancial Planning and Importance Financial planning is essentiallypreparation of a financial blueprint of an organisation’s future operations. Theobjective of financial planning is to ensure that enough funds are available atright time.

Financial planning strives to achieve the following twin objectives.

(a) To ensure availability of funds whenever these are required:(b) To see that the firm does not raise resources unnecessarily:

Financial planning is an important part of overall planning of any businessenterprise. It aims at enabling the company to tackle the uncertainty in respectof the availability and timing of the funds and helps in smooth functioning ofan organisation.

Capital Structure and FactorsCapital Structure and FactorsCapital Structure and FactorsCapital Structure and FactorsCapital Structure and Factors One of the important decisions under financialmanagement relates to the financing pattern or the proportion of the use ofdifferent sources in raising funds. On the basis of ownership, the sourcesof business finance can be broadly classified into two categories viz., ‘ownersfunds’ and ‘borrowed funds’. Capital structure refers to the mix between ownersand borrowed funds.

Deciding about the capital structure of a firm involves determining therelative proportion of various types of funds. This depends on various factorswhich are: Cash Flow Position, Interest Coverage Ratio (ICR), Debt ServiceCoverage Ratio (DSCR), Return on Investment (RoI), Cost of debt, Tax Rate,Cost of Equity, Floatation Costs, Risk Consideration, Flexibility, Control,

2015-16(21/01/2015)


263

Regulatory Framework, Stock Market Conditions, and Capital Structure ofother Companies.

Fixed and Working CapitalFixed and Working CapitalFixed and Working CapitalFixed and Working CapitalFixed and Working Capital Fixed capital refers to investment in long-termassets. Management of fixed capital involves around allocation of firm’s capitalto different projects or assets with long-term implications for the business.These decisions are called investment decisions or capital budgeting decisions.They affect the growth, profitability and risk of the business in the long run.

Factors affecting the Requirement of Fixed Capital are: Nature of Business,Scale of Operations, Choice of Technique, Technology Upgradation, GrowthProspects, Diversification, Financing Alternatives and Level of Collaboration.

Apart from the investment in fixed assets, every business organisationneeds to invest in current assets. This investment facilitates smooth day-to-day operations of the organisation. Current assets are usually more liquid butcontribute less to the profits than fixed assets.

Factors affecting the working capital requirement are: Nature of Business,Scale of Operations, Business Cycle, Seasonal Factor, Production Cycle, CreditAllowed, Credit Availed, Operating Efficiency, Availability of Raw Material,Growth Prospects, Level of competition, and rate of Inflation.

EXERCISESEXERCISESEXERCISESEXERCISESEXERCISES

Objective–type questionsObjective–type questionsObjective–type questionsObjective–type questionsObjective–type questions

1. The cheapest source of finance is:

a. debenture b. equity share capital

c. preference share d. retained earning

2. A decision to acquire a new and modern plant to upgrade an old one is a:

a. financing decision

b. working capital decision

c. investment decision

d. None of the above

3. Other things remaining the same, an increase in the tax rate on corporateprofits will:

a. make the debt relatively cheaper

b. make the debt relatively the dearer

c. have no impact on the cost of debt

d. we can’t say

2015-16(21/01/2015)

BUSINESS STUDIES

264

4. Companies with a higher growth pattern are likely to:

a. pay lower dividends

b. pay higher dividends

c. dividends are not affected by growth considerations

d. none of the above

5. Financial leverage is called favourable if:

a. Return on Investment is lower than the cost of debt

b. ROI is higher than the cost of debt

c. Debt is easily available

d. If the degree of existing financial leverage is low6. Higher debt-equity ratio results in:

a. lower financial risk

b. higher degree of operating risk

c. higher degree of financial risk

d. higher EPS7. Higher working capital usually results in:

a. higher current ratio, higher risk and higher profits

b. lower current ratio, higher risk and profits

c. higher equity, lower risk and lower profits

d. lower equity, lower risk and higher profits

8. Current assets are those assets which get converted into cash:

a. within six months b. within one year

c. between one and three years d. between three and five years

9. Financial planning arrives at:

a. minimising the external borrowing by resorting to equity issues

b. entering that the firm always have significantly more fund thanrequired so that there is no paucity of funds

c. ensuring that the firm faces neither a shortage nor a glut of unusablefunds

d. doing only what is possible with the funds that the firms has at itsdisposal

2015-16(21/01/2015)


265

10. Higher dividend per share is associated with:

a. high earnings, high cash flows, unstable earnings and higher growthopportunities

b. high earnings, high cash flows, stable earnings and high growthopportunities

c. high earnings, high cash flows, stable earnings and lower growthopportunities

d. high earnings, low cash flows, stable earnings and lower growthopportunities

11. A fixed asset should be financed through:

a. a long-term liability b. a short-term liability

c. a mix of long and short-term liabilities

12. Current assets of a business firm should be financed through:

a. current liability only b. long-term liability only

c. both types (i.e. long and short term liabilities)

Short answer questionsShort answer questionsShort answer questionsShort answer questionsShort answer questions

1. What is meant by capital structure?

2. Discuss the two objectives of financial planning.

3. What is ‘Financial Risk?’ Why does it arise?

4. Define ‘Current Assets’. Give four examples of such assets.

5. Financial management is based on three broad financial decisions. Whatare these?

6. What are the main objectives of financial management? Briefly explain.

7. How does working capital affect both the liquidity as well as profitabilityof a business?

Long answer questionsLong answer questionsLong answer questionsLong answer questionsLong answer questions

1. What is working capital? How is it calculated? Discuss five importantdeterminants of working capital requirement.

2. “Capital structure decision is essentially optimisation of risk-returnrelationship.” Comment.

3. “A capital budgeting decision is capable of changing the financial fortunesof a business.” Do you agree? Give reasons for your answer?

4. Explain the factors affecting the dividend decision.

2015-16(21/01/2015)

BUSINESS STUDIES

266

5. Explain the term ‘Trading on Equity’. Why, when and how it can be usedby a company?

Case ProblemCase ProblemCase ProblemCase ProblemCase Problem

‘S’ Limited is manufacturing steel at its plant in India. It is enjoying a buoyantdemand for its products as economic growth is about 7%-8% and the demandfor steel is growing. It is planning to set up a new steel plant to cash on theincreased demand. It is estimated that it will require aboutRs. 5000 crores to set up and about Rs 500 crores of working capital to startthe new plant.

Questions

1. Describe the role and objectives of financial management for this company.

2. Explain the importance of having a financial plan for this company. Givean imaginary plan to support your answer.

3. What are the factors which will affect the capital structure of this company?

4. Keeping in mind that it is a highly capital-intensive sector, what factorswill affect the fixed and working capital. Give reasons in support of youranswer.

Project WorkProject WorkProject WorkProject WorkProject Work

1. Pick up the annual reports of 2 or more companies engaged in the sameline of business. You can access this data on the respective website of thecompanies and other sources. Compare their capital structures. Analysethe reasons for the difference. You can also use ratio analysis for this.Prepare a report of your findings and discuss it in the class with the help ofyour teacher.

2. From the annual reports that you use in activity, analyse the working capitalof the companies. You can use short-term solvency ratios. Study theoperating cycle of the line of business you have choosen and prepare areport as to the soundness of the working capital management of thecompanies you are studying. Prepare a report of your findings and discussit in class with the help of your teacher.

2015-16(21/01/2015)

Chapter_1 Busineess Studies

Documents

Transcript of Chapter_1 Busineess Studies