1. Business finance and financial management
Business finance: the funds a business requires to set up, operate and expand.
Financial management: procurement of funds at minimum cost and their effective utilisation, keeping risk in view. It affects the size and mix of fixed and current assets, the mix of long-term and short-term funds, the debt-equity proportion and the profit retained, so it decides the financial health of the firm.
Objective — wealth maximisation: every decision should increase the market price of equity shares. A decision is good if the benefit it brings is more than its cost, after allowing for risk.
| Balance-sheet item | Decision it reflects |
|---|---|
| Fixed assets (size and mix) | Long-term investment |
| Current assets (cash, stock, debtors) | Working capital |
| Debt vs equity | Financing (capital structure) |
| Retained earnings | Dividend |
| Why a business needs funds | Imagined example |
|---|---|
| To set up: land, building, machinery | A Nashik winery buys tanks and a bottling line |
| To run day to day: materials, wages, bills | It buys grapes and pays harvest workers |
| To grow and modernise | It adds a cold store and a visitor centre |
Key terms
- Business finance
Funds needed by a business for all its activities.
- Wealth maximisation
The objective of increasing the market value of the company's equity shares.
2. Investment decision
Long-term (capital budgeting): investing in fixed assets or projects. Important because it affects long-term growth and earning capacity, involves large amounts, carries risk, and is irreversible except at a heavy cost.
Short-term (working capital): levels of cash, stock and receivables.
Factors: cash flows of the project; rate of return (with risk); investment criteria used to compare projects.
| Factor | What the finance team asks |
|---|---|
| Cash flows of the project | How much cash will it bring in, year by year? |
| Rate of return | Is the expected return attractive for its risk? |
| Investment criteria | Which method ranks the projects (payback, return, and so on)? |
Key terms
- Capital budgeting
Decision to invest funds in long-term assets or projects.
3. Financing and dividend decisions
Financing decision: the quantum of funds from long-term sources — shareholders' funds (equity, retained earnings) and borrowed funds (debentures, loans). Debt has a lower cost but higher risk; equity is safer but costlier.
Factors: cost; risk; floatation costs; cash flow position; fixed operating cost; control considerations; state of the capital market.
Dividend decision: how much profit is distributed and how much retained.
Factors: amount of earnings; stability of earnings; stability of dividends; growth opportunities; cash flow position; shareholders' preference; taxation policy; stock market reaction; access to the capital market; legal constraints; contractual constraints (loan conditions).
| Factor | Effect on the choice of source |
|---|---|
| Cost | Cheapest suitable source preferred |
| Risk | Debt is riskier than equity for the company |
| Floatation cost | Costly share issues push towards loans |
| Cash flow position | Strong, steady cash flows allow more debt |
| Fixed operating cost | High fixed costs call for less debt |
| Control | Fear of dilution favours debt |
| State of capital market | Booming market eases share issues |
| Pushes dividend up | Pushes dividend down |
|---|---|
| High and stable earnings | Good growth opportunities |
| Strong cash position | Loan conditions (contractual constraints) |
| Shareholders want regular income | Legal limits and high tax on dividends |
| Easy access to the capital market | Weak cash position |
Key terms
- Retained earnings
Profit kept in the business instead of being paid as dividend; an internal source of finance.
4. Financial planning
A financial blueprint of the firm's future operations: estimates of funds needed, their timing and their sources. Prepared for three to five years and split into one-year budgets.
Objectives: (1) funds should be available when needed; (2) the firm should avoid raising more than it requires.
Importance: prepares the firm for different future situations and shocks; coordinates the various business functions; reduces waste and duplication; links present with future and investment with financing; sets standards for evaluating performance.
| Month (imagined Alleppey coir unit) | Cash needed (₹ lakh) | Cash coming in (₹ lakh) | Gap to arrange (₹ lakh) |
|---|---|---|---|
| April | 12 | 14 | none |
| May (fibre bought in bulk) | 30 | 15 | 15 |
| June | 14 | 16 | none |
Key terms
- Financial plan
An estimate of the amount, timing and sources of funds a business will need.
5. Capital structure and trading on equity
Capital structure: the mix of debt and equity (owners' funds) in long-term finance. Debt is cheaper (interest is tax-deductible, lenders bear less risk) but raises financial risk because interest and repayment are fixed obligations.
Trading on equity: raising the proportion of debt to increase earnings per share (EPS = EAT ÷ number of equity shares). Favourable when ROI > rate of interest; unfavourable when ROI is lower.
Factors: cash flow position; interest coverage ratio (EBIT ÷ interest); debt service coverage ratio; return on investment; cost of debt; tax rate; cost of equity; floatation costs; risk; flexibility; control; regulatory framework; stock market conditions; capital structure of other companies.
| Item (₹) | Plan A: all equity | Plan B: ₹20 lakh debt at 10% |
|---|---|---|
| EBIT | 6,00,000 | 6,00,000 |
| Less interest | 0 | 2,00,000 |
| EBT | 6,00,000 | 4,00,000 |
| Less tax at 30% | 1,80,000 | 1,20,000 |
| EAT | 4,20,000 | 2,80,000 |
| Number of ₹10 shares | 4,00,000 | 2,00,000 |
| EPS | 1.05 | 1.40 |
| Item (₹) | Plan A: all equity | Plan B: ₹20 lakh debt at 10% |
|---|---|---|
| EBIT | 3,20,000 | 3,20,000 |
| Less interest | 0 | 2,00,000 |
| EBT | 3,20,000 | 1,20,000 |
| Less tax at 30% | 96,000 | 36,000 |
| EAT | 2,24,000 | 84,000 |
| EPS | 0.56 | 0.42 |
| Favour MORE debt | Favour LESS debt |
|---|---|
| Strong, steady cash flows | Uncertain or seasonal cash flows |
| High interest coverage ratio and DSCR | Low coverage ratios |
| ROI above cost of debt | ROI below cost of debt |
| High tax rate (interest saves tax) | High business risk already |
| Owners want to keep control | Need for flexibility to borrow later |
| Costly share issue (high floatation cost) | Booming share market (easy equity) |
Key terms
- Financial risk
The chance that a firm cannot meet its fixed payments on debt.
- Trading on equity
Using more fixed-cost debt to increase earnings per share.
- Interest coverage ratio
EBIT divided by interest; how many times interest is covered.
6. Fixed capital and working capital
Fixed capital: funds in long-term assets. Its management matters because of long-term growth, large amounts, risk and irreversibility. Factors: nature of business; scale of operations; choice of technique; technology upgradation; growth prospects; diversification; financing alternatives (leasing); level of collaboration.
Working capital: funds in current assets. Gross = total current assets; net = current assets − current liabilities. Factors: nature of business; scale; business cycle; seasonal factors; production cycle; credit allowed; credit availed; operating efficiency; availability of raw material; growth prospects; level of competition; inflation.
| Basis | Fixed capital | Working capital |
|---|---|---|
| Assets financed | Land, building, plant, machinery | Stock, debtors, cash |
| Period | Many years | Within one operating cycle |
| Usual sources | Long-term: shares, debentures, term loans | Short-term: trade credit, bank overdraft |
| Factor | Needs MORE fixed capital when… |
|---|---|
| Nature of business | it manufactures rather than trades |
| Scale of operations | the plant is large |
| Choice of technique | the method is capital-intensive |
| Technology upgradation | machines become outdated quickly |
| Growth prospects | capacity is built ahead of demand |
| Diversification | new product lines are added |
| Financing alternatives | leasing is not available |
| Level of collaboration | facilities are not shared with other firms |
| Factor | Needs MORE working capital when… |
|---|---|
| Nature of business | it manufactures rather than trades |
| Scale of operations | output and sales are large |
| Business cycle | the economy is booming |
| Seasonal factors | it is the peak season |
| Production cycle | goods take long to make |
| Credit allowed | customers get long credit |
| Credit availed | suppliers give little credit |
| Operating efficiency | stock and debtors move slowly |
| Raw material availability | large safety stocks are needed |
| Growth, competition, inflation | the firm is growing, competing hard, or prices are rising |
Key terms
- Fixed capital
Funds invested in long-term assets such as land, buildings and machinery.
- Working capital
Funds invested in current assets such as stock, debtors and cash.
- Operating cycle
Time taken to convert cash into materials, goods, debtors and back into cash.
Exam tips
Common mistakes
- Writing "profit maximisation" as the objective: write wealth maximisation (market value of equity shares).
- Forgetting the condition for trading on equity: ROI must exceed the rate of interest.
- Skipping steps in EPS sums: show interest, EBT, tax, EAT, number of shares and EPS.
- Mixing fixed-capital factors with working-capital factors.
- Treating debt as riskier for the lender: in this chapter, debt is riskier for the company.
How marks are usually awarded
- 1 mark: correct option or term.
- 3 marks: three points, each with a line of explanation.
- 5 marks: five explained points, or a full EPS working with a conclusion.
- Case questions: quote the line, name the decision or factor, explain it.