Chapter 1 – Business Finance

1. Chapter 1 – Business Finance

2. Definition – Financial Management • Finance is the blood stream of every business • Kuchal S. C. has defined Financial Management as “Financial Management deals with procurement of funds and their effective utilization in the business”

3. Aspects

4. Working capital requirements Raw materials Goli Fixed Capital Requirements Shop Franchise

5. Functions of Financial Management 1. Forecasting Monetary requirements • It is important for Goli to decide the following: 1. Purpose of funds- • Amount required- Goli has to determine for what all purposes funds are required i.e. For Franchisee agreement or Raw material or Salary of employee or all of the following. OR

6. Functions of Financial Management 3. When – Funds are required in the beginning or after a certain period of time. 4. Duration of Funds- Repayment Schedule 5. Kind of Funds- Own Funds or Borrowed Funds.

7. Functions of Financial Management 2. Sources of Funds: Own Funds Borrowed Funds Always better to strike a balance between the two.

8. Functions of Financial Management 3. Utilization of Funds • Once money is received Short Term funds should be used to buy day to day assets. Long term funds should be used to buy Fixed assets

9. Functions of Financial Management 4. Dividend Policy • Once profits are earned goli has to take the decision whether to reap the profits and take it as dividend or keep it in business for future expansion. • This decision is taken in financial management

10. Functions of Financial Management 5. Analysis of performance • Since Financial resources are scare a company has to analyze • Utilization of funds in an efficient manner • Cost of raising funds is reasonable ( dividend and interest is the cost )

11. Functions of Financial Management 6. Role of Advisor Gives advice on pricing policy , mergers & acquisitions (M&A), expansion policy, dividend policy, hiring policy etc. Financial manager

12. Functions of Financial Management 7. Day to day functions • Financial Books • Financial Statements • Group of people : Debtors , Creditors and Directors.

13. Objectives of Financial Management

14. Earning profit is the prime objective • Financial management aims at efficient use of monetary funds. This leads to reduction is finance cost. • Importance of profit maximization: • Difficult for a business without profits • Enables business to run smoothly • Helps business to generate employment • Helps in distributing higher dividend • Creates good public image Increase Profits Expenses Income

15. Wealth maximization is a broad concept and includes profit maximization. • The wealth of the shareholders is based on the market price of the shares of the company. • Market price of shares wealth of shareholders

16. Need of social objective • Business organization cannot operate in isolation • Works in society and needs the society to grow. • Give and take relationship

18. J.H.Boneville has defined financial planning as “The financial plan of a corporation has two-fold aspects, it refers not only to capital structure of the corporation, but also to the financial policies which corporation has adopted or intends to adopt”.

19. Importance of Financial Planning • 1. Helps in achieving growth: • Because of financial plan, business can determine how much funds are required and the source of raising the same. • Thus financial planning helps in getting the funds on time as a result helping in expansion of business.

20. Importance of Financial Planning 2. Improving image: • With financial planning, funds are available when payments are to be made hence there are no defaults resulting in improvement in the image of business.

21. Importance of Financial Planning 3. Team Spirit: • Financial plan is a master plan and considers requirements of all departments. Therefore, the process of financial planning requires information from all the departments which are interlinked with each other. This process helps them to think in the same direction and helps build team spirit throughout the organization.

22. Importance of Financial Planning 4. Cost of funds: • This cost fluctuates due to various changes in economy like change in tax rates, monetary policy, economic conditions etc. Financial planning takes into consideration such changes.

23. Importance of Financial Planning 5. Improves co-ordination: • All the divisions of business such as production, purchase, sale, distribution, finance etc. have to work together to create a effective and efficient Financial Plan.

24. Importance of Financial Planning 6. Decision making: • Financial plan helps to take the decision as to whether there is need for funds and accordingly either borrow or use retained earnings.

25. Trick questionWhat is the difference between financial management and financial planning?

26. Capital Structure • Capital Means Long Term Funds Structure means Composition According to R. H. Wessel, capital structure is “the long term sources of funds employed in a business enterprise”

27. 1. Equity share capital: • Money raised by issue of equity shares is called as equity share capital. • The equity shareholders are the owners of the company and like every owner, they bear the risk and enjoy returns in form of dividend. • The dividend earned by equity shareholders is not fixed and it depends on the profits earned by the company. 2. Preference share capital: • Money raised by issue of preference share is referred to as preference share capital. • Preference shareholders are given preference over the equity shareholders while distributing dividend and also in repayment of capital at the time of liquidation. • Further, they enjoy fixed dividend every year. They also get to vote on matters related to them. • Components of Capital Structure

28. 3. Borrowings: • A company can raise long term funds by way of debt. A company can borrow funds from outsiders in the following ways: 1. Bonds, debentures and public deposits2. Loans 4. Retained profits: • Retained profits = Net Profit – Dividend distributed to shareholders • Retained profits are the profits of the business that remain after dividend is paid to shareholders. • Components of Capital Structure

29. Factors influencing Capital Structure

30. Internal Factors 1. Size of business:

31. Internal Factors 2. Future capital requirements: • A company will not require funds only once. It may require funds at various stages. • If the company requires large amount of funds in the future, it may opt for debt funds at present and later raise funds by issue of equity shares

32. Internal Factors 3. Ideology of management: • Risk involved with borrowed capital. • Borrowed capital not repaid, the assets of the company can be sold to repay the amount. Risk appetite Borrowings Risk appetite Borrowings

33. Internal Factors 4. Nature of business:

34. Internal Factors 5. Trading on equity: •  Profit occurs in the following situation: • Therefore, a company which adopts trading on equity may raise funds by issue of debentures and loans.

35. Example on trading on equity Company A has more debt funds than Company B. The rate of return on investment is 20 percent (2,00,000*100/10,00,000). The cost of debt is 10 percent. As long as the rate of return is more than cost of debt, it will always be beneficial to have more debt than equity as can be seen from the above example. In the current scenario, the capital structure of company A is favourable. However, if the rate of return falls below cost of debt, capital structure of company B will be more favourable.

36. Internal Factors 6. Expected business risk: • Interest has to be paid when funds are borrowed irrespective of profit or loss. • Payment of dividend is not mandatory and the company which suffers a loss may choose not to pay dividend. • Greater risk Borrowings • Lower risk Borrowings

37. Internal Factors 7. Requirement period:

38. Internal Factors 8. Nature of cash flow: • Interest and principal on loan is to be paid periodically • Continuous fixed outflow of money. Hence, Stable cash flow aBorrowings a Unstable cash flow aBorrowings X

39. Internal Factors 9. Age of company: • New company - difficult to borrow funds from outsiders • Old companies - opt for mix of equity and debt – easier and cheaper

40. Internal Factors 10. Level of control: • If Equity shareholders do not want to dilute their holding they will opt for Debt Funds.

41. External Factors 1. Expected cost of capital: • The rate of return to be paid to the providers of capital is the “cost of capital” • Equity shareholders - higher risk - high rate of return in • Preference shareholders and debenture holders – lower risk- lower rate of return.

42. External Factors 2. Extent of development of capital market: • Capital Market is the place where equity shares are traded. • Good network of capital market a Investors willing to invest in equity shares a

43. External Factors 3. Terms of lending: • Rate of interest for raising debt Complex terms of lending a Issue of preference shares / equity shares a

44. External Factors 4. Economical conditions • Generally, when an economy is going through a recession, the investor sentiment is low and people stay away from equity shares as it involves high risk.   • Practical example: In the early part of 2013, two IPOs were withdrawn due to poor investor response. (Hindustan Times Report on 5th May, 2013)

45. External Factors 5. Risk appetite of investors:

46. External Factors 6. Need to consider taxes: • Tax rates are high, debt funds preferred as interest is deductible expenditure

47. External Factors 7. Attitude of rating agencies: • If the rating agencies give poor ratings to debentures of a company, then the company may have to source a major part of its funds by issue of equity shares.

48. External Factors 8. Level of competition: • Generally, if the competition is high, the profit margins are low. In such cases, company would prefer equity funds over debt funds.

49. External Factors 9. Government policies:The ratio of debt funds to equity funds of a company is called as “debt-equity” ratio. The Securities Exchange Board of India (SEBI) has prescribed a maximum debt equity ratio of 2:1 i.e. the debt in a company’s balance sheet cannot exceed twice the amount of subscribed equity share capital. Thus, companies have to take into consideration rules and regulations of the government.

50. Fixed Capital • Fixed capital is that portion of total capital which is invested in fixed assets such as land, buildings, equipment, etc. It is real or physical assets that are not used directly in the production of goods. National Accounts defines Fixed Capital as “The stock of tangible, durable fixed assets owned or used by resident enterprises for more than one year. This includes building, plant, machinery, vehicle, equipment etc”.