(Chapter- 1) Part-ll

Business finance
Meaning:-Every enterprise, whether big, medium or small, needs finance to carry on its operation and achieve its targets.
Without adequate finance m no enterprise can possibly accomplish its objectives. Finance refers to the management of flow of
money in an organization. Business finance is referred to an activity or a process which is concerned with acquisition of funds,
use of funds and distribution of profit by a business firm.
It refers to that part of the management activity which is concerned with efficient planning and controlling of financial affairs
of the enterprise.
According to Massie Financial management is the operational activity of a business that is responsible for obtaining and
effectively utilizing the finds necessary for efficient operations.
Scope of financial management:Financial decisions

Investment decision

Dividend decision

Financial decision

Investment in fixed assets

Dividend payment policy

Capital structure decision

Investment in current assets

retaining of surplus funds

Financial decision: - it refers to the determination as to how the total funds required by the business will be obtained from
various ling-term sources. Long-term financial sources capital, retained earning, preference share capital, debenture, longterm loan, etc.
Factor affecting financial decision:1) Cost: - the cost of all the source of finance is different. The rate of interest on dept, fixed rate of the expectations of
the shareholders of the equity happen to be favorable, the benefit of cheap finance can be availed of by choosing dept
capital.
2) Risk: - dept capital is most risk and from the point of view of risk it should not be used.
3) Cash flow position: - of the cash flow position of the company is good the payment of interest on the dept and the
refund of capital can be easily made. Therefore, in order to take advantage of cheap financial, dept can be given
priority.
4) Control consideration: - the ultimate control of the company is that is the equity shareholders. Greater the number of
equity shareholder, the greater will the control in the hands of more people. This is not a good situation. Therefore,
from this point of view the equity share capital should be avoided.
5) State of capital market: - bullish time brings more profit. Therefore, the people like to invest more in equity share. On
the contrary the profits are low when there is a bear market. The people give preference to debt capital in order to
earn more profit. Therefore, the source of financial should be choosing keeping in view the position of the market.
Investment decision: - it refers to the selection of assets on which funds will be invested by the business. Assets which are
obtained by the business are of two type i.e. long term assets and short term assets. On this basis, investment decision is also
divided into two parts:
i) Long term investment decision: - this is referred to as the capital budgeting decision. For example, buying a new
machine. For the same purpose, the finance manager has to make a comparative study of various alternatives available in
the market on the basis of their cost and profitable. These decisions are very important as they affect the earning of the
business over the long run.

ii) Short term investment: - this is referred to as the working capital management. It relates to the investment in short
term assets, such as cash, stock, in these assets as they affect the liquidity position of the business. For the same purpose
the relative profitability and liquidity of these assets are compared.
Factor affecting investment decision:1) Cash flows of the project: - we know investment decision is related with investment in long term assets. These
assets involve both cash outflow over a series of years. The amount needs for investment is known as cash
outflow, on the other hand, returns form the same investment is known as cash inflows. Both of these need to
be analyzed carefully before finalizing the investment.
2) The rate of return: - a project may not be profitable as compared to other. The criterion to decide the
profitability of various is their respective rate of returns. The rate of return is calculated on the basis of
expected return of the project and risk attached with it. If two projects are of the same risk class, the project
having higher rate of return will be accepted.
3) Investment criteria involve: - there may be many criteria of the investor while investing the long term assets.
These are: funds involved, rate of go for a particular investment or not. For the same purpose, capital
budgeting techniques are applied and accordingly decisions are taken.
4) Pay-back period: - pay-back period of project refers to the numbers of years required to recover the initial
investment in that project.
5) Risk involved: - besides above factors, the company should also analyses the risks involved in different
investment proposals. The company should choose less risky projects some investment proposals may require
lower initial investment or may bring higher rate of return but at the same time may involve huge risks. Such
projects should be avoided.
Dividend decision: - it refers to the determination of how much part of the earning should be distributed among shareholders
by the way of dividend and how much should be retained for meeting future needs as retained earning. Generally, the
shareholders want that they should get the maximum dividend and the managers want that the maximum amount of money
should be kept to fulfils the future needs of business =. However the financial manager has to strike a balance so that both the
parties remain satisfied. This decision is also called disposal of surplus decision.
Factor affecting Dividend decision:1) Earning: - the dividend is paid out of the present and reserved profits. Therefore, greater amount of total will
ensure greater dividend.
2) Stability of dividends: - every company adopts the policy of maintaining the stability of dividend per share. (Here
the stability of dividend means that the dividend will in no case is allowed to fall. It is always good if the dividend
remains stable or increase.) From this point of view, a little change in profit should not be allowed any increase or
decrease in the dividend.
3) Growth opportunities: - if the company has opportunities for growth, it will require more finance. In such a
situation, a major part of the income should be retained and a small part of it should be paid as dividend.
4) Cash flow position: - the payment of dividend results in outflow of cash. It is possible that the company may have
enough income but it is equally possible that it may have sufficient cash to pay dividend. In this way, the cash flow
of the company is a factor that determines the dividend decision. The better the cash flow position of the company
the better will be the capacity of the company to pay dividend.
5) Stock market reaction: - dividend and the market value of the share are directly related. It means that if the
dividend is declared at a higher rate, it is considered to be good news. As a result, the price of the shares increases.
Similarly, decrease in the dividend decreases the market prices of the shares. Therefore, a finance manager should
always keep in the effect on the market price of shares while determining the rate of dividend.
6) Access to capital market: - in case of need if a company can easily collect finance in the capital market, it should
declare dividend at a higher rate otherwise not.

Objective of finance management: 1)

2)
3)
4)

To ensure availability of sufficient funds at a reasonable cost.

To ensure effective utilization of funds.
To ensure safety of funds by creation reserves, reinvesting the profit, etc.
To ensure wealth maximization for owner.

Finance planning
Finance planning means deciding in advance how much to spend, on what to spend, depending upon the availability of funds.
It aims at estimating the capital requirement and determining its composition
According to walker and baughn,financial planning pertains to function of finance and include the determination of firms
financial objective, financial policy, and financial procedures.
Process of financial planning:Determination of
financial objective

Determination of
financial policies

Determination of
financial procedures

Objective of business finance:1) To ensure timely availability of finance: - the first objective of financial planning is to make finance available in
time. Under it, the long term and short term financial needs are anticipated and then the sources of availability of
finance are located.
2) To ensure proper balance of finance: - it is always ensured that the balance of cash should neither be in excess nor
short. The balance of cash in both situations is harmful. If the balance of cash needed is rupees five lakh but the
actual cash balance it ten lakhs, the cash of five lakhs will remain idle and it will incur loss of interest. On the
contrary, if will damage the reputation of the company for not making timely payments.
Importance of finance planning: 1) Cost effective: - financial planning should be in such a way that cost of using the funds is lower. Equity and loans
should be planned in such a way that the use of funds is cost effective. A reasonable ratio of debt and equity be
planned to minimize cost of financing.
2) Simplicity: - a financial plan should be simple to understand and administer. The sources suggested for raising
funds should be simple. The raising of debentures or bonds is difficult than the raising of equity.
3) Ensures co-ordination: - financial planning helps in coordination various sources of funds and also in function
areas. It helps in allocation resources properly for different activities as per their requirements.
4) Optimum utilization of funds: - the plans for raising must be commensurate with requirements. A good plan
facilitates maximum utilization of funds. There should not be either more or less funds as compared to financial
needs. Both over capitalization and under capitalization should be avoided. The funds should be optimally used.
5) Solvency and liquidity: - solvency means availability of sufficient funds to meet liability and liquidity means
availability of sufficient cash or bank balance to meet current liabilities. A financial plan must ensure that funds ate
available for short term and long term needs of the business.
6) Helps in avoiding wastage of finance: - in the absence of financial planning, wastage of finance resources may take
place. This arises due to the complex nature of business operations, such as excessively over- or underestimation
of finance for a particular business operation. Such type of wastage can be avoiding through financial planning.
7) It helps in link the present with the future: - it makes effort to link the present with the future. By doing so, it
helps to minimum the risk of future uncertainties.

8) Helps in creating link between investment and financial decision: - it helps in deciding that where to invest and
from where the required fund will be made available. Under it, the mix of share capital and dept capital is made in
such a manner that cost of capital is reduced to minimum.
9) Financial control: - all financial activities are kept under complete control with the help of financial planning. Under
it, standards of financial performance are set. Actual performance is compared with the standards so set.
Deviations and their causes are traced and corrective measures are taken.
Limitation of financial planning: 1) Difficulty in change: - once a financial plan is prepared then it becomes difficult to change it. A changed situation
may demand change in financial plan but managerial personnel may not like it. Even otherwise, assets might have
been purchased and raw material and labour costs might have been incurred. It becomes very difficult to change
financial plan under such situations.
2) Difficulty in forecasting: - financial plans are prepared by taking into account the expected situation in the future.
Since the future is always uncertain and things may not happen as these are expected so the utility of financial
planning is limited. The reliability of financial planning is uncertain and very much doubted.
3) Problem of coordination: - financial function is the most important of all the functions. Other functions influence a
decision about financial plan. While estimating financial needs productions. Policy, personnel requirements,
marketing possibilities are all taken into account. Unless otherwise difficult. Often there is a lack of coordination
among different functions. Even indecision among personnel disturbs the process of financial planning.
4) Rapid changes: - the growing mechanization of industry is bringing rapid changes in industrial process. The method
of production, marketing devices, consumer preferences create new demands every time, the incorporation of
new change require a change in financial plan becomes very difficult to adjust a financial plan for incorporating fast
changes situations. Unless a financial helps the adoption of new techniques its utility limited.

Capital structure
Meaning: - capital structure means the proportion of dept and equity used for financing the operations of a business. The
essence of capital structure is to determine the relative proportion of equity and dept. equity in broader sense means owners
fund and debt is long term loans raised from outside. A capital structure will be optimum when the proportion of equity and
dept is such that it results in increase in the shareholders value of the share. It is very difficult to determine an idle capital
structure but that combination will be the best which will increase the value of shares held by the shareholders. It means that
capital structure decision should try to maximize shareholders wealth.
Capital Gearing
It refers to the relationship between equity capital and long term dept. in simple words; it means the ratio between
various types of securities in the capital structure of the company. Capital gearing has a direct bearing on the divisible
profits of a company and hence a proper capital gearing is very important for the smooth running of enterprise. In a high
geared company the fixed cost of capital is higher leaving lesser divisible profits for the equity share holders. In case of
low geared company, the fixed cost of capital by way of fixed divisible on preference shares and interest on debentures
is lowaffecting
and the the
equity
shareholders
get a higher
rate of dividend.
Factor
choice
of capital may
structure:
1) Cash flow position: - while making a choice of the capital structure the future cash flow position should be kept in
mind. Dept capital should be used only if the cash flow position is really good because a lot of cash is needs in
order to make payment of interest and refund of capital.
2) Cost of dept: - the capacity of a company to take dept depends on the cost of dept. in case the rate of interest on
the dept capital is less, more dept capital can be utilized and vise versa.
3) Return on investment (ROI): - the greater return on investment of a company increases its capacity to utilize more
dept capital. The calculation of return on investment is made with the help of the following formula:
ROI=EBIT/Total investment

4) Dept service coverage ratio (DSCR): -this ratio removes the weakness of ICR this shows the cash flow position of
the company. It is calculated in the following way:
DSCR = Profit after tax + depreciation + interest+ non cash expenses written off
Preference dividend + interest + repayment obligation
This ratio tells us about the cash payment to be made (e.g. preference dividend, interest and dept capital
repayment) and the amount of cash available. Better ratio means the better capacity of the company for dept
payment. Consequently, more dept can be utilized in the capital structure.
5) Tax rate: -the rate of tax affects the cost of dept. if the rate of tax is high, the cost of dept decreases. The reason is
the deduction of interest on the dept capital from the profit considering it a part of expenses and a saving in taxes.
6) Flexibility: - according to this principle, capital structure should be fairly flexible. Flexibility means that, if need be,
amount of capital in business could be increase or decrease easily. Reducing the amount of capital in business is
time Company has more capital than as necessary then both the above-mentioned capital can be repaid. On the
other hand, repayment of equity of share capital is not possible by the company during its lifetime. Thus form the
viewpoint of flexibility to issue debt capital and preference share capital is the best.
7) Control: - according to this factor, at the time of preparing capital structure, it should be ensured that the control
of the existing shareholders (owners) over the affairs of the company is not adversely affected. If funds are raised
by issuing equity shares, then the company is not adversely affected. If funds are raised by issuing equity shares,
then the no. of companys shareholders will increase and it directly affect s the control of existing shareholders. In
other words, now the number of owners controlling the company increases. This situation will not be acceptable to
the existing shareholders. On the contrary, when funds are raised through dept capital, there is no effect on the
control of the company because the debentures have no control over the affairs of the company. Thus, for those
who support this principle dept capital is the best.
8) Stock market conditions: - stock market conditions refer to upward or downward trends in capital market. Both
these condition have their influence on the selection of sources of finance. When the market is dull, investors are
mostly afraid of investing in the share capital due to high risk. On the contrary, when conditions in the capital
market are cheerful, they treat investment in the share capital as the best choice to reap profits. Companies
should, therefore, make selection of capital sources keeping in view the conditions prevailing in the capital market.

Fixed capital
Meaning: - it refers to that capital which is used for the purchase of fixed assets, such as land, building, machinery, furniture,
etc. to earn income for a long term is the motive behind purchase of these assets and not to sell them off immediately. These
assets represent that part of firms capital which is blocked on a permanent or fixed basis and the business does not intend to
dispose of these assets and for this reason fixed capital is also known as block capital.
Factors affecting the requirement of fixed capital: 1) Nature of business: - Need of fixed capital depends upon the nature of business. Usually, nature of business is of
two kinds: manufacturing business and trading business. In case of manufacturing business, large amount of fixed
capital. On the contrary, in case of trading business in which finished good are bought and sold, less amount of
fixed capital is needed.
2) Scale of operation: - larger the spread of business activities, greater is the need for fixed capital. If a manufacturing
enterprise is operation on a small scale, it will enterprise will need relatively more amount of fixed capital.
3) Choice of technique: - those manufacturing enterprise which make use of modern and automatic, need large
amount of fixed capital. On the other hand, those enterprises in which production is carried out mainly through
manual labour need for fixed capital is very less.
4) Diversification: - diversification means running in more products then merely one product. Those organizations
which wish to adopt diversification certainly need more need fixed capital. For example, if a textile manufacturing
company starts the business of paper manufacturing, it shall have to invest heavily in land, building, machinery,
etc. therefore, it will require more additional fixed capital.

5) Growth prospects: -there are two type of organization from the point of view of growth: i) such org, which have
more make a choice of the sources of finance well in advance so that in case of need additional financial can be
made available.
6) Level of collaboration: - it means seeking the help of other organization in order to run business. For example, if
means income for the bank allowing ATM facility in the form of rent while the bank getting this facility will not
have to invest in fixed assets. Therefore, it can be said that collaboration helps reducing the need for fixed capital.
7) Technology up-gradation: - there are some businesses where fixed asset is used and which does require
immediate change. These days computer technology is undergoing rapid changes. Therefore, those companies
whose business is computer based need more fixed capital.
Capital budgeting
Means: Capital budgeting means the decision regarding investment in fixed assets that yield income for a long period.

Working capital
Means: -funds are also needed for sort term purposes for the purchase of raw material, payment of wages and other day to
day expenses, etc. these funds are known as working capital. In simple words, working capital refers to that part of the firms
capital which is required for financing short term or current assets such as cash, marketable securities, debtors and inventories.
Difference between current assets and current liabilities is called working capital.
Concept of working capital: There are two concepts of working capital:
1) Gross working capital
2) Net working capital
In the broad sense, the terms working capitals refers to the gross working capital and represent the amount of funds invested
in current assets. Thus, the gross working capital is the capital invested in total current assets of the enterprise. Current assets
are those which in the ordinary course of business can be converted into cash within a short period of normally one accounting
year. Examples of current assets are:
1)
2)
3)
4)

Cash in hand and bank balances.

Bills receivables.
Short term loans and advances.
Inventories of stocks

In a narrow sense, the term working capital refers to the net working capital. Net working capital is the excess of current of
assets over current liabilities.
Factors affecting the requirement of working capital: 1) Nature of business: - the requirement of working capital depends on the nature of business. The nature of
business is usually of two types: manufacturing business and trading business. In the case of manufacturing
business it takes a lot of time in converting raw material into finished goods. Therefore capital remains invested for
a long time in raw material, semi-finished goods and the stocking of the finished goods. Consequently, more
working capital is required. On the contrary, in case of trading business the goods are sold immediately after
purchasing or sometimes the sale is affected even before the purchase itself. Therefore, very little working capital
is required. Moreover, in case of service businesses, the working capital is almost nil since there is nothing in stock.

2) Scale of operation: - there is a direct link between the working capital and the scale of operations. In other words,
more working capital is required in case of big organization while less working capital is needed in case of small
organization.
3) Credit allowed: - those enterprise which sell goods on cash payment basis need little working capital but those who
provide facilities to the customers need more working capital.
4) Operation efficiency: - operating efficiency means efficiently completing the various business operation. Operating
efficiency of every organization happens to be different. Some such examples are: (i) converting raw material into
finished goods at the earliest, (ii) selling the finished goods quickly, and (iii) quickly getting payment from the
debtors. A company which has a better operating efficiency has to invest less in stock and the debtors. Therefore,
it requirement less working capital, while the case is different in respect of companies with less operation
efficiency.
5) Growth prospects: - growth means the development of the sale of business operation(production, sale, etc.). the
organization which have sufficient possibilities of growth require more working capital, while the case is different
in respect of companies with less growth prospects.

6) Business cycle: - the need for the working capital is affected by various stages of the business cycle. During the
boom period, the demand of a product increases and sales also increases. Therefore, more working capital is
needed. On the contrary, during the period of depression, the demand decline and it affects both the production
and sales of goods. Therefore, in such a situation less working capital is required.
Business cycle
Boom
Decline

improvement

Depression
7) Level of competition: - higher level of competition increases the need for more working capital. In order to face
competition, more stock is required for quick delivery and credit facility for a long period has to made available.
8) Inflation: - inflation means rise in prices. In such a situation more capital is required than before in order to
maintain the previous scale of production and sales. Therefore, with the increasing rate of inflation, there is a
corresponding increase in the working capital.