Unit – IX: Business Finance
OBJECTIVE QUESTIONS (1 MARK)
1. Define Financial Management.
Ans: Financial Management is the operational activity of a business that is responsible for a) Obtaining b) effectively utilizing the funds necessary for efficient operations.
2. What is meant by Financial Planning?
Ans: Financial Planning refers to determination of firm’s financial objectives, financial policies and financial procedure.
3. What is Working Capital?
Ans: The capital required for day to day operations of the business is called Working capital.
4. State the difference between gross working capital and net working capital.
Ans: Gross working capital is the sum/ aggregate of the current assets, whereas Net working capital = Current assets – current liabilities.
5. State the decisions involved in financial management. 2015
Ans: a) Investment decision b) Financing decision c) Dividend decision
6. State the primary objective of financial management.
Ans: To maximize the shareholders wealth.
7. What is meant by capital budgeting decision?
Ans: A long term Investment decision is called capital budgeting decision.
Ans: a) to ensure availability of fund whenever required. b) To see that the firm does not raise funds unnecessarily.
9. What is capital structure?
Ans: Capital structure is the relative proportion of different sources of long term finance.
10. What is disinvestment? 2013, 2014
Ans: Disinvestment refers to the use of a concerted economic boycott to pressure a government, industry, or company towards a change in policy, or in the case of governments, even regime change.
LONG QUESTIONS (3/5/8 MKS)
1. What is meant by ‘Financial management’ Discuss its role and objectives. 2013, 2014
Ans: Business Finance or Financial management refers to that part of the management activity which is concerned with the planning, raising, controlling and administration of the funds used in the business. Its main objective is to use the funds of the business in the most appropriate way.
In simple words we can say financial management refers to “Efficient acquisition of finance, efficient utilisation of finance and efficient distribution and disposal of surplus funds for smooth working of company.”
Financial management plays the following role:
a) Determination of fixed assets: Fixed assets have an important contribution in increasing the earning capacity of the business. Long term investment decisions also called capital budgeting decision which is one of the prime objectives of a finance manager
b) Determination of current assets: Current assets are needed to meet the day to day transactions of the business. The total investment in current assets is to be determined and the split up into its elements is required.
c) Determination of long term and short term finance: Under this a Finance manager has to maintain a proper ratio of short term and long term sources of finance after estimating its requirement.
d) Determination of proportion of various long term source of finance: A balanced decision related to capital structure is to be made. The proportion of debt and equity is to be determined.
e) Determination of various items in the Profit and loss account: The financial decisions affect the various items to appear in the profit and loss account.
Objectives of financial management:
Efficient financial management requires existence of some objectives or goals because judgment as to whether or not a financial decision is efficient is to be made in light of some objective. The two main objectives of financial management are:
1) Profit Maximisation: It is traditionally being argued, that the objective of a company is to earn profit, hence the objective of financial management is profit maximisation. Thus, each alternative is to be seen by the finance manager from the view point of profit maximisation.
2) Wealth maximisation: The companies having profit maximisation as its objective may adopt policies yielding handsome profits in the short run which are unhealthy for the growth, survival and overall interests of the business. A company may not undertake planned and prescribed shut-downs of the plant for maintenance, and so on for maximising profits in the short run. Thus, the objective of a firm should be to maximise its value or wealth.
2. What is financial planning? What are its three aspects? Mention its objectives and importance. 2015
Ans: Financial Planning is the process of estimating the capital required and determining its composition. It is the process of framing financial policies in relation to procurement, investment and administration of funds of an enterprise. In simple words, it refers to determination of firm’s financial objectives, financial policies and financial procedure.
Three aspects of financial planning:
a) Creation of wealth: It Includes Setting financial goals and constructing a savings and investment plan. This aspect of financial planning talks all about wealth building, tax planning and budgeting.
b) Protection of wealth: Primarily this is about insurance. A proper risk protection strategy will protect us from the most common risks.
c) Succession of wealth: Wealth succession is about realising our goals and managing for the future. This means retirement planning and estate planning.
Objectives of Financial Planning: Financial planning is done to achieve the following two objectives:
1.The main objective of financial planning is that sufficient fund should be available in the company for different purposes. It ensures timely availability of finance.
2.Excess funding is as bad as inadequate or shortage of funds. If there is surplus money, financial planning must invest it in the best possible manner.
Importance of Financial Planning
Financial Planning is required to avoid shortage or surplus of finance. It is important because:
a) It facilitates collection of optimum funds: The financial planning estimates the precise requirement of funds which means to avoid wastage and over-capitalisation situation.
b) Basis for financial control: Financial planning helps in setting up standard performance and thereafter it is compared with the actual performance. The deviations, if any are analysed, Causes found out and corrective action is taken.
c) Link between investment and financing decisions: Financial planning helps in deciding debt/equity ratio and by deciding where to invest this fund. It creates a link between both the decisions.
d) Helps in investing finance in right projects: Financial plan suggests how the funds are to be allocated for various purposes by comparing various investments proposals. Selecting right projects is the key of success for any organisation.
e) Helps in coordination of various business activities: It helps in coordinating the various business activities such as sales, purchases, production, finance etc.
3. Discuss in brief the factors affecting capital structure. OR ‘Determination of capital structure of a company is influenced by a number of factors’ explain six such factors. 2012, 2014, 2016
Ans: Capital structure refers to the mix of sources from where long term funds required by a business may be raised i.e. what should be the proportion of equity share capital, preference share capital, internal sources, debentures and other sources of funds in total amount of capital which an undertaking may raise for establishing its business. In simple words, capital structure means the proportion of debt and equity used for financing the operations of business and it is calculated by the following formula:
Capital structure = Debt/Equity.
Following factors are to be considered before determining capital structure.
1. Cash flow position: If cash flow position of the company is sound, then debt can be raised and if cash flow is not sound debt should be avoided and it must employ more of equity in its capital.
2. Interest coverage ratio: It is the ratio that expresses the number of times the Net profit before interest and tax covers the interest liabilities. Higher the ratio better is the position of the firm to raise debt.
3. Control: Issue of Equity shares dilutes the control of the existing shareholders, whereas issue of debt does not as the debenture holders do not participate in the management. Thus if control is to be retained, equity should be avoided.
4. Cost of debt: If firm can arrange borrowed fund at low rate of interest then it will prefer more of debt as compared to equity.
5. Stock market conditions: If the stock market is bullish, the investors are adventurous and are ready to invest in risky securities. In this case, equity can be issued even at a premium. Whereas in the Bearish phase, when the investors become cautious, debt should be issued as there is a demand for fixed cost security.
6. Regulatory framework: Before determining the capital structure of a company, the guidelines of SEBI and concerned regulatory authority is to be considered.
7. Flexibility: Excess of debt may restrict the firm’s capacity to borrow further. To maintain flexibility it must maintain some borrowing power to take care of unforeseen circumstances.
8. Tax rate: As interest on debt is treated as an expense, it is tax deductable. Dividend on equity is the distribution of profit so is not tax deductable. Thus if the tax rates are high, issue of debt is an attractive means as it is economical in nature.
4. What is fixed capital? Explain its importance. Explain briefly five factors determining the amount of fixed capital. 2015
Ans: Fixed capital refers to the capital which is used for the purchase of fixed assets, such as land, building, machinery etc. Managing fixed capital is related to investment decision and it is also called capital budgeting. The capital budgeting decision affects the growth and profitability of the company.
Significance of capital budgeting decision: It is more important due to the following reasons:
1. As capital budgeting decisions involve investment in long term fixed assets, it affects the long term growth.
2. Large amount of funds blocked for a long period, the decision should be taken rationally.
3. As such a decision affects the returns of the firm as a whole, it involves more risk.
4. These long term decisions taken once cannot be reversed back, without incurring heavy losses. Thus capital budgeting decisions should be taken after careful study and deep analysis.
Following factors are to be considered before determining its requirement:
1. Scale of operations: There is a direct link between the scale of business and fixed capital. Larger business needs more fixed capital as compared to the small organizations.
2. Nature of Business: If a firm is a manufacturing fir, it requires to purchase fixed assets for the production process. It needs investment in fixed assets, so require more fixed capital. Similarly if it is a Trading firm where the finished goods are only traded i.e. purchased and sold, it needs less fixed capital.
3. Choice of technique: The Manufacturing firm using the modern, latest technology machines has to invest more funds in the fixed assets, so they require more fixed capital. On the other hand, firms using the traditional method of production where the task is performed manually by the labourers, it requires less fixed capital.
4. Diversification: There are few firms and organizations who deal in a single product. These investments in fixed assets is low, whereas the firms dealing in number of products (Diversification) requires more investment in purchasing different fixed assets, it requires more fixed capital.
5. Financing alternatives: If the manufacturing firm actually buys the assets and blocks huge funds in the fixed assets, it requires more fixed capital.
5. What is meant by Working capital? How is it calculated? Discuss five determinants of working capital requirements. 2012, 2013, 2014
Ans: Working capital is the capital required for meeting day to day requirements/operations of the business. Simply, it refers to excess of current assets over current liabilities.
Calculation of working capital:
a) Gross working capital: This refers to the total investment made in all the current assets such as stock, debtors, bills receivable etc. It is calculated by adding all the current assets.
b) Net working capital: This refers to excess of current assets over current liabilities. It is calculated as: Net working capital= current assets – current liabilities. If current liabilities are more than current assets then working capital becomes negative. 2016
Following factors are to be considered before determining the requirement of working capital.
1. Scale of operations: There is a direct link between the scale of business and working capital. Larger business needs more working capital as compared to the small organizations.
2. Nature of Business: The manufacturing organizations are required to purchase raw materials, convert them into finished goods, maintain the stock of raw materials; semi finished goods and finished goods before they are offered for sale. They have to block their capital for labour cost, material cost etc, so they need more working capital. In the trading firm processing is not performed. Sales are affected immediately after receiving goods for sale. Thus they do no block their capital and so needs less working capital.
3. Credit allowed: If the inventory is sold only for cash, it requires less working capital as money is not blocked in debtors and bills receivable. But due to increased competition, credit is usually allowed. A liberal credit policy results in higher amount of debtors, so needs more working capital.
4. Credit availed: If goods are purchased only for cash, it requires more working capital. Similarly if credit is received from the creditors, the requirement of working capital decreases.
5. Availability of Raw materials: If the raw materials are easily available in the market and there is no shortage, huge amount need not be blocked in inventories, so it needs less working capital. But if there is shortage of materials, huge inventory is to be maintained leading to larger amount of working capital.
6. Mention the need and importance of Working Capital. 2015
Ans: Need and Importance of Working Capital: Working capital is the life blood and nerve center of business. No business can run successfully without an adequate amount of working capital. The main advantages or importance of working capital are as follows:
1. Strengthen the Solvency: Working capital helps to operate the business smoothly without any financial problem. Purchase of raw materials and payment of salary, wages and overhead can be made without any delay.
2. Enhance Goodwill: Sufficient working capital enables a business concern to make prompt payments and hence helps in creating and maintaining goodwill.
3. Easy Obtaining Loan: A firm having adequate working capital, high solvency and good credit rating can arrange loans from banks and financial institutions in easy and favorable terms.
4. Regular Supply of Raw Material: Quick payment of credit purchase of raw materials ensures the regular supply of raw materials from suppliers. Suppliers are satisfied by the payment on time.
5. Smooth Business Operation: Working capital is really a life blood of any business organization which maintains the firm in well condition. Any day to day financial requirement can be met without any shortage of fund. All expenses and current liabilities are paid on time.
7. Distinguish between fixed capital and working capital. 2015
Ans: The difference between fixed capital and working capital is as follows:
a) Purpose: Fixed capital is used to buy fixed assets like land and building whereas Working capital is used to carry out day to day operations.
b) Assets included: Fixed capital consists of land, building, tools, machines etc. whereas Working capital consists of cash, marketable securities, accounts receivable, stock etc.
c) Time period: Fixed capital includes long term financial decisions whereas Working capital includes short term financing decisions.
d) Activities: Fixed capital is mainly required for operational activities whereas Working capital is required for trading activities.
e) Calculation: Fixed capital is calculated by deducting long term liabilities from total fixed assets whereas working capital is calculated by deducting current liabilities from current assets.
8. Mention various functions of a Finance Manager. 2014
Ans: Functions of a Finance Manager: The twin aspects, procurement and effective utilisation of funds are crucial tasks faced by a finance manager. The financial manager is required to look into the financial implications of any decision in the firm. Some of the important decisions as regards finance are as follows:
1) Estimating the requirements of funds: A business requires funds for long term purposes i.e. investment in fixed assets and so on. A careful estimate of such funds is required to be made. Forecasting the requirements of funds is done by a finance manager by the use of techniques of budgetary control and long range planning.
2) Financing decision or Decision regarding capital structure: Once the requirements of funds are estimated, a decision regarding various sources from where the funds would be raised is to be taken.
3) Investment decision: Funds procured from different sources have to be invested in acquiring fixed assets as well as current assets. When decision regarding fixed assets is taken it is called capital budgeting decision.
4) Dividend decision: Dividend Decision: This decision is concerned with distribution of surplus funds. The profit of the firm is distributed among various parties such as creditors, employees, shareholders, debenture holders etc. Under this decision the finance manager decided how much to be distributed in the form of dividend and how much to keep aside as retained earnings.
5) Supply of funds to all parts of the organisation or cash management: The finance manager has to ensure that all sections i.e. branches, factories, units or departments of the organisation are supplied with adequate funds.
6) Keeping in touch with stock exchange quotations and behavior of share prices: It involves analysis of major trends in the stock market and judging their impact on share prices of the company's shares.
9. What are various types of financial decisions or finance functions? Explain them briefly. 2016
Ans: The finance functions relate to three major decisions which every finance manager has to take:
a) Investment decision or capital budgeting
b) Finance Decision or Capital Structure decision
c) Dividend decision
a) Investment decision: Funds procured from different sources have to be invested in acquiring fixed assets as well as current assets. When decision regarding fixed assets is taken it is called capital budgeting decision.
Significance of capital budgeting decision: It is more important due to the following reasons:
1) As capital budgeting decisions involve investment in long term fixed assets, it affects the long term growth.
2) Large amount of funds blocked for a long period, the decision should be taken rationally.
3) As such a decision affects the returns of the firm as a whole, it involves more risk.
4) These long term decisions taken once cannot be reversed back, without incurring heavy losses. Thus capital budgeting decisions should be taken after careful study and deep analysis.
Factors affecting investment/capital budgeting decisions
1) Cash flow of the project: The amount of expected cash inflow from an investment proposal must be assessed before investing in the proposal.
2) Return on investment: An investment proposal with high expected return should be preferred.
3) Risk involved: The company must try to calculate the risk involved in every proposal and should prefer the investment proposal with moderate degree of risk only.
b) Finance decision: The second important decision which finance manager has to take is deciding source of finance. Under this decision finance manager has to decide how much to raise from owner’s fund and how much to raise from borrowed fund. This type of decision is also known as capital structure decision. For details refer question no. 3.
c) Dividend decision: Refer question no. 10
10. What is dividend decision? What are the factors affecting dividend decision of a company? 2012, 2016
Ans: Dividend Decision: This decision is concerned with distribution of surplus funds. The profit of the firm is distributed among various parties such as creditors, employees, shareholders, debenture holders etc. Under this decision the finance manager decided how much to be distributed in the form of dividend and how much to keep aside as retained earnings.
Factors affecting dividend decision: A firm's dividend policy is influenced by the large numbers of factors. Some factors affect the amount of dividend and some factors affect types of dividend. The following are the some major factors which influence the dividend policy of the firm.
1. Legal requirements: There is no legal compulsion on the part of a company to distribute dividend. However, there certain condition imposed by law regarding the way dividend is distributed.
2. Firm's liquidity position: Dividend payout is also affected by firm's liquidity position. In spite of sufficient retained earnings, the firm may not be able to pay cash dividend if the earnings are not held in cash.
3. Repayment need: A firm uses several forms of debt financing to meet its investment needs. These debts must be repaid at the maturity. If the firm has to retain its profits for the purpose of repaying debt, the dividend payment capacity reduces.
4. Expected rate of return: If a firm has relatively higher expected rate of return on the new investment, the firm prefers to retain the earnings for reinvestment rather than distributing cash dividend.
5. Stability of earning: If a firm has relatively stable earnings, it is more likely to pay relatively larger dividend than a firm with relatively fluctuating earnings.
6. Access to the capital market: If a firm has easy access to capital markets in raising additional financing, it does not require more retained earnings. So a firm's dividend payment capacity becomes high.
11. “To avoid the problem of shortage and surplus of funds, what is required in financial management? Name the concept and explain four points of importance. 2015
Ans: Financial Planning is required to avoid shortage or surplus of finance. Financial Planning is important because:
a) By planning utilization of finance, it reduces waste, duplication of efforts and gaps in the planning.
b) It helps in coordinating the various business activities such as sales, purchases, production, finance etc.
c) Financial planning helps in setting up standard performance and thereafter it is compared with the actual performance. The deviations, if any are analysed, Causes found out and corrective action is taken.
d) It helps in avoiding shocks and surprises as proper provision regarding shortage or surplus is made in advance by anticipating future receipts and payments.
12. Distinguish between financial planning and financial management.
Ans: Comparison between financial planning and financial management
Financial management refers to that part of the management activity which is concerned with the planning, raising, controlling and administration of the funds used in the business.
It refers to determination of firm’s financial objectives, financial policies and financial procedure.
It is wider in scope, it includes financial planning.
It is narrow in scope as it is one segment of financial management.
Its objective is to manage all the activities related to finance.
Its objective is to ensure availability of necessary funds.