Class 12 Business Studies Notes Chapter 1 (Financial Management) – Business Studies-II Book

Detailed Notes with MCQs of Chapter 1: Financial Management from your Business Studies-II book. This is a crucial chapter, not just for your board exams, but also forms the foundation for many concepts tested in government recruitment exams. Pay close attention.

Chapter 1: Financial Management - Detailed Notes for Government Exam Preparation

1. Meaning and Concept of Financial Management:

• Definition: Financial Management refers to the efficient acquisition of finance, efficient utilisation of finance, and efficient distribution and disposal of surplus for the smooth working of the company.
• It deals with the procurement of funds and their effective utilization in the business.
• It involves managing all the financial activities and resources of an organization.
• Core Idea: Making optimal decisions regarding investment, financing, and dividends to maximize shareholder wealth.

2. Role of Financial Management in an Organisation:

• Determining Capital Requirements: Assessing both fixed capital (for long-term assets like land, machinery) and working capital (for day-to-day operations like inventory, receivables).
• Determining Capital Structure: Deciding the mix of debt (borrowed funds) and equity (owner's funds) in the total capital. This involves analysing the cost and risk associated with each source.
• Choice of Sources of Funds: Selecting the appropriate sources for raising funds (e.g., shares, debentures, loans, retained earnings) based on cost, risk, control considerations, and tenure.
• Investment of Funds: Allocating funds into profitable ventures and assets (both long-term and short-term) that yield the highest possible returns for the risk involved.
• Disposal of Surplus/Profits: Deciding how much profit to retain for reinvestment (retained earnings) and how much to distribute to shareholders as dividends.
• Management of Cash: Ensuring availability of adequate cash for meeting liabilities and day-to-day expenses while avoiding idle cash.
• Financial Control: Evaluating financial performance using tools like ratio analysis, cost control, and budgetary control to ensure activities align with plans.

3. Objectives of Financial Management:

• Primary Objective: Wealth Maximization:
  • This is considered the most important and universally accepted objective.
  • It means maximizing the market value of the company's equity shares.
  • Market price of shares acts as an indicator of the company's performance and shareholder wealth.
  • Achieved by making optimal financial decisions that increase the net present worth of the firm.
  • It considers the time value of money and risk associated with returns.
  • Focuses on long-term benefits and growth.
• Other Objectives (often seen as means to achieve wealth maximization):
  • Profit Maximization: Traditionally considered important, but has limitations. It ignores the time value of money, risk factors, and can lead to unethical practices or short-term focus. It's ambiguous (Profit before tax? After tax? EPS?).
  • Procurement of Sufficient Funds: Ensuring timely availability of funds at a reasonable cost.
  • Efficient Utilisation of Funds: Deploying funds in assets and operations productively.
  • Ensuring Safety of Funds: Protecting investments from undue risk.
  • Maintaining Liquidity: Ensuring the firm can meet its short-term obligations.

4. Financial Decisions:

Financial management involves making three key decisions:

• (A) Investment Decision (Capital Budgeting Decision):

  • Meaning: Relates to the selection of assets in which funds will be invested by the firm.
  • Types:
    • Long-term Investment Decision (Capital Budgeting): Involves committing large funds for a long period in fixed assets (e.g., new machinery, new branch). These decisions are crucial as they affect long-term profitability, are often irreversible, and involve huge amounts.
    • Short-term Investment Decision (Working Capital Management): Relates to managing current assets (inventory, debtors, cash) and current liabilities. Affects day-to-day operations, liquidity, and profitability.
  • Factors Affecting Capital Budgeting Decisions:
    • Cash Flows of the Project: Expected returns (cash inflows) over the life of the investment.
    • Rate of Return: The expected profitability of the project.
    • Investment Criteria Involved: Techniques used to evaluate proposals (e.g., Payback Period, NPV, IRR - Note: Calculation details are usually beyond NCERT scope, but understanding the concept is important).
    • Risk Involved: Uncertainty associated with the expected returns.

• (B) Financing Decision:

  • Meaning: Relates to determining the optimal capital structure – deciding the proportion of funds to be raised from various long-term sources (debt, equity, retained earnings).
  • Key Consideration: Balancing Cost and Risk.
    • Cost: Debt is generally cheaper (interest is tax-deductible) than equity (dividends are paid out of after-tax profits).
    • Risk: Debt is riskier as interest payment and principal repayment are legal obligations (financial risk). Equity is less risky for the firm.
  • Factors Affecting Financing Decisions:
    • Cost: Cost of raising funds from different sources.
    • Risk: Financial risk associated with each source (especially debt).
    • Cash Flow Position: Ability to meet fixed payment obligations (interest, principal). Strong cash flow supports higher debt.
    • Control Considerations: Equity issuance dilutes ownership control; debt does not.
    • Floatation Costs: Costs incurred in issuing securities (e.g., underwriting fees, brokerage). Higher for equity.
    • Fixed Operating Costs: High fixed operating costs favour lower debt (lower business risk allows taking more financial risk, and vice versa).
    • Capital Market Conditions: Market sentiment (bullish vs. bearish) affects the ease of raising funds via debt or equity.
    • Regulatory Framework: SEBI guidelines and company law provisions.
    • Tax Rate: High tax rates make debt relatively cheaper (due to tax deductibility of interest).

• (C) Dividend Decision:

  • Meaning: Relates to the distribution of profit – how much profit earned should be distributed to shareholders as dividends and how much should be retained in the business for future investment (retained earnings).
  • Key Consideration: Balancing shareholder expectations for current income (dividends) with the firm's need for funds for future growth (retained earnings).
  • Factors Affecting Dividend Decisions:
    • Amount of Earnings: Dividends are paid out of current and past earnings. Higher earnings allow higher dividends.
    • Stability of Earnings: Companies with stable earnings can afford a higher and more stable dividend payout ratio.
    • Stability of Dividends: Companies generally prefer to maintain a stable dividend per share, increasing it only when confident of maintaining the higher level.
    • Growth Opportunities: Firms with significant investment opportunities may retain more earnings to finance growth.
    • Cash Flow Position: Dividend payment involves cash outflow. Sufficient cash is necessary.
    • Shareholder Preference: Preferences of shareholders (e.g., retired individuals may prefer regular dividends, younger investors may prefer capital gains from reinvestment).
    • Taxation Policy: Dividend Distribution Tax (DDT) or tax treatment of dividends in the hands of shareholders can influence the decision. High taxes may favour retaining earnings.
    • Access to Capital Markets: If raising funds externally is easy and cheap, the firm might pay higher dividends. If difficult, it might retain more.
    • Legal Constraints: Company law provisions regarding dividend payment (e.g., out of profits, not capital).
    • Contractual Constraints: Loan agreements might restrict dividend payments.

5. Financial Planning:

• Meaning: Process of estimating the fund requirements of a business and specifying the sources of funds. It is essentially the blueprint for the firm's financial activities. It ensures that enough funds are available at the right time.
• Objectives:
  • To Ensure Availability of Funds Whenever Required: Includes estimating future needs and planning for raising them.
  • To See That the Firm Does Not Raise Resources Unnecessarily: Avoids idle funds and unnecessary costs.
• Importance:
  • Helps in forecasting future business situations, enabling better preparation.
  • Helps in avoiding business shocks and surprises.
  • Facilitates coordination among various business functions (e.g., production, marketing).
  • Reduces waste, duplication of efforts, and gaps in planning.
  • Links the present with the future.
  • Provides a basis for financial control by setting standards.
  • Helps in linking investment and financing decisions continuously.

6. Capital Structure:

• Meaning: Refers to the mix between owners' funds (equity) and borrowed funds (debt) in the total capital of a firm.
  • Capital Structure = Debt / Equity
• Financial Leverage (Trading on Equity):
  • Refers to the proportion of debt in the total capital.
  • It is favourable when the Return on Investment (ROI) of the company is higher than the Cost of Debt (Interest Rate). In such cases, using more debt increases the Earnings Per Share (EPS) for equity shareholders.
  • However, it increases the financial risk of the company.
• Factors Determining Capital Structure (Similar to factors affecting Financing Decision):
  • Cash Flow Position
  • Interest Coverage Ratio (ICR): High ICR indicates better ability to meet interest obligations, allowing more debt.
  • Debt Service Coverage Ratio (DSCR): Considers both interest and principal repayment obligations. High DSCR allows more debt.
  • Return on Investment (ROI): If ROI > Cost of Debt, use more debt (favourable leverage).
  • Cost of Debt: Lower cost of debt allows higher debt proportion.
  • Tax Rate: Higher tax rate makes debt cheaper.
  • Cost of Equity: As debt increases, financial risk increases, making equity shareholders expect a higher return, thus increasing the cost of equity.
  • Floatation Costs
  • Risk Consideration (Financial Risk vs. Business Risk)
  • Flexibility: Maintain borrowing capacity for unforeseen needs.
  • Control
  • Regulatory Framework
  • Stock Market Conditions
  • Capital Structure of Other Companies (Industry norms)

7. Fixed Capital:

• Meaning: Refers to the investment in long-term assets (or fixed assets) like land, building, plant, machinery, furniture, etc. Required for establishing and running the business over a long period.
• Factors Affecting Requirement of Fixed Capital:
  • Nature of Business: Manufacturing concerns need higher fixed capital than trading concerns.
  • Scale of Operations: Large-scale operations require more fixed assets than small-scale operations.
  • Choice of Technique: Capital-intensive techniques require more fixed capital than labour-intensive techniques.
  • Technology Upgradation: Industries with rapid technological obsolescence need higher fixed capital for replacements.
  • Growth Prospects: Companies planning growth need more fixed capital.
  • Diversification: Diversifying into new product lines increases fixed capital needs.
  • Financing Alternatives: Availability of leasing facilities can reduce the immediate need to purchase fixed assets.
  • Level of Collaboration/Joint Ventures: Sharing facilities can reduce individual fixed capital requirements.

8. Working Capital:

• Meaning: Refers to the capital required for meeting day-to-day operating expenses, holding current assets (like inventory, debtors, cash), and meeting short-term liabilities. Ensures smooth functioning of the business operations.
• Concepts:
  • Gross Working Capital: Total investment in current assets.
  • Net Working Capital: Current Assets - Current Liabilities. Represents the portion of current assets financed by long-term funds.
• Types based on time:
  • Permanent Working Capital: Minimum level of current assets required continuously.
  • Variable/Temporary Working Capital: Additional working capital needed to meet seasonal or cyclical fluctuations.
• Factors Affecting Requirement of Working Capital:
  • Nature of Business: Trading firms generally need less working capital (shorter operating cycle) than manufacturing firms. Service industries may need even less.
  • Scale of Operations: Larger firms need more working capital.
  • Business Cycle: Boom periods require more working capital (higher sales, production); recession periods require less.
  • Seasonal Factors: Businesses with seasonal demand (e.g., woollens, coolers) need higher working capital during peak season.
  • Production Cycle: Longer production cycle means funds are tied up longer, requiring more working capital.
  • Credit Allowed (Debtors): Liberal credit policy increases the amount tied up in debtors, needing more working capital.
  • Credit Availed (Creditors): Liberal credit terms from suppliers reduce the working capital requirement.
  • Operating Efficiency: Better management of inventory, receivables etc., reduces working capital needs.
  • Availability of Raw Material: Need to stock more if raw material supply is erratic, increasing working capital.
  • Growth Prospects: Growing companies need more working capital to support higher levels of activity.
  • Level of Competition: High competition may force liberal credit terms or higher inventory levels, increasing working capital.
  • Inflation: Rising prices increase the funds required for maintaining the same level of inventory and debtors.
  • Technology Upgradation: Can affect the production cycle and efficiency, impacting working capital needs.

Multiple Choice Questions (MCQs):

1. The primary objective of Financial Management is:
   (a) Profit Maximization
   (b) Wealth Maximization
   (c) Ensuring availability of funds
   (d) Maximizing sales

2. Investment decisions relate to:
   (a) Selection of sources of funds
   (b) Distribution of profits
   (c) Selection of assets in which funds will be invested
   (d) Management of cash

3. Capital structure refers to the mix between:
   (a) Current assets and current liabilities
   (b) Fixed assets and current assets
   (c) Debt and Equity
   (d) Short-term and long-term funds

4. Which of the following factors favours the use of more debt in the capital structure?
   (a) High tax rate
   (b) High floatation costs for equity
   (c) High Return on Investment (ROI) compared to cost of debt
   (d) All of the above

5. Working Capital is the capital required for:
   (a) Purchase of fixed assets
   (b) Payment of long-term liabilities
   (c) Meeting day-to-day operating expenses
   (d) Payment of dividends

6. 'Trading on Equity' or Financial Leverage is considered favourable when:
   (a) Cost of Debt > Return on Investment (ROI)
   (b) Return on Investment (ROI) > Cost of Debt
   (c) Return on Investment (ROI) = Cost of Debt
   (d) The company uses only equity finance

7. Which decision determines how much profit should be retained and how much distributed?
   (a) Investment Decision
   (b) Financing Decision
   (c) Dividend Decision
   (d) Capital Budgeting Decision

8. A manufacturing company using capital-intensive techniques would generally require:
   (a) Lower Fixed Capital
   (b) Higher Fixed Capital
   (c) Higher Working Capital only
   (d) Lower Working and Fixed Capital

9. Financial planning aims to ensure:
   (a) Availability of funds whenever needed
   (b) That the firm does not raise resources unnecessarily
   (c) Both (a) and (b)
   (d) Only long-term fund requirements are met

10. Which of the following is NOT a factor affecting the Dividend Decision?
    (a) Stability of Earnings
    (b) Cash Flow Position
    (c) Nature of Business (as a primary factor for fixed capital)
    (d) Growth Opportunities

Answer Key for MCQs:

1. (b)
2. (c)
3. (c)
4. (d)
5. (c)
6. (b)
7. (c)
8. (b)
9. (c)
10. (c) (While nature of business indirectly affects earnings/growth, it's primarily listed as a factor for capital requirements, not directly for dividend policy itself compared to the others)

Make sure you understand these concepts thoroughly. Financial Management decisions directly impact a firm's value and survival. Go through these notes, refer back to your NCERT textbook for examples, and practice more questions. Let me know if any specific area needs further clarification.