Definitions [3]
Answer the following question.
Give the meaning of Financial Management.
Financial management refers to the efficient acquisition, allocation, and usage of funds by the company. It is carried out with the primary aim of reducing the cost of the funds that are procured, minimizing the risk, and effective distribution of funds to different opportunities.
Answer in one sentence.
Define working capital.
Gerstenbergh defines it as “The excess of current assets over current liabilities.”
Answer in one sentence.
Define capital structure.
According to R. H. Wessel, “The long term sources of funds employed in a business enterprise.”
Formulae [3]
\[\frac{\mathrm{Debt}}{\mathrm{Equity}}\] (D/E)
\[\frac{\mathrm{Debt}}{\mathrm{Debt}+\mathrm{Equity}}\] \[\left(\frac{D}{D+E}\right)\]
\[\frac{\mathrm{EBIT}}{\text{Total Investment}}\times100\]
Key Points
- Financial management = optimal procurement + usage of finance.
- Primary objective = maximise shareholders' wealth via market value of equity shares.
- Reduces cost of funds and controls financial risk.
- Decisions affect both the Balance Sheet (assets, capital structure) and P&L (interest, depreciation, dividends).
- Ensures effective deployment and timely availability of funds.
- Financial planning prepares a financial blueprint for future operations.
- It ensures funds are available at the right time and in the right amount.
- It avoids both shortage and excess of funds.
- It includes short-term budgets and long-term plans for growth and capital expenditure.
- The process starts with sales forecasts and estimates profits, cash needs, and external funding.
- Debt can support growth, but excessive debt can harm the business.
- Owners should use cash-flow analysis and financial statements before borrowing.
- Financial planning tackles uncertainty of funds and supports smooth functioning and survival of business.
- It forecasts future conditions and enables preparation of alternative financial plans.
- It helps avoid business shocks and surprises by preparing the company for the future.
- It coordinates sales and production through clear policies, procedures and budgets.
- Detailed action plans reduce waste, duplication of efforts and planning gaps.
- It links present decisions with future requirements and connects investment and financing decisions.
- It sets detailed objectives that make evaluation and comparison of actual performance with planned results easier.
- Capital structure = Mix of owners' funds and borrowed funds.
- Debt is cheaper but riskier than equity.
- Financial risk increases with higher debt.
- Financial leverage is measured by D/E or D/(D+E).
- Optimal capital structure maximizes shareholders' wealth.
- Favourable Financial Leverage: RoI > Cost of Debt → EPS increases.
- Unfavourable Financial Leverage: RoI < Cost of Debt → EPS decreases.
- Trading on Equity should be used only when RoI exceeds the Cost of Debt.
- Fixed capital is the investment in long-term assets, while current assets are converted into cash within one year.
- Fixed capital decisions (capital budgeting) involve acquiring, expanding, replacing, or modernising fixed assets.
- Fixed assets should be financed through long-term sources, not short-term funds.
- Capital budgeting is important because it involves large investments, long-term growth, risk, and irreversible decisions.
- Fixed capital requirements depend on the nature and scale of business, technology, growth prospects, and diversification.
- Leasing and collaboration can reduce the need for fixed capital investment.
