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Working capital is that part of total capital that is required to meet day-to-day expenses, to buy raw materials, to pay wages and other expenses of routine nature in the production process or we can say it refers to excess of current assets over current liabilities.

Working Capital = Current Assets – Current Liabilities 

Factors affecting working capital requirements are. the following :

1. Nature of business: The basic nature of a business influences the amount of working capital required. A trading organization usually needs a lower amount of working capital compared to a manufacturing organization. This is because, in trading, there is no processing required. In a manufacturing business, however, raw materials need to be converted into finished goods, which increases the expenditure on raw material, labour and other expenses.

2. Scale of operation: For firms which are operating on a higher scale of operations, the quantum of inventory, debtors required is generally high. Such organizations, therefore, require large amount of working capital as compared to the organizations which operate on a lower scale.

3. Production Cycle: Production cycle is the time span between the receipts of raw materials and their conversion into finished goods. Some businesses have a longer production cycle while some have a shorter one. Working capital requirement is higher in firms with longer processing cycle and lowers in firms with shorter processing cycle.

4. Credit Allowed: Different firms allow different credit terms to their customers. A liberal credit policy results in a higher amount of debtors, increasing the requirements of working capital.

5. Credit Availed: Just as a firm allows credit to its customers it also may get credit from its suppliers. The more credit a firm avails on its purchases, the working capital requirement is reduced.

Investment decisions can be long term or short term. A long term investment decision is also called a capita! budgeting decision. It involves committing the finance on a long term basis, e.g., making investment in a new machine to replace an existing one or acquiring new fixed assets or opening a new branch etc. These decisions are very crucial for any business. They affect its earning capacity over the long-run.

Assets of a firm, profitability and competitiveness, are all affected by the capital budgeting decisions. Moreover, these decisions normally involve huge amounts of investment and are irreversible except at a huge cost. Therefore, once made, it is almost impossible for a business to wriggle out of such decisions. Therefore, they need to be taken with utmost care. These decisions must be taken by those who understand them comprehensively. A bad capital budgeting decision normally has the capacity to severely damage the financial fortune of a business.

Use of higher debt increases the, cost of equity as the financial risk faced by the equity shareholders increases; debt can therefore be used only up to a certain level.

Capital structure refers to the mix between owners and borrowed funds. It can be calculated as (Debt/Equity).

Debt and equity differ significantly in their cost and riskiness for the firm. Cost of debt is lower than cost of equity for a firm because lender’s risk is lower than equity shareholder’s risk since lenders earn on assured return and repayment of capital and therefore they should require a lower rate of return.

Debt is cheaper but is riskier for business because payment of interest and the return of principal is obligatory for the business. Any default in meeting these commitments may force the business to go into liquidation. There is no such compulsion in case of equity’, which is, therefore, considered riskless for the business. Higher use of debt increases the fixed financial charges of business. As a result, increased, use of debt increases the financial risk of a business.

Capital structure of a business thus affects both the profitability and the financial risk. A capital structure will be said to be optimal when the proportion of debt and equity is such that it results in an increase in the value of the equity share.

Equity share capital is the most costly capital even the rate of dividend is not certain on it.

Trading on equity or financial leverage.

Use of higher debt increases the cost of equity as the financial risk faced by equity shareholders increases, hence debt should be used upto a level.

i. Capital structure decision is related to proportion of debt (risk) and equity (return). 

ii. Debt is cheaper but is more risky for a business because payment of interest and the return of principal is obligatory for the business. Any default in meeting these commitments may force the business to go into liquidation. There is no such compulsion in case of equity, which is therefore, considered riskless for the business. 

iii. Debt component in the total capital generates higher return for equity shareholders as interest payable on debt is deductible from earning before tax payment. iv. Thus, capital structure decision affects risk as well as return. So, it is true capital structure decision is essentially optimization of risk-return relationship. 

(a) Dividend 

(b) Factors affecting Dividend Decision

(1) Stability Earnings :

A company having stable earnings can declare higher dividends. Otherwise, pay lower dividend.

(2) Stability of Dividends :

Companies generally follow a policy of stabilising dividend per share. Dividend per share is not altered if the change in earnings is small.

(3) Growth Opportunities:

Companies having good growth opportunities retain more money out of their earnings to finance the required investment. In such a case, they can declare dividend at a lower rate. 

(4) Cash Flow Positions :

Availability of enough cash in the company is necessary for declaration of dividend.

(5) Shareholders’ Preference :

While declaring dividends, managements must keep in mind the preferences of the shareholders in this regard.

(6) Taxation Policy :

A company is required to pay tax on dividend declared by it. If tax on dividend is higher, company will prefer to pay less by way of dividends whereas if tax rates are lower, then more dividends can be declared by the company.

(7) Capital Market:

Reputed companies have easy access to the capital market and, therefore, they can pay higher dividends than the smaller companies.

(8) Legal Constraints:

The companies Act has laid down certain restrictions regarding payment of dividend. No dividend can be paid out of capital.

It is ‘Trading on Equity’.

(c) Competition

(a) Capital – Capitalisation structure

(i) Fixed capital 

(ii) Fixed Capital :

Fixed capital refers to the capital needed for the the acquisition of fixed assets to be used for a longer period. Factors affecting Fixed Capital 

(1) Nature of Business :

A trading concern needs lower investment in fixed assets compared with a manufacturing organization.

(2) Scale of Operations:

An organisation operating on large scale require more fixed capital as compared to an organisation operating on small scale.

(3) Choice of Technique :

A capital-intensive organisation requires more amount of fixed capital than labour intensive organisations. 

(4) Technology Upgradation :

Organisations using assets which become obsolete faster require more fixed capital as compared to other organisations.

(5) Growth Prospects :

Higher growth of an organisation generally requires higher investment in fixed assets. 

(6) Diversification :

The firms dealing in number of products (Diversification) requires more investment in fixed capital. 

(7) Use of Fixed Assets:

Companies acquiring fixed assets on hire purchase or lease system require lesser amount as against cash purchases.

(a) Capital Budgeting 

(b) Importance of Financial Planning 

(1) It ensures adequate funds from various sources. 

(2) It reduces the uncertainty about the availability of funds. 

(3) It integrates the financial policies and procedures. 

(4) It helps the management to eliminate waste of funds and reduce cost. 

(5) It helps to achieve a balance between the inflow and out flow of funds and ensure liquidity. 

(6) It serves as the basis of financial control

(7) It helps to reduce cost of financing to the minimum. 

(8) It helps to ensure stability and profitability of business.

(9) It makes the firm better prepared to face the future.

(a) Working Capital:

Working capital is that portion of capital required for investing in current as-sets for meeting day to day working of an organization. Current assets can be converted into cash within a period of one year.

They provide liquidity to the business. Working capital is of two types: 

(1) Gross working capital = Total of current asset 

(2) Net working capital = Current assets – Current Liabilities

(b) Factors affecting Working Capital 

(1) Nature of Business :

A trading organisation usually needs a smaller amount of working capital as compared to a manufacturing organisation. 

(2) Scale of Operations:

A large scale organisation requires large amount of working capital as compared to the organisations which operate on a lower scale. 

(3) Business Cycle :

In the boom period larger amount of working capital is needed to meet the demand. In case of depression, demand for goods declines so less working capital is required.

(4) Seasonal Factors:

During peak season demand of a product will be high and thus high working capital will be required as compared to lean season. 

(5) Production Cycle:

Production cycle is the time span between the receipt of raw material and their conversion into finished goods. Working capital requirement is higher in firms with longer processing cycle and lower in firms with shorter processing cycle. 

(6) Credit Policy :

A liberal credit policy results in higher amount of debtors, increasing the requirement of working capital. 

(7) Operating Efficiency :

If cash, debtors and inventory are efficiently managed, working capital requirement can be reduced.

(8) 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.

Financial planning

Because these decisions involve huge capital investment and are related for long period.

(a) Dividend decision 

(b) Factors affecting Dividend Decision 

(1) Stability Earnings :

A company having stable earnings can declare higher dividends. Otherwise, pay lower dividend.

(2) Stability of Dividends :

Companies generally follow a policy of stabilising dividend per share. Dividend per share is not altered if the change in earnings is small.

(3) Growth Opportunities:

Companies having good growth opportunities retain more money out of their earnings to finance the required investment. In such a case, they can declare dividend at a lower rate.

(4) Cash Flow Positions :

Availability of enough cash in the company is necessary for declaration of dividend.

(5) Shareholders’ Preference :

While declaring dividends, managements must keep in mind the preferences of the shareholders in this regard.

(6) Taxation Policy :

A company is required to pay tax on dividend declared by it. If tax on dividend is higher, company will prefer to pay less by way of dividends whereas if tax rates are lower, then more dividends can be declared by the company.

(7) Capital Market:

Reputed companies have easy access to the capital market and, therefore, they can pay higher dividends than the smaller companies

(8) Legal Constraints:

The companies Act has laid down certain restrictions regarding payment of dividend. No dividend can be paid out of capital.

(a) Financial Planning 

(b) Importance of Financial Planning 

(1) It ensures adequate funds from various sources.

(2) It reduces the uncertainty about the availability of funds. 

(3) It integrates the financial policies and procedures. 

(4) It helps the management to eliminate waste of funds and reduce cost.

(5) It helps to achieve a balance between the inflow and outflow of funds and ensure liquidity. 

(6) It serves as the basis of financial control

(7) It helps to reduce cost of financing to the minimum. 

(8) It helps to ensure stability and profitability of business. 

(9) It makes the rm better prepared to face the future

(a) Dividend decision 

(b) Maximization of shareholder's wealth 

(c) Growth opportunities

(a) The firm will not be able to honour its commitments and carry out it's plans. 

(b) Financial planning helps in forecasting what may happen in future under different business situations. 

(c) Co-ordination. 

Working capital is needed in current assets of business such as purchasing raw material, making payment to creditors, paying utility bills, etc.

Factors affecting Fixed Capital 

(1) Nature of Business : A trading concern needs lower investment in fixed assets compared with a manufacturing organization.

(2) Scale of Operations:

An organisation operating on large scale require more fixed capital as compared to an organisation operating on small scale.

(3) Choice of Technique :

A capital intensive organisation requires more amount of fixed capital than labour intensive organisations. 

(4) Technology Upgradation :

Organisations using assets which become obsolete faster require more fixed capital as compared to other organisations. 

(5) Growth Prospects :

Higher growth of an organisation generally requires higher investment in fixed assets.

(6) Diversification :

The firms dealing in number of products (Diversification) requires more investment in fixed capital. 

(7) Use of Fixed Assets:

Companies acquiring fixed assets on hire purchase or lease system require lesser amount as against cash purchases.

(a) Stock market reactions 

(b) Safety 

(c) Respect for law

(a) Dividend Decision 

(b) Factors affecting Dividend Decision 

(1) Stability Earnings :

A company having stable earnings can declare higher dividends. Otherwise, pay lower dividend.

(2) Stability of Dividends :

Companies generally follow a policy of stabilising dividend per share. Dividend per share is not altered if the change in earnings is small.

(3) Growth Opportunities:

Companies having good growth opportunities retain more money out of their earnings to finance the required investment. In such a case, they can declare dividend at a lower rate.

(4) Cash Flow Positions :

Availability of enough cash in the company is necessary for declaration of dividend.

(5) Shareholders’ Preference :

While declaring dividends, managements must keep in mind the preferences of the shareholders in this regard.

(6) Taxation Policy :

A company is required to pay tax on dividend declared by it. If tax on dividend is higher, company will prefer to pay less by way of dividends whereas if tax rates are lower, then more dividends can be declared by the company.

(7) Capital Market:

Reputed companies have easy access to the capital market and, therefore, they can pay higher dividends than the smaller companies.

(8) Legal Constraints:

The companies Act has laid down certain restrictions regarding payment of dividend. No dividend can be paid out of capital.

i.Promoting hoarding and black-marketing of goods. 

ii.By participating in social work he still fulfills his social objectives.

Financial management has to take important decisions with respect to the following three problems:
(A) Decisions related to investment
(B) Decisions related to financing
(C) Decisions related to dividend

(A) Decisions related to investment:

• Business requires capital investment in various assets that too for a long and fixed term. This includes investment in machinery, land, etc.
• It is always a risk to identify the best asset in which investment should be made. Hence it is very crucial that decision of investment is evaluated in terms of expected return and risk.

(B) Decisions related to financing:

Investment decisions are connected with the assets of the company while financing decisions are related to the capital structure.

Capital structure of the company consists of
(a) equity shares
(b) equity shares and preference shares
(c) equity shares and debentures
(d) equity shares, preference shares and debentures.

Financial manager has to take decision regarding the portion to be maintained between equity and debt in capital structure. A fine balance between equity capital and debt is necessary so as to maximize the returns of the company.

(C) Decisions related to dividend:

• Dividend is a part of profit of a company which is distributed among its shareholders. Dividend is a return to shareholders on their investment.
• The financial manager has to tactfully decide what part of profit should be distributed as dividend and what part of profit should be retained in business.

• A human being remains alive as long as blood keeps circulating his body. Moreover, if any part of the body is devoid of sufficient quantity of blood then that part or organ may start functioning abnormally.
• Capital does the same job for the business. If the business lacks blood, it will start functioning abnormally and eventually die.
• Capital must be provided in order to see that all the department and functions of the business work smoothly. Absence of capital means death of business.
• Hence it is rightly said that working capital is the life-blood of business.

Characteristics of an Ideal Capital Structure:

• Simplicity
• Profitability,
• Adequacy of Finance
• Flexibility,
• Economy,
• Balancing,
• Liquidity,
• Attractiveness and
• Solvency.

Characteristics of financial management:

1. Branch of management: Financial management is a branch of management. It includes the function of planning and control for the use of finance.

2. Wide scope:

• The scope of financial management is extremely wide. Its scope includes estimating the need of finance, acquiring finance, maximum utilization, proper allocation and its planning and controlling.
• It covers all financial operations, right from the inception of business.

3. Base of the managerial decisions:

• Financial management is the base for managerial decisions.
• All major decisions regarding production, sales, research, development, etc. are based on financial management.

4. Relation with financial decisions:

• Financial management is also related with taking financial decisions.
• Financial decisions such as new investment, capital structure, dividend policy, etc. are all associated with financial management.
• Financial management makes use of modern mathematical techniques for taking financial decisions.

5. Goal of maximization of owner’s economic welfare:

Financial management aims at maximizing economic welfare of the business owner. For this, it works with two approaches: (i) Profit maximization and (ii) Wealth maximization.

6. Key position: Financial management holds key position in organizational structure of business unit.

7. Relation with other areas of management:

• If there is sufficient finance and proper financial management then the financial management will be more flexible in formulating policies related to production, sales, incentives, etc.
• On this basis we can say that financial management is related with different areas of management such as production management, marketing management, personnel management, etc.

8. Division into two parts:

• Financial management can be divided mainly into two parts namely
  1. Management of long term fixed capital and
  2. Management of working capital.
• Fixed capital management includes planning for expansion of fixed assets such as building, machines, land, etc., while working capital management takes care of day-to-day expenses.

The time period between the procurement of raw materials and manufacturing finished goods is called the production cycle

Types of Capital Structure:

(A) Capital structure of only equity of shares
(B) Capital structure of preference shares with equity shares
(C) Capital structure of debentures with equity shares
(D) Capital structure of preference shares and debentures with equity shares

An ideal capital structure should have the following characteristics:

1. Simplicity: It becomes easy to administer capital structure, if lesser varieties of securities are issued.
2. Profitability: The capital structure should be planned in such a way that profit remains optimum.
3. Adequate finance: Various sources should be combined properly so that adequate finance can be obtained.
4. Flexibility: Capital structure of the company should be flexible so that it can be changed as per the requirements and circumstances.
5. Economy: Various sources should be combined in a manner that optimizes the cost of capital.
6. Balancing: There should be a proper equilibrium between owner’s capital and borrowed capital.
7. Liquidity: The capital structure should be so designed that few sources can be liquidated when needed so as to set-off the liability and debts of the company in time.
8. Attractiveness (Impressive): Capital structure should be designed in such a manner that investors find it impressive. An impressed investor will stay loyal to the company and even invest more.
9. Solvency: The proportion of borrowed capital should not be so large that burden of interest cannot be borne by the company and risk of insolvency increases.

Concept of Financial Management: It refers to that part of the management activity which is concerned with the efficient planning and controlling of financial affairs of the enterprise. In other words, it can be said that under financial management, first of all, need for finance is estimated and then different sources of obtaining finance and its quantum are determined and finally arrangements are made for the distribution of profit.

Objective of Financial Management: The objective of financial management is to maximise the wealth of the owners of the business to the maximum extent.

According to this approach, owners’ interest can be best served by wealth maximisation. Wealth maximisation means to increase the capital invested in the business by the shareholders. Market price of the shares is the index of the capital invested. If the market price of the shares increases, it can be said that capital (wealth) invested by the shareholders has been appreciating. On the contrary, fall in the market price of the shares has an adverse effect on their wealth. Wealth of the shareholders can be computed by the following formula.

Finance:

• In layman language, management of finance is called financial management.
• Finance is the blood of business.
• Business can neither be started without finance nor can it sustain without it. Thus, finance is the foundation stone of business.

Financial management:

• The activity done at managerial level for planning and controlling financial resources for the business enterprise is called financial management.
• Under financial management, the managers try to optimally manage the financial resources so that the business earns a satisfactory return.

Various definitions of financial management:

• According to F. W. Paish, “In the modern economy, based on utilization of funds, financial management means acquiring of required funds at the required time.”
• According to Raymond J. Chambers, “Financial management means to take decisions about financial matters to implement then smoothly and to review, them.”
• According to Prof. M. Kimbal, “Financial management means acquisition of fund, its optimum utilization and its appropriate allocation.”
• From all these definitions we can conclude that the scope of financial management is so wide that it covers all the financial decisions of business, right from the inception.

Characteristics of Financial Management:

• Branch of Management
• Wide Scope,
• Base of the Managerial Decisions,
• Relation with Financial Decisions
• Goal of Maximization of Owner’s Economic Welfare
• Key Position
• Relation with other areas of Management
• Division into TWo Parts.

Concept and Definition of Financial Management:

• Practically financial management means management of finance functions.
• Financial management means acquisition of fund, its optimum utilization and its appropriate allocation.
• The field of financial management is wide. It includes all the financial decisions since inception to expansion and end of business.

Short-term Investment Decision.

Investment decision/Capital budgeting decision.

Investment decision/Capital budgeting decision: Investment decision refers to how the firm’s funds are invested in different assets so as to earn the highest possible return to the investors.

Objectives of Financial Planning:

(i) To ensure availability of adequate funds at the right time: This includes a proper estimation of funds required for different purposes such as for the purchase of long-term assets or to meet day-to-day expenses of business, it estimates the time at which the funds are to be made available. Based on these facts, funds could be raised from short-term and long-term sources.

(ii) To see that the firm does not raise resources unnecessarily: Excess funding is almost as bad as inadequate funding. So, the financial manager must see to it that the company does not raise more capital than the requirement of the business. In case, there is surplus cash or liquidity, the excess funds should be utilized judiciously.

Wealth Maximisation is an important decision of financial management. It means to increase the capital invested in the business by the shareholders. Market price of the shares is the index of the capital invested. If the market price of the shares increases, it can be said that capital (wealth) invested by the shareholders has been appreciating. On the contrary, fall in the market price of the shares has an adverse effect on their wealth. Wealth of the shareholders can be computed by the following formula: Shareholder’s Current Wealth in a Company = Number of Shares × Market Price Per Share For example, a person buys 100 shares of XYZ Co. at the rate of Rs. 100 per share. It means that his wealth in the company is worth Rs. 10,000 (100 × 100). After some time, market price of the share rises to Rs. 120 per share. It means that his wealth in the company has gone up to Rs. 12,000 (100 × 120). In other words, his wealth has increased by Rs. 2,000. On the contrary, if the market price of the share falls to Rs. 80 per share, then his wealth in the company will be reduced to Rs. 8,000 (100 × 80). It is, therefore, clear that wealth maximisation is possible only when market price of the shares rises. Question arises what steps should be taken by the financial manager to raise the market price of his company’s shares?

Answer to this question is that he should take all the three main financial decisions as under:

i. Optimum Investment Decision: It means he should take such decisions regarding investment as are relatively more profitable.

ii. Optimum Financing Decision: It means that he should make such a mix of debt capital and share capital as has the minimum cost of capital.

iii. Optimum Dividend Decision: It means that total profits of the company should be distributed among the shareholders in such a manner that they feel satisfied and at the same time company also has sufficient reserve to meet its future requirements.

Wealth Maximisation is the primary objective of financial management which means maximizing the market value of investment in the shares of the company.

It is possible only by:

(i) Ensuring availability of sufficient funds at reasonable cost.

(ii) Ensuring effective utilization of funds.

(iii) Ensuring safety of funds by creating reserves, reinvestment of profits, etc.

(a) If the working capital is higher, it results in higher current ratio, higher risk and higher profits.

(c) Higher debt-equity ratio results in higher degree of financial risk.

(c) Investment decision is related to careful selection of assets in which funds will be Invested by firms. Thus, the above case comes under the investment decision.

Major determinants of dividend decisions are as follows:

(i) Earnings

(ii) Cash flow position

(iii) Taxation policy

(iv) Shareholder preference

(b) If ROI is higher than cost of debt, financial leverage, in that case, is called favorable.

(d) Return on investment is higher than cost of debt.

When ROI is higher than cost of Debt