Financial Management is the activity concerned with planning, raising, controlling, and administering funds used in a business. Its goal is to maximise shareholder wealth by making optimal decisions about investment, financing, and dividends.
Objectives of Financial Management
- The primary objective is wealth maximisation (maximising market value of equity shares), which is superior to profit maximisation because:
- It considers time value of money — a rupee today is worth more than a rupee tomorrow.
- It considers risk — higher expected returns often come with higher risk.
- It focuses on long-term value, not just current profit.
Financial Decisions — The Three Core Decisions
1. Investment Decision (Capital Budgeting)
How should a firm allocate its long-term funds among different assets?
- Long-term investment decisions involve acquiring fixed assets (land, machinery, plant). These are evaluated using techniques like Payback Period, NPV (Net Present Value), and IRR (Internal Rate of Return).
- Short-term investment decisions (Working Capital Management) involve managing current assets (cash, debtors, inventory) and current liabilities efficiently.
Factors affecting investment decisions: cash flows of the project, expected rate of return, risk involved.
2. Financing Decision
How should a firm raise the funds it needs?
- A firm can raise funds through:
- Owners' funds (Equity): Equity shares, retained earnings. Equity shareholders are residual claimants; they get paid last but have ownership rights.
- Borrowed funds (Debt): Debentures, bank loans, bonds. Debt has a fixed obligation (interest) and is tax-deductible.
Financial Leverage (Trading on Equity): Using debt (borrowed funds) to increase returns on equity shareholders' investment. It amplifies returns when EBIT > Interest cost, but also amplifies losses when returns are low.
Capital Structure is the mix of debt and equity. An optimal capital structure maximises firm value and minimises the overall cost of capital.
- Factors affecting financing decision:
- Cost of capital
- Cash flow position
- Control considerations (more equity = less control dilution for owners)
- Risk appetite of management
- Tax considerations (interest on debt is tax-deductible)
- Floatation costs
3. Dividend Decision
What portion of net profit should be paid to shareholders as dividends, and what portion should be retained?
Dividend payout ratio = Dividends / Net Profit x 100
Retention ratio = Retained Earnings / Net Profit x 100
- Factors affecting dividend decision:
- Earnings stability — only stable companies pay regular dividends.
- Growth opportunities — high-growth firms prefer to retain earnings.
- Cash flow position — dividends require cash, not just profits.
- Tax considerations — dividends may be taxed differently than capital gains.
- Legal restrictions — dividends can only be paid from profits, not capital.
- Shareholders' preferences — some prefer regular income; others prefer capital growth.
Financial Planning
Financial Planning is the process of estimating the funds required and determining their sources and timing. It ensures that enough funds are available at the right time.
Objectives: Ensuring availability of funds; ensuring that the firm does not raise funds unnecessarily (over-capitalisation is wasteful).
Importance: Facilitates growth, helps in coordination, reduces uncertainty, helps in anticipating surplus or shortage of funds.
Trading on Equity (Financial Leverage)
Trading on equity means using borrowed funds to increase the return earned by equity shareholders. It works when EBIT > Interest cost.
Company B has equity Rs. 5,00,000 and debt Rs. 5,00,000 at 12%. EBIT = Rs. 2,00,000.
- Interest = 12% x 5,00,000 = Rs. 60,000; EBT = Rs. 1,40,000
- Return on equity = 1,40,000 / 5,00,000 = 28% (vs. 20% with no debt)
If EBIT < Interest, leverage harms equity shareholders.
---
Common mistakes
- Profit maximisation ignores risk and time value; wealth maximisation accounts for both — always prefer wealth maximisation as the objective.
- Trading on equity benefits equity holders only when return on investment exceeds the cost of debt.
- Dividend and retained earnings are inversely related — more dividends mean less reinvestment and vice versa.
---
Summary
Financial management centres on three decisions: investment (where to deploy funds), financing (how to raise funds), and dividend (how much to distribute). Wealth maximisation and sound financial planning ensure long-term organisational health.