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NCERT · Class 12 · Business Studies

Chapter 9: Financial Management

Practice each question, then open the answer or worked solution.

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Short Answer Questions NCERT Business Studies Solutions Class 12 Chapter 9

7 questions
Q1Written answer

What is financial risk? Why does it arise?

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Worked solution

Financial risk is said to be the situation when a company is unable to meet its set of fixed expenses such as interest payment, loan repayment and preference dividend pay-out. It is a situation where a company is unable to meet its financial obligations. Financial risk arises due to the high level of debt in the capital structure. A high level of debt leads to a high amount of interest which increases the chances of defaulting on payment.

Q2Written answer

Define a ‘current asset’. Give four examples of such assets.

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The current assets of a firm are those assets that have the potential to be converted into cash or cash equivalents within the current accounting period. Current assets provide liquidity to the company. Examples of current assets are cash, short-term investment, marketable securities and debtors.

Q3Written answer

What are the main objectives of financial management? Briefly explain.

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The main objective of financial management is the maximisation of shareholders’ wealth. Therefore, financial management is all about making those decisions that will bring gains for the shareholders. Gains can be said to be achieved when the market value of shares rises. Once the primary objective of wealth maximisation is achieved, the other objectives, such as maintaining liquidity and proper utilisation of funds, are fulfilled along with it.

Q4Written answer

Financial management is based on three broad financial decisions. What are these?

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Financial management is the technique of proper allocation, acquisition and use of funds by the company. The three broad financial decisions on which financial management is based are investment decisions, financial decisions and dividend decisions.

Q5Written answer

Sunrises Ltd., dealing in readymade garments, is planning to expand its business operations in order to cater to the international market. For this purpose, the company needs an additional 80,00,000 to replace machines with modern machinery of higher production capacity. The company wishes to raise the required funds by issuing debentures. The debt can be issued at an estimated cost of 10%. The EBIT for the previous year of the company was 8,00,000, and the total capital investment was 1,00,00,000. Suggest whether the issue of debenture would be considered a rational decision by the company. Give reasons to justify your answer. (Ans. No, the Cost of Debt (10%) is more than ROI which is 8%).

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Worked solution

A company is able to issue debentures for fundraising when the debt cost is less than the cost of capital.

In this question, the cost of capital of Sunrises Limited is 10% which is 8,00,000, as the total capital is 80,00,000.

Now, the return on investment is calculated as

ROI = Return / Investment

= 8,00,000/1,00,00,000

= 8 %

Assuming that the company will be operating with the same efficiency, the additional investment of 80,00,000 will have an ROI of 8%, which will amount to 6,40,000.

The cost of debt will be 8,00,000, which is more than the ROI of 6,40,000. Therefore, it is advisable for a company not to issue a debenture when the cost of debt is higher than the cost of capital.

Q6Written answer

How does working capital affect both the liquidity as well as the profitability of a business?

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Working capital in a business is the surplus that is determined by subtracting current liabilities from the current assets of the organisation. By increasing the working capital, the liquidity of an organisation increases. But more current assets present in business results in a fall in profitability of the organisation, as current assets offer low returns, which cause a decline in the profit of a business.

Q7Written answer

Aval Ltd. is engaged in the business of export of canvas goods and bags. In the past, the performance of the company had been up to expectations. In line with the latest demand in the market, the company decided to venture into leather goods, for which it required specialised machinery. For this, the Finance Manager Prabhu prepared a financial blueprint of the organisation’s future operations to estimate the number of funds required and the timings with the objective of ensuring that enough funds are available at the right time. He also collected relevant data about the profit estimates for the coming years. By doing this, he wanted to be sure about the availability of funds from the internal sources of the business. For the remaining funds, he is trying to find out alternative sources from outside.

a. Identify the financial concept discussed in the above paragraph. Also, state the objectives to be achieved by the use of the financial concept so identified. (Financial Planning)

b. ‘There is no restriction on payment of dividends by a company.’ Comment. (Legal & Contractual Constraints)

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Worked solution

a. The financial concept discussed here is capital budgeting; it is the decision regarding capital investment which will have an impact on the profitability of the company in the long term.

The company wants to invest in new machinery, which needs investment, this will have a direct impact on the operations, which will result in affecting the profitability of the organisation.

The following objectives can be achieved:

1. Cash flow: Investment will bring new machinery, which will increase organisations’ profitability.

2. When a company wants to raise funds from both inside and outside the organisation, it will be helpful to analyse that return generated from such investment will be more than the cost of capital.

3. Investment used: The company is planning to raise funds from both inside and outside. It is important to know that funds from internal and external sources will have different rates of interest.

b. Companies pay dividends to shareholders, which are part of the company earnings. Paying of dividends is based on the following factors:

1. Legal Constraint: Legal constraints are such constraints that are mentioned in the company laws which impact paying out dividends on certain occasions. It should be followed properly.

2. Contractual Constraints: Paying out of dividends reduces cash in the company. Money that is raised as a loan will put certain restrictions on the company for paying dividends, such constraints are called contractual constraints.