Chapter 9: Financial Management

Working capital in a business is the surplus that is determined by subtracting current liabilities from the current assets of the organisation. Current assets are those assets that can be converted into cash or cash equivalent within the current accounting period. Two broad categories of working capital can be classified:

1. Gross Working Capital

2. Net Working Capital

Gross Working Capital is referred to as the current assets that are present in the balance sheet of a company.

Net Working Capital is the difference between current assets and current liabilities present in the balance sheet of an organisation. Net working capital is considered to be more relevant for capital financing and management.

Working capital is calculated as

Working Capital = Current Assets – Current Liabilities

The following are the determinants of the working capital requirement:

1. Business Type: The nature of the business of a firm determines its working capital requirement. The size and type of operations of an organisation will affect the extent of working capital required. For example, firms that offer services will have low working capital requirements, whereas a manufacturing plant will have a large working capital requirement. The operating cycle of such a firm is more.

2. Scale of operations: The extent of the scale of operations is a determining factor for working capital. A firm having a large scale of operation will see an increase in working capital requirement as firms have a high requirement of maintaining inventory. Similarly, a firm having a small scale of operations will have a low working capital requirement.

3. Fluctuations of Business Cycle: The working capital will also vary with the different phases in which a business is running. During high demand in the market, there will be a high requirement for production; so, working capital will be more, whereas in terms of low demand.

4. Production Cycle: Every industry will have a different production cycle depending on the type of industry. A firm having a longer production cycle will have a higher requirement of working capital, and firms having a short production cycle will have a low working capital requirement.

5. Growth Prospects: Companies that have higher growth prospects and are looking for expansion have a higher working capital requirement.

Capital structure is the combination of debt and equity, which is used by a company to finance its requirements for funds. Debt can be obtained in the form of loans, while equity is generated through retained earnings or common stock. Borrowed funds can be in the form of loans, debentures, bank loans, etc. While in the case of an owner’s fund, it can be in the form of preference share capital, reserves, retained earnings, equity share capital, etc.

Debt and equity both have their risk and profitability. Debt is a relatively cheap source while the greater risk is there, and equity is comparatively expensive but is of lower risk for the firm. Fundraising through debt is cheaper, while same with equity is expensive. Debt, though cheaper, has more risks, as it has an obligation towards lenders. For equity, there is no such compulsion to pay dividends.

Also, the return offered by the sources leads to an increase in value per share. Debt gives higher returns per share but increases the risk comparatively many times.

Therefore, capital structure decisions should be taken into consideration with return and the amount of risk involved.

Capital budgeting decision needs to be taken very carefully, as the fortunes of a business can be changed with such a decision. The decision of capital budgeting is the allocation of fixed capital to different projects. Capital budgeting involves purchasing new assets, or it can be regarding the replacement or modernisation of the assets. All these decisions have a long-term impact on the business and can affect profitability and risk.

The following points highlight the importance of capital budgeting decisions:

1. Investment in long-term assets will yield returns in future and, by doing so, affect the future prospects of a business. Therefore, the kind of decision taken by a company will reflect on its long-term growth.

2. A large amount of funds is required to acquire assets. Therefore, the money that is invested will be blocked for a certain period, which makes it all the more important to plan capital budgeting decisions.

3. Acquiring assets is of high risk because it has a long-term impact on the business. If the return on the asset is less than the investment, the business will be impacted.

4. Decisions, once made, are irreversible as reversing leads to a great amount of loss.

A dividend decision is a decision to share a portion of profit which is to be shared between shareholders and what should be kept as retained earnings. The following factors affect dividend decisions:

1. Businesses are able to pay dividends from current and past earnings. A company which is having higher earnings will be in a better position to pay dividends in comparison to a company having limited earnings.

2. Companies having stable earning are in a good position to provide dividends as compared to companies which are inconsistent in earnings.

3. Companies follow a stable dividend-sharing policy. It will only be changed when there is a rise in earning.

4. Companies that are looking for higher growth may keep a certain portion of earning as dividends while investing the majority in expansion. Therefore, such companies offer lesser dividends.

5. If the company does not have a good cash flow, it will impact the dividends paid out.

6. Company must also check the shareholder preferences while paying dividends, as shareholders may require a certain amount of dividend.

7. Taxation policies play a major role in deciding the dividends. A policy levying high tax on dividend distribution leads to companies offering lower dividends and vice versa.

8. Stock market prices will fluctuate depending on the dividend that is declared. It can rise with a high dividend payout while declining with a low dividend payout.

9. There can be contractual constraints at the time of offering loans that are imposed by the lender in the form of an agreement. Such agreements need to be checked before issuing dividend payouts.

10. Companies having greater access to capital markets can pay a higher dividend and vice versa.

11. Companies have to follow the rules, regulations and restrictions of the Companies Act while declaring dividend pay-out.

Trading on equity is a process of using debt in order to produce a gain for the owners. In this process, new debt is taken in order to gain new assets with which they can earn a greater level of interest, which is more than the interest that is paid for the debt. This process is practised as the equity shareholders are only interested in the income that is generated from the business. It is only practised by a company when the rate of return on investment is greater than the rate of interest for the fund that is borrowed. This practice is a form of financial leverage that a company exercises. There is an increase in earnings per share when this process is adopted.

Trading on equity is profitable only when the return on investment is greater than the amount of funds borrowed. It is said that trading on equity shall be avoided if the return on investment is less than the rate of interest from the funds that are borrowed.

Solution coming soon.