FINANCIAL MANAGEMENT

FINANCIAL MANAGEMENT IN EXPANSION OF CAPITAL Expansion of capital implies to broaden the capital base of the enterprise by issuing long term sources of finance. There are two broad sources of long-term finance : Equity or Shareholders’ funds (a) Equity Share Capital (b) Retained Earnings (c) Preference Share Capital (B) Debt or Loan Funds (a) Loans (b) Debentures

FEATURES OF EQUITY SHARES (a) EQUITY SHARE CAPITAL Equity shares represent the ownership position in a company. The holders of these shares are called equity shareholders who are legal owners of the company. Their capital is permanent capital as it has no maturity date. They get dividend in return whose rate is not fixed. Therefore, an equity is also called variable income security. FEATURES OF EQUITY SHARES Right to Income Claim on Assets Right to Control Voting Rights Limited Liability

ADVANTAGES OF EQUITY CAPITAL 1. No compulsion to pay dividends 2. Permanent Capital 3. Cushion to Lenders 4. Tax-Exemption DISADVANTAGES OF EQUITY CAPITAL Cost Risk Earnings Dilution Product Ownership Dilution

(b) RETAINED EARNINGS ADVANTAGES OF RETAINED EARNINGS Retained earning means that part of trading profits which is not distributed in the form of dividends but retained by directors for future expansion of the company. Retained earning is an internal source if finance available to the company. In other words, it is a sacrifice made by equity shareholders also referred to as internal equity. Companies normally retain 30 percent to 80 percent of profit after tax for financing growth. ADVANTAGES OF RETAINED EARNINGS 1. Ready Availability : Being an internal source, these earnings are readily available to the management and directors don’t have to ask outsiders for finance. 2. Cheaper than External Equity : Retained earnings are cheaper than external equity because the floatation costs, brokerage costs, underwriting commission are other issue expenses are eliminated.

DISADVANTAGES OF RETAINED EARNINGS 3. No ownership Dilution : Relying on retained earnings eliminates the fear of ownership dilution and loss of control by the existing shareholders. 4. Positive Connotation : Retained earnings carry positive connotation as compared to equity issue as far as stock market is concerned. DISADVANTAGES OF RETAINED EARNINGS Limited Finance : The amount which can be raised by way of retained earnings will be limited to an extent only. Keeping in view a stable dividend policy, the directors can't exhaust the whole balance retained. As a result, the variability of profit after tax is substantially transmitted to retained earnings. High Opportunity Cost : The retained earnings are nothing but sacrifice of profits shareholders. In other words, retained earnings in dividend foregone by equity shareholders. This sacrifice increases the opportunity cost of retained earnings.

(c) PREFERENCE SHARE CAPITAL Shares which enjoy the preferential rights as to dividend and repayment of capital in the event of winding up of the company over the equity shares are called preference shares. The holder of preferences shares will get a fixed rate of dividend. FEATURES OF PREFERENCE SHARES 1. Claim on Income and Assets : Preference shares have a prior claim on the company’s income/dividends during its life time and prior claim on the assets of the company in the event of liquidation. Preference capital is paid after that of a debenture and before that of equity shares.

2. Voting Rights : Preferences shareholders have no voting right but they are granted voting right if the company skips preference dividend for three years. 3. Fixed Dividend : the dividend rate paid to the preference shareholders in fixed and dividends are not tax deductible also. There is no legal obligation to pay preference dividend. 4. Redemption : Redeemable preferences shares are those which have a specified maturity date whereas iredeemable preference shares are permanent or perpetual which are payable only in the event of winding up of a company. 5. Call Feature : The call feature permits the company to buy back preference shares at a stipulated buy-back price or cell price. 6. Tax-Exempt : Preference shares are tax-exempt in the hands of investors. The paying company, however, is required to pay & dividend tax of 10 percent.

(B) DEBT OR LOAN FUNDS Loans or Long-term Loans : The term loan here means long-term loans given by financial institutions. Term-loans also known as term-finance represent a debt finance which is repayable in less than 10 years. Long-term loans are raised to meet the financial requirements of the firm for acquiring fixed assets like the following or for expansion of the business. These assets could be : Land & Building Plant & Machinery Installation Expenses Vehicles Furniture & Fixtures

FEATURES OF LONG TERM LOANS Maturity : An explained, term loans are generally repayable within 5 to 15 years. whereas loans advanced by commercial banks are for a period of 3 to 5 years. 2. Currency : Financial institution give rupee loans as well as foreign currency term-loans. Rupee loans are given for setting up a new unit, for expansion, renovation and modernization of projects. FIs give foreign currency term-loans for meeting foreign currency expenditure like importing plant, machinery, equipment, technical know-how etc. 3. Security : If the loans are secured by assets acquired, this is known as prime security whereas if term loans are secured by company’s current and future assets, this is called secondary security. 4. Restrictive Covenants : In order to protect their interest further, the FIs generally impose restrictive conditions on the borrowers. 5. Interest and Principle Payment : Interest charges are tax-deductible in the hands of borrowing firm and borrower is also penalized for any default. Generally, the principal amount is repayable by the borrowing firm over a period of 6 to 10 years in semi-annual instalments.

(b) DEBENTURES FEATURE OF DEBENTURES A company may require large number of funds to finance its new project or its expansion. This requirement is met by the company partly by raising share capital and partly by depending on long term borrowing. When a company borrows money from the public, it issues certificated under its common-seal acknowledging a debt due by it to its holder. These certificates are called ‘Debentures”. FEATURE OF DEBENTURES Denomination : Debentures in India are issued in different denomination. Smaller public sector companies issue debentures in denomination of Rs. 100 which increases to Rs. 1000 in larger public sector companies. Security : Most of the debenture issues in India are secured by mortgages on the immovable properties of the company and a floating charge on its other assets.

3. Interest Rate : The interest rate, which is fixed and known to the debenture holders at the time of its issue, is called the contractual rate of interest. 4. Maturity : The maturity of a debenture means the length of time after the expiry of which the company returns the par value to debenture holders and terminates the debentures. 5. Buy-back (call) provision : Buy-back provision enables the company to redeem the debentures at a certain price before the maturity date. 6. Convertibility : Convertible debentures are those where an option is given to debenture holders to convert them into equity or preference shares at a stated rate of exchange after a certain period.

DIFFERENCES BETWEEN EQUITY AND DEBT DIFFERENCES BETWEEN TERM-LOAN AND DEBENTURES Debentures provide more flexibility than term-loans as they offer greater variety of choices with respect to maturity, interest rate, security, repayment and other special features. In case of debenture, the firm deals with numerous investors and in case of a term loan, a firm has to deal with one or few FIs. DIFFERENCES BETWEEN EQUITY AND DEBT Voice in Management Claims in Income and Assets Maturity Tax Treatment

FINANCIAL MANAGEMENT IN CURRENT OPERATIONS Financial management- whether large or small- is a critical element for success in business. Many potential enterprises fail because of faulty financial planning. Financial management is that managerial activity which is concerned with the planning and controlling of firm’s financial resources. Financial management in current operations means two concepts of working capital : Gross Working Capital Net Working Capital

COMPONENTS OF WORKING CAPITAL Cash : Cash is one of the most liquid and important components of working capital. Holding cash involves cost because the worth of cash held, after a year will be less than the value f cash as on today. Marketable Securities : These securities also don’t give much yield to the business of two reasons. (a) Marketable securities act as a substitute for cash, (b) These are used are temporary investments. Accounts Receivable : Too many debtors always lock up the firm’s resources especially during inflationary tendencies. When goods are sold, inventories are reduced and accounts receivables are created. Inventory : Inventories must be properly managed so that this investment doesn't become too large, as it would result in blocked capital which could be put to productive use elsewhere. Prepaid Expenses represent the services owned to the company, thereby eliminating the need for later cash outlays.

OPERATING CYCLE The operating cycle of a firm is defined as the amount of time that elapses from the point when the firms input material and labour turn into production process to the point when case is collected from the sale of finished product that contains these production inputs. The firm’s OC is simply the sum of the average age of inventory (AAI) and the average collection period (ACP) : OC = AAI + ACP cash Row materials Debters Work in progress Finished goods OPERATING CYCLE

FACTORS AFFECTING WORKING CAPITAL REQUIREMENTS Nature of Business The requirement of working capital of an enterprise depends upon the nature of business. A trading concern like a garments show room, a service concern like an electricity undertaking or a transport corporation have a short operating cycle. So their requirement for working capital is small.

Size of the Enterprise An enterprise working on a high level of activity has a higher level of working capital requirement and vice-versa. Seasonality of Operations Those firms which have marked seasonality in their operations have fluctuating working capital requirements. A firm manufacturing refrigerators will have maximum sales during summers seasons and minimum sales during winter seasons thus affecting its working capital.

Production Policy A firm having the product of seasonal nature may follow a policy of steady production in order to dampen the fluctuations in working capital requirements. A manufacturer of refrigerator will not intensify the production activity during the peak business rather he will follow a steady production throughout the year. Market Conditions When competitive conditions are prevailing in the market, a larger inventory of finished goods in needed as customers may not be inclined to wait. So conditions demand higher level of working capital, more investment in finished goods and debtors as well.

SOURCE OF FINANCING WORKING CAPITAL A firm can adopt three types of financing policies to finance its working capital Short-term Financing Long-term Financing Spontaneous Financing

Short-Term Financing Working Capital loan from commercial banks Cash credit Overdraft Demand Loan Purchasing and Discounting of Bills Public Deposits Factoring

Spontaneous Financing Advances from Customers Another way to raising funds for short- term requirement is demand for an advance from one’s own customer. For example, customers are asked for an advance at the time of booking a car, a computer, a flat etc. This money can be utilized by the entrepreneur to partly finance the working capital requirement. This is one of the cheapest source of short-term finance because the rate of interest paid to the customer for giving advance is either nil or every nominal.

Long-Term Finance Equity or Shareholders’ Funds Equity Share Capital Retained Earnings Preference Share Capital Debt or Loan Funds Loans Debentures

Advantages of Short-term Financing Speed A short-term loan can be obtained much faster than the long-term credit. A long term loan lender may ask for loan agreement, security and through examination of financial strength of the borrower. If the firm need funds in a hurry the firm should look to the short- term markets.

Flexibility If funds are needed only for seasonal or cyclical reasons, a firm would not commit itself to long-term debt for three reasons. Floatation costs are very high when raising long-term debt but marginal for short-term credit Long-term loan payment can be paid back early provided the loan agreement includes a pre-paid provision. Prepayment penalties could be expensive. Long -term agreement contains provisions, or covenant, which constrain the firm’s future actions.

Cost of Short-term Debt Interest rates are generally lower on short-term debts than on long-term debts. Under normal conditions, interest costs on short-term borrowing will be lesser than on a long-term borrowing

Disadvantages of Short-term Financing Risk for Short-term Borrowing Although short-term debt is less expensive than the long-term debt, short-term credit subjects the firm to more risk than does the long-term financing. This occurs because of two reasons. If two firm borrows a long-term basis, its interest cost will be relatively stable over time, but if it uses short-term credit, its interest expense will fluctuate widely, at times going quite high. too much dependence on short-term borrowing may drag the firm to the level of bankruptcy if the interest costs goes too high

If a firm borrows heavily on short-term basis, its may find itself unable to repay this debt, and it may be in such a weak financial position that the lender will not extend the loan, this too could force the firm into bankruptcy during credit crunch.