Financial Management — Meaning, Objectives & Three Decisions

Financial management class 12 NCERT explained — the meaning of business finance, the wealth-maximisation objective, and the three financial decisions (investment, financing, dividend) every firm faces, illustrated with the Tata Steel–Corus deal.

1.1 Introduction — Why Every Firm Faces Three Big Money Questions

Every business — from a corner shop to a global giant like Tata Steel — must answer three money questions at every stage of its life. Where to invest? Where to raise the money from? And how much of the profit to give back to shareholders? NCERT opens this chapter with a powerful real example: in 2007, Tata Steel acquired the Dutch steel firm Corus in a 12-billion-USD deal — the largest cross-border purchase by an Indian private company at that time. Tata Steel raised over USD 8 billion of debt for the deal, set up a special purpose vehicle (Tata Steel UK), drew on internal accruals, and even sold preference shares to its sister company Tata Sons. The total outlay reached around Rs 36,500 crore. Every part of that mix — debt vs equity, internal vs external, parent vs SPV — was a financial decision^?.

Such decisions need careful financial planning^?, an understanding of the resulting capital structure^?, and the riskiness and profitability of the enterprise. They have a direct bearing on shareholders and employees alike. They demand an understanding of business finance, the major financial decision areas, financial risk and the working-capital needs of the business.

1.2 Meaning of Business Finance

The money required for carrying out business activities is called business finance. Almost every activity inside a firm consumes finance. Finance is needed to establish a business, to run it, to modernise it, to expand it, or to diversify it. It is needed to buy a variety of assets — both tangible (machinery, factories, buildings, offices) and intangible (trademarks, patents, technical expertise). Finance is also central to running day-to-day operations — buying material, paying bills and salaries, collecting cash from customers — at every stage in the life of a business entity. Adequate finance, therefore, is crucial for both the survival and the growth of a business.

1.3 Financial Management — Definition and Scope

All finance comes at a cost. Hence the funds raised must be managed with the same care as a craftsman manages a tool. Financial Management is concerned with the optimal procurement as well as the usage of finance. For optimal procurement, the firm identifies and compares different available sources in terms of their costs and the risks they carry. The funds so procured must then be invested in such a way that the returns exceed the cost at which the money was raised.

In short, financial management aims at (a) reducing the cost of funds procured, (b) keeping the risk under control, and (c) ensuring effective deployment of funds. It also aims at securing enough funds whenever they are required and at avoiding idle finance. The future of a business depends a great deal on the quality of its financial management.

1.3.1 Importance — Why Financial Management Cannot be Over-Emphasised

The role of financial management has a direct bearing on the financial health of a business. Almost every item in the financial statements — Balance Sheet and Profit and Loss Account — is affected, directly or indirectly, by some financial-management decision. Some prominent examples are:

Hence the financial statements of a business are largely determined by financial-management decisions taken earlier. Future statements will likewise depend on past and current decisions. The overall financial health of the business is set by the quality of its financial management — good financial management mobilises resources at low cost and deploys them in the most lucrative activities.

1.4 Objectives of Financial Management — Wealth Maximisation

The primary aim of financial management is to maximise shareholders' wealth^?. Because a company's funds belong to the shareholders, the way those funds are invested and the return they earn determine the share's market value. Wealth maximisation, therefore, means maximisation of the market price of equity shares. The market price of an equity share rises if the benefit from a decision exceeds the cost involved.

All financial decisions aim at making sure that each decision is efficient and adds some value. Such value addition tends to push up the market price of shares. Efficient decision-making is selecting the best alternative out of all the available ones. When investing in a new machine, the aim is that benefits exceed cost; when procuring finance, the aim is to reduce the cost so that net value addition is even higher. Decisions that decrease the share price are poor financial decisions.

1.4.1 Wealth Maximisation vs Profit Maximisation

Older textbooks treated profit maximisation as the objective of financial management. Modern theory, and NCERT, prefer wealth maximisation for several reasons. Profit ignores the timing of returns, the risk involved, and the difference between accounting profit and the cash flows that actually reach the shareholder. Wealth maximisation captures all three.

1.5 The Three Financial Decisions — An Overview

Financial management is concerned with the solution of three major issues — corresponding to the three questions of investment, financing and dividend. In the financial context, this means selecting the best investment alternative and the best financing alternative and the best dividend policy. Each is summarised below; the next part of this chapter examines them in depth.

1.5.1 Investment Decision (Capital Budgeting)

A firm's resources are scarce compared with the uses to which they can be put. The firm therefore has to choose where to invest these resources so that they earn the highest possible return for the investors. The investment decision relates to how the firm's funds are invested in different assets.

Investment decisions are of two types:

• Long-term investment decisions — also called capital budgeting^? decisions. They commit finance for a long period — installing a new machine, replacing an existing one, opening a new branch, launching a new product line. They are crucial because they affect earning capacity in the long run; they involve huge amounts and are irreversible except at a heavy cost.
• Short-term investment decisions — also called working-capital decisions. They concern the levels of cash, inventory and receivables. They affect day-to-day operations and influence the liquidity as well as the profitability of the business.

1.5.2 Financing Decision (Capital Structure)

The financing decision deals with the quantum of finance to be raised from various long-term sources — short-term sources are studied under working-capital management. The main sources are:

• Shareholders' funds — equity capital and retained earnings (no compulsion to pay returns or repay capital).
• Borrowed funds — debentures and other forms of debt; interest must be paid whether or not the firm earns a profit, and principal must be repaid on maturity. The risk of default on these payments is called financial risk.

A firm needs a judicious mix of debt and equity. Debt is generally the cheapest source — interest is tax-deductible, lowering the after-tax cost — but it brings financial risk. Each source also has a floatation cost (the cost of raising the funds itself), which must be considered. The financing decision determines the overall cost of capital and the financial risk of the enterprise.

1.5.3 Dividend Decision

The third decision concerns the distribution of dividend — that portion of profit which is paid to shareholders. The choice is: how much of the after-tax profit will be paid out as dividend, and how much will be retained in the business. Dividends are the shareholders' current income; retained earnings reinvested in the firm raise the firm's future earning capacity. The size of retained earnings, therefore, also influences the financing decision (more retention means less external funding needed). The dividend decision must be taken keeping in mind the overall objective of maximising shareholders' wealth.

1.5.4 Three Decisions in Numbers — Tata Steel–Corus Snapshot

The opening case becomes more concrete in numbers. Of the roughly Rs 36,500 crore Tata Steel arranged, the bulk came from borrowing, with smaller portions from preference shares issued to Tata Sons and from internal accruals. The chart below visualises that mix — debt-heavy, but cushioned by equity-like sources.

Source: NCERT Box, Tata Steel acquisition of Corus, 2007. Approximate proportions; the exact split varied as bridge loans were refinanced. The example shows how the financing decision (debt-heavy) reshaped the capital structure of the acquirer.