Small Business Management Notes - Financial Management | B.Com Notes

Financial management is management principles and practices applied to finance. General management functions include planning, execution and control. Financial decision making includes decisions as to size of investment, sources of capital, extent of use of different sources of capital and extent of retention of profit or dividend payout ratio. Financial management, is therefore, planning, execution and control of investment of money resources, raising of such resources and retention of profit/payment of dividend.

Howard and Upton define financial management as "that administrative area or set of administrative functions in an organisation which have to do with the management of the flow of cash so that the organisation will have the means to carry out its objectives as satisfactorily as possible and at the same time meets its obligations as they become due.

Bonneville and Dewey interpret that financing consists in the raising, providing and managing all the money, capital or funds of any kind to be used in connection with the small business.

Osbon defines financial management as the "process of acquiring and utilizing funds by a small business”.

Considering all these views, financial management may be defined as that part of management which is concerned mainly with raising funds in the most economic and suitable manner, using these funds as profitably as possible.

Nature or Features or Characteristics of Financial Management

Nature of financial management is concerned with its functions, its goals, trade-off with conflicting goals, its indispensability, its systems, its relation with other subsystems in the firm, its environment, its relationship with other disciplines, the procedural aspects and its equation with other divisions within the organisation.

The finance function encompasses the activities of raising funds, investing them in assets and distributing returns earned from assets to shareholders. While doing these activities, a firm attempts to balance cash inflow and outflow. It is evident that the finance function involves the four decisions viz., financing decision, investment decision, dividend decision and liquidity decision. Thus the finance function includes:

1. Investment Decision: The investment decision, also known as capital budgeting, is concerned with the selection of an investment proposal/ proposals and the investment of funds in the selected proposal. A capital budgeting decision involves the decision of allocation of funds to long-term assets that would yield cash flows in the future. Two important aspects of investment decisions are:

(a) The evaluation of the prospective profitability of new investments, and

(b) The measurement of a cut-off rate against that the prospective return of new investments could be compared.

Future benefits of investments are difficult to measure and cannot be predicted with certainty. Risk in investment arises because of the uncertain returns. Investment proposals should, therefore, be evaluated in terms of both expected return and risk. Besides the decision to commit funds in new investment proposals, capital budgeting also involves replacement decision, that is decision of recommitting funds when an asset become less productive or non-profitable. The computation of the risk-adjusted return and the required rate of return, selection of the project on these bases, form the subject-matter of the investment decision.

Long-term investment decisions may be both internal and external. In the former, the finance manager has to determine which capital expenditure projects have to be undertaken, the amount of funds to be committed and the ways in which the funds are to be allocated among different investment outlets. In the latter case, the finance manager is concerned with the investment of funds outside the small business for merger with, or acquisition of, another firm.

2.Financing Decision: Financing decision is the second important function to be performed by the financial manager. Broadly, he or she must decide when, from where and how to acquire funds to meet the firm’s investment needs. The central issue before him or her is to determine the appropriate proportion of equity and debt. The mix of debt and equity is known as the firm’s capital structure. The financial manager must strive to obtain the best financing mix or the optimum capital structure for his or her firm. The firm’s capital structure is considered optimum when the market value of shares is maximized.

The use of debt affects the return and risk of shareholders; it may increase the return on equity funds, but it always increases risk as well. The change in the shareholders’ return caused by the change in the profit is called the financial leverage. A proper balance will have to be struck between return and risk. When the shareholders’ return is maximized with given risk, the market value per share will be maximized and the firm’s capital structure would be considered optimum. Once the financial manager is able to determine the best combination of debt and equity, he or she must raise the appropriate amount through the best available sources. In practice, a firm considers many other factors such as control, flexibility, loan covenants, legal aspects etc. in deciding its capital structure. 

3. Dividend Decision: Dividend decision is the third major financial decision. The financial manager must decide whether the firm should distribute all profits, or retain them, or distribute a portion and return the balance. The proportion of profits distributed as dividends is called the dividend-payout ratio and the retained portion of profits is known as the retention ratio. Like the debt policy, the dividend policy should be determined in terms of its impact on the shareholders’ value. The optimum dividend policy is one that maximizes the market value of the firm’s shares. Thus, if shareholders are not indifferent to the firm’s dividend policy, the financial manager must determine the optimum dividend-payout ratio. Dividends are generally paid in cash. But a firm may issue bonus shares. Bonus shares are shares issued to the existing shareholders without any charge. The financial manager should consider the questions of dividend stability, bonus shares and cash dividends in practice. 

4. Liquidity Decision: Investment in current assets affects the firm’s profitability and liquidity. Current assets should be managed efficiently for safeguarding the firm against the risk of illiquidity. Lack of liquidity in extreme situations can lead to the firm’s insolvency. A conflict exists between profitability and liquidity while managing current assets. If the firm does not invest sufficient funds in current assets, it may become illiquid and therefore, risky. But if the firm invests heavily in the current assets, then it would loose interest as idle current assets would not earn anything. Thus, a proper trade-off must be achieved between profitability and liquidity. The profitability-liquidity trade-off requires that the financial manager should develop sound techniques of managing current assets and make sure that funds would be made available when needed. 

Finance is the lifeblood of small business concern, because it is interlinked with all activities performed by the small business concern. In a human body, if blood circulation is not proper, body function will stop. Similarly, if the finance not being properly arranged, the small business system will stop. Arrangement of the required finance to each department of small business concern is highly a complex one and it needs careful decision. Quantum of finance may be depending upon the nature and situation of the small business concern. But, the requirement of the finance may be broadly classified into two parts:

Long-term Financial Requirements or Fixed Capital Requirement: Financial requirement of the small business differs from firm to firm and the nature of the requirements on the basis of terms or period of financial requirement, it may be long term and short-term financial requirements. Long-term financial requirement means the finance needed to acquire land and building for small business concern, purchase of plant and machinery and other fixed expenditure. Long term financial requirement is also called as fixed capital requirements. Fixed capital is the capital, which is used to purchase the fixed assets of the firms such as land and building, furniture and fittings, plant and machinery, etc. Hence, it is also called a capital expenditure.

Short-term Financial Requirements or Working Capital Requirement: Apart from the capital expenditure of the firms, the firms should need certain expenditure like procurement of raw materials, payment of wages, day-to-day expenditures, etc. This kind of expenditure is to meet with the help of short-term financial requirements which will meet the operational expenditure of the firms. Short-term financial requirements are popularly known as working capital.

Fixed capital is the capital, which is needed for meeting the permanent or long-term purpose of the small business concern. Fixed capital is required mainly for the purpose of meeting capital expenditure of the small business concern and it is used over a long period. It is the amount invested in various fixed or permanent assets, which are necessary for a small business concern.

According to the definition of Hoagland, “Fixed capital is comparatively easily defined to include land, building, machinery and other assets having a relatively permanent existence”.

Characteristics of Fixed Capital

● Fixed capital is used to acquire the fixed assets of the small business concern.

● Fixed capital meets the capital expenditure of the small business concern.

● Fixed capital normally consists of long period.

● Fixed capital expenditure is of nonrecurring nature.

● Fixed capital can be raised only with the help of long-term sources of finance.

Sources of finance mean the ways for mobilizing various terms of finance to the industrial concern. Sources of finance state that, how the companies are mobilizing finance for their requirements. The companies belong to the existing or the new which need sum amount of finance to meet the long-term and short-term requirements such as purchasing of fixed assets, construction of office building, purchase of raw materials and day-to-day expenses. Sources of finance may be classified under various categories according to the following important heads:

1. Based on the Period

Sources of Finance may be classified under various categories based on the period. Long-term sources: Finance may be mobilized by long-term or short-term. When the finance mobilized with large amount and the repayable over the period will be more than five years, it may be considered as long-term sources. Share capital, issue of debenture, long-term loans from financial institutions and commercial banks come under this kind of source of finance. Long-term source of finance needs to meet the capital expenditure of the firms such as purchase of fixed assets, land and buildings, etc.

Long-term sources of finance include:

● Equity Shares

● Preference Shares

● Debenture

● Long-term Loans

● Fixed Deposits

Short-term sources: Apart from the long-term source of finance, firms can generate finance with the help of short-term sources like loans and advances from commercial banks, moneylenders, etc. Short-term source of finance needs to meet the operational expenditure of the small business concern.

Short-term source of finance include:

● Bank Credit

● Customer Advances

● Trade Credit

● Factoring

● Public Deposits

● Money Market Instruments

2. Based on Ownership

Sources of Finance may be classified under various categories based on the period:

An ownership source of finance include

● Shares capital, earnings

● Retained earnings

● Surplus and Profits

Borrowed capital include

● Debenture

● Bonds

● Public deposits

● Loans from Bank and Financial Institutions.

3. Based on Sources of Generation

Sources of Finance may be classified into various categories based on the period.

Internal source of finance includes

● Retained earnings

● Depreciation funds

● Surplus

External sources of finance may be include

● Share capital

● Debenture

● Public deposits

● Loans from Banks and Financial institutions

4. Based in Mode of Finance

Security finance may be include

● Shares capital

● Debenture

Retained earnings may include

● Retained earnings

● Depreciation funds

Loan finance may include

● Long-term loans from Financial Institutions

● Short-term loans from Commercial banks.

The capital required for a small business is of two types. These are fixed capital and working capital. Fixed capital is required for the purchase of fixed assets like building, land, machinery, furniture etc. Fixed capital is invested for long period, therefore it is known as long-term capital. Similarly, the capital, which is needed for investing in current assets, is called working capital. The capital which is needed for the regular operation of small business is called working capital. Working capital is also called circulating capital or revolving capital or short-term capital.

In the words of John. J Harpton “Working capital may be defined as all the shot term assets used in daily operation”.

According to “Hoagland”, “Working Capital is descriptive of that capital which is not fixed. But, the more common use of Working Capital is to consider it as the difference between the book value of the current assets and the current liabilities.

From the above definitions, Working Capital means the excess of Current Assets over Current Liabilities. Working Capital is the amount of net Current Assets. It is the investments made by a small business organisation in short term Current Assets like Cash, Debtors, Bills receivable etc.

Concepts of Working Capital

There are two concepts of working capital:

Gross working capital refers to investment in all current assets -raw materials, work-in-progress, finished goods, book debts, bank balance and cash balance. The gross concept of working capital is significant in the context of measuring working capital needed, measuring the size of the small business, continued and smooth flow of operations of the small business and the like.

Net working capital refers to the excess of current assets over current liabilities. That is, value of current assets minus value of current liabilities (current liabilities include trade creditors, bills payable, outstanding expenses such as wages, salaries, dividend payable and tax payable, bank overdraft, etc.) The net concept of working capital is significant in the context of financing of working capital, the short term liquidity aspects of the small business, and the like.

Classification of Working Capital

Some portion of working capital is fixed natured and some portion fluctuates for some time. In the view point working capital classified in to 2 classes,

Fixed or permanent working capital: The fund, which is required to produce a certain amount of goods or services at a certain period of time, is called Fixed working capital. The minimum amount of cash money, A/R, which are kept to operate the small business is called Fixed working capital.

Variable working capital: When extra working capital is required then a addition to fixed working capital due to seasonal causes or increased production or sales, this working capital is variable working capital. So, the working capital which fluctuates with keeping the relation between production & Sales is variable working capital.

Working Capital means excess of current assets over current liabilities. Such Working Capital is required to smooth conduct of small business activities. It is as important as blood to body. An organisation’s profitability depends on the quantum of Working Capital available to it. Adequate Working Capital is a source of energy to any small business organisation. It is the life blood of an organisation. The following points will highlight the need of adequate working capital:

a) Enables a company to meet its obligations: Working capital helps to operate the small business smoothly without any financial problem for making the payment of short-term liabilities. Purchase of raw materials and payment of salary, wages and overhead can be made without any delay. Adequate working capital helps in maintaining solvency of the small business by providing uninterrupted flow of production.

b) Enhance Goodwill:  Sufficient working capital enables a small business concern to make prompt payments and hence helps in creating and maintaining goodwill. Goodwill is enhanced because all current liabilities and operating expenses are paid on time.

c) Facilitates obtaining Credit from banks without any difficulty: A firm having adequate working capital, high solvency and good credit rating can arrange loans from banks and financial institutions in easy and favorable terms.

d) Regular Supply of Raw Material: Quick payment of credit purchase of raw materials ensures the regular supply of raw materials fro suppliers. Suppliers are satisfied by the payment on time. It ensures regular supply of raw materials and continuous production. Prompt payments to its creditors also enable a company to take advantage of cash and quantity discounts offered by them.

e) Smooth Small business Operation: Working capital is really a life blood of any small business organization which maintains the firm in well condition. Any day to day financial requirement can be met without any shortage of fund. All expenses and current liabilities are paid on time.

f) Ability to Face Crisis: Adequate working capital enables a firm to face small business crisis in emergencies such as depression.

g) It improves the prospects of prosperity and progress of a company.

Thus, adequate Working Capital is an important factor for prosperity and smooth running of a small business organisation. It is rightly called as the “backbone” of the financial structure of a small business organisation.

The level of working capital is influenced by several factors which are given below:

There are broadly three methods of estimating the requirement of working capital of a company viz. percentage of revenue or sales, regression analysis, and operating cycle method. Estimating working capital means calculating future working capital. It should be as accurate as possible because planning of working capital would be based on these estimates and bank and other financial institutes finances the working capital needs based on such estimates only.

a) Percentage of Sales Method: It is the easiest of the methods for calculating the working capital requirement of a company. This method is based on the principle of ‘history repeats itself’. For estimating, relationship of sales and working capital is worked out for say last 5 years. If it is constantly coming near say 40% i.e. working capital level is 40% of sales, the next year estimation is done based on this estimate. If the expected sales is 500 million dollars, 200 million dollars would be required as working capital.

Advantage of this method is that it is simple to understand and calculate also. Disadvantage includes its assumption which is difficult to be true for many organizations. So, where there is no linear relationship between the revenue and working capital, this method is not useful. In new startup projects also this method is not applicable because there is no past.

b) Regression Analysis Method: This statistical estimation tool is utilized by mass for various types of estimation. It tries to establish trend relationship. We will use it for working capital estimation. This method expresses the relationship between revenue & working capital in the form of an equation (Working Capital = Intercept + Slope * Revenue). Slope is the rate of change of working capital with one unit change in revenue. Intercept is the point where regression line and working capital axis meets.

c) Operating cycle method: Operating cycle is the time duration required to convert sales, after the conversion of resources into inventories and cash.  The operating  cycle of a manufacturing co involves 3 segments:

i)  Acquisition of resources like  raw labor, material, fuel and power 

ii) Manufacture of the product that includes conversion of raw material into  work  in  process  and into finished goods, and

iii) sales of the product either for cash or credit.  Credit sales create book debts for collection (debtors).

The length  of  the  operating  cycle  of a  manufacturing co  is  the  sum  of - i)   inventory conversion period (ICP) and ii)   Book debts conversion period (BDCP) collectively, they are sometimes called as gross operating cycle (GOC).

GOC = ICP + DCP

The Inventory conversion period is the entire time needed for producing and selling the product and includes:

(a) Raw material conversion time (RMCP)

(b) Work in process conversion period (WIPCP) and

(c)  Finished good conversion period (FGCP).

ICP = RMCP + WIPCP + FGCP

The payables deferral period (PDP) is the length of time the firm is capable to defer payments on various resource purchases. The variation between the gross operating cycle and payables deferrals period is the net operating cycle (NOC).

NOC = GOC- Payables deferral period.

Sources of working capital are many. There are both external and internal sources. The external sources are both short-term and long-term. Trade credit, commercial banks, finance companies, indigenous bankers, public deposits, advances from customers, accrual accounts, loans and advances from directors and group companies etc. are external short-term sources. Companies can also issue debentures and invite public deposits for working capital which are external long term sources. Equity funds may also be used for working capital. A brief discussion of each source is attempted below.

Trade credit is a short term credit facility extended by suppliers of raw materials and other suppliers. It is a common source. It is an important source. Trade credit is an informal and readily available credit facility. It is unsecured. It is flexible too; that is advance retirement or extension of credit period can be negotiated. Trade credit might be costlier as the supplier may inflate the price to account for the loss of interest for delayed payment.

Commercial banks are the next important source of working capital finance commercial banking system in the country is broad based and fairly developed. Straight loans, cash credits, hypothecation loans, pledge loans, overdrafts and bill purchase and discounting are the principal forms of working capital finance provided by commercial banks.  They provide loan in the following form:

Finance companies abound in the country. About 50000 companies exist at present. They provide services almost similar to banks, though not they are banks. They provide need based loans and sometimes arrange loans from others for customers. Interest rate is higher. But timely assistance may be obtained.

Indigenous bankers also abound and provide financial assistance to small business and trades. They change exorbitant rates of interest by very much understanding.

Public deposits are unsecured deposits raised by small businesses for periods exceeding a year but not more than 3 years by manufacturing concerns and not more than 5 years by non-banking finance companies. The RBI is regulating deposit taking by these companies in order to protect the depositors. Quantity restriction is placed at 25% of paid up capital + free services for deposits solicited from public is prescribed for non-banking manufacturing concerns. The rate of interest ceiling is also fixed. This form of working capital financing is resorted to by well established companies.

Advances from customers are normally demanded by producers of costly goods at the time of accepting orders for supply of goods. Contractors might also demand advance from customers. Where sellers* market prevail advances from customers may be insisted. In certain cases to ensure performance of contract in advance may be insisted.

Accrual accounts are simply outstanding dues to workers, suppliers of overhead service requirements and the like. Outstanding wages, taxes due, dividend provision, etc. are accrual accounts providing working capital finance for short period on a regular basis.

Loans from directors, loans from group companies etc. constitute another source of working capital. Cash rich companies lend to liquidity crunch companies of the group.

Commercial papers can be used to raise funds. It is a promissory note carrying the undertaking to repay the amount on or after a particular date. Normally it is an unsecured means of borrowing and the companies are allowed to issue commercial papers as per the regulations issued by SEBI and Company’s Act.

Debentures and equity fund can be issued to finance working capital so that the permanent working capital can be matchingly financed through long term funds.

Working Capital requirements depend upon the operating cycle (O) of the small business. The operating cycle begins with the acquisition of raw material and ends with the collection of receivables. Operating cycle consists of the following important stages:

1. Raw Material and Storage Stage, (R)

2. Work in Process Stage, (W)

3. Finished Goods Stage, (F)

4. Debtors Collection Stage, (D)

5. Creditors Payment Period Stage. (C)

Operating cycle is calculated as follows: O = R + W + F + D–C

Each component of the operating cycle can be calculated by the following formula:

R = Average Stock of Raw Material/Average Raw Material Consumption Per Day

W= Average Work in Process Inventory/Average Cost of Production Per Day

F = Average Finished Stock Inventory/Average Cost of Goods Sold Per Day

D = Average Book Debts/Average Credit Sales Per Day

C = Average Trade Creditors /Average Credit Purchase Per Day