Financial Management

Managing a firm’s funds: the investment, financing and dividend decisions, financial planning, capital structure and trading on equity, and fixed and working capital.

Key ideas

• Financial management gets the right amount of funds at the right time and cost and puts them to good use; its main aim is to maximise shareholders’ wealth.
• The investment decision chooses the assets (long-term ones by capital budgeting), the financing decision the mix of debt and equity, and the dividend decision how much profit to pay out.
• Financial planning estimates how much money is needed and where it will come from, so funds are ready when needed and not raised needlessly.
• Capital structure is the mix of debt and equity; debt is cheaper because interest is tax deductible, but it raises financial risk.
• Trading on equity uses debt to raise EPS; it works only when the return on investment is higher than the rate of interest.
• Fixed capital needs depend on the nature and scale of business, the technique and technology used, growth and diversification.
• Working capital needs depend on the nature and scale of business, the business cycle, seasons, the production cycle, credit allowed and taken, and operating efficiency.

Remember

Watch out

• Forgetting tax: EPS uses earnings after interest AND tax.
• Counting patents, furniture or debentures issued as current assets.
• Thinking more debt always raises EPS: when ROI is below the interest rate, it lowers EPS.

Worked example