Financial Management
Financial Management tests the financing, investment and dividend decisions at a computational level: ratio interpretation, leverage, time value of money and the link between risk and required return.
Core rules
- The objective is shareholder wealth maximisation, not accounting profit maximisation.
- Operating leverage = Contribution/EBIT. Financial leverage = EBIT/EBT. Combined leverage = OL × FL.
- Where preference capital exists, FL = EBIT ÷ [EBT − Preference dividend/(1 − t)], because the dividend is paid out of post-tax profit.
- Key ratios: current ratio, quick ratio, debt–equity, interest coverage (EBIT/Interest), return on equity.
- Time value of money: use annuity factors for level cash flows and compound/discount in the correct direction; a rupee today is worth more than a rupee later.
Worked example
Sales ₹10,00,000; variable cost 60% of sales; fixed cost ₹2,00,000; interest ₹50,000. Contribution = ₹4,00,000; EBIT = ₹2,00,000; EBT = ₹1,50,000. OL = 4,00,000/2,00,000 = 2.0; FL = 2,00,000/1,50,000 = 1.33; CL = 2.67. A 10% rise in sales therefore lifts EBIT by 20% and profit before tax by about 26.7%.
Traps
Using sales instead of contribution in operating leverage; using PAT instead of EBT in financial leverage; omitting the tax gross-up on preference dividend; assuming a higher current ratio is always better, when idle cash and slow-moving inventory also inflate it.