Financial Management
Financial management deals with procuring and using funds efficiently. This domain tests the three decisions, capital structure and leverage, fixed versus working capital, and the factors that shape each.
The three decisions
- Investment decision: long-term in fixed assets (capital budgeting) and short-term in working capital.
- Financing decision: the capital structure, that is the mix of debt and equity.
- Dividend decision: how much profit to distribute and how much to retain.
Capital structure and leverage
Debt is cheaper because interest is tax-deductible, but it raises financial risk. Financial leverage = EBIT ÷ (EBIT − Interest). Using debt to magnify earnings per share is called trading on equity.
Fixed versus working capital
Fixed capital funds land, plant and machinery and is needed long-term. Working capital = current assets − current liabilities and funds day-to-day operations. Factors for fixed capital: nature of business, scale of operations, technology, growth plans, diversification. Factors for working capital: nature of business, business cycle, operating cycle, credit policy, availability of raw material.
Worked example
EBIT is ₹10 lakh and interest is ₹2 lakh. Leverage = 10 ÷ (10 − 2) = 1.25, so a 10% change in EBIT produces a 12.5% change in EPS. Reasoning: leverage magnifies both profit and risk, which is why a highly geared firm is riskier. For working capital, current assets of ₹6 lakh and current liabilities of ₹2.5 lakh give ₹3.5 lakh.
Traps that cost marks
Confusing capital structure (debt plus equity) with financial structure (all liabilities including current); assuming more debt always lowers the cost of capital; confusing the operating cycle with the business cycle.