Financial Management NCERT Solutions | Business Studies (BST) Class 12 - Commerce PDF Download

Very Short Answer Type Questions

Q2: State the two objectives of financial planning.
Ans:

1. To ensure the availability of funds whenever required.
2. To avoid raising resources unnecessarily and ensuring funds are used optimally.

Q3: Name the concept of financial management which increases the return to equity shareholders due to the presence of fixed financial charges.
Ans: Trading on Equity.

Q4: Amrit is running a ‘transport service’ and earning good returns by providing this service to industries. Giving reason, state whether the working capital requirement of the firm will be ‘less’ or ‘more’.
Ans: The working capital requirement of the firm will be less because the transport business involves minimal investment in current assets like inventory or receivables, which reduces the need for working capital.

Q5: Ramnath is into the business of assembling and selling televisions. Recently he has adopted a new policy of purchasing the components on three months' credit and selling the complete product in cash. Will it affect the requirement of working capital? Give reason in support of your answer.
Ans: The requirement for working capital will be less because purchasing components on credit delays cash outflow, while selling the products in cash ensures immediate cash inflow, reducing the need for working capital. 

Short Answer Type Questions

Q2: Define current assets? Give four examples of such assets.
Ans: Current assets are those assets of the business which can be converted into cash within a period of one year. Cash in hand or at bank, bills receivables, debtors, finished goods inventory are some of the examples of current assets.

Q3: What are the main objectives of financial management? Briefly explain.
Ans: The main objectives of financial management are:

1. Profit Maximization: Ensuring the business earns adequate returns on its investments.
2. Wealth Maximization: Enhancing the value of shareholders by increasing the company’s market value.
3. Maintaining Liquidity: Ensuring sufficient funds are available for operational needs.
4. Optimal Utilization of Funds: Efficiently allocating resources to achieve maximum output.

Q4: Financial management is based on three broad financial decisions. What are these?
Ans: Financial management is concerned with the solution of three major issues relating to the financial operations of a firm corresponding to the three questions of Investment, financing and dividend decision. In a fmancial context, it means the selection of best financing alternative or best investment alternative. The finance function therefore, is concerned with three broad decision which are as follows

1. Decision: The investment decision relates to how the firm’s funds are invested in different assets.
2. Financing Decision: This decision is about the quantum of finance to be raised from various long term sources and short term sources. It Involves identification of various available sources of finance.
3. Dividend Decision: This decision relates to distribution of dividend. Dividend is that portion of profit which is distributed to shareholders the decision involved here is how much of the profit earned by company is to be distributed to the shareholders and how much of it should be retained in the business for meeting investment requirements.

Q5: Sunrises Ltd. dealing in readymade garments, is planning to expand its business operations in order to cater to international market. For this purpose the company needs additional ₹80,00,000 for replacing machines with modern machinery of higher production capacity. The company wishes to raise the required funds by issuing debentures. The debt can be issued at an estimated cost of 10%. The EBIT for the previous year of the company was ₹,00,000 and total capital investment was ₹1,00,00,000. Suggest whether issue of debenture would be considered a rational decision by the company. Give reason to justify your answer. (Ans. No, Cost of Debt (10%) is more than ROI which is 8%).
Ans: No, the issue of debentures would not be a rational decision.
Reason: The Cost of Debt is 10%, which is higher than the Return on Investment (ROI) of 8%. This would reduce shareholder returns due to increased financial cost and lower profitability.

Q6: How does working capital affect both the liquidity as well as profitability of a business?
Ans:  The working capital should neither be more nor less than required. Both these situations are harmful. If the amount of working capital is more than required, it will no doubt increase liquidity but decrease profitability. For instance, if large amount of cash is kept as working capital. then this excessive cash will remain idle and cause the profitability to fall. On the contrary, if the amount of cash and other current assets are very little, then lot of difficulties will have to be faced in meeting daily expenses and making payment to the creditors. Thus, optimum amount of both current assets and current liabilities should be determined so that profitability of the business remains intact and there is no fall in liquidity.

Q7: Aval Ltd. is engaged in the business of export of canvas goods and bags. In the past, the performance of the company had been upto the expectations. In line with the latest demand in the market, the company decided to venture into leather goods for which it required specialised machinery. For this, the Finance Manager Prabhu prepared a financial blueprint of the organisation’s future operations to estimate the amount of funds required and the timings with the objective to ensure that enough funds are available at right time. He also collected the relevant data about the profit estimates in the coming years. By doing this, he wanted to be sure about the availability of funds from the internal sources of the business. For the remaining funds, he is trying to find out alternative sources from outside. 
Questions:
(a) Identify the financial concept discussed in the above paragraph. Also, state the objectives to be achieved by the use of financial concept so identified. ( Financial Planning). 
(b) ‘There is no restriction on payment of dividend by a company’. Comment. ( Legal & Contractual Constraints) 
Answers:
(a) Identify the financial concept discussed in the above paragraph. Also, state the objectives to be achieved by the use of the financial concept so identified.
Ans:
Financial Concept: Financial Planning.
Objectives:

1. To estimate the amount of funds required.
2. To ensure the availability of funds at the right time.
3. To ensure optimal utilization of funds.

(b) ‘There is no restriction on payment of dividend by a company’. Comment.
Ans: This statement is not entirely correct. There are legal and contractual constraints on the payment of dividends, such as:

1. Legal Constraints: Companies can pay dividends only from profits as per legal guidelines.
2. Contractual Constraints: Loan agreements or debenture terms may restrict dividend payouts to maintain financial stability.

Long Answer Type Questions

• Nature of Business: Businesses like trading companies and service providers usually need less working capital compared to manufacturing companies.
• Scale of Operations: Larger businesses require more working capital because they have more inventory and accounts receivable, while smaller businesses need less.
• Business Cycle: The current phase of the economy affects working capital needs. During a boom, higher sales and production lead to greater working capital requirements, whereas needs decrease during a recession.
• Seasonal Factors: Some businesses experience seasonal fluctuations. They need more working capital during peak seasons due to increased activity, but less during off-seasons.
• Production Cycle: The production cycle is the time it takes to convert raw materials into finished goods. A longer cycle requires more funds to cover raw materials and other expenses.
• Credit Allowed: Different companies provide varying credit terms to their customers based on competition and customer reliability. More generous credit policies lead to higher accounts receivable and thus more working capital needs.
• Credit Availed: Firms may also receive credit from suppliers. The more credit they use, the less working capital they need to maintain.
• Availability of Raw Materials: If raw materials are readily available, businesses can keep lower stock levels, reducing working capital needs. Conversely, scarce materials require higher stock levels and more working capital.
• Time Lag: Also known as lead time, this is the period between placing an order and receiving materials. Longer time lags necessitate more working capital to cover the need for larger inventories.

Q2: “Capital structure decision is essentially optimisation of risk-return relationship.” Comment.
Ans: Capital structure refers to the mix between owners and borrowed funds. It can be calculated as(Debt/Equity). Debt and equity differ significantly in their cost and riskiness for the firm. Cost of debt is lower than cost of equity for a firm because lender’s risk is lower than equity shareholder’s risk, since lenders earn on assured return and repayment of capital and therefore they should require a lower rate of return. Debt is cheaper but is more risky for a business because payment of interest and the return of principal is obligatory for the business. 
Any default in meeting these commitments may force the business to go into liquidation. There is no such compulsion in case of equity, which is therefore, considered riskless for the business. Higher use of debt increases the fixed financial charges of a business. As a result increased. use of debt increases the financial risk of a business. 
Capital structure of a business thus, affects both the profitability and the financial risk. A capital structure will be said to be optimal when the proportion of debt and equity is such that it results in an increase in the value of the equity share.

Q3: “A capital budgeting decision is capable of changing the financial fortunes of a business.” Do you agree? Give reasons for your answer? 
Ans: Investment decision can be long term or short term. A long term Investment decision is also called a capital budgeting decision. It involves committing the finance on a long term basis. e.g., making investment in a new machine to replace an existing one or acquiring a new fixed assets or opening a new branch etc. These decisions are very crucial for any business. They affect its earning capacity over the long-run, assets of a firm, profitability and competitiveness, are all affected by the capital budgeting decisions. Moreover, these decisions normally involve huge amounts of investment and are irreversible except at a huge cost. Therefore, once made, it Is almost impossible for a business to wriggle out of such decisions. Therefore, they need to be taken with utmost care. These decisions must be taken by those who understand them comprehensively. A bad capital budgettng decision normally has the capacity to severely damage the financial fortune of a business.

Q4: Explain the factors affecting dividend decision? 
Ans: Dividend decision relates to distribution of profit to the shareholders and its retention in the business for meeting the future investment requirements. How much of the profits earned by a company will be distributed as profit and how much will be retained in the business is affected by many factors. Some of the important factors are discussed as follows 

• Earnings: Dividends are paid out of current and past year earnings. Therefore, earnings is a major determinant of the decision about dividend. 
• Stability of Earnings: Other things remaining the same, a company having stable earning is in a position to declare higher dividends As against this, a company having unstable earnings is likely to pay smaller dividend. 
• Growth Opportunities: Companies having good growth opportunities retain more money out of their earnings so as to finance the required investment. The dividend in growth companies. is therefore, smaller than that in non-growth companies. 
• Cash Flow Position: Dividends Involve an outflow of cash. A company may be profitable but short on cash. Availability of enough cash in the company is necessary for declaration of dividend by it. 
• Shareholder Preference: If the shareholder in general, desire that at least a certain amount should be paid as dividend, the companies are likely to declare the same. 
• Taxation Policy: If tax on dividend is higher It would be better to pay less by way of dividends. As compared to this, higher dividends may be declared if tax rates are relatively lower. 
• Stock Market Reaction: For investors. an increase in dividend is a good news and stock prices react positively to It. Similarly a decrease in dividend may have a negative impact on the share prices in the stock market.
• Access to Capital Market: Large and reputed companies generally have easy access to the capital market and therefore. depend less on retained earnings to finance their growth These companies tend to pay higher dividends than the smaller companies which have relatively low access to the market. 
• Legal constraints: Certain provisions of the Company’s Act place restriction on payouts as dividend. Such provisions have to be adhered, while declaring dividends. 
• Contractual Constraints: While granting loans to a company, sometimes the lender may impose certain restrictions on the payment of dividends in future The companies are required to ensure that the dividends does not violate the terms and conditions of the loan agreement in this regard

Q5: Explain the term ‘Trading on Equity’? Why, when and how it can be used by company. 
Ans: Trading on Equity: It refers to using borrowed funds (debt) to enhance returns to equity shareholders.

• Why: To maximize shareholder returns by taking advantage of the lower cost of debt.
• When: Suitable when the Return on Investment (ROI) is higher than the cost of debt.
• How: By issuing debentures, loans, or other debt instruments to fund projects while keeping the equity component low.

Q6: ‘S’ Limited is manufacturing steel at its plant in India. It is enjoying a buoyant demand for its products as economic growth is about 7–8 per cent and the demand for steel is growing. It is planning to set up a new steel plant to cash on the increased demand. It is estimated that it will require about ₹5000 crores to set up and about ₹500 crores of working capital to start the new plant.
Questions:

(a) Describe the role and objectives of financial management for this company.
(b) Explain the importance of having a financial plan for this company. Give an imaginary plan to support your answer.
(c) What are the factors which will affect the capital structure of this company? 
(d) Keeping in mind that it is a highly capital-intensive sector, what factors will affect the fixed and working capital. Give reasons in support of your answer.
Answers:
(a) Describe the role and objectives of financial management for this company.
Ans:
Role of Financial Management:

1. Ensure availability of funds for setting up the plant and operations.
2. Optimize the cost of capital to enhance shareholder wealth.
3. Manage the company’s cash flow for smooth operations.

Objectives:

1. Maximize ROI by investing in profitable projects.
2. Maintain financial stability and liquidity.
3. Ensure optimal utilization of resources.

(b) Explain the importance of having a financial plan for this company. Give an imaginary plan to support your answer.
Ans:
Importance of Financial Planning:

1. Ensures timely availability of funds for the plant and working capital.
2. Minimizes wastage of resources by planning expenditures.

Imaginary Financial Plan:

• Capital Expenditure: ₹5000 crores for plant setup (funded through equity and long-term debt).
• Working Capital: ₹500 crores to meet initial operational needs.
• Debt-Equity Ratio: Maintain a ratio of 2:1 to balance risk and return.

(c) What are the factors which will affect the capital structure of this company?
Ans:

1. Cost of Debt: Interest rates on borrowed funds.
2. Business Risk: High risk in the steel sector requires more equity to maintain financial stability.
3. Cash Flow Position: Adequate cash flow supports higher debt.
4. Tax Benefits: Interest on debt is tax-deductible, making debt attractive.

(d) Keeping in mind that it is a highly capital-intensive sector, what factors will affect the fixed and working capital? Give reasons in support of your answer.
Ans:

Factors Affecting Fixed Capital:

1. Nature of Business: Steel manufacturing requires significant investment in plant and machinery.
2. Technology: Advanced machinery demands higher fixed capital.

Factors Affecting Working Capital:

1. Production Cycle: Longer cycles in steel production require more working capital.
2. Inventory Management: Maintaining raw materials and finished goods impacts working capital needs.
3. Credit Policy: Liberal credit terms to customers increase receivables and working capital requirements.