Chapter financial-management: Financial Management Short Questions | business studies Class 12 CBSE

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Chapter financial-management: Financial Management Short Questions | business studies Class 12 CBSE | ByteNotes.in

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Question 1

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What is meant by business finance?

Business finance refers to the money required for carrying out various business activities at every stage of a business entity's life.
Finance is needed to establish a business, run it, modernise it, expand it, or diversify it into new areas.
It is required for acquiring tangible assets like machinery and buildings, as well as intangible assets like trademarks and patents, and for day-to-day operations.

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Question 2

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Define Financial Management and state its primary aim.

Financial Management is concerned with optimal procurement as well as the usage of finance for achieving the goals of a business enterprise.
Its primary aim is to maximise shareholders' wealth, referred to as the wealth-maximisation concept, by increasing the market price of equity shares.
It also aims at reducing the cost of funds, keeping risk under control, and ensuring the effective and timely deployment of funds.

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Question 3

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What is a capital budgeting decision? Why is it important?

A capital budgeting decision is a long-term investment decision involving the commitment of finance on a long-term basis in fixed assets such as plant, machinery, or new branches.
These decisions are important because they affect the earning capacity, profitability, size of assets, and competitiveness of the firm in the long run.
These decisions are largely irreversible and involve huge amounts of investment, making careful evaluation essential before they are taken.

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Question 4

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What is meant by financial risk? Why does it arise?

Financial risk is the chance or possibility that a firm would fail to meet its fixed financial obligations such as interest payments, preference dividends, and repayment of principal.
Financial risk arises due to the use of debt in the capital structure, as interest payment and repayment of principal are obligatory regardless of whether the firm earns a profit.
Higher the proportion of debt in the total capital, greater is the financial risk faced by the company.

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Question 5

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Distinguish between owners' funds and borrowed funds as sources of business finance.

Owners' funds consist of equity share capital, preference share capital, and reserves and surpluses (retained earnings) and carry no fixed obligation for repayment or return.
Borrowed funds include loans from financial institutions, debentures, and public deposits; interest payment and principal repayment are obligatory regardless of profitability.
Owners' funds are considered riskless for the business while borrowed funds carry financial risk and are cheaper due to the tax deductibility of interest.

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Question 6

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What is the dividend decision? Name any two factors that affect it.

The dividend decision relates to how much of the profit earned (after tax) by the company should be distributed to shareholders as dividends and how much should be retained in the business as retained earnings.
Two important factors affecting the dividend decision are: (i) Amount of Earnings — dividends are paid out of current or past earnings, so earnings are a major determinant; and (ii) Cash Flow Position — a company needs sufficient cash to pay dividends even if it has made profits.
Retained earnings reinforce the future earning capacity of the firm while dividends constitute current income for shareholders; both aspects must be balanced.

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Question 7

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What is financial planning? State its twin objectives.

Financial planning is essentially the preparation of a financial blueprint of an organisation's future operations, estimating fund requirements and identifying sources.
Its first objective is to ensure availability of funds whenever required — estimating the quantum and timing of funds needed for different purposes and specifying their sources.
Its second objective is to ensure that the firm does not raise resources unnecessarily, since excess funding adds to cost and may encourage wasteful expenditure.

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Question 8

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Define capital structure. How is it calculated?

Capital structure refers to the mix between owners' funds (equity) and borrowed funds (debt) used by a company to finance its operations and assets.
It can be calculated as a debt-equity ratio (Debt/Equity) or as the proportion of debt out of total capital (Debt / Debt + Equity).
An optimal capital structure is one where the proportion of debt and equity is such that it results in an increase in the value of the equity share and maximises shareholders' wealth.

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Question 9

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What is Trading on Equity? Under what condition is it favourable?

Trading on Equity refers to the increase in profit earned by equity shareholders due to the presence of fixed financial charges like interest paid on debt.
It is favourable when the Return on Investment (RoI) of the company is higher than the cost of debt, causing the Earnings Per Share (EPS) to rise with increased use of debt.
When RoI is lower than the cost of debt, Trading on Equity is unfavourable and the use of more debt will reduce the EPS.

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Question 10

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Why is debt considered cheaper than equity as a source of finance?

Debt is cheaper than equity because lenders bear lower risk than equity shareholders since they earn an assured return and guaranteed repayment of capital.
Interest paid on debt is a tax-deductible expense, reducing the effective cost of debt further, whereas dividends are paid out of after-tax profits.
For example, a company borrowing at 10% with a 30% tax rate effectively pays only 7% after tax, making debt significantly cheaper than equity.

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Question 11

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Define fixed capital and working capital.

Fixed capital refers to the investment in long-term assets such as plant and machinery, land and buildings, and vehicles that remain in the business for more than one year.
Working capital refers to the investment in current assets — such as cash, debtors, inventory, and bills receivable — that facilitate the smooth day-to-day operations of a business.
Net Working Capital (NWC) is defined as the excess of current assets over current liabilities, expressed as NWC = CA − CL.

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Question 12

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What is the Interest Coverage Ratio (ICR)? What does a higher ICR indicate?

The Interest Coverage Ratio (ICR) refers to the number of times a company's Earnings Before Interest and Taxes (EBIT) covers its interest payment obligation; it is calculated as EBIT divided by Interest.
A higher ICR indicates lower risk of the company failing to meet its interest payment obligations, suggesting greater capacity to take on debt.
However, ICR alone is not an adequate measure since a firm may have high EBIT but low cash; apart from interest, repayment obligations must also be considered.

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Question 13

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How does the Nature of Business affect the requirement of working capital?

The basic nature of a business significantly influences the amount of working capital required.
A trading organisation usually needs a smaller amount of working capital than a manufacturing organisation because there is no processing involved and sales can be effected immediately upon receipt of materials.
Service industries which do not have to maintain inventory require even less working capital compared to manufacturing businesses, which must first convert raw materials into finished goods before any sales are possible.

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Chapter sections

Chapter financial-management: Financial Management | Short Questions

What is meant by business finance?

Define Financial Management and state its primary aim.

What is a capital budgeting decision? Why is it important?

What is meant by financial risk? Why does it arise?

Distinguish between owners' funds and borrowed funds as sources of business finance.

What is the dividend decision? Name any two factors that affect it.

What is financial planning? State its twin objectives.

Define capital structure. How is it calculated?

What is Trading on Equity? Under what condition is it favourable?

Why is debt considered cheaper than equity as a source of finance?

Define fixed capital and working capital.

What is the Interest Coverage Ratio (ICR)? What does a higher ICR indicate?

How does the Nature of Business affect the requirement of working capital?

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