Unit 2: Financial management

I. Orientation — The Financial Management Framework

Financial management is the planning, procurement, allocation, control, and monitoring of money in a business. Its governing principle is to use limited financial resources efficiently while maintaining profitability, liquidity, solvency, and sustainable growth.

• Primary objective: Financial decisions should increase the economic value of the enterprise while controlling risk.
• Profitability: The business must earn sufficient income over costs; it is commonly measured through profit margin or return on investment.
• Liquidity: The enterprise must have enough cash or near-cash assets to meet short-term obligations such as wages and supplier payments.
• Solvency: The business must remain capable of meeting long-term obligations, including repayment of loans.
• Financial control: Budgets, accounts, statements, and variance analysis help compare actual performance with plans.
• Core decisions:
  • Investment decision: Selecting assets or projects in which funds will be invested.
  • Financing decision: Choosing between owners’ funds, retained earnings, loans, and other sources.
  • Working-capital decision: Managing cash, inventory, receivables, and current liabilities.
• Basic accounting convention: Every transaction affects at least two accounts under the double-entry system, keeping the accounting equation balanced.

Assets = Capital + Liabilities

II. Funds — Financial Resources of an Enterprise

Funds are monetary resources available to establish, operate, and expand a business.

A. Funds

Funds must be obtained from suitable sources and used according to the business’s cost, risk, and repayment capacity.

• Owners’ funds: Capital contributed by proprietors, partners, or shareholders gives ownership rights and normally has no compulsory repayment date.
• Retained earnings: Profit kept within the enterprise finances growth without creating additional debt.
• Borrowed funds: Bank loans, debentures, public deposits, and trade credit must be repaid and generally carry interest.
• Short-term sources: Bank overdrafts, trade credit, and short-duration loans mainly finance day-to-day operations.
• Long-term sources: Equity capital, long-term loans, and debentures commonly finance buildings, machinery, and expansion.
• Choice of source:
  • Cost: Interest, dividends, and issue expenses affect the effective cost of finance.
  • Risk: Excessive borrowing increases fixed interest obligations.
  • Control: Issuing additional ownership capital may dilute existing control.
  • Period: The maturity of finance should broadly match the useful life of the asset.
• Fund flow: Inflows include capital contributions, sales receipts, and borrowings; outflows include asset purchases, expenses, taxes, and loan repayments.

III. Capital Requirements — Investment in Business Assets

Capital is the wealth invested in business resources to generate goods, services, and income.

A. Fixed capital and working capital

Fixed capital supports long-term capacity, whereas working capital supports the continuing operating cycle.

1. Fixed capital

   • Meaning: Money invested in long-term assets such as land, buildings, machinery, vehicles, patents, and equipment.
   • Characteristics: It remains committed for several accounting periods and is not normally purchased for resale.
   • Determinants: Manufacturing method, scale of operation, technology, expansion plans, and whether assets are purchased or leased affect requirements.
   • Recovery: Its cost is generally allocated over the asset’s useful life through depreciation, except for assets such as land that may not be depreciated.

2. Working capital

   • Gross working capital: The total value of current assets, including cash, inventory, receivables, and short-term investments.
   • Net working capital: The excess of current assets over current liabilities.

Net Working Capital = Current Assets − Current Liabilities

• Operating cycle: Cash is used to purchase materials, materials become finished goods, goods are sold, and receivables are converted back into cash.
• Insufficiency: Too little working capital may cause production interruptions and delayed payments.
• Excess: Too much may indicate idle cash, excessive inventory, or poor collection of debts.

IV. Cost and Selling Decisions — Measuring and Recovering Expenditure

An entrepreneur must determine the cost of output before setting a sustainable selling price.

A. Costing and pricing

Costing measures expenditure attributable to a product or service, while pricing determines the amount charged to the customer.

• Direct costs: Costs traceable to one unit or job, such as timber used in a table or wages paid to the carpenter.
• Indirect costs: Shared overheads such as factory rent, supervision, electricity, insurance, and administration.
• Fixed costs: Costs such as monthly rent that remain broadly constant within a relevant output range.
• Variable costs: Costs such as raw materials that change with production volume.
• Total and unit cost:

Total Cost (TC) = Fixed Cost (FC) + Variable Cost (VC)
Unit Cost = Total Cost ÷ Number of Units

• Cost-plus pricing: A profit mark-up is added to unit cost.

Selling Price = Unit Cost + Profit Mark-up

• Market-based pricing: Price is influenced by customer demand, competitors, product differentiation, and perceived value.
• Break-even point: The output at which total revenue equals total cost.

Break-even Units = Fixed Cost ÷ (Selling Price per Unit − Variable Cost per Unit)

• Example: If fixed cost is ₹60,000, price is ₹100, and variable cost is ₹60 per unit, break-even output is ₹60,000 ÷ ₹40 = 1,500 units.

V. Financial Planning — Decisions Across Time Horizons

Financial planning estimates future requirements and coordinates expected income, expenditure, investment, and financing.

A. Long-term planning and short-term planning

Long-term planning establishes strategic financial direction, while short-term planning converts strategy into operational targets.

1. Long-term planning

   • Period: Commonly covers more than one year and may extend for three, five, or more years.
   • Decisions: Business expansion, new products, plant acquisition, technology, long-term borrowing, and capital structure.
   • Methods: Capital budgets, projected financial statements, and investment appraisal support decisions.
   • Risk: Forecast uncertainty rises because markets, costs, technology, and regulation can change.

2. Short-term planning

   • Period: Usually covers up to one year and may be divided into monthly or quarterly budgets.
   • Decisions: Cash balances, inventory purchases, credit collection, wages, production schedules, and temporary borrowing.
   • Cash budget: It estimates cash receipts and payments to identify expected surpluses or shortages.
   • Coordination: Short-term budgets should support long-term objectives rather than maximize immediate profit at the expense of growth.

VI. Accounting Records — Systematic Recording of Transactions

Accounting records provide reliable evidence of transactions and form the basis of financial statements.

A. Book keeping

Book keeping is the systematic identification, recording, classification, and preservation of financial transactions.

• Purpose: It establishes what the business owns, owes, earns, spends, receives, and pays.
• Source documents: Invoices, bills, receipts, bank statements, debit notes, credit notes, and vouchers support entries.
• Double entry: Every transaction has equal debit and credit effects.

Total Debits = Total Credits

• Accounting cycle: Source documents lead to journal or subsidiary-book entries, ledger posting, trial balance, adjustments, and financial statements.
• Benefits: Accurate records assist decision-making, taxation, fraud control, debt collection, and comparisons between periods.
• Limitation: Book keeping records transactions; accounting additionally interprets, analyses, and communicates their results.

VII. Journal — Book of Original Entry

The journal records transactions chronologically before they are classified in ledger accounts.

A. Journal

A journal entry identifies the accounts debited and credited, the amounts, and a brief explanation called narration.

• Format: Entries generally contain the date, particulars, ledger folio, debit amount, and credit amount.
• Debit-credit principle:
  • Assets and expenses: Increases are generally debited; decreases are credited.
  • Capital, liabilities, and income: Increases are generally credited; decreases are debited.
• Example: Furniture purchased for cash for ₹20,000 increases furniture and decreases cash.

Furniture Account Dr.    ₹20,000
    To Cash Account                 ₹20,000
(Being furniture purchased for cash)

• Compound entry: One transaction may involve more than two accounts, provided total debits equal total credits.
• Correction value: Chronological recording and narration create an audit trail for verification.

VIII. Ledger — Classified Accounts

The ledger groups journal entries account by account so that balances can be determined.

A. Ledger

A ledger is the principal book containing separate accounts for assets, liabilities, capital, income, and expenses.

• Posting: Debit and credit information is transferred from journals or subsidiary books to the relevant ledger accounts.
• Account structure: A traditional account has a debit side and a credit side, often represented as a “T-account.”
• Balancing: The difference between the two sides is carried down as the closing balance and brought forward to the next period.
• Illustration: Cash received is posted to the debit of Cash Account, while cash paid is posted to its credit.
• Trial balance: Ledger balances are listed to test the arithmetical equality of debits and credits.
• Limitation: Agreement of a trial balance does not detect every error, such as complete omission or posting to the wrong account of the same type.

IX. Specialised Records — Efficient Recording of Repetitive Transactions

Specialised books reduce repeated journal entries and divide accounting work efficiently.

A. Subsidiary books

Subsidiary books are books of original entry used for frequently recurring transactions of a similar nature.

• Purchases book: Records credit purchases of goods intended for resale, not cash purchases or asset purchases.
• Sales book: Records credit sales of goods; cash sales are entered in the cash book.
• Purchases returns book: Records goods returned to credit suppliers.
• Sales returns book: Records goods returned by credit customers.
• Cash book: Records cash and bank receipts and payments; it may also function as a ledger account.
• Bills receivable book: Records bills accepted by customers in favour of the business.
• Bills payable book: Records bills accepted by the business in favour of creditors.
• Journal proper: Records transactions not covered elsewhere, including opening, closing, adjustment, transfer, and rectification entries.
• Control advantage: Periodic totals are posted to ledger control accounts, reducing the volume of individual postings.

X. Financial Reporting — Period-End Business Position

Financial statements summarise accounting information for owners, managers, lenders, investors, and regulators.

A. Annual financial statement

An annual financial statement reports financial performance, financial position, and related information for an accounting year.

• Income statement: Shows revenue and expenses and determines profit or loss for the period.

Profit = Revenue − Expenses

• Balance sheet: Presents assets, liabilities, and owners’ equity at a specified date.
• Cash flow statement: Classifies cash flows into operating, investing, and financing activities.
• Notes and disclosures: Explain accounting policies, commitments, contingencies, and important details behind reported figures.
• Adjustments: Closing accounts may require depreciation, accrued expenses, prepaid expenses, outstanding income, inventory valuation, and provisions.
• Users:
  • Internal users: Owners and managers assess performance, liquidity, and resource use.
  • External users: Banks, investors, suppliers, tax authorities, and regulators evaluate risk and compliance.
• Qualities: Statements should be relevant, reliable, comparable, understandable, and prepared consistently under applicable accounting requirements.

XI. Taxation — Compulsory Contribution and Business Compliance

Taxation is the compulsory levy imposed by government on income, transactions, property, or consumption under applicable law.

A. Taxation

Businesses must calculate, collect, pay, and report taxes according to the rules of their jurisdiction.

1. Direct taxes

   • Meaning: Taxes imposed directly on the income or profits of a person or enterprise.
   • Business effect: Income tax reduces post-tax profit and must be considered in financial planning.
   • Responsibility: The legal taxpayer generally bears the tax burden directly.

2. Indirect taxes

   • Meaning: Taxes imposed on goods or services and commonly collected from customers by registered businesses.
   • Business effect: The enterprise records tax collected on sales and eligible tax paid on purchases according to applicable rules.
   • Responsibility: The business acts as a collector and remits the net amount to the government.

• Compliance records: Invoices, returns, payroll records, purchase records, sales records, and payment evidence must be preserved for the prescribed period.
• Tax planning: Lawful use of deductions, allowances, timing rules, and business structures may reduce liability.
• Tax evasion: Concealing income, fabricating expenses, or falsifying records is illegal and may result in interest, penalties, or prosecution.
• Jurisdictional variation: Tax rates, registration thresholds, filing dates, and allowable deductions depend on the law currently applicable to the business.