Students should refer to Worksheets Class 12 Business Studies Financial Management Chapter 9 provided below with important questions and answers. These important questions with solutions for Chapter 9 Financial Management have been prepared by expert teachers for Class 12 Business Studies based on the expected pattern of questions in the Class 12 exams. We have provided Worksheets for Class 12 Business Studies for all chapters on our website. You should carefully learn all the important examinations questions provided below as they will help you to get better marks in your class tests and exams.
Financial Management Worksheets Class 12 Business Studies
One Mark Questions:
Question. The cheapest source of finance is
b) Equity share capital
c) Preference share
d) Retained earnings
Question. The decision of acquiring a new machine or opening a new branch is an example for
a) Financing decision
b) Working capital decision
c) Investment decision
Question. The decision of how much to be raised from which source is an example for
a) Financing decision
b) Working capital decision
c) Investment decision
Question. Companies with higher growth pattern are likely
a) To pay lower dividends
b) To pay higher dividends
c) That dividends are not affected by growth issues
Question. Current assets are those assets which get converted into cash
a) Within six months
b) Within one year
c) Between 1 and 3 years
d) Between 3 and 5 years
Question. A fixed asset should be financed through
a) A long-term liability
b) A short-term liability
c) A mix of long- and short-term liability
Question. What is Business finance?
Answer: Money required for carrying out business activities is called as business finance. (OR)
Funds needed to establish, to run, to modernize, to expand and to diversify the business is called business finance.
Question. State the primary objective/aim of financial management
Answer: The primary objective/aim of financial management is to maximize shareholders wealth. i.e., wealth maximization.
Question. What do you understand by ‘Capital Structure’?
Answer: Capital structure refers to the mix between owners funds (i.e., Equity) and borrowed funds (i.e., Debt)
Question. Write the meaning of ‘Financial Risk’.
Answer: Financial risk refers to a position when a company is unable to meet its fixed financial charges namely interest payment, preference dividend and repayment obligations.
Financial risk is the chance that firm would fail to meet its payment obligations.
Question. Give an example for fixed asset.
Answer: Building, furniture, land.
Question. Give an example for current asset.
Answer: Cash, stock, bills receivable.
Question. How do you calculate Net Working Capital?
Answer: Net Working Capital=Current assets – Current liabilities
Two Mark Questions:
Question. What is financing decision?
Answer: The decision about the quantum of finance is to be raised from various long term and short-term sources of finance is called as financing decision.
• Thus, it is concerned with how much funds to be raised and from which source.
• Example: a decision taken to raise Rs 1 crore by the issues of equity share worth Rs 60lakh by the issue of debenture worth Rs 20lakh and borrowings from bank Rs 20lakh.
Question. What is financial leverage? Write the formula to calculate financial leverage.
Answer: The proportion of debt in the overall capital is called as financial leverage.
Formula: Debt / Equity
Debt / Debt + Equity
Question. Give the meaning of Dividend decision
Answer: It is a financial decision which relates to how much of the profits earned by the company are to be distributed to the shareholders and how much of it should be retained in the business. Thus, it relates to the appropriation of profits.
Question. Give the meaning of ‘Trading on equity’
Answer: Trading on equity refers to increase in profit earned by the equity shareholders due to the presence of fixed financial charges like interest.
It is a situation where companies employ cheaper debt in their capital structure to enhance the earnings per share (EPS)
Question. What do you understand by financial management?
Answer: Financial management is concerned with optimal procurement and usage of finance. Thus, financial management means procurement of required funds at minimum cost and utilization of such funds in an effective manner.
Question. Write the formula to calculate Debt Service Coverage Ratio.
Answer: Debt Service Coverage Ratio (DSCR) =Profit after tax + Depreciation + Interest + Non-cash expenses / Preference dividend + Interest + Repayment obligation.
Question. Give the meaning of Investment Decision with an example.
Answer: It is a financial decision which relates to how the firm’s funds are invested in different assets. Example: a decision to make investment of Rs 5 crores in a new machine or a decision to make investment of Rs 2 crores in opening new branch and so on.
Question. State the twin objectives of financial planning.
a) To ensure availability of funds whenever required.
b) To see that the firm does not raise resources unnecessarily.
Question. Explain any 4 factors affecting dividend decisions.
Answer: Dividend decision is a financial decision which relates to how much of the profits earned by the company is to be distributed to the shareholders and how much of it should be retained in the business.
Factors affecting dividend decisions are:
(a) Amount of earnings: Dividends are paid out of current and past earnings, Therefore, earnings are a major factors which influences dividend decision.
(b) Stability of Earnings: Stable earning of the company will help the company to announce higher dividend. On the other hand, unstable dividend will make the company to announce fewer dividends to the owners.
(c) Stability of Dividends: Companies generally follow a policy of stabilizing (maintaining consistency in dividends per share) but this is increased only when they have confidence that earning potential has gone up and just earnings of current year. Therefore, the small increase in the profits of the company, current and past year will not give increased dividends to the shareholders.
(d) Growth Opportunities: Companies having good growth opportunities retain more money out of their earnings to finance the required investment, therefore the dividends declared by such companies having growth opportunities will be lesser compared to the companies which are having less growth opportunities.
(e)Cash Flow Position: Position of the company also influences the amount of dividends to be declared. If inflows of cash are more, higher dividends can be paid on the other hand lower dividends can be paid if there are less inflow of cash in the organization.
(f) Shareholder Preference: While declaring dividends, management, must keep in mind the preferences of the shareholders in this regard. If the shareholders in general expect a minimum amount of dividends to be declared, then the management has to declare the same.
(g) Taxation Policy: If tax on dividend is higher, it is better to pay less by way of dividends. As companies are levied with tax on dividends called as dividend distribution tax, the rate of such tax should be taken into consideration while declaring dividends.
(h) Stock Market Reaction: Increase in the dividend amount will lead the stock market to react positively and a decrease in dividend may have a negative impact on share price in the stock market. Thus, the possible improvement of the dividend policy on the equity share price is one of the important factors considered by the management while taking dividend decision.
(i) Approach to Capital Market: Large companies can easily raise share capital from the public and they do not depend much on retained earnings as a source of funds and as such declare good amount of dividends. On the other hand, those companies which cannot raise capital from capital market will have to depend on retained earnings as a source of fund and they declare smaller amount of dividends.
(j) Legal Constraints: Certain provisions of the Companies Act put some restrictions on companies for payments of dividends. Such restrictions should be considered while declaring the dividend.
(k) 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 dividend does not violate the terms of the loan agreement in this regard.
Four Mark Questions:
Question. Explain any 4 factors affecting financing decisions.
Answer: Factors affecting financing decisions are:
(a) Cost: The cost of raising funds through different sources should be analyzed and the source which is the cheapest one should be selected by the financial manager.
(b) Risk: The risk connected with each of its sources should be taken into consideration when deciding the source of finance.
(c) Floatation Costs: It refers to amount paid for underwriters or brokers for raising the capital or debt. Higher the floatation cost, less attractive the source.
(d) Cash Flow Position of the company: A stronger cash flow position may make debt financing more viable than collecting capital through equity.
(e) Fixed Operating Costs: If a business has high level of fixed operating costs such as building rent, Insurance premium, salaries etc. It must reduce fixed financing cost. In such situation lower debt financing is better. If fixed operating cost is less, more of debt financing is preferred.
(f) Control Considerations: Financing through equity shares may lead to dilution of management control over the business whereas financing through debt will not have such control over business.
(g) State of Capital Markets: Health of the capital market may also affect the choice of source of fund. During the period when stock market is rising more people invest in equity. If the capital market is down raising the capital through issue of equity shares would be difficult.
Question. What is capital budgeting decision? Explain briefly the factors affecting the capital budgeting decision.
Answer: A long term investment decision is called capital budgeting decision. For example, a decision to make investment in a new machine, a decision to open a new branch etc.
Factors affecting capital budgeting decisions are:
(a) Cash flows of the project: When a company takes an investment decision involving huge amount it expects to generate some cash flows over a period. These cash flows are in the form of a cash receipts and payments over the life of an asset. The amount of cash flows should be carefully analyzed before making decision to invest.
(b) The Rate of Return: The most important criterion is the rate of return of the project. These calculations are based on the expected returns from each proposal and the risk involved in the investment.
Example: If there are two projects A and B with the equal risk involved and with a rate of return of 10 percent and 12 percent respectively, then under normal circumstance, project B will be selected as the rate of return is 12 percent which is higher than project A.
(c)The investment criteria involved: The decision to invest involves number of different criteria such as amount of investment, risk involved, interest rate, cash flows and rate of return. There are different techniques to evaluate investment proposals which are known as capital budgeting techniques which evaluate the best project on different basis.
Question. Explain the 4 factors affecting the fixed capital requirement of an organization.
Answer: Fixed capital refers to investment in long term assets or fixed assets such as investment in plant and machinery, investment in building etc.
Factors affecting fixed capital requirements are:
1. Nature of Business: The type of business has a bearing upon the fixed capital requirements. A manufacturing company needs more fixed capital as compared to a trading company, as trading company does not require to plant and machinery etc.
2. Scale of Operations: The companies which are operating on large scale requires more fixed capital as they need more machines and other assets whereas small-scale enterprise need less amount of fixed capital.
3. Choice of Technique: Some organizations are capital intensive whereas others are labour intensive. A capital-intensive organization requires higher investment in plant and machinery as it relies less on manual labour. The requirement of fixed capital of such organization would be higher. Labor-intensive organizations on the other hand require less investment in fixed assets. Hence their fixed capital requirement is lower.
4. Technology Upgradation: Industries in which technology up gradation is fast need more amount of fixed capital as and when new technology is invented old machines become obsolete and they need to buy new plants and machinery whereas companies where technology up gradation is slow requires less amount of fixed capital as they can manage with old machines.
5. Growth Prospects: Higher growth of an organization generally requires higher investment in fixed assets. Even when such growth is expected a company may choose to create higher capacity in order to meet the anticipated higher demand quicker.
6. Diversification: Companies which have plans to diversify their activities by including more range of products requires more plants and machineries which means more fixed capital .E.g., a textile company is diversifying and starting a cement manufacturing plant , its investment in fixed capital will increase.
7. Financing Alternatives: When an asset is taken on lease, the firm pays lease rentals and uses it. By doing so it avoids huge sums required to purchase it. Availability of leasing facilities, they may reduce the funds required to be invested in fixed assets, thereby reducing the fixed capital requirements such a strategy is specially suitable in high risk lines of business.
8. Level of Collaboration: If companies prefer collaborations or joint venture, they will need less fixed capital as they can share plant and machinery with their collaboration but if a company prefers to operate as an independent unit, then there is more requirement of fixed capital.
Question. Explain any 4 factors affecting the working capital requirement of an organization.
Answer: Working capital refers to the capital required for day to day working of an organization.
Factors affecting the working capital requirement
1. Nature of Business: The manufacturing company requires huge amount of working capital. In case of trading concern or retail shop, the requirement of working capital is less because the length of operating cycle is small. The manufacturing company requires huge amount of working capital because they must convert raw material into finished goods and sell them on cash or credit basis, maintain the inventory of raw materials as well as finished goods. Similarly service industries need not maintain inventory and hence require less working capital.
2. Scale of operation: For organizations which operate on higher scale of operation the quantum of inventory and debtors required is generally high in such organizations, therefore, require large amount of working capital as compared to the organizations which operate on a lower scale.
3. Business Cycle: When business cycle is in boom period the market flourishes resulting in more demand, more production, more stock and more trade receivable which means more amount of working capital is required whereas during depression period, low demand and less inventories are required to be maintained and therefore less debtors and less working capital will be required.
4. Seasonal Factors: The working capital requirement is constant to the companies which sell goods throughout all the seasons whereas for the companies which are selling seasonal goods requires huge amount during the season as more demand, more stock must be maintained and fast supply is needed whereas during off season demand will be very low, hence, less working capital is needed.
5. Production Cycle: Production cycle is the time span between the receipt of raw material and their conversion into finished goods. Some businesses have a longer production cycle while some have a shorter one. Duration and the length of production cycle affect the amount of funds required for raw materials and expenses. Consequently, working capital requirement is higher in firms with longer processing cycle and lower in firms with shorter processing cycle.
6. Credit Allowed: Different firms allow different credit terms to their customers. These depend upon the level of competition that a firm faces as well as the credit worthiness of their clients. A liberal credit policy results in higher amount of debtors, increasing the requirement of working capital.
7. Credit Availed: just as a firm allows credit to its customers it also gets credit period from its suppliers. If suppliers of raw materials are giving long term credit, then company can manage with less amount of working capital whereas if suppliers are giving only short credit period then company will require more working capital to make payment to the creditors.
8. Operating efficiency: Firms with high degree of efficiency have low wastage and can manage with low level of inventory and during operating cycle these firms bear fewer expenses and they can manage with less working capital and vice versa.
9. Availability of raw materials: If the raw materials are easily available and there is a ready supply of raw materials and input, then less amount of working capital is required whereas if the supply of raw materials is not smooth then firm need to maintain large inventory to carry on operating cycle smoothly for which they require more working capital.
10. Growth prospects: If the growth potential of a concern is perceived to be higher, it will require larger amount of working capital so that it is able to meet higher production and sales target whenever required.
11. Level of Competition: If the market is competitive then company will have to adopt liberal credit policy and to supply goods on time, high inventories must be maintained. Therefore, high amount of working capital will be required. A business with less competition or having a monopolistic position will require less working capital.
12. Inflation: Working capital requirement is also determined by price level changes. For example, during inflation, increase in price of raw materials, wage lead to rise in working capital requirements.
Question. Explain with any 4 points the importance of financial planning.
Answer: The preparation of a financial blueprint of organization’s future operations is called financial planning.
Importance of financial planning are:
(i) It helps in forecasting about happenings in future under different business situations. This in turn helps the business to handle situations in better way.
(ii) It helps in avoiding business shocks and surprises and helps the company in preparing for the future.
(iii) It helps in co-coordinating various business functions e.g., sales and production functions by providing clear policies and procedures.
(iv)Detailed plans of action prepared under financial planning, helps in reducing waste, duplication of efforts, gaps in planning.
(v) It tries to link the present with the future.
(vi) It provides a link between investment and financing decisions on a continuous basis.
(vii) By spelling out detailed objectives for various business segments. It helps in evaluation of actual performance easier.
Question. Explain any four factors affecting the choice of capital structure.
Answer: Capital structure means the proportion of debt and equity used for financing the operations of business.
Factors affecting the choice of capital structure are.
1. Cash Flow Position: Size of projected cash flows must be considered before issuing debt. Cash flows must not only cover fixed cash payment obligations but there must be sufficient buffer also. It must be kept in mind that a company has cash payment obligations for (i) normal business operations; (ii) for investment in fixed assets; and (iii) for meeting the debt service commitments i.e., payment of interest and repayment of principal.
2. Interest Coverage Ratio (ICR): The interest coverage ratio refers to the number of times a company is earning before the payment of interest and taxes to cover the interest payment obligation
. This may be calculated as follows:
ICR = EBIT/ Interest
High ICR means companies can have more of borrowed fund securities whereas lower ICR means less borrowed fund securities should be preferred.
3. Debt Service Coverage Ratio (DSCR): Debt Service Coverage Ratio takes care of the deficiencies referred to in the Interest Coverage Ratio (ICR). It is calculated as follows:
DSCR= profit after tax+ depreciation+ interest+ non-cash expenses
Preference dividend+ interest+ repayment
If DSCR is higher the company can have more debt in capital structure, as high DSCR indicates ability of company to repay its debt. If DSCR is lower, then the company must avoid debt and should depend upon equity capital only.
4. Return on Investment (ROI): ROI helps in deciding capital structure. It ROI of the company is higher, it can choose to use trading on equity to increase its EPS i.e., its ability to use debt is greater.
5. Cost of debt: If a company can arrange borrowed funds at lower rate of interest, then it will prefer more debt as compared to equity .
6. Tax Rate: Since interest is a deductible expense, cost of debt is affected by the tax rate. For example if a firm is borrowing at 10%, if the tax rate is 30%, the after tax cost of debt is only 7%. A higher tax rate, thus, makes debt relatively cheaper and increases its attraction vis-à-vis equity.
7. Cost of Equity: Stock owners expect a rate of return from the equity which is commensurate with the risk they are assuming. When a company increases debt, the financial risk faced by the equity holders, increases. Consequently, their desired rate of return may increase. It is for this reason that a company cannot use debt beyond a point. If debt is used beyond that point, cost of equity may go up sharply and share price may decrease in spite of increased EPS. Consequently, for maximization of shareholders’ wealth, debt can be used only up to a level.
8. Floatation Costs: Process of raising resources also involves some cost. Public issue of shares and debentures requires considerable expenditure. Getting a loan from a financial institution may not cost so much. These considerations may also affect the choice between debt and equity and hence the capital structure.
9. Risk Consideration: Financial risk refers to a position when a company is unable to meet its fixed financial charges namely interest payment, preference dividend and repayment obligations. Apart from the financial risk, every business has some operating risk (also called business risk). Business risk depends upon fixed operating costs. Higher fixed operating costs result in higher business risk and vice-versa. The total risk depends upon both the business risk and the financial risk. If a firm’s business risk is lower, its capacity to use debt is higher and vice-versa.
10. Flexibility: If a firm uses its debt potential to the full, it loses flexibility to issue further debt. To maintain flexibility, it must maintain some borrowing power to take care of unforeseen circumstances.
11. Control: Debt normally does not cause a dilution of control. A public issue of equity may reduce the managements’ holding in the company and make it vulnerable to takeover. This factor also influences the choice between debt and equity especially in companies in which the current holding of management is on a lower side.
12. Regulatory Framework: Every company operates within a regulatory framework provided by the law e.g., public issue of shares and debentures has to be made under SEBI guidelines. Raising funds
from banks and other financial institutions require fulfillment of other norms. The relative ease with which these norms can, be met or the procedures completed may also have a bearing upon the choice of the source of finance.
13. Stock Market Conditions: If the stock markets are bullish, equity shares are more easily sold even at a higher price. Use of equity is often preferred by companies in such a situation. However, during a bearish phase, a company may find raising of equity capital more difficult and it may opt for debt. Thus, stock market conditions often affect the choice between the two.
14. Capital Structure of other Companies: A thorough analysis of debt-equity ratios of other companies must be examined carefully which may provide an idea whether they are following them or deviating from them. However, care must be taken that the company does not follow the industry norms blindly.
Practical Oriented Question :
Question.As a financial consultant give the list of any ten factors which affect the choice of capital structure.
• Cash flow position
• Interest coverage ratio (ICR)
• Debt service coverage ratio (DSCR)
• Return on investment (ROI)
• Cost of debt
• Tax rate
• Cost of equity
• Floatation costs
• Risk consideration
• Regulatory framework
• Stock market conditions
• Capital structure of other companies