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CAPITAL - FIXED AND WORKING Business finance refers to the money and credit employed in business firms. 2.2 IMPORTANCE OF FINANCE FOR BUSINESS Finance is the lifeblood of business. Adequate finance provides the following benefits to a business concern:1. The firm can meet its liabilities in time. Prompt payment of debts helps in raising its credit-standing. As a result, the firm can easily borrow funds as and when necessary. 2. The firm can take advantage of business opportunities. For example, it can buy materials in bulk at a low price. 3. The firm can carry on its business smoothly, and without any interruptions. 4. The firm can replace its plant and machinery in time, thereby improving the efficiency of its operations. 5. The firm can face recession, trade cycles, and other crises more easily and confidently. 6. An enterprise with adequate funds can pay wages and salaries in time and spend on the welfare of employees. These help in attracting, retaining and motivating talent. 2.3 SOURCES OF FINANCE FOR DIFFERENT BUSINESS FIRMS 1. Capital for sole proprietorship business: In a sole proprietorship, owned capital consists of the owner's own contribution and retained profits credited to his capital account at the end of each financial year. He may also borrow money from banks and financial institutions. Long term loans for purchase of fixed assets are available from State Financial Corporations and other financial institutions. A sole proprietor may also buy raw materials and finished goods on credit from the suppliers. 2. Capital for partnership firm: The owned capital is contributed by the partners in an agreed ratio. Retained profits credited to the accounts of partners also constitute a part of owned capital. A partnership firm can also raise loans from commercial banks and financial institutions. Sometimes, partners also advance loans to the firm. It can obtain short-term credit from suppliers of raw materials and finished goods. 3. Capital for joint stock company 2.4 FINANCIAL PLANNING Meaning: Financial planning is the process of estimating the financial requirements of an organisation, choosing the sources of funds and deciding how the funds are to be utilised. Features: 1. Financial planning involves deciding when, how and why financial activities. 2. Like any other planning, it is future oriented and involves forecasting. 3. It involves deciding objectives, policies, procedures, methods, and programmes concerning funds. 4. The scope of financial planning is wide; it consists of: a) estimating the amount of fixed capital and working capital needed in business and b) selecting the appropriate sources of funds and the ratio in the total amount. 5. Formulating policies for use of funds and disposal of earnings. Importance: 1. A sound financial plan helps a business enterprise to avoid the problems of shortage and surplus of funds. 2. It is helpful in maintaining a proper balance between equity and debt funds 3. Financial planning helps in effective utilisation of funds. Wastage of capital is eliminated. 4. Financial planning provides policies and procedures for coordinating different functional areas or departments of a business. 5. Actual utilisation of funds can be kept in accordance with the planned utilisation. 6. It helps the company to prepare for facing business shocks and surprises in future. 2.5 FACTORS AFFECTING CAPITAL STRUCTURE Capital structure means the composition or make up of the amount of long term funds. Ownership funds consist of share capital, and retained earnings. Borrowed funds include debentures, and long-term loans. The ratio between equity and debt is called capital gearing or financial leverage. When the proportion of debt is high, it is called high gearing or trading on thin equity. On the other hand, when equity dominates the capital structure, it is known as low gearing or trading on thick equity. FACTORS AFFECTING CAPITAL STRUCTURE:1. Trading on equity (Financial Leverage): When a company uses borrowed funds in the regular conductive business along with equity capital, it is said to be trading on equity. When the rate of earnings of a company is higher than the rate of interest at which funds are borrowed, equity shareholders can get earnings per share due to two reasons. Firstly, the rate of return on investment is more than the rate of interest and dividend payable on debt and preference, capital, respectively. Secondly, interest paid on debt is deducted from profits while calculating tax. Trading on equity is however, desirable only when: a) The rate of earnings is higher than the rate of interest, and the rate of preference, dividend. b) The company's earnings are stable and regular to pay at least the interest on debentures. c) There are sufficient fixed assets to offer as securities to the lender. When the proportion of equity is such that it results in increase in shareholder wealth. The capital structure may be called optimum. 2. Exercise of control: Since equity shareholders have voting rights and therefore control of the company lies in their hands. If the promoters of the company want to retain control in their own hands, they may not issue additional equity shares to the public. 3. Need for flexibility: Debentures, and preference shares can be paid off whenever the company feels necessary. But equity shares cannot be paid off during the lifetime of a company. 4. Nature of business: Companies enjoying regular and liberal earnings, for example public utilities can afford to have high capital gearing on the other hand, business firms which are subject to wide fluctuation in demand and earnings may find it safer to depend more on equity, capital and preference shares. New stagnant firms may find it more difficult to issue debentures in preference, then well established and growing companies. The companies should be able to generate enough cash inflows to meet its fixed commitments on debt projected cash flow statement can be prepared to judge future, cash flows, or liquidity position of the company 5. Cost of financing: In a good financial structure, the cost of capital should be reasonably low. Cost of capital depends upon the prevailing rate of interest return expected by potential investors, expenses, and administrative expenses. Normally, the cost of debt is lower than that of equity. 6. Period and purpose of financing: For funds required for permanent investment, equity shares are the appropriate choice. 7. Capital market conditions: The state of capital market influences the choice of securities to be issued. During boom, investors are willing to take risk and invest in equity shares, but in a bearish market or downswing investors prefer safe investment. Therefore, preference shares and debentures carrying a fixed rate of return, are likely to be more marketable in a depression. 8. Statutory requirements: Banking companies are prohibited from issuing any type of securities except equity shares. Government of India has laid down norms of debt equity ratio and ceilings on public deposits. The companies act and SEBI guidelines must be observed while raising funds from the public. Thus, state regulations regarding the issue of securities have a bearing on capital structure. 9. Needs of investors: investors, attitudes and requirements regarding income and risk is an important consideration in designing capital structure. A company may issue securities of different kinds and varying denominations to meet the likings of potential investors. 10. Cash flow position: the ability of the company to generate enough cash flow to meet as fixed commitments, also influences the capital structure. The company may be earning sufficient profits, but it may not be generating cash inflows at the time of payment of interest and loan instalments. The company should analyse its liquidity position and prepare projected cash flow statements before deciding debt equity ratio. 2.6 MEANING OF FIXED CAPITAL Fixed capital refers to the funds required for acquisition of fixed assets. Fixed assets are meant for generating income. Fixed capital is also known as black capital because it is blocked up in fixed assets for the lifetime of the enterprise. Fixed capital is required for establishing a new enterprise as well as for modernisation, expansion and diversification. Fixed capital is raised through long-term sources of finance, such as shares, revenues, and retained earnings, and long-term loans. 2.7 FACTORS AFFECTING FIXED CAPITAL 1. Nature of business: manufacturing enterprises require heavy investment in fixed assets, such as land and buildings, and plant and machinery. Public utility undertakings concerns also require heavy investment and fixed assets. Trading concerns require less investment in fixed capital. 2. Size of the business: The scale of operations also determines the amount of fixed capital. A large sized enterprise requires a great amount of fixed capital than a small scale firm. 3. Nature of products: A company manufacturing capital goods will require a large amount of fixed capital. On the other hand, a firm 4. 5. 6. 7. producing consumer products will need a small amount of fixed capital. Method of production: a company employing capital intensive techniques of production will require higher amount of capital as compared to a company employing labour intensive technique . Diversity of product lines: a multiproduct company manufacturing diversified products requires more fixed capital than a firm, manufacturing a single product. Similarly, an enterprise manufacturing, each part of finished product by itself requires a greater amount of fixed capital as compared to a firm, which buys component parts from outside and simply assemble them in its own factory. Mode of acquiring fixed assets: a business from which purchases fixed assets on cash down basis requires a huge amount of fixed capital. on the other hand, an enterprise which acquires assets on leases or hire purchase will need less fixed capital. Intangible assets: the amount invested in acquiring Goodwill, patents, copyrights, etc, also influence the amount of fixed capital needed for business. 2.8 MEANING OF WORKING CAPITAL Working capital means the capital invested in current assets, such as cash, stock of goods, debtors, and short-term investments. It represents the liquid funds which are required for the day-to-day operation operations of an enterprise. Working capital is also known as circulating capital or revolving capital because it keeps on circulating or revolving in business. It is invested recovered and re-invested repeatedly during the operating cycle of a business. Cash Raw materials work in progress Finished goods Receivables cash Gross working capital: Gross working capital means the total amount of funds invested in current assets. Grass working capital= Book, value of current assets Net working capital: Excess of current assets over current liability. Net Working capital = Current assets - current liabilities Purpose of working capital: a) to purchase raw material, spare parts, operating operating supplies,etc. b) to pay wages and salaries to staff. c) to meet day-to-day expenses like fuel power, rent, taxes, advertising, delivery services, etc. 2.9 TYPES OF WORKING CAPITAL 1. Permanent working capital:- it refers to the minimum amount of working capital required permanently to operate the minimum minimum level of business activity. It is permanently locked up in current assets. It is therefore raised through long-term sources of finance. a. Initial working capital: Initial working capital is that part of permanent working capital, which is required at the time of commencement of a business. In the initial stage, the business usually does not get credit from suppliers. Therefore, all operating expenses have to be incurred in cash. The capital to meet initial operating expenditure is generally provided by the owners. b. Regular working capital: It means that part of permanent working capital which is required for the continuous business operations. It represents the excess of current assets over current liabilities. It consists of enough cash to meet short-term obligations to build up inventory and enough stock of finished goods to ensure quick delivery to customers. 2. Temporary or variable working capital: it is required to meet seasonal and special needs of business. It is fluctuating in nature and is therefore known as variable working capital. It is generally raised from short-term sources of finance. a. Seasonal working capital: it means the extra working capital required during a particular season to fulfil the demand of the seasonal busy periods. b. Special working capital: It is advisable to set up a reserve working capital to act as a question in times of emergencies. A business for me set aside additional funds to cope with unforeseen contingency such as a) Special operations to meet sudden, but in demand, b) unusually stagnant periods or depression, leading to piling up of inventory, c) strikes, lockouts, and natural calamity like earthquake, flood fire, etc. 2.11 FACTORS AFFECTING WORKING CAPITAL 1. Nature of business: Manufacturing firms require considerable working capital. On the other hand, public utility undertakings required less working capital. 2. Size of business:- Firms carrying on large scale operations and undertaking high volume of production require more working capital, then small scale firms. 3. Manufacturing cycle: longer is the time gap between the purchase of raw materials and production of finished goods higher is the need for working capital. 4. Rapidity of turnover: Turnover means the speed with which the amount of working capital is recovered by the sale of goods. When the turnover is rapid, the amount of working capital required is small. 5. Terms of purchase and sale: a business firm requires comparatively small amount of working capital if it buys goods and services on credit and sells them in cash. 6. Credit policy: When a liberal credit policy is followed, more working capital is required. On the contrary, smaller working capital is needed in case of a credit policy. 7. Operating efficiency: Better utilisation of resources leads to reduction in cost and improves profitability. As a result, the need for working capital is reduced. Profit margins and flow of regular income from sales. Also reduce the amount of working capital required in a business. 8. Goodwill of business: An enterprise enjoying good reputation in the market can easily and quickly obtain short-term loans from commercial banks. It requires a less amount of working capital. 9. Growth and expansion plans: Growing an expanding firm requires more working capital than a stagnant firm. 10. Seasonal variations: Working capital requirements of businesses which are subject to seasonal variations are comparatively high during a particular season. 11. Cyclic fluctuations: Cyclical changes create emergency demands for working capital. During boom period, there is a need for larger working capital to support higher. 2.12 COMPARISON BETWEEN FIXED AND WORKING CAPITAL BASIS FIXED CAPITAL WORKING CAPITAL Meaning Capital invested in Capital invest in fixed assets current assets Time span of invested for long time invested for short time investment period period Circulation does not circulate or keep on circulating or change its form changing its form Sources shares, debentures, public deposits, trade and long-term loans credit, bank Purpose to generate income to meet day-to-day expenses Another term Block capital Circulating capital
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