1.1 Introduction
1.2 Meaning, role and objectives of financial management
1.3 Financial planning - Meaning and Importance
1.4 Capital structure - Meaning and factors influencing capital structure
1.5.A Fixed capital - Meaning and factors affecting their requirement
1.5.B Working capital – Meaning and factors affecting their requirement
1.6 Distinction between
1.1 INTRODUCTION
Business finance is a broad concept. It deals with all financial activities of business. The term business covers both commerce and industry. In simple words, business finance applies to all financial activities of agriculture, industry, banking, transport insurance, etc. Thus, the scope of business finance includes commercial finance, industrial finance, property finance, corporate finance and even agriculture Business finance.
Business finance deals with raising, administering and disbursing funds by a business firm or an organization. In business finance importance of capital, financial planning and financial management are highlighted.
In actual practice business finance refers to corporation finance. In this era of multinationals, the business finance is almost identified with 'corporation finance'. Corporation finance deals with financial matters of corporate enterprise.
In an academic world, the term 'corporation finance' is now known as 'financial management'.
Unit objective :
After shidying this chapter you should be able to know-
Meaning, role and objectives of financial management
Meaning and importance of financial planning
Meaning and factors affecting capital structure
Meaning and factors affecting fixed capital
Meaning and factors affecting working capital
1.2 MEANING OF FINANCIAL MANAGEMENT
Financial Management is a specialised function of general management. It refers to management of business funds. It is mainly concerned with raising of finance and its effective untilization for achievement of goals of the organization.
Definition
The term 'financial management' has been defined by different authors. A few definitions given by eminent authors are given below:
1. Ezra Soloman : "Financial Management is concerned with effective use of an important economic resource, namely capital, funds."
2. Kuchal S.C. : "Financial Management deals with procurement of funds and their effective utilization in business.
From the above definitions it is clear that there are two basic aspects of financial management.
(a) Raising of funds
(b) Effective utilization of funds.
Thus, we can see that financial management is an operational function. It deals with planning, organizing, directing, co-ordinating and controlling financial activities. It is rightly called as 'Resource Management'. Since most, of the business activities involve use of finance, the financial management has acquired a vital place in modem business world.
Role of Financial Management
Financial Management is essential for all types of organizations i.e. profit making organizations or non-profit making organizations. It plays a crucial role in making best use of financial resources.
There has been significant development in Indian economy since the introduction of new economic policy in July 1991. Free market economy and free access to global investment have made financial management more complex than what it was earlier. Today it is the most important area of corporate management. The subject matter of financial management is changing at a rapid pace. It has become more significant because of developments at national and international levels. All this has a direct impact on 'corporate financial policies.'
The financial, management has become a subject of considerable importance in developing countries like India. All business entities arise out of the savings of the society. The savings in developing countries are meagre. These scarce resource of savings have to be used in many developmental activities. It is very essential that the funds which are used in business activities are well managed.
The role of financial management can be considered with detailed study of each activity i.e. functions of financial management.
Functions of Financial Management
The functions of financial management can be divided into two
(A) Routine functions
(B) Executive functions
(A) Routine functions
1. Record keeping and reporting
2. Preparation of various financial statements
3. Cash planning
4. Credit management
5. Providing information to Board of Directors on current financial position for making decisions of purchases, marketing, pricing, etc.
(B) Executive Functions:
1. Forecasting financial requirements : Financial needs have to be carefully estimated m business. Money may be required for long term purpose i.e. fixed capital and for short term purpose i.e. working capital. A careful forecasting of such funds must be made.
Forecasting of finance means projection of financial needs of business for some time ahead. It is nothing but budgeting financial needs of the expected programmes.
Forecasting is not only concerned with amount of money required for a programme but also includes.
a) Durations of funds (5 years, 10 years, etc)
b) Timing of supply of funds
c) Kinds of funds (owned or borrowed, etc.)
2. Deciding sources of funds : Once the need of finance is revealed, various sources of funds must be considered. Different type of securities like shares, debentures etc. can be issued to raise funds. Funds may also be borrowed from financial institutions and lenders. An utmost care is to be taken while selecting the sources of funds. There should be a proper balance between long term funds and short term funds. The funds raised from owners and outsiders have to be in certain proportion If a firm has committed to finance from lenders the terms and conditions of credit should be borne in mind. Thus, financial decisions should be exercised with great care and caution.
3. Investment decisions : Investment decisions refer to the decisions regarding utilization of funds raised by the firm. It relates to the selection of assets in which funds are to be invested. The funds can be invested in two types of assets, namely –
a) Long term assets or fixed assets
b) Short term assets or current assets.
A large portion of initial funds invested in fixed assets such as land, building, machinery, equipments and furniture, etc. This decision making is popularly known as 'capital budgeting'.
The aspect of investment decisions relating to current assets is known as 'working capital management'. Cash, account receivables; and inventory form the element of current assets. A finance manager has to ensure efficient utilization of every current asset to maintain control on cash inflow and cash outflow.
4. Dividend policy : A business firm is basically a profit earning organization. The earnings, of a firm depend upon efficient utilization of funds. Financial management is also concerned with the decision to declare dividend. A finance manager has to decide what portion of profit is to be retained in the business and balance is to be distributed among shareholders. The shareholders are generally more interested in getting higher rate of dividend while Board of Directors wants to retain earnings for future expansion. The finance manager balances the expectations of investors and use of retained earnings to acquire additional assets.
5. Checking and analysis of financial performance : The checking and analyzing financial performance is very essential to carry out financial functions smoothly For this various financial statements are prepared and analyzed. This is of great value in improving techniques of financial control.
6. Advising Board of Directors : A finance manager provides advice to Board of Directors in respect of financial matters. He suggests various solutions for any financial difficulty. Normally finance manager gives advice on important matters such as pricing, expansion, acquisition, dividend policy etc.
Objectives of Financial Management
Business firms are profit oriented organizations. Their objectives are expressed in terms of money. The basic objectives of financial management are as follows -
a) Profit maximisation
b) Wealth maximisation
Let us learn this in detail.
A. Profit maximisation
Profit maximisation is a basic principle of any business activity. According to this principle, all functions of business aim at profit. The principle of 'profit maximisation' is a traditional concept. It is based on assumption that 'profit is a tool of measuring the success of business firm'. In simple words, the, business firm should undertake only such activities that increase profit. The business activities which decrease profit should be avoided.
Profit maximization is considered to be the most important business objective because of the following reasons -
1. It is difficult for business to survive without profit.
2. Profit is a tool of measuring the success of a business firm.
3. High level profitability results in better returns (dividend) to the shareholders.
4. High level profitability can generate fluids, which can 6e used for future expansion of business.
5. Profit maximization has to be achieved for socio-economic welfare.
B. Wealth maximisation : According to Prof. Soloman Ezra the ultimate goal of financial management should be the maximization of owners' wealth.
According to him, maximization of profit is unreal and half motive. The proper aim of financial management is wealth maximization of equity shareholders.
Wealth maximization is also known as 'value maximization.' It means maximising net present value of a firm.
The focus of financial management- is on wealth maximization of its owners' i.e. suppliers of equity capital. The wealth of shareholders is reflected in market value of the shares. So wealth maximization means the maximization of market price of shares. The wealth of equity shareholders is maximized only when market value of equity shares is maximized.
Equity shares are traded in share market. The share price of a company, quoted in share market. index, is a reflection of its earning capacity, dividend and retention policy. Financial decision making should aim at maximizing market value of equity shares of company.
Additional information :
Besides the above objectives let us consider the most recent and important aspect of a firm's objective i.e. social satisfaction objective.
The business firms in recent time not only think about investors but also welfare of all people in general. The social satisfaction and social welfare are now given equal importance. A business firm operates in society. Therefore, it has certain responsibilities towards society. The interests of suppliers, customers, creditors, employees of company and government are to be protected. The shareholders expect high rate of dividend, customers want products of good quality at reasonable prices, society requires effective and efficient use of scarce resources of production and government insists on obeyance of rules and regulations and payment of taxes regularly. Thus, business firm has to make fulfilment of all such social responsibilities. The profit rnaximization or wealth maximization cannot be the only objective of 6usiness firm. Frorn social point of view the business firms should recognize their social obligations too.
1.3 FINANCIAL PLANNING
Meaning : Financial planning is an important function of financial. management. It is a continuous process in day-to-day administration of business. It is not. possible for finance manager to go ahead unless he prepares 'financial plan'. Financial planning is not only required for profit making but even for survival of a firm. The term financial planning refers to assessment of financial requirements and arranging the sources of capital.
Modern management lays a great emphasis on detailed 'financial plan'. The financial plan must include information about economic environment in which business operates, It , establishes targets of sales and profit. It promotes co-ordination, of resources and efforts to reach these targets. Thus, financial planning is 'an advance programming of all plans of financial management'.
Definition :
J. H. Boneville
"The financial plan of a corporation has two fold, aspects, it refers not only to capital structure of the corporation, but also to the financial policies which corporation. has adopted or intends to adopt."
Thus, Boneville has considered two important things for financial planning i.e.(1) capital structure and (2) financial policies. This will ensure best possible use of funds.
Importance of financial planning : The finance manager gets entire information about the firms activities. On this basis he prepares financial plan. In his efforts to construct financial plan, he is able to build up information. This information is useful for other functions for decision making. An excellent management information system is an asset which serves as 'guide' for overall activities of firm.
Let us discuss significance of financial planning with the following points –
1. Elimination of waste : Due to financial planning, it is possible to eliminate the wasteful expenditure. There are several factors such as change in government policy on taxes, fluctuating interest rates, etc. which can be anticipated and tackled with the help of financial planning. Many organizations have suffered irreversible damage due to wasteful expenditure because of lack of financial planning.
2. Co-ordination : Co-ordination is the most vital part of management Finance holds the key to a11 activities of organization such as production, distribution, marketing and personnel. These activities will hamper if not supported by proper financial planning. It is responsibility of finance manager to bring about co-ordination among all departmental heads of organization. In other words, financial planning should match production planning, distribution planning, personnel planning and overall corporate planning.
3. Dynamism : Financial planning is a demanding exercise, which requires dynamism on the part of finance manager It means finance manager must take initiative and face various changing financial situations as and when they arise Accurate forecast of future trends are required for effective planning. Unprofitable ventures can be avoided while profitable projects can be undertaken when such forecasts are available. Thus, dynamism becomes an integral part of effective financial planning.
4. Communication : Communication is an effective tool of management. Financial planning enables the finance manager to communicate various aspects of financial plan to, the executives of other departments. Detailed policies and procedures must be made known to every one in the organization, so that there is no wastage of time, goodwill and financial resources. Effective financial planning helps finance manager to communicate easily with others in the organization.
5. Decision making : It is necessary for a firm to take appropriate and timely decisions to achieve its objectives. Financial planning prepares, itself for attainment of these objectives. Any scheme, how so ever effective, cannot go through unless budgetary provision is made in the financial planning.
6. Integration : Financial planning gives a fairly good idea to the firm about its available resources. Financial planning is to be completed in all consultation and co-operation of other departments. This promotes team spirit among all executives. The financial planning assists in integration of firm's activities.
7. Futuristic : Financial planning is effective when it foresees events. It means, it must take into account not only present but also future developments. This futuristic element of financial plan helps for advance programming.
Sound financial planning is the key to successful business operations.
- Comment.
1.4 CAPITAL STRUCTURE
Meaning : Capital structure constitutes two words i.e. capital arid structure Capital refers to investment of funds in the business while structure means arrangement of different components in proper proportion. Thus capital structure means 'mix-up of various sources of funds in desired proportion'.
Once the capital requirement of firm, is decided, attention is given to the kind of capital sources which can be raised to meet this need.
A company can raise its capital from different sources i.e. owned capital or borrowed capital or both. The owned capital consists of equity share capital, preference share capital, reserves and surplus. On the other hand, borrowed sources are debentures, loans, etc. Proportion of different sources are used in capital structure.
To decide capital structure means, to decide upon the ratio of different securities in total capital. It is nothing but 'composition of capital'.
Definition :
Weston and Bringham
"Capital structure is the permanent financing of firm represented by long term debt, preferred stock and net worth."
R. H. Wessel
"The long term sources of funds employed in a business enterprise."
John H. Hampton
"A firm's capital structure is the relation, between the debt and equity securities that makes up the firm's financing of its assets."
Thus, the term capital structure means 'financing mix'. It refers to the proportion of different securities raised by a firm for long term finance.
Components / parts of capital structure
There are four basic components of capital structure. They are as follows :
1) Equity share capital : It is the basic source of financing activities of business. Equity share capital is provided by equity shareholders. They buy equity shares and help a business_ firm to raise necessary funds. They bear ultimate risk associated with ownership. Equity shares carry dividend at fluctuating rate, depending upon profit.
2) Preference share capital : Preference shares carry preferential right as to payment of dividend and have priority over, equity shares for return of capital when the company is liquidated. These shares carry dividend at a fixed rate. They have limited voting rights.
3) Retained earnings : It is an internal source of financing. It is nothing but ploughing back of profit.
4) Borrowed capital : It comprises of the following -
a) Debentures : A debenture is an acknowledgement of loan raised by company. Company has to pay interest at an agreed rate.
b) Term loan : Term loans are provided by bank and other financial institutions. They carry fixed rate of interest .
To understand above concept thoroughly, we shall consider following balance sheet
Example :
Balance sheet of Sunrise Company Limited as on 31st March 2012,
Liabilities
|
Amount
Rs
|
Assets
|
Amount
Rs.
|
Share Capital
5000 Equity Shares
of Rs. 10 each fully paid 1000, 10% Preference Shares of 100 each fully paid
Reserves & Surplus
General & Surplus
Liabilities
1000, 12% Debentures of
Rs. 100 each fully paid
Sunday Creditors
Bank Overdraft
Bills Payable
|
50,000
1,00,000
20,000
1,00,000
40,000
20,000
10,000
|
Fixed Assets
Building
Plant & Machinery
Current Assets
Cash in hand
Cash at Bank
Sunday Debtors
Inventories
|
2,00,000
80,000
14,000
24,000
12,000
10,000
|
3,40,000
|
3,40,000
|
Capital Structure = Equity shares + Preference Shares + Reserves + Debentures
= 50,000 + 1,00000 + 20,000 + 1,00,000
= 2,70,000
Factors influencing capital structure:
Factors
Internal Factors External Factors
1. Requirement of capital 1. Market conditions
2. Size and nature of business 2. Attitude of investors
3. Growth of business firm 3. Cost of capital
4. Adequate and stable earning 4. Government regulations
5. Cash position . 5. Attitude of financial institutions
6. Period of finance 6. Rate of interest
7. Future plan 7. Taxation
8. Trading on equity 8. Competition
9. Capital gearing
10. Attitude of management
The pattern of capital structure of various firms varies widely. There is no hard and fast rule for the proportion of owned funds and borrowed funds. So to determine the best pattern of capital structure many factors are to be borne in mind. The factors which play vital role in capital structure determination are divided into two -
A) Internal factors
B) External Factors
A. Internal Factors
1. Requirement of capital : When a new business is. started, it cannot issue variety of securities. This is because there is considerable risk involved, at initial stages of new company. The, ideal structure for new company is to raise capital through equity shares.
Other types of securities may be issued by company in future. The company may require additional funds for expansion or modernization, etc.
2. Size and nature of business : The size of business has great impact on its capital structure. Large manufacturing companies have huge investments in fixed assets such as land, machinery, building etc. Further these fixed assets can be offered as securities against issue of debentures. Hence, these firms may raise funds by issue of equity shares along with debentures.
On the other hand trading concerns require more working capital. They can raise funds by issue of equity as well as preference shares.
In case of small companies capital requirement is less They have less capacity to raise funds from external sources.
3. Growth of business firm : Different capital structures may be required at various stages of development of company.
At initial stages of development, equity capital and short term loans are the main sources of finance. When a company grows in size, it can utilize sources of finance such as preference shares, debt capital etc.
The well established concerns with goodwill and reputation can acquire funds from various sources. .
4. Adequate and stable earning : The business firms with stable earning will have 'stable earnings per share' (i.e. EPS). Such companies can utilize source of debt capital as they can easily pay a fixed rate of interest. Therefore, developed companies usually employ more amount of loan capital.
The business firm with unstable earning should not opt debt in their capital structure, as they may face difficulty in meeting fixed amount of interest.
5. Cash position : The companies. expecting large and stable cash inflow in future, can utilize large amount of debt capital in their capital structure.
It is quite risky for those companies whose cash inflow is unstable and unpredictable to have debt capital. It is because when company raises loan capital it becomes compulsory to pay interest on that. If company fails to pay interest, this may cause situation of financial insolvency for the company.
6. Period of finance : While framing capital structure the 'period for which finance is needed', should also be considered.
If funds are required on regular basis, the company should raise funds through issue of equity shares.
If funds are required for short period of time the firm should raise funds through issue of debentures or redeemable preference shares.
7. Future plan and development : While designing capital structure, management should keep in mind the future development and expansion plans. Equity capital can be issued in the beginning. The debentures and preference shares may be issued in future to finance developmental plans.
8. Trading on equity : The use of borrowed capital for financing a firm is known as Trading on equity. The policy of 'Trading on equity' is based on premise that, if the rate of interest on debt is lower than rate of companies earning, the equity shareholder will enjoy advantage in the form of additional profit. Higher rate of dividend to equity shareholders improves goodwill of the company. It increases market value of shares. This improves creditworthiness of the company and company will be able to raise further loan at. lower rate of interest.
But if company earnings are not sufficient, it may face financial crises. The interest on debt has to be paid even in case of loss. The whole earnings may exhaust in payment of interest.
No dividend would be declared to shareholders. This will affect goodwill and creditworthiness of the company. It will not be able to raise further loans.
Thus, trading on equity is double edged sword. It may increase income of shareholders if the things go right. On the other hand, it increases risk of loss under adverse conditions.
9. Capital gearing : It is a ratio between debt capital (fixed interest) and equity capital (variable dividend). If the proportion of debt capital is high as compared to equity share capital, it is high gearing. On the other hand, if the proportion of debt capital is less as compared to equity share capital, it is a state of low gearing. A proper mix of various types of finance should be maintained in capital structure, so that the interest of equity shareholders is protected.
10. Attitude of Management : The capital structure is influenced by the attitude of persons in the management. The management's attitude towards 'control of firm', should be noted minutely. If the management has strong will of exclusive control, then preference shares and debt capital are used as source of finance.
B. External Factors
1. Market conditions : The pattern of capital is also influenced by prevailing market conditions. Readiness of investors to purchase shares, interest rate, stages of business cycle, tax, risk of investment, etc together form market conditions.
The various methods of financing should be considered in the prevailing market conditions. For eg: If share market is in a declining situation, a company should not issue equity shares but issue debt. On the other hand, during the period of boom in share market, it should issue equity shares to raise capital.
2. Attitude of investors : Attitude of investors also plays an important role. in determination of capital structure. The investors who are ready to take risk and expect higher returns prefer equity shares for investment. On the contrary, cautious investors, who are interested in safe and assured income, invest in debentures.
3. Cost of capital : Cost of capital is one of the important factors while designing capital structure. The cost of capital is the minimum return expected by its supplier. The expected return depends upon the degree of risk. The high degree of risk is assumed by shareholders than debt holders. In case of debt holder, rate of interest is fixed, while rate of dividend given to shareholders is not fixed. The loan of debt holder is repaid within the prescribed period whereas shareholders get back their capital only when company is liquidated. Thus 'debt' is a cheaper source of capital than equity. The preference share capital is also cheaper but not cheap as debt. However, it should be realized that company cannot minimize cost of capital by employing only debt.
At a particular point beyond which, debt becomes more expensive because of increased risk of excessive debt.
4. Government rules and regulations : Statutory obligations play important role in capital structure decision. The SEBI has prescribed debt : equity ratio norm of 2:1. A higher debt-equity ratio of 3:1 has been permitted for large capital intensive project. The small-industrial projects are given concession and aid by government to avail more debt capital as compared to equity capital.
5. Attitude of financial institutions : It is another factor which is to be considered while determining capital structure.
If financial institutions prescribe high terms of lending, then management has to move to other source of financing.
If financial institutions prescribe easy terms of lending, it would be advantageous to obtain funds at cheaper rate.
6. Rate of interest : The prevailing rate of interest plays vital role in determining, capital structure: If prevailing interest rates are higher, firms will delay debt financing. On the other hand, if prevailing interest rates, are lower, firm will opt for debt financing.
7. Taxation : Interest paid against debt is tax deductable expenditure. Dividend is not considered as tax deductable expenditure for the company. As such, issue of debt capital is more advantageous than issue of share capital.
The companies with higher taxes employ debt capital as it is tax deductable expense.
8. Competition : The firms which are facing cut-throat competition prefer to issue equity shares, because their earnings are not certain and adequate. But the companies which have monopolies may issue debt capital because of certainty of earnings.
Sound or appropriate Capital Structure
There is no ideal pattern of capital structure. An appropriate mix of securities in capital structure help in maximization of 'earning per share' i.e. EPS.
Example :
A Sunrise Company Ltd. has share capital of Rs. 2,00,000 divided in 20,000 equity shares. This company has an expansion programme requiring an investment of another Rs. 1,00,000. The management is considering alternatives as follows –
a) Issue of 10,000 equity shares of Rs. 10/- each
b) Issue of 10,000 12% preference shares of Rs. 10 /- each.
c) Issue of 1000 10% debentures of Rs. 100/- each
Let us calculate EPS assuming the earning of company is Rs. 50,000 before interest and tax (i.e. EBIT) and tax rate at 50%.
Present and Projected Earning per share
Particular
|
Present capital structure
|
Proposed capital structure
| ||
All Equity
|
All Equity
|
Equity + Preference
|
Equity + Debt.
| |
Earning before interest
|
50,000
|
50,000
|
50,000
|
50,000
|
Less Interest
|
-
|
-
|
-
|
10,000
|
Less Tax @ 50%
|
50,000
25,000
|
50,000
25,000
|
50,000
25,000
|
40,000
20,000
|
Less Pref. Dividend
|
-
|
-
|
12,000
|
-
|
Profit
|
25,000
|
30,000
|
20,000
|
20,000
|
No. of Equity share
|
20,000
|
30,000
|
20,000
|
20,000
|
EPS
|
1.25
|
-0.83
|
-0.65
|
1.00
|
The above table indicates that use a debenture in capital structure is desirable:
1.5.A. FIXED CAPITAL
Meaning
The concept of 'fixed capital' was first theoretically analysed by economist David Recardo. It refers to any kind of real or physical capital i.e. fixed assets. It is not used for the production of goods. Fixed capital is that portion of total capital which is invested in fixed assets such as land, building, equipment, etc.
According to Karl Mark
"Fixed capital also circulates, except that the, circulation time is much longer".
A fixed asset may be held for 5, 10 or 20 years and more. Thereafter it may be sold or re-used.
In National Accounts, it is defined as "the stock of tangible, durable fixed assets owned or used by resident enterprises for more than one year.
This includes building plant, machinery, vehicle, equipment, etc."
The European system of National and Regional Accounts includes intangible assets such as computer software, copyright etc within the definition of fixed assets.
An owner can obtain funds for purchase of fixed assets from capital market. Funding can come from selling shares, issuing debentures, bonds or even long term loans.
A person who invests money in fixed capital, is tying up his money in fixed assets, with hopes to make a future profit. Such an investment goes along with risk.
Factors affecting requirement of Fixed Capital
Factors affecting fixed capital requirement
Nature of business
Size of business
Growth and expansion of business
Stage of development of business
Business cycle
1. Nature of business : The nature of business certainly plays a vital role in determining fixed capital requirement. For e.g. Rail, Road and other public utility services have large fixed investment. They need to invest in huge sum in fixed assets. Their working capital requirements are nominal, because they supply services and not product. They deal in cash sales only.
2. Size of business : The size of business also affects fixed capital needs. A general rule applies that the bigger the business, the higher the need of fixed capital. Size of firm, either in terms of its assets or sales, affects the need of fixed capital.
3. Growth and expansion : A growing firm may need to invest money in fixed assets in order to sustain its growing production and turnover.
4. Stage of development of business : The requirement of fixed capital for a new undertaking is greater than that of an established business.
5. Business cycle : When there is boom period in the economy, additional investment in permanent assets may be made by firm to increase their production capacity. Hence the need of fixed capital increases .
1.5.B. WORKING CAPITAL
Meaning
There is no universally accepted definition of working capital. Various financial experts have used this term in different ways.
Some explain it in a narrow sense while some in a wide sense. In the narrow sense, it is the "difference between current assets and current liabilities".
Gerstenbergh defines it as follows
"The excess of current assets over current liabilities".
The current assets minus current liabilities approach refers to 'net working capital'. Gerstenbergh does not call it as working capital. He prefers to call it as circulating capital.
In broad sense, the term working capital is defined as follows
1. Mead, Baker & Mallot
"Working Capital means current assets:"
2. J. S. Mill
"The sum of current assets is working capital of a business."
3. Western and Brigham
"Working capital refers to a firm's investment in short term assets - cash, short term securities, account receivable and inventories".
This approach has broader application. It takes into consideration all current resources of the company. It refers to 'gross working capital.'
Factors affecting the requirement of working capital
Factors affecting working capital requirement
Nature of business
Size of business
Volume of sale
Production cycle
Business cycle
Factors affecting
Terms of purchase and Sale
Credit capital
Growth and expansion
Management ability
External factors
Requirement of cash
Seasonal fluctuation
1. Nature of business : The working capital requirements are highly influenced by the nature of business. Industrial and manufacturing enterprises, trading firms require large sum of working capital. Big retail stores need a large amount of working capital as they have to maintain large stock of variety of goods. .It is because they have to satisfy varied and continuous demand of consumers.
2. Size of business : The size of business also affects the requirement of working capital. Size of the firm may be estimated in terms of scale of operation. A firm with large scale operation will require more working capital.
3. Volume of sale : This is the most important factor affecting size of working capital. The volume of sale and the size of working capital are directly related with each other. If the volume of sales increases, there is an increase in amount of working capital.
4. Production cycle : The process of converting raw material into finished goods is called. 'production cycle.'
If the production cycle period is longer, the firm needs more, amount of working capital. If the manufacturing cycle is short, it requires less working capital.
5. Business cycle : When there is upward-swing in economy, sales will increase. This will lead to increase in investment in stock. This act will require additional working capital.
During recession, period, sales- will decline and consequently the need of working capital will also decrease.
6. Terms of purchase and sales : If credit terms of purchases are favourable and terms of sales are less liberal, then requirement of cash will be less. Thug working capital requirement will be reduced. A firm gets more time for payment to suppliers. A firm which enjoys more credit facilities needs less working capital.
On the other hand, if firm does not get proper credit for purchases and adopts liberal credit policy for sales, requires more working capital. .
7. Credit control : Credit control includes the factors such as volume of credit sales, the terms of credit sales, the collection policy, etc. If credit control policy is sound, it is possible for the company to improve its cash flow. If credit policy is liberal, it creates a problem of collection of funds. It can increase possibility of bad debt. A firm selling on easy credit terms require more working capital. The firm making cash sales requires less working capital.
8. Growth and expansion activities : The working capital requirement of a firm will increase with growth of firm. The growth of firm is in terms of sales or even fixed assets.
A growing company needs funds continuously to support large scale operation.
9. Management ability : The requirement of working capital is reduced if there is proper coordination in production and distribution of goods.
A firm stocking on heavy inventory calls for higher level of working capital.
10. External factors : If the financial institutions and banks provide funds to the firm as and when required, the need of working capital is reduced.
11. Requirement of cash : The working capital requirement is also influenced by the amount of cash required by firm for various purposes.
If the requirement of cash is more then company needs higher amount of working capital.
12. Seasonal fluctuations : The demand for products may be of seasonal nature. During certain season the size of working capital may be bigger than that in another period for e.g. Before rainy season umbrella and raincoat manufacturing companies need more working capital to manufacture above goods so that they can put these goods before mansoon starts.
1:6 DISTINCTION BETWEEN
Sr. NO.
|
Points
|
Fixed Capital
|
Working Capital
|
1.
|
Meaning
|
Fixed capital refers to any kind of physical capital i.e. fixed assets.
|
Working capital refers to current assets minus current liabilities.
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2.
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Nature
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It stays in business almost permanently i.e. for more than one accounting year.
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Working capital is circulating capital
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3.
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Purpose
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It is not used up in production of product but invested in fixed assets such as land building, equipment, etc.
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Working capital is invested in short term assets such as cash, account receivable, inventory, etc.
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4.
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Sources
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Fixed capital funding can come from selling shares, debentures, long term loans, bonds, etc.
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Working capital can be funded with short term loans, deposits, trade credit, etc.
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5.
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Objective of investor
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Investor invests money in fixed capital hoping to make future profit.
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Investor invests money in working capital for getting immediate return.
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6.
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Risk involved
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Investment in fixed capital implies a risk.
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Investment in working capital is less risky.
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SUMMARY
Business finance deals with all financial activities of business. Business finance is almost identified with corporation finance and now it is known as financial management.
Financial management is concerned with raising of funds and their effective utilisation in business. Financial planning is an advance programming of all plans of financial management.
Capital structure refers to the proportion of different securities raised by a firm for long term finance.
Fixed capital is that portion of capital which is invested in fixed assets such as land, building, equipments, etc.
Working capital refers to a firm's investment in short term assets such as cash, account receivable and inventories.
Key Terms
Business finance : Corporation finance or financial management .
Financial Management : Management of business funds.
Forecasting of finance : Budgeting financial needs
Profit maximization : Principle of business that aims at making maximum profit.
Wealth maximization : The maximization of market price of shares.
Financial planning : Advance programming of financial plan.
Capital Structure : Composition of capital
Trading on equity : Use of borrowed funds for financing business.
Capital Gearing : Ratio between debt capital and equity capital.
Fixed Capital : Funds invested in fixed assets.
Working capital : Sum of current assets.
EXERCISE
Q.1 A. Select the correct answer from the possible choices given below and rewrite the statements .
1. Business finance deals with ……………. activities of business.
a) manufacturing b) selling c) financial
2. A business firm is basically ……………… organization
a) profit - oriented b) service oriented ' c) Non-profit.
3. Normally ……………… gives advice to Board of Directors in respect of financial matters.
a) Auditor b) Secretary c) Finance Manager
4. Wealth maximization of owner means maximization of …………… of shares.
a) face value b) market value c) issue value
5. Due to ............... planning it is possible-to eliminate wasteful expenditure.
a) Financial b) Sales c) Production
6. The ............... means mix-up of various sources of funds in desired proportion.
a) Capital structure b) Term loan c) Retained profit
7. Large manufacturing companies have …………… investment in fixed assets.
a) huge b) small c) moderate
8. Big retail stores require large amount of …………….. capital.
a) fixed b) working c) loan
9. The ……………… concerns can acquire funds from various sources.
a) well established b) newly established c) small trading
10. Trading on equity means use of ............... capital for financing a firm
a) Equity b) Preference c) Borrowed
11. During the period of boom in share market ……………. are issued to raise capital.
a) bonds b) debentures c) equity shares,.
12. The investors who are ready to take risk prefer ………………. shares far investment.
a) Preference b) equity c) bonus.
13. If share market is depressed a company should issue ………………. capital.
a) debt b) owned c) mix
14. The ……………… is considered as tax deductable expenditure.
a) dividend b) bonus c) interest
15. The ............... capital stay in business almost permanently.
a) fixed b) working c) debt
16. The difference between current assets and current liabilities is ............... capital.
a) debt b) fixed c) working
17. A firm selling on credit terms require ……………. working capital.
a) more b) medium c) less
18. A firm making cash sales requires ............... working capital.
a) less b) more c) no
19. If volume of sales increases, there is ……………… in amount of working capital.
a) an increase b) a decrease c) no change .
20. The SEBI has prescribed debt - equity ratio norm of ..............
a) 1:1 b) 2:1 c) 2:2
Q.1 B. Match the pairs.
Group A
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Group B
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a. Financial management
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1. Minimise market value of equity shares
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b. Wealth maximization
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2. Investment in fixed assets
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c. Financial plan
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3. Ratio of buying and selling
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d. Capital structure
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4. Management of business funds
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e. Fixed capital
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5. Ad hoc programming of finance
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6. Investment in current assets
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7. Management of business activities
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8. Maximise market value of equity shares
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9. Ratio of different securities in capital
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10. Advance programming of financial management
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Q.1 C Write a word or a term or a phrase which can substitute each of the following statements .
1. A function concerned with raising of finance and its effective utilization in business.
2. The basic principle of business activities that aims at profit.
3. The principle which means maximization of market price of equity shares.
4. An advance programming of all plans of financial management.
5. A mix up of various sources of funds in desired proportion.
6. The ratio between debt capital (fixed interest) and equity capital (variable dividend).
7. The use of borrowed capital for financing business firm.
8. The portion of total capital which is. invested in fixed assets.
9. The sum of current assets of the business.
10. The difference between current assets and current liabilities.
Q.2 Distinguish between the following.
1. Fixed capital and Working capital
Q.3 Write notes on.
1. Role of financial management .
2. Objectives of financial planning
3. Importance of financial planning
4. Capital structure and its components
Q.4 State, with reasons, whether the following statements are True or False.
1. Financial management is essential for all types organization
2. The proper aim of financial management is wealth maximization.
3. Maximisation of profit is real and complete motive.
4. It is not possible to go ahead without financial plan.
5. There is hard and fast rule for the proportion of owned funds and borrowed funds.
6. Trading on equity is double edged sword.
7. Requirement of working capital does not depend upon any factor.
Q.5 Answer in brief.
2. What are the objectives of financial management?
3. What is financial planning? State importance of financial planning.
4. What is fixed capital? State factors affecting requirement of fixed capital.
Q.6 Answer the following questions.
1. What is capital structure? What are the internal and external factors influencing capital structure.
2. What is working capital? State the factors affecting requirement of working capital.
