Chapter 2- Capital

Chapter 2- Financing

Business Finance refer to the Money and Capital Employed in the business.

Financing means making money available when it is needed. 

 

Financial Planning includes the following steps

1. Estimating the amount of funds required.
2. Raising the funds required using various sources finance 
3. Managing the funds so that there is neither surplus/idle  money nor shortage of money which may affect smooth functioning of the enterprise
4. and Controlling all the money so that it put to the best and most use in the business. 

Q. Discuss the role of Capital Planning for smooth and effective functioning of an enterprise.

Ans: A good Capital Planning may help an entrise in the following

         1. Ensure adequate availability of funds at all times. 

        2. It serves as guide towards deciding suitable capital plan and maintain proper balance between Debt and Equity

       3 Helps in effective utilization of funds across different projects of the enterprise.

       4. To Decide on various policies and programmes for different departments.

       5. Exercise an effective control over the financial activities of an enterprise.

Q. Capital Structure and Factors affecting Capital Structure:

Ans.

 Meaning of Capital Structure

Capital Structure is referred to as the ratio of different kinds of securities raised by a firm as long-term finance. The capital structure involves two decisions-

a.     Type of securities to be issued are equity shares, preference shares and long term borrowings (Debentures and Loans).

b.     Relative ratio of securities can be determined by process of capital gearing. Deciding the ratio between Debt ( Borrowed money) and Equity(Owners Funds) is known Capital Gearing. In case proportion of Debt is more than Equity, the capital structure is said to be highly geared. On the other hand, if the proportion of Equity is greater than Debt, it will be a low geared Capital Structure.

Factors Determining Capital Structure

1.     Trading on Equity- In case a company uses borrowed funds to finance its Capital requirements, along with equity capital, it is said to be trading on equity. In case the earnings of the company are higher than rate of dividend on preference capital and the rate of interest on borrowed capital, equity shareholders are at an advantage and can get higher rate of earnings per share. Therefore,  a company should go for a judicious blend of preference shares, equity shares as well as debentures. Trading on equity becomes more important when expectations of shareholders are high.

2.     Degree of control- Equity shareholders have voting rights and elect directors of a company. Preference shareholders have restricted voting rights while debenture holders have no voting rights. If the company’s management policies are such that they want to retain their voting rights and control over the company in their hands, additional funds should be raised from issue of debentures and preference shares.

3.     Flexibility of financial plan- In an enterprise, the capital structure should be such that there enough possibility of extension and contraction of funds. Debentures and loans can be refunded back as the time requires. While equity capital cannot be refunded at any point which provides rigidity to plans. Therefore, in order to make the capital structure flexible, the company should go for issue of debentures and other loans.

4.     Needs of investors-   Capital structure should give enough choice to all kind of investors to invest. Bold and adventurous investors generally go for equity shares, whereas conservative and cautious investors who want regular returns and safety of investment chose to invest in Debentures and Preference shares.

5.     Capital market condition-  The state of capital market has a huge influence of the investment decisions of the investors. During the depression period, the risk appetite of investors is generally low and would prefer to invest in securities which offer regular return and safe. Hence the company should issue debentures and preference shares during conditions of depression (bearish market). While in period of boom and inflation, the investors are willing to take risks and invest in equity shares.

6.     Period of financing-  For funds required for permanent use, a company should issue equity shares, for medium term and long term- debentures and preference shares should be issued.

7.     Cost of financing- In a capital structure, the company has to look to the factor of cost when securities are raised. It is seen that for profit earning companies, debentures is a cheaper source of finance as compared to equity shares, where equity shareholders demand an extra share in profits. Hence a company should estimate and compare the costs of different sources of finance before making a choice among them.

8.     Cash Flow Position:  An established business which has a growing market and high sales turnover, the company is in position to meet fixed commitments. Interest on debentures has to be paid regardless of profit. Therefore, when sales are high, thereby the profits are high and company is in better position to meet such fixed commitments like interest on debentures and dividends on preference shares. If company is having unstable sales, then the company is not in position to meet fixed obligations. So, equity capital proves to be safe in such cases.

Q: - What are the capital needs for different types of business organizations and briefly discuss the sources from which funds can be raised by each of them?

Ans: 1) Sole Proprietorship: Sole proprietor works on small scale. His capital needs are less as compared to Joint Stock Company or a firm. He can raise his capital needs through the following sources:-

i)                    He can invest his own capital.

ii)                  He can borrow from his friends and relatives.

iii)                He can borrow from the bank for short term needs and long term loans may be provided by financial institutions such as  State Financial Institution.

iv)                He can retain profits and reinvest in the business.

v)                  He can take advances from the customers. And he can also buy goods on credit and pay them later on.

vi)                The central or State Govt. may also provide financial support to small scale traders.

  2. Partnership:- A partnership business operates on a higher scale as compared t o sole proprietorship. The amount of funds required depends upon the nature and size of business. A manufacturing concern may require more capital as compared to a trading concern. A partnership firm can raise funds through the following sources:-

i)          Capital contribution by the partners

ii)         Borrowing from friends and relatives.

iii)        Borrowings from banks and financial institutions

iv)        Advances from customers

v)         Sometimes partners may also advance loans to the firm.

3. Joint Stock Company:- A Joint Stock Company operates on a large scale. Financial requirements are huge as compared to a partnership firm. A company can have more members. The total funds required depend upon many factors such as nature of business, size of the business etc. It has more options to raise funds.  There are various sources for raising long term as well as short term funds. The following are the sources for raising funds for long term:

i)          Equity Shares

ii)         Preference Shares

iii)        Debentures

iv)        Loans from Special Financial Institutions

v)         Ploughing  back of profits i.e retained profits

Funds can also be raised for short term through the following sources:

i)        Public Deposits

ii)      Trade Credits

iii)    Advances from Customers

iv)    Loans from Banks and other short term borrowings from commercial banks like –

Discounting of bills of Exchange

Bank Overdraft

Cash Credits 

Q: - What is fixed capital? Discuss the factors on which requirement of fixed capital depends.

Ans.: The capital invested in fixed or permanent assets like land and buildings, plant and machinery, furniture, etc.. is known as fixed or block capital.

   Fixed capital is that portion of the capital which is represented by fixed assets. Fixed capital is known as block capital because it is blocked in fixed assets for a long period of time. Therefore, it is raised through long term sources like shares, debentures, long term loans and retained earnings. 

   The amount of fixed capital required for an enterprise depends on the following factors:-

1.Nature of business a manufacturing enterprise and public utility concerns like water and sewerage, electricity companies, telephone companies etc require a larger amount of fixed capital as compared to a trading or commercial concerns.

2. Scale of operations.  A large enterprise generally requires greater fixed capital than a small scale enterprise.  For instance, a large scale steel enterprise like the Tata and Iron steel company requires a huge investment in fixed assets in comparison with a mini steel plant.

3, Nature of products: A company manufacturing consumer goods like toothpaste, cream, pens etc. will require a smaller amount of fixed capital. On the other hand, a company manufacturing heavy and capital goods like, machinery, plant, refrigerators, cars etc will require large amount of fixed capital.

4. Diversity of production line: A company manufacturing multi-products will require large amount of fixed capital as compared to business unit manufacturing a single product.

5. Degree of mechanization:  The technique of production also affects the amount of fixed capital. A firm using automatic machinery requires greater fixed capital than another firm of same size using labour or hand tools. For example, a textile mill using power looms needs more fixed capital than a hand-loom.

6. Mode of acquiring fixed assets:  A company purchasing its fixed assets on cash basis will need large amount of fixed capital as compared to a company which purchases on installment basis, or lease basis or on rent.

7.Scope of activities.  An enterprise which produces all parts of a product will require more fixed capital than the concern which is engaged in assembling the parts purchased from other firms.

Working Capital

   Every business requires some finance to acquire current assets like raw material, stock of goods and cash needed for day to day expenses of the business. Funds needed for such purposes forms a part of working capital.  In other words – working capital is that part of the total capital which is required to meet the day to day expenses of the business and to maintain a minimum balance in current assets.

Different concepts of working capital:-

Gross working Capital :-It is sum total of all the current assets of the business e.g. cash, stock, short term investments, debtors, bills receivable, expenses prepaid, incomes receivable. Current assets keep on circulating in a circular manner. E.g. Cash is used to acquire raw material, which is converted into finished goods. Finished goods are sold and converted into receivables (debtors and bills receivables), which ultimately are realized and converted into cash.

Net Working Capital ;-  It means the difference between Current Assets and Current Liabilities. Excess of current assets over current liabilities represent net working capital. There are various current liabilities, which have to be met out of the current assets. Current assets should always be more than the current liabilities; otherwise the business might land into financial crisis.

Permanent Working capital:- It represent that part of the working capital which remains permanently blocked in the current assets of the business e.g. minimum balance of Cash that should always be maintained in the business to meet any emergency requirement, and the balance of finished goods kept as reserve to meet any emergency order etc.

Variable Working Capital :-  It is that part of the working capital which keeps on changing with the change in the nature and size of the business.

FACTORS DETERMINING REQUIREMENT OF WORKING CAPITAL:-

1.Nature of business. The nature of the business is the basic factor deciding the amount of working capital. Public utilities undertakings require a very small amount of working capital. Trading concerns and financial undertakings require relatively large amount, whereas manufacturing undertakings require a sizeable amount of working capital.

2. Size of business:  The working requirements are directly proportional to the size of the business. It is also affected by the increase and expansion of the scale of business.

3. The proportion of cost of raw material to total cost:  Where the cost of raw material used in manufacturing a product is large in proportion to the total cost, the requirement or working capital will be large. That is why cotton textiles and sugar mills require huge amount of working capital. A building contractor also needs large amount of working capital for this reason.

4. Use of manual labour or machines: - A business undertaking using modern machines and techniques for production requires small amount of working capital compared to labour intensive industries where requirement is large due to more burden of payment of wages and salaries.

5. Seasonal variation:- In certain industries raw material is not available throughout the year. They have to buy raw material in bulk during the season to maintain uninterrupted production during the entire year. As such more amount of working capital will be required to keep stock of raw material.

6. Terms of credit : A company purchasing its raw material for cash and selling its finished goods on credit will be requiring more amount of working capital. On the contrary if a concern is in a position to buy its raw material on credit and sell its finished products on cash basis will require less amount of working capital. The length of the period also effects the requirement of working capital.

7. Production Policy: In certain industries, the demand for the product is subject to wide fluctuations due to seasonal variations.  If it is decided to keep the production constant throughout the year to generate sufficient stock for the season, large amount of working capital will have to be blocked up in finished products. On the other hand if the production policy is to reduce the production during off-season, the requirement of working capital will reduce consideration.

8. Working capital cycle:  In a manufacturing concern, the working capital cycle starts with the purchase of raw material and ends with the realisation of cash form the sale of finished good. The longer the cycle, the more will be the requirement of working capital.

IMPORTANCE/SIGNIFICANCE OF WORKING CAPITAL

   Adequate working capital is required to meet day to day working of the business and pay the operating expenses of the business. Sufficient working capita indicates solvency of the business. The liabilities are discharged in time and the business attains better image in the market. Regular payment of salaries and wages boost the morale of employees. The main points of importance can be discussed under the following headings:-

1.Timely payment of dues.  Timely payment of dues to parties and creditors is possible, if the business has adequate working capital. This will increase the goodwill of the business.

2.Ensure solvency of the business : Adequate working capital ensure short-term solvency of the business.  A running business might be closed for want of sufficient working capital when payment is not made to the creditors and of interest in time.

3.High credit-worthiness:  The credit status of the business depends on its ability to pay outsiders and the promptness with which payments are actually made. Credit-worthiness of the business is rated high if its working capital position is found satisfactory.

4.Timely payment of Dividend  Liquid cash is necessary for the payment of dividends. Due to scarcity of money, if dividends are not given to shareholders, an adverse reaction may be created among them. As a result the business may lose its reputation.  Therefore, adequate working is very much needed for timely payment of dividends.

5. Taking advantage of cash discounts: A business having sufficient working capital is able to take advantage of cash discounts offered by suppliers in return for prompt payments.

6. Meeting daily operating expenses: It is necessary to purchase raw materials, pay wages and salaries, and incur various expenses in order to keep the flow of production uninterrupted, the smooth operations of the business largely depend on the adequate working capital

7. Enhancing morale of employees: A business is able to pay wages and salaries regularly provided it has enough working capital. It enhances the morale of its employees. The sense of security and the confidence of the workers of the workers depend on the strength o the working capital of the business.

       8.  Availing of better market opportunities:  In case the market conditions are not
        favorable to get good price for the product in the short run, a business with adequate   
      working capital can wait by holding up stocks in order to secure higher price.

Difference between Fixed and Working Capital
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