CH.2 Capital - Fixed and Working Flashcards
Business finance meaning and definition
Business finance refers to the money and credit employed in business firms.
According to B.O. Wheeler, “Business finance is concerned with the acquisition and utilisation of capital funds in meeting the financial needs and overall objectives of a business enterprise”.
Business finance may be defined as planning, raising, managing and controlling all the money or capital funds of any kind used in connection with business.
Nature of business finance
- Business finance includes all types of capital or funds used in business.
- Business finance is needed in all types of businesses - large or small, manufacturing or trading etc.
- Business finance is a wide term
- The amount of business finance required differs from one business firm to another depending upon its nature and size.
- The availability of finance determines the scale of operations of business.
Importance of finance for business
Finance is the lifeblood of business.
In the absence of finance, the production and sale of goods and services are not possible.
In business, finance is required for (a) establishing an enterprise (b) purchase of fixed assets and current assets (c) expansion for growth and modernisation of business
Adequate finance provides the following benefits:
1. The firm can meet its liabilities on time
2. The firm can take advantage of business opportunities
3. The firm can carry out its business smoothly and without any interruptions
4. The firm can replace its plant and machinery on time.
5. Finance helps bridge the gap between production and sales.
Capital meaning
The term ‘capital’ refers to the investment made in an enterprise for the purpose of earning profits.
In business capital is required for production as well as distribution of goods and services.
Capital requirements differ according to the nature and size of business.
Sources of finance for different types of business firms
- Capital for Sole Proprietorship Business -
A sole proprietor operates at a small scale and, therefore, requires a limited amount of capital. The proprietor brings in his own capital.
In 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. The proprietor can raise loans from his friends and relatives.
He may also borrow money from banks and financial institutions.
Short-term loans for working capital may be obtained from commercial banks and long-term loans from State Financial Corporations and other financial institutions. - Capital for Partnership Firm - Capital requirements as well as the capital base of a partnership is bigger than that f a sole trader business. The owned capital is contributed by the partners in an agreed ratio. A partnership firm can also raise loans from commercial banks and financial institutions.
- Capital for Joint Stock Company - A joint stock company generally requires a large amount of capital. A public company can raise huge capital through the issue of shares. It can raise borrowed capital through debentures and loans. Long-term loans can be obtained from financial institutions. Short term loans are available from commercial banks.
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.
Financial planning features
- Financial planning involves deciding when, how and why of financial activities.
- Like any other planning it is future oriented and involves forecasting.
- It involves deciding objectives, policies, procedures, methods and programs concerning funds.
- The scope of financial planning is wide. IT consists of:
a) estimating the amount of fixed capital and working capital needed in business
b) selecting the appropriate sources of funds and their ratio in the total amount
c) formulating polices for use of funds and disposal of earnings.
While formulating the financial plans of a business enterprise, the following factors should be kept in view:
- Objectives - All financial plans should be designed to achieve the financial objectives of an enterprise. The basic financial objectives is the procurement of funds at the the lowest cost and the best possible utilisation of funds.
- Nature of industry - The characteristics of a particular industry in which the enterprise is operating in will determine the financial needs of business and the investment of funds. For example, if the industry is capital intensive ( eg. petrochemicals, iron and steel etc.) the business will require more funds to build and maintain manufacturing capacity.
- Size of the firm - A large enterprise aiming at a steady growth will need more funds.
- Government regulations - Financial policies and regulations of the government affect both availability and cost of funds. For example, reduction in interest rates has reduced the cost of raising debt in India.
- Degree of risk - the degree of risk which an enterprise is willing to assume influences financial planning. Therefore, ratio between equity and debt capital is decided keeping in view the profits and management attitudes of business.
Capital structure meaning and definition
Capital structure means the composition or make up of the amount of long-term funds. Long-term funds can be obtained from: (a) owners and (b) borrowers. Ownership funds consist of share capital and retained earnings. Borrowed funds include debentures and long-term loans. The ratio between equity (owned funds) and debt (borrowed funds) is called capital gearing or financial leverage. When he 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.
According to C.W. Gerstenberg, “Capital structure means the type of securities to be issued and the proportionate amounts that make up the capitalisation”.
Factors affecting capital structure
a) Trading on equity (Financial Leverage) - When a company uses borrowed funds in the regular conduct of 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 a higher earning per share due to two reasons.
First, 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.
b) Exercise of Control - In a company, 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.
c) Nature of Business - Companies enjoying regular and liberal earnings eg. public utilities can afford to have high capital gearing. On the other hand, business firms which are subject to wide fluctuations in demand and earnings may find it safer to depend more on equity capital and preference shares. New firms may find it more difficult to issue debentures and preference shares than well established and growing companies.
d) 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.
e) Cash Flow Positions - The ability of the company to generate enough cash flow to meet its 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.
Meaning of fixed capital
Fixed capital refers to the funds required for the acquisition of fixed assets. Fixed assets are meant for generating income. These assets are used permanently for business operations. Land and building, plant and machinery, motor vehicles etc. are examples of fixed assets.
Fixed capital is also known as ‘block capital’ because it is blocked up in fixed assets for the life time of the enterprise.
According to Wheeler, “fixed capital is invested in fixed or long-term assets. The amount of fixed capital needed, therefore, varies directly with the amount of fixed assets owned or used by a business”.
Factors affecting fixed capital
- Nature of business - The amount of fixed capital varies from industry to industry. Manufacturing enterprises require heavy investment in fixed assets such as land and buildings and plant and machinery.
- Size of the Business - The scale of operations also determines the amount of fixed capital. A large-sized enterprise requires a greater amount of fixed capital than a small scale firm. For example, a giant steel company such as Tata Iron.
- Nature of Products - The types of products produced also determines the amount of fixed capital. A company manufacturing capital goods like machinery will require a large amount of fixed capital. On the other hand, a firm producing consumer products like soaps will need a small amount of fixed capital.
- Method of Production - A company employing capital-intensive techniques of production require higher amount of capital as compared to a company employing labour-intensive techniques such as hand tools.
- Diversity of Product Lines - A multi-product company manufacturing diversified products requires more fixed capital than a firm manufacturing a single product.
- Mode of acquiring fixed assets - A business firm which purchases fixed assets on cash down basis requires huge amount of fixed capital.
- Intangible assets The amount invested in acquiring goodwill. patents, copyrights etc. also influence the amount of fixed capital needed for business.
Meaning of working capital + diagram
Working capital means the capital invested in working assets or current assets such as cash, debtors etc. It represents the liquid funds which are required for the day-to-day operations of a business.
According to Shubin, “working capital is the mount of funds necessary to cover the cost of operating the enterprise.”
Working capital is also known as circulating capital or revolving capital because it keeps on circulating or revolving in business.
The term working capital is used in two senses - gross working capital and net working capital.
Gross working capital means the total amount of funds invested n current assets. Current assets are those assets which are converted into cash in the ordinary course of business.
Gross working capital = Book value of current assets
Net working capital means the excess of current assets over current liabilities.
Net working capital = Current assets - current liabilities.
Need of working capital
i) to purchase raw materials
ii)to pay wages and salaries to staff
iii) to meet day-to-day expenses
Types of working capital with diagram
- Permanent Working Capital - It refers to the minimum amount of working capital required permenantly to operate the minimum level of business activty. It is permanently locked up in current assets.
There are two kinds:
a) initial working capital - It is that part of permanent working capital which is required at the time of commencement of a business.
b) Regular Working Capital - It means that part of working capital which is required for the continuous business operations. - Temporary or Variable Working Capital - It is the working capital that is required in addition to permanent working capital. It is required to meet seasonal and special needs of a business. It is fluctuating n nature. There are two types:
a) Seasonal working capital - It means the extra working capital required during a particular season.
According to Gerstenberg, “Beyond their initial and regular circulating capital most business will require at stated intervals a larger amount of current assets to fill the demands of the seasonal busy periods”.
b) Special Working Capital - It refers to extra funds required to meet future contingencies that may arise in business.
For example:
i) special operations to meet sudden spurt in demand
ii) periods of depression leading up to piling up of inventory
iii) strikes and natural calamities
