Chapter 2: Capital — Fixed And Working

A firm that decides to manufacture garments must buy a building and machines before a single garment is sold. It must then buy cloth, pay wages and meet freight and electricity bills for several weeks before its first customers settle their accounts. Both are demands for money, but they are not the same demand. The first locks up funds for years in assets that are not meant for sale; the second locks up a smaller sum for a short while in stock, debtors and cash, and releases it again as soon as sales are realised. Every business firm therefore faces two questions at once: how much money is needed and for how long, and from where it is to be raised. The answers depend on the form of the organisation, the industry it operates in and the degree of risk its owners are willing to carry. This chapter examines business finance and its importance, the sources of finance open to different types of business firms, the process of financial planning, the factors that shape capital structure, and the meaning, types and determinants of fixed capital and working capital.

Figure

Fig. 2.0-1 — Machines And Materials On A Factory Floor Photograph of a garment factory floor showing rows of industrial sewing machines with bales of cloth stacked alongside them.

2.1 Business Finance And Its Importance

A business firm has to spend before it earns. A building has to be taken, machines installed, materials bought, wages paid and freight met, and every one of these payments falls due long before the goods reach a customer and the sale proceeds come back. The money and credit arranged to bridge that gap is business finance.

Business finance refers to the money and credit employed in a business firm so that its operations can be carried on without interruption. Financing means making money available at the time it is needed. The term is wider than the mere raising of funds, because a firm that raises money and then employs it badly is no better placed than a firm that could not raise it at all.

Definition

Business Finance Business finance is the money and credit employed in a business firm. In the words of B. O. Wheeler, it is concerned with the acquisition and utilisation of capital funds in meeting the financial needs and overall objectives of a business enterprise.

Nature Of Business Finance

It covers funds of every kind — owned funds brought in by the proprietors and borrowed funds raised from outsiders are both business finance, since the firm has to arrange, employ and account for both.
It is needed by every business firm — large or small, manufacturing or trading, because no form of business escapes the gap between payment and receipt.
It is a wide function — it includes estimating the amount of funds required, selecting the sources, investing the funds raised, managing cash, disposing of earnings and controlling the whole of it.
The amount required differs from firm to firm — it depends on the nature and size of the business, and it varies for the same firm from one period to another as its activity expands or contracts.
It determines the scale of operations — a firm can produce and sell only as much as its funds allow it to buy, hold and wait for.

Where Finance Is Required

Finance is required at three points in the life of a firm. It is required at the outset, to establish the enterprise and meet the cost of promotion and setting up; it is required continuously, to buy fixed assets that produce the goods and current assets that keep production and sale moving; and it is required again for expansion, growth and modernisation once the firm has established itself. The significance of finance has grown in modern business because the scale of operations is larger, techniques are capital-intensive and competition compels firms to modernise.

Business Example

Finance Has Its Own Officer The finance function is important enough to be given statutory recognition. Under the Companies Act, 2013, the Chief Financial Officer is treated as key managerial personnel, and prescribed classes of companies are required to appoint one.

Importance Of Adequate Finance

Prompt payment of dues — a firm with adequate funds meets its liabilities on the due date, which raises its credit standing and makes further borrowing easier and cheaper.
Uninterrupted operations — materials, wages and overheads can be met as they fall due, so production and selling continue without stoppage.
Advantage of opportunities — a firm with funds in hand can buy materials in bulk at a low price or accept a large order at short notice, which a firm short of cash must let pass.
Timely replacement of assets — plant and machinery can be replaced or modernised before they become obsolete, and the efficiency of operations is thereby maintained.
Strength in a downturn — recession and trade cycles can be faced with reserves rather than by selling assets in distress.
Regular payment to employees — wages and salaries paid on time improve the sense of security among employees and help the firm to attract and retain talent.
Goodwill in the market — a firm known to be financially sound obtains better terms from banks, suppliers and investors, and its reputation itself becomes an asset.

Adequacy, however, works in both directions. Funds raised in excess of requirement lie idle, earn nothing and reduce the return on the capital employed, while funds raised short of requirement halt the very operations they were meant to support. The object is therefore the right amount of finance, at the right time and at the right cost — which is the task of financial planning, taken up in Section 2.3.

2.2 Sources Of Finance For Different Types Of Business Firms

The term capital refers to the investment made in an enterprise for the purpose of earning profits. Capital is needed both for producing goods and for distributing them, and the amount needed differs according to the nature and the size of the business.

Whatever the firm, the funds it uses fall into two classes. Owned funds are contributed by the proprietors themselves or generated by the business and retained in it; they carry no obligation to repay. Borrowed funds are obtained from outsiders and must be returned with interest on agreed dates. The classification is set out in FC 2.1.

Flowchart

FC 2.1 — Sources Of Finance By Class Of Fund Sources of finance → Owned funds, Borrowed funds; Owned funds → Capital brought in by the proprietor or partners, Share capital, Profits retained in the business; Borrowed funds → Loans from friends and relatives, Loans from commercial banks, Long-term loans from financial institutions, Debentures, Credit from suppliers

What differs from one form of organisation to another is not this classification but the reach of the firm within it. A lender parts with money only where repayment is reasonably assured, and what assures repayment differs sharply between a proprietor trading on his own account and a company owning assets of its own.

2.2.1 Sole Trader

A sole trader operates on a small scale and therefore requires a limited amount of capital. The owned capital consists of the proprietor’s own contribution together with the profits retained in the business and credited to the capital account at the close of each financial year.

Beyond this the proprietor may raise loans from friends and relatives, who lend on the strength of personal acquaintance rather than security. Short-term loans for working capital may be obtained from commercial banks, and long-term loans for the purchase of fixed assets from State Financial Corporations and other financial institutions. Central and State Governments extend special assistance to small-scale units in order to encourage entrepreneurship and self-employment.

Business Example

A Lender For Small Firms The Small Industries Development Bank of India, known as SIDBI, is a development financial institution established to finance and promote micro, small and medium enterprises. Institutions of this kind, along with the State Financial Corporations, allow small firms to obtain term finance that ordinary commercial lending may not reach.

The proprietor may also buy raw materials and finished goods on credit from suppliers, but this trade credit is available only for a short period. The total reach of a sole trader remains narrow, because the firm has no separate legal existence and every lender is in substance lending against the personal standing and unlimited liability of one individual.

Trade Term

Trade Credit Credit allowed by a supplier of goods, under which the buyer takes delivery at once and pays after an agreed period. It is a short-term source of finance obtained without formal security.

2.2.2 Partnership Firm

The capital requirement and the capital base of a partnership are both larger than those of a sole trader, since several persons contribute to the firm in an agreed ratio. Profits retained and credited to the accounts of the partners also form part of the owned capital.

A partnership can raise loans from commercial banks and financial institutions, and lenders are more willing than in the case of a sole trader because the personal liability of all the partners stands behind the debt. Partners may themselves advance loans to the firm over and above their capital. The firm can acquire machinery and equipment on instalment or hire purchase, and obtain short-term credit from suppliers of raw materials and finished goods. What it cannot do is approach the general public for funds.

2.2.3 Joint Stock Company

A joint stock company generally requires a large amount of capital, and it is the only form of organisation equipped to raise it. A public company can collect capital from a large number of investors through the issue of shares, and can raise borrowed capital through debentures. It supplements these with long-term loans from financial institutions and short-term loans from commercial banks, and it may retain profits in the form of reserves instead of distributing them.

The company can reach so far because it is a separate legal person with an existence of its own. Its assets and earning capacity, not the private means of its members, answer for its debts, and an investor’s loss is limited to the amount unpaid on the shares held. A private company, however, is prohibited from inviting the public to subscribe to its securities, and must therefore depend on its members, directors and their relatives, along with borrowings.

The three forms are compared in Table 2.1.

Table

The form of organisation therefore settles the outer limit of what a firm can raise. Within that limit, how much is raised and in what proportion is a matter of deliberate decision, and that decision begins with financial planning.

2.3 Financial Planning

A firm that discovers its need for funds only when a payment falls due has no choice left. It must take whatever money is available, from whoever will part with it, at whatever cost is demanded. A firm that estimates the same need a year in advance can compare sources, negotiate terms and arrange the funds before the need becomes urgent. The difference between the two is financial planning.

Financial planning is the process of estimating the financial requirements of an organisation, choosing the sources from which the funds are to be raised, and deciding how those funds are to be utilised. It is undertaken in advance of the requirement, and it is concerned as much with the use of money as with its collection.

Definition

Financial Planning Financial planning is the process of estimating the financial requirements of an organisation for a specified period, selecting the sources from which the required funds are to be raised, and deciding how the funds so raised are to be utilised.

Features Of Financial Planning

It settles the when, how and why of financial activity — the timing of the requirement, the manner of raising it and the purpose it serves are all determined before any money is raised.
It is forward looking — like every other kind of planning it rests on forecasting, and its accuracy depends on the quality of the estimates of sales, costs and profits on which it is built.
It is a framework, not a single decision — objectives, policies, procedures, methods and programmes concerning funds are all laid down, so that later decisions are taken within a settled frame.
Its scope is wide — it extends from the estimate of the requirement to the disposal of earnings, as set out in FC 2.2.

Flowchart

FC 2.2 — Scope Of Financial Planning Estimating the amount of fixed capital and working capital needed → Selecting the appropriate sources of funds and fixing their ratio in the total amount → Framing policies for the use of the funds and the disposal of earnings

Financial planning thus carries within it decisions concerning capitalisation, capital structure, capital budgeting, credit and collection, and dividend policy.

Importance Of Financial Planning

It avoids both shortage and surplus of funds — because current and future requirements are estimated in advance, the firm is neither halted for want of money nor left holding idle funds that earn nothing.
It guides the building of a sound capital structure — the plan fixes the balance between owned and borrowed funds, and so bears directly on the return earned by the shareholders.
It secures effective utilisation of funds — money is allotted to projects in the order of their importance, and the wastage that follows from unplanned spending is reduced.
It coordinates the departments — production, purchase and sales all work within the limits the plan lays down, so that one department’s spending does not defeat another’s requirement.
It makes control possible — actual utilisation can be compared with planned utilisation, and a deviation can be traced and corrected while it is still small.
It prepares the firm for shocks — a plan that provides for contingencies allows the firm to meet an unexpected setback without disturbing its regular operations.

Business Example

Money Arranged Before It Is Needed A firm that intends to commission a new unit eighteen months hence approaches its lenders at once. A term loan proposal has to be appraised, sanctioned and documented before a single instalment is released, and a firm that waits until the machinery is ordered will find the funds arriving after the payment is due.

Factors Considered In Framing A Financial Plan

Objectives — every plan is designed to serve the financial objectives of the firm, the basic one being to procure funds at the lowest cost and put them to the best possible use.
Nature of the industry — a capital-intensive industry such as iron and steel or petrochemicals needs large funds to build and maintain capacity, while a growing industry needs them for expansion and a competitive one for modernisation and research.
Size of the firm — a large enterprise aiming at steady growth needs more funds, and its past record, credit standing and reputation determine how easily it can obtain them.
Capital market conditions — the cost of the alternative sources and the attitude of banks and financial institutions decide which type of security it is prudent to issue.
Government regulations — financial policies and regulations affect both the availability and the cost of funds, and a plan has to be framed within them.
Degree of risk the firm will assume — funds raised by issuing shares carry little risk, since a dividend need not be paid when profits are inadequate, but too heavy a dependence on shares dilutes the control of the existing owners.

The last of these factors leads directly to the question of proportion. Once the total requirement is settled, the firm must decide how much of it is to be owned and how much borrowed, and that decision is the subject of capital structure.

2.4 Capital Structure And The Factors Affecting It

The long-term requirement of a firm can be met from two directions, and the two behave quite differently. Owned funds carry no promise of repayment and no fixed return, but they dilute the control of the existing owners and are the costlier of the two. Borrowed funds leave control untouched and cost less, but interest must be paid and the principal repaid on the due date whether the year has been profitable or not. The proportion in which a firm combines them is its capital structure.

Capital structure means the composition or make-up of the amount of long-term funds employed in a business. It is concerned with two things together: the types of securities to be issued, and the relative amount raised through each of them.

Definition

Capital Structure Capital structure means the composition of the long-term funds of a firm. In the words of C. W. Gerstenberg, capital structure means the type of securities to be issued and the proportionate amounts that make up the capitalisation.

Flowchart

FC 2.3 — Composition Of Capital Structure Long-term funds → Owned funds, Borrowed funds; Owned funds → Share capital, Retained earnings; Borrowed funds → Debentures, Long-term loans

The two classes are compared in Table 2.2.

Table

Capital Gearing

The ratio between equity, that is owned funds, and debt, that is borrowed funds, is called capital gearing or financial leverage. Where the proportion of debt is high the structure is said to be highly geared, or trading on thin equity; where equity dominates it is said to be low geared, or trading on thick equity.

Trade Term

Capital Gearing The ratio between owned funds and borrowed funds in the long-term capital of a company. A high gearing means debt forms the larger part; a low gearing means equity does.

Trading On Equity

A company is said to be trading on equity when it uses borrowed funds along with equity capital in the ordinary conduct of its business. The practice raises the earnings per share of the equity shareholders for two reasons. First, the rate of return earned on the total funds employed is higher than the rate of interest paid on debt and the rate of dividend payable on preference capital, so the surplus left after serving those fixed claims belongs entirely to the equity shareholders. Second, interest paid on debt is deducted from profits while computing tax, which reduces the effective burden of the debt.

The advantage, however, is conditional. Trading on equity is desirable only where the rate of earnings is higher than the rate of interest and the rate of preference dividend; where earnings are stable and regular enough to pay at least the interest on debentures in every year; and where the company owns sufficient fixed assets to offer as security to the lenders. If the rate of earnings falls below the rate of interest, the shortfall is borne by the equity shareholders and their earnings fall instead of rising. Fixed charge securities therefore carry a threat of insolvency, since debt must be served even in a year of loss. The choice is in the end a trade-off between return and risk.

Factors Affecting Capital Structure

Trading on equity — where the return on investment comfortably exceeds the rate of interest, a larger share of debt raises the earnings of the equity shareholders and the company can afford to gear its structure higher.
Exercise of control — equity shares carry voting rights, so a fresh issue reduces the hold of the existing owners. Promoters who wish to retain control raise the additional funds through debentures and preference shares instead, and the factor weighs most in closely held companies.
Need for flexibility — debentures and preference shares can be paid off when the company no longer needs them, whereas equity shares cannot be paid off during its life. A structure that leaves room for adjustment is preferred, and loan agreements are kept free of heavy restrictions.
Nature of the business — a company with regular and liberal earnings, such as a public utility, can carry a high gearing, while a firm whose demand and earnings fluctuate widely is safer depending on equity, since it cannot promise a fixed payment out of an uncertain income.
Cost of financing — the cost of debt is normally lower than the cost of equity, and a high rate of tax makes debt cheaper still. Against this must be set the floatation cost and the legal formalities involved in an issue of securities.
Period and purpose of financing — funds required permanently are best raised by equity shares, medium-term needs by debentures and preference shares. Finance for an expansion that will itself raise earning capacity may safely be raised through fixed charge securities.
Capital market conditions — in a boom, investors are willing to take risk and equity shares are readily subscribed; in a depressed market they prefer safety, and securities carrying a fixed rate of return find a readier market.
Statutory requirements — the rules governing the issue of securities and the raising of funds from the public must be observed, and they limit what a company in a regulated industry may issue.
Needs of investors — securities of different kinds are issued to suit different investors. Those who seek capital gain and a voice in management are attracted by equity shares, and those who want a regular return with safety by debentures and preference shares.
Cash flow position — a company may earn a good profit and still not hold cash on the date interest or an instalment falls due. Projected cash flow statements are therefore examined before the debt-equity ratio is settled.

Business Example

The Regulator Watches The Issue A company that raises long-term funds from the public by issuing shares or debentures must do so in accordance with the requirements laid down by the Securities and Exchange Board of India. The ease with which a company can meet these requirements influences the source it finally chooses.

Case Snippet

Case 2.1 — Control Or Cheaper Funds Meghdoot Industries Ltd. requires additional long-term funds to set up a second unit. Its promoters together hold a little more than half of the equity and are unwilling to see that holding reduced. The company’s earnings have been steady for several years, and it owns land and plant that lenders are willing to accept as security. Q. Name the factor affecting capital structure that is decisive here, and state one reason why the company may prefer debentures to a fresh issue of equity shares.

Whatever the mix chosen, the funds so raised have to be put to work in two different ways: a part is sunk in assets that will serve the business for years, and a part circulates through its day-to-day operations. The first is fixed capital, taken up next.

2.5 Fixed Capital And The Factors Affecting It

No firm can produce anything until the apparatus of production is in place. Land has to be taken, a building put up, machinery installed and vehicles bought, and all of this has to be paid for before the first unit is sold. The funds required for acquiring such assets are fixed capital.

Fixed assets are the assets used permanently in the operations of the business for the purpose of generating income — land and buildings, plant and machinery, furniture and fixtures and motor vehicles. They are not bought for resale, and they cannot be disposed of without breaking up the business itself. The word ‘fixed’ refers to the permanence of their use, not to their value, which changes with wear, obsolescence and the market.

Definition

Fixed Capital Fixed capital is the amount invested in assets that are used over and over again for a long period. According to Shubin, it means the funds required for the acquisition of those assets that are to be used over and over for a long period, such as land, building, machinery, equipment and tools.

Trade Term

Block Capital Another name for fixed capital, so called because the money is blocked up in fixed assets for the lifetime of the enterprise and cannot be withdrawn without disturbing the business.

Figure

Fig. 2.5-1 — Plant Installed In A Manufacturing Unit Photograph of heavy production machinery installed on the floor of an Indian manufacturing unit, with an operator at the controls.

Fixed capital is needed both for establishing a new enterprise and for the modernisation, expansion and diversification of an existing one. Because the funds remain locked up for years, they are raised from long-term sources — shares, debentures, retained earnings and long-term loans. Short-term borrowing cannot be used for the purpose, since the lender would demand repayment long before the asset had earned back its cost.

Three consequences follow from this permanence, and they explain why fixed capital decisions are taken with such care. The amounts involved are large; the commitment runs over many years; and the decision is largely irreversible, because a machine bought for a particular process cannot be sold again except at a heavy loss. A wrong decision therefore burdens the firm for the whole working life of the asset.

Factors Affecting Fixed Capital

Nature of the business — a manufacturing enterprise and a public utility such as a railway or an electricity supply undertaking must own heavy plant before they can serve anyone, while a trading concern that merely buys and sells needs comparatively little.
Scale of operations — a large enterprise producing a high volume needs greater capacity, and capacity means buildings and machines. A large integrated steel plant therefore requires far more fixed capital than a mini steel plant.
Nature of the products — a firm manufacturing capital goods such as machinery and engines requires a large amount of fixed capital, whereas a firm producing consumer articles such as soap, hair oil or toothpaste requires much less. Heavy industries such as shipbuilding need more of it than light industries such as a sugar mill.
Type of manufacturing process — processing industries, in which the material is treated and transformed, require heavier plant than assembly and service industries, in which bought-out parts are put together or a service is rendered.
Method of production — a firm employing capital-intensive techniques such as automatic machinery needs more fixed capital than a firm of the same size employing labour-intensive techniques. A power loom unit requires far more than a handloom unit producing the same cloth.
Diversity of product lines and scope of activities — a multi-product firm requires more fixed capital than a single-product firm, and a firm that manufactures every part of the finished product itself requires more than one that buys the components from outside and only assembles them.
Mode of acquiring fixed assets — a firm that buys its assets outright must find the whole cost at once, while a firm that takes them on lease or hire purchase spreads the payment and needs less fixed capital to begin with.
Intangible assets — amounts paid to acquire goodwill, patents and copyrights are also a permanent investment, and they add to the fixed capital requirement without adding anything visible to the plant.
Growth and expansion plans — a firm that intends to expand must acquire capacity in advance of the demand it expects, so its requirement is higher than that of a firm content to hold its present level of activity.

Business Example

Two Firms, Two Requirements A steel producer must invest in ore handling equipment, furnaces and rolling mills before it can sell a single tonne of steel. A firm that only trades in steel needs a godown, a weighbridge and a delivery vehicle. The two may record similar sales, yet their fixed capital requirements differ enormously.

Fixed capital, then, builds the earning apparatus and stays locked in it. But an apparatus by itself produces nothing: it must be fed with materials, manned by workers who are paid weekly or monthly, and kept running while the goods are made, sold and finally collected for. The funds that do this work are working capital.

2.6 Working Capital — Meaning, Need And Types

Money leaves a business long before it returns to it. Materials are bought and paid for, wages are paid at the end of the week or the month, power and freight bills fall due, and only after the goods have been made, sold and collected for does the cash come back. Something has to fill that interval, and that something is working capital.

Working capital means the capital invested in current assets — cash, stock of goods, debtors, bills receivable and short-term investments. These are the liquid funds required for the day-to-day operations of an enterprise, and unlike fixed capital they are not sunk in the business but pass through it.

Definition

Working Capital Working capital is the capital invested in current assets. According to Shubin, it is the amount of funds necessary to cover the cost of operating the enterprise; in a going concern it is a revolving fund consisting of cash receipts from sales which are used to cover the cost of current operations.

Working capital is also known as circulating capital or revolving capital, because it is invested, recovered and invested again, over and over, during the life of the business. Gerstenberg described circulating capital as the current assets of a company which are changed in the ordinary course of business from one form to another — from cash to inventories, inventories to receivables and receivables back into cash. In a manufacturing concern this movement takes the form of an operating cycle, shown in FC 2.4.

Flowchart

FC 2.4 — The Operating Cycle Of Working Capital Cash → Raw materials → Work in progress → Finished goods → Receivables → Cash

The longer this cycle takes to complete, the longer the firm’s money stays locked in it, and the larger the amount that must be provided.

Figure

Fig. 2.6-1 — Raw Material Held In A Godown Photograph of sacks and bales of raw material stacked in a factory godown, awaiting issue to production.

Need For Working Capital

To purchase raw materials, spare parts and operating supplies — production cannot begin until the materials are in the store, and suppliers rarely wait for the goods to be sold before demanding payment.
To pay wages and salaries — labour is paid at short and fixed intervals, whether or not the goods produced have been sold.
To meet day-to-day expenses — fuel, power, rent, taxes, advertising and delivery charges fall due continuously through the year and have to be met out of liquid funds.

2.6.1 Gross And Net Working Capital

The term working capital is used in two senses. Gross working capital means the total amount of funds invested in current assets, that is, the book value of all the assets that are converted into cash in the ordinary course of business.

Net working capital means the excess of current assets over current liabilities. Current assets here include cash in hand, cash at bank, sundry debtors, bills receivable, marketable securities, inventory and prepaid expenses; current liabilities include sundry creditors, bills payable, short-term loans repayable within a year and outstanding expenses.

Net working capital = Current assets − Current liabilities

Definition

Net Working Capital Net working capital is the excess of the current assets of a firm over its current liabilities. A positive figure indicates that the short-term obligations of the firm are covered by assets that will be converted into cash within the same period.

Table

2.6.2 Permanent Working Capital

A part of the working capital never leaves the business. However low the level of activity falls, some cash must be held, some stock carried and some credit allowed to customers. This minimum amount, required permanently to operate the minimum level of business activity, is permanent working capital. Since it is locked up in current assets as surely as fixed capital is locked in fixed assets, it is raised from long-term sources of finance. The full classification is set out in FC 2.5.

Flowchart

FC 2.5 — Types Of Working Capital Working capital → Permanent working capital, Temporary working capital; Permanent working capital → Initial working capital, Regular working capital; Temporary working capital → Seasonal working capital, Special working capital

Initial working capital — the part required at the time of commencement of a business, to start its activities. A new firm is not yet known to its suppliers and usually gets no credit from them, so all its operating expenses must be met in cash. This amount is generally provided by the owners themselves.
Regular working capital — the part required for the continuous conduct of operations once the business is running. It consists of enough cash to meet short-term obligations as they fall due, enough inventory to keep production going and enough finished stock to deliver to customers promptly.

2.6.3 Temporary Working Capital

Temporary working capital is the amount required over and above the permanent requirement, to meet the seasonal and special needs of the business. It fluctuates with circumstances and is therefore also called variable working capital. Because the need is short-lived, it is raised from short-term sources, which can be repaid once the need passes.

Seasonal working capital — the extra amount required during a particular season. Firms dealing in goods of a seasonal nature, such as woollen garments, fans or umbrellas, need more funds during their busy season to buy materials and engage additional labour. Agricultural produce such as sugarcane, wheat and cotton must likewise be bought in bulk in the season in which it is harvested.
Special working capital — the extra amount kept for contingencies that cannot be foreseen. A reserve of this kind acts as a cushion against a sudden spurt in demand calling for special operations, a stagnant period or depression in which inventory piles up unsold, and losses caused by strikes, lockouts or natural calamities such as flood, fire or earthquake.

Business Example

A Year’s Cane In One Season A sugar mill can crush cane only during the crushing season, which lasts a few months. The whole of the year’s requirement has to be bought and paid for within that period, and the funds stay locked in stock and finished sugar for months afterwards. Seasonal working capital of this order is raised from short-term sources.

Table

How large the permanent portion is, and how often and how heavily the temporary portion is called upon, differs sharply from one business to another. The circumstances that account for that difference are examined next.

2.7 Factors Affecting Working Capital

No single figure of working capital suits every firm, and no single figure suits the same firm through the year. The amount required depends on how long money stays locked up in the operating cycle, how much of that period the firm can pass on to its suppliers, and how steadily the business runs. The factors below are all versions of those three questions.

Nature of the business — public utilities and service organisations sell largely for cash, hold little or no stock and have almost no gap between production and sale, so they need very little working capital. Trading and manufacturing concerns must carry stocks and sell on credit, and therefore need a great deal.
Scale of operations — a firm handling a large volume of business must hold larger stocks, carry more debtors and keep more cash to pay its current liabilities. A departmental store needs far more working capital than a hawker selling the same class of goods.
Length of the operating cycle — the longer the time between the purchase of raw material and the realisation of the sale, the longer the funds remain tied up. A firm manufacturing an aircraft needs much more working capital than a firm producing confectionery, because its money is locked up for months rather than days.
Rapidity of turnover — turnover is the speed at which working capital is recovered through sales. Where goods move quickly the same rupee finances several rounds of trading in a year, and a smaller amount suffices; where they move slowly, more is needed.
Terms of purchase and sale — a firm that buys on credit and sells for cash uses its suppliers’ money to finance its stock and needs very little of its own. A firm that pays cash for its purchases and sells on credit finances both ends itself and needs a great deal.
Credit policy — a liberal policy towards customers builds up debtors and locks funds up in them, while a strict policy releases the funds sooner. The gain in working capital has to be weighed against the sales that a strict policy may cost.
Availability of raw material and seasonal variations — where a material is available only during part of the year, the whole requirement must be bought and stored in that period, and a large amount is blocked during the season. Firms whose sales are seasonal need extra funds during the busy months and less in the slack months.
Business cycles — during a boom, sales and prices both rise and more working capital is required to support the higher level of activity. During a depression, sales decline and the requirement falls, although unsold stock may itself lock up funds that were expected to be released.
Operating efficiency — better utilisation of resources reduces cost and raises the margin on each sale, so a larger part of the requirement is met from the firm’s own regular inflow and less has to be provided from outside.
Goodwill and credit standing — a firm with a good reputation obtains short-term loans from banks and credit from suppliers easily and on favourable terms, and can therefore work with a smaller amount of its own funds.
Growth and expansion plans — a growing firm needs more working capital to support a rising level of activity, and a firm operating in a period of rising prices needs more merely to hold the same quantity of stock and debtors as before.
Dividend policy — a firm that pays cash dividends regularly must hold cash for the purpose, while a firm that retains its profits keeps that money available for operations.
Management’s attitude towards risk — a management willing to run a risk operates with a thin margin of working capital and relies on arrangements with its bankers to borrow at short notice. A cautious management keeps a larger cushion and accepts the lower return that idle funds bring.

Business Example

A Business That Holds No Stock An electricity distribution company sells a product that cannot be stored. It carries no inventory of what it supplies, and it bills its consumers at regular intervals. Undertakings of this kind therefore work with a small requirement of working capital against a very heavy investment in fixed capital.

Case Snippet

Case 2.2 — Two Firms, Two Cycles Ashwini Engineering Works builds industrial transformers to order. Each transformer takes about seven months to complete, and customers are allowed ninety days to pay. Vaishali Foods, in the same industrial estate, bakes bread and biscuits every morning, delivers them to retailers the same day and is paid within a week. The two firms record broadly the same annual sales. Q. Name the factor that accounts for the difference in their working capital requirements, and state which of the two firms needs the larger amount.

Taken together, these factors decide how much working capital a firm ought to hold. What follows from holding the right amount, and how working capital differs from the fixed capital examined earlier, is taken up next.

2.8 Importance Of Working Capital And Comparison With Fixed Capital

A firm may own an excellent plant and still be unable to run it. If there is no money to buy materials or to pay the wage bill, the machinery stands idle and the fixed capital sunk in it earns nothing. Adequate working capital is therefore the first condition of continuous operation, and its absence is among the costliest failures a financial plan can commit.

Advantages Of Adequate Working Capital

Timely payment of dues — creditors are paid on the due date, which establishes the short-term solvency of the firm and preserves its standing in the market.
Smooth and uninterrupted working — materials can be bought, wages paid and expenses met as they arise, so the flow of production and distribution is not broken.
High credit worthiness — a firm known to hold a satisfactory margin of working capital obtains loans from banks and financial institutions readily and on more favourable terms.
Benefit of cash discount — a firm with liquid funds can settle its bills within the discount period and buy its goods cheaper, an advantage denied to a firm that must delay payment.
Advantage of business opportunities — a special order can be accepted at short notice, materials can be bought in bulk during the season, and stock can be held back for a better price. The bargaining power of such a firm is correspondingly high.
Good relations with employees — wages and salaries paid on time strengthen the confidence of employees in the firm and help to retain them.
Regular payment of dividends — dividends are paid in cash, and a company that cannot pay them on time for want of cash loses its reputation among shareholders even though its profits are adequate.
Strength to face a downturn — a firm with sufficient funds can tide over a period of depression, keep its plant reasonably employed and maintain its solvency until conditions improve.

Business Example

The Discount That Is Lost Suppliers commonly allow a cash discount for payment within a stated number of days. A firm holding liquid funds takes the discount and lowers the cost of everything it buys, while a firm short of cash lets the period lapse and pays the full invoice value for the same goods.

The Case For An Optimum Amount

Working capital held in excess of requirement is not a virtue. Idle funds earn nothing, they pull down the return on the capital employed, and they encourage loose buying and the accumulation of stock the business does not need. Working capital short of requirement is worse: operations are interrupted, plant capacity is under-utilised, the discount is lost and the credit standing suffers. What a firm seeks is neither the largest nor the smallest amount but the optimum, at which neither profitability nor liquidity is sacrificed to the other.

Fixed And Working Capital Compared

Both are capital, and both are raised from the sources examined earlier in this chapter, but they do different work and behave differently once invested. The points of distinction are set out in Table 2.5.

Table

A firm therefore has to answer two questions and not one. How much money must be sunk permanently in the apparatus that will earn for it, and how much must be kept circulating so that the apparatus can be used. Fixed capital decides what the business is capable of producing; working capital decides whether it actually produces it.

2.9 Summary

Business finance is the money and credit employed in a business firm; financing means making that money available at the time it is needed. It covers the estimation of the requirement, the choice of sources, the investment of the funds raised and the control of their use.
Finance is required at three points — to establish the enterprise, to acquire fixed and current assets for present operations, and to finance expansion, growth and modernisation.
Adequate finance enables a firm to pay its dues promptly and raise its credit standing, to work without interruption, to take advantage of business opportunities, to replace and modernise its plant in time, to face a downturn, to pay its employees regularly and to build goodwill. Funds raised in excess of requirement lie idle and reduce the return on capital employed.
The funds a firm uses are either owned or borrowed, and the form of organisation fixes how far it can reach for each:

A sole trader depends on his own capital, retained profits, loans from friends, relatives and banks, government assistance to small units, and trade credit.
A partnership adds the capital of several partners, loans advanced by the partners themselves, and purchases on instalment or hire purchase, but cannot approach the public.
A joint stock company alone can raise capital from the public through shares and debentures, and supplements these with reserves and loans, because its own assets and earning capacity answer for its debts.

Financial planning is the process of estimating the financial requirements of an organisation for a period, selecting the sources of funds and deciding how they are to be used. It is future oriented and rests on forecasting.
The scope of financial planning covers the estimate of fixed and working capital needed, the selection of sources and their ratio in the total, and the policies for the use of funds and the disposal of earnings.
Financial planning avoids both shortage and surplus of funds, guides the building of a sound capital structure, secures the effective utilisation of funds, coordinates the departments, makes control possible and prepares the firm for shocks. The factors kept in view while framing a plan are the objectives of the firm, the nature of the industry, the size of the firm, capital market conditions, government regulations and the degree of risk the firm will assume.
Capital structure is the composition of the long-term funds of a firm — the types of securities issued and the amount raised through each. The ratio between owned funds and borrowed funds is capital gearing; a high proportion of debt is trading on thin equity, and a dominance of equity is trading on thick equity.
Trading on equity means using borrowed funds along with equity capital. It raises the earnings of equity shareholders where the rate of earnings exceeds the rate of interest and preference dividend, and because interest is deducted from profits before tax. It is desirable only where earnings are stable and sufficient fixed assets are available as security, since debt has to be served even in a year of loss.
The factors affecting capital structure are trading on equity, exercise of control, need for flexibility, nature of the business, cost of financing, period and purpose of financing, capital market conditions, statutory requirements, needs of investors and cash flow position.
Fixed capital is the amount invested in assets used over and over for a long period. It is also called block capital, because it is blocked up in fixed assets for the lifetime of the enterprise, and it is therefore raised from long-term sources. Such decisions involve large amounts and are largely irreversible.
The amount of fixed capital required depends on the nature of the business, the scale of operations, the nature of the products, the type of manufacturing process, the method of production, the diversity of product lines and scope of activities, the mode of acquiring fixed assets, the intangible assets acquired and the growth plans of the firm.
Working capital is the capital invested in current assets to meet day-to-day operations:

Gross working capital is the total amount invested in current assets.
Net working capital is the excess of current assets over current liabilities, and it shows the short-term solvency of the firm.

Working capital is also called circulating capital, because it passes repeatedly through the operating cycle from cash to raw materials, work in progress, finished goods and receivables, and back to cash. The longer the cycle, the larger the amount locked up.
Working capital is of two types, classified by the permanence of the requirement:

Permanent working capital, raised from long-term sources, consists of initial working capital needed at the commencement of business and regular working capital needed for continuous operations.
Temporary working capital, raised from short-term sources, consists of seasonal working capital needed during a busy season and special working capital held against contingencies.

The working capital requirement depends on the nature and scale of the business, the length of the operating cycle, the rapidity of turnover, the terms of purchase and sale, the credit policy, the availability of raw material and seasonal variations, business cycles, operating efficiency, goodwill and credit standing, growth plans, dividend policy and the management’s attitude towards risk.
Adequate working capital secures timely payment of dues, smooth working, high credit worthiness, the benefit of cash discount, the ability to seize opportunities, good relations with employees, regular dividends and the strength to face a depression. Both excess and shortage are failures, and the object is an optimum amount at which neither profitability nor liquidity is sacrificed.
Fixed capital is invested for a long period, does not change its form and is raised from long-term sources; working capital is invested for a short period, keeps changing its form and is raised largely from short-term sources. Fixed capital decides what a business is capable of producing, and working capital decides whether it produces it.

Flowchart

FC 2.6 — Capital In A Business Firm At A Glance Capital → Fixed capital, Working capital; Fixed capital → Land and buildings, Plant and machinery, Furniture, fixtures and vehicles; Working capital → Permanent working capital, Temporary working capital; Permanent working capital → Initial, Regular; Temporary working capital → Seasonal, Special

2.10 Points to Ponder

A company lowers its cost of funds by borrowing more and lowers its risk by depending on equity. Where along that range should a firm whose earnings rise and fall with the monsoon place itself, and what would justify the choice?
Promoters who avoid a fresh issue of equity in order to retain control may be protecting the company from an unwelcome takeover, or protecting themselves from accountability. Is the exercise of control a legitimate consideration in framing capital structure, or a private interest presented as a financial one?
Trade credit is often described as a source of finance that costs nothing. What does a firm that leans heavily on it actually give up, and at what point does the reliance begin to weaken the firm’s bargaining position with its suppliers?
A management that operates with a thin margin of working capital earns a higher return so long as conditions remain normal. Is that efficiency rewarded, or risk that has simply not yet been tested?
Fixed capital decisions are described as largely irreversible. Given that plant can be leased, sold second-hand or converted to another use, how far does that description still hold, and for which kinds of business does it hold most strongly?
Financial planning rests on forecasts of sales, costs and profits that later events may prove badly wrong. If the estimates are unreliable, is a financial plan of any value, or does its value lie in something other than the accuracy of its figures?

2.11 Objective Questions

The working capital requirement of a firm that buys its goods on credit and sells them for cash is likely to be [1]

higher than that of a firm which buys for cash and sells on credit
lower than that of a firm which buys for cash and sells on credit
the same as that of a firm which buys for cash and sells on credit
unaffected by the terms of purchase and sale

The funds required at the time of commencement of business, before a new firm is able to obtain credit from its suppliers, are called [1]

regular working capital
seasonal working capital
initial working capital
special working capital

Assertion (A): A company whose earnings fluctuate widely is safer depending more on equity capital than on debentures. Reason (R): Interest on debentures has to be paid even in a year in which the company earns no profit. [1]

Both (A) and (R) are true, and (R) is the correct explanation of (A).
Both (A) and (R) are true, but (R) is not the correct explanation of (A).
1. is true but (R) is false.
1. is false but (R) is true.

Match each term in Column A with its description in Column B. [1]

Column A	Column B
a. Block capital	i. The ratio between owned funds and borrowed funds
b. Circulating capital	ii. Capital that changes its form in the course of the operating cycle
c. Capital gearing	iii. The use of borrowed funds along with equity capital in the ordinary conduct of business
d. Trading on equity	iv. Capital blocked in fixed assets for the lifetime of the enterprise

Fill in the blank: The excess of current assets over current liabilities is known as ________ working capital. [1]

2.12 Check Your Concepts

State any two purposes for which a business firm requires working capital. [2]
Distinguish between gross working capital and net working capital on any three bases. [3]
Explain, with reasons, why the length of the operating cycle affects the amount of working capital a firm must hold. [3]
Explain any four factors that a company should consider while deciding its capital structure. [4]
What is meant by fixed capital? Explain any five factors that determine the amount of fixed capital required by a business enterprise. [6]

2.13 Case-Based Questions

Neelkanth Ceramics Ltd. proposes to install a second kiln, the cost of which will absorb the whole of its retained earnings and a good deal more. Its directors are unwilling to see their present shareholding reduced. The company’s earnings have been steady for six years and it owns land and plant that lenders are willing to accept as security. The tiles it manufactures take about four months to travel from raw clay to the collection of payment from the customer.

Name the type of capital required for the second kiln, and state one source, other than retained earnings, from which the company should raise it. [2]
State whether the company’s working capital requirement is likely to be high or low, and give one reason drawn from the case in support of the answer. [2]