Ashwin’s Commerce World

Capital- fixed & working

Definition of Business finance

Business finance refers to the money and credit employed in business firms. It is that aspect of business which is
concerned with the arrangement of cash and credit so that business firms may, at all times, have the means to carry
out their operation smoothly.
Nature of Business finance not mentioned in syllabus
1. Business finance includes all types of capital or funds used in business.
2. Business finance is needed in all types of business – large or small, manufacturing or trading and so on.
Importance of Business finance
1. The firm can meet its liabilities in time. Prompt payment of debts helps in raising its credit-standing. As a result, the
firm can easily borrow funds as and when necessary.
2. A firm with adequate funds can purchase the necessary fixed assets and current assets.
3. The firm can take advantage of business opportunities. For example, it can buy materials in bulk at a low price.
4. The firm can carry on its business smoothly and without any interruptions.
5. The firm can replace its plant and machinery in time, thereby improving the efficiency of its operations.
6. The firm can face recession, trade cycles and other crises more easily and confidently.
7. Sound financial position enables an enterprise to enjoy goodwill or reputation in the business world.

What is the importance of Finance to a Business Concern? [ISC 2017, SQP 2018] 2 Marks
SOURCES OF BUSINESS FINANCE
Source of finance for different types of business firms Capital requirements differ according to the nature and size of
business. Requirement of capital for different types of business firm are as follows:
SOLE PROPRIETORSHIP FIRM PARTNERSHIP FIRM JOINT STOCK COMPANY
• Own capital and retained earnings. • Owned capital contributed by • Issue of shares.
• Loans from friends and relatives. partners in agreed ratio. • Retained profits.
• Loans from banks and financial • Retained profits. • Issue of debentures and
institutions. • Loan from commercial banks bonds.
• Long term loans from state financial and financial institutions. • Long term loans from
corporations. • Short term loans from financial institutions.
• Short term finance from commercial suppliers of raw materials and • Short term loans from
banks. finished goods. commercial banks.

Mention any 4 Sources of Finance for a proprietary form of Business. (2009) 2 Marks
Financial planning
Financial planning is the process of estimating the financial requirements of an organisation, choosing the sources of
funds and deciding how the funds are to be utilised.

FEATURES
i. Financial planning involves deciding when, how and why of financial activities.
ii. Like any other planning it is future oriented and involves forecasting.
iii. It involves deciding objectives, policies, procedures, methods and programs concerning funds.
iv. The scope of financial planning is wide. It consists of:
(a) estimating the amount of fixed capital and working capital needed in business

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(b) selecting the appropriate sources of funds and their ratio in the total amount.
(c) formulating policies for use of funds and disposal of earnings

IMPORTANCE
a. A sound financial plan helps a business enterprise to avoid the problems of shortage and surplus of funds. This is
because intelligent estimates of current and future capital requirements are made in financial planning. In the absence
of an accurate financial plan, the business may face a shortage of funds and its growth might be restricted.
b. Financial planning serves as a guide in developing a sound capital structure so as to maximise returns to shareholders.
It is helpful in maintaining a proper balance between equity and debt funds.
c. Financial planning helps in effective utilisation of funds. Funds can be allocated for various projects in accordance
with their relative significance. Thus, wastage of capital is eliminated.
d. Financial planning provides policies and procedures for coordinating different functional areas or departments of a
business.
e. A financial plan enables the management to exercise effective control over the financial activities of an enterprise.
Actual utilisation of funds can be kept in accordance with the planned utilisation.
f. It helps the company to prepare for facing business shocks and surprises in future.
Factors affecting capital structure
Capital Structure means the proportion of owner’s fund and borrowed fund in the total fund of the business.
The ratio between equity (owned funds) and debt (borrowed funds) is called capital gearing or financial leverage.

What is Capital Gearing Ratio? (2015) 2 Marks

When the proportion of debt is high, it is called high gearing or trading on thin equity. On the other hand, when
equity dominates the capital structure, it is known as low gearing or trading on thick equity.

THE FACTORS AFFECTING CAPITAL STRUCTURE ARE GIVEN BELOW:

Explain any 4 factors affecting capital Plan of a Company (2016/ 2005) 4 Marks
Briefly explain any 5 factors to be considered while preparing a suitable capital plan 5 Marks

1. 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.
Trading on equity is, however, desirable only when:
a. The rate of earnings is higher than the rate of interest and the rate of preference dividend.
b. The company’s earnings are stable and regular to pay at least the interest on debentures.
c. There are sufficient fixed assets to offer as security to the lenders.
Example:
Total Shares: 100 Rate of earning =10 % Rate of Interest on Loan = Case A (5%) & Case B (15%)

CASE-A CASE-B
TOTAL FUNDS 10,000 10,000
Own funds 6,000 6,000
Borrowed 4,000 4,000
TOTAL EARNINGS (10 % OF TOTAL CAPITAL) (A) 1,000 1,000
- Interest to be paid (B) 5 % of 4,000 15 % of 4,000
= 200 = 600
EARNING BEFORE TAX (A)-(B) 800 400
- Tax (50% of earning) 400 200
EARNING AFTER TAX (EAT) 400 200
EARNING PER SHARE (EAT/ Total Shares) 4 2

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2. Exercise of Control: In a company, equity shareholders have voting rights and, therefore, control of the company
lies in their hands. If the promoters (Starters) of the company want to retain control in their own hands, they may
not issue additional equity shares to the public. In such a case, more funds can be raised by issuing debentures and
preference shares. This factor is particularly important in closely held companies whenever promoters have low
shareholding.
3. Need for Flexibility: A good capital structure should be flexible so that adjustments can be made whenever the need
arises. Debentures and preference shares can be paid off whenever the company feels necessary. But equity shares
cannot be paid off during the life-time of a company. While raising debt, the company should ensure that there are
minimum restrictions in loan agreements.
4. Nature of Business: Companies enjoying regular and liberal earnings, e.g., public utilities can afford to have high
capital gearing (more loans). 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 and stagnant firms may find it more difficult to issue debentures and preference shares than well-established
and growing companies.
5. Cost of Financing: In a good financial structure, the cost of capital should be reasonably low. Cost of capital depends
upon the prevailing rate of interest, return expected by potential investors, expenses and administrative expenses.
Issue expenses or floatation costs of shares are high. Normally, the cost of debt is lower than that of equity.
6. Period of Financing: For funds required for permanent investment equity shares are the appropriate choice.
Debentures and preference shares are preferable for medium-term finance.
7. Capital Market Condition: During boom investors are willing to take risk and invest in equity shares. But in a
bearish market, or down swing investors prefer safe investment. Therefore, preference shares and debentures
carrying a fixed rate of return are likely to be more marketable in a depression.
8. Statutory Requirements: The Companies Act and SEBI guidelines must be observed while raising funds from the
public. Thus, state regulations regarding the issue of securities have a bearing on capital structure.
.

Fixed capital
Fixed capital refers to the funds required for acquisition of fixed assets. Fixed assets are meant for generating income.
These assets are used permanently for business operations.
Fixed Capital is also known as ‘block capital’ because it is blocked up in fixed assets for the life time of the enterprise.
What is Fixed Capital? Discuss 4 Factors that affect fixed capital. (2016/2007) 6 Marks

THE FACTORS AFFECTING FIXED CAPITAL REQUIREMENTS:

1. 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. Public utility
undertakings like railways, city transport undertakings and electricity supply concerns also require heavy investment
in fixed assets. But trading concerns require less investment in fixed capital.
2. Size of the Business: The scale of operations also determines the amount of fixed capital. A large-sized enterprise
requires a greater amount of fixed capital than a small scale firm. For example, a giant steel company such as the
Tata Iron and Steel Company (TISCO) needs a huge investment in fixed capital as compared to mini steel plant.
3. Nature of Products: The types of products produced also determines the amount of fixed capital. A company
manufacturing capital goods like machinery, engines, etc., will require a large amount of fixed capital. On the other
hand, a firm producing consumer products like soaps, hair oil, toothpaste, etc., will need small amount of fixed
capital. Similarly, firms operating in heavy industries such as ship-building require greater fixed capital than firms
operating in light industries such as sugar mill.

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4. Method of Production: A company employing capital-intensive techniques of production such as automatic
machinery requires higher amount of capital as compared to a company employing labour-intensive techniques
such as hand tools.
5. Diversity of Product Lines: A multi-product company manufacturing diversified products requires more fixed
capital than a firm manufacturing a single product. Similarly, an enterprise manufacturing each part of finished
product by itself requires a greater amount of fixed capital as compared to a firm which buys component parts from
outside and simply assembles them in its own factory.
6. Mode of Acquiring Fixed Assets: A business firm which purchases fixed assets on cash down basis requires huge
amount of fixed capital. On the other hand, an enterprise which acquires land and building, plant and machinery and
other fixed assets on lease or hire purchase will need less fixed capital.
7. Intangible Assets: The amount invested in acquiring goodwill, patents, copyrights, etc., also influence the amount
of fixed capital needed for business.
Working capital
Working capital means the capital invested in working assets or
current assets such as cash, stock of goods, debtors and short-term
investments, etc. It represents the liquid funds which are required for
the day-to-day operations of an enterprise. Working capital is also
known as circulating capital or revolving capital because it keeps on
circulating or revolving in business. It is invested, recovered and
reinvested repeatedly.
Why is Working Capital also known as Circulating Capital? (2016) 2 Marks
What is Working Capital? (1996, 2009) 2 Marks

The term working capital is used in two senses—Gross Working Capital & Net Working Capital.
Gross Working Capital: Gross working capital means the total amount of funds invested in current assets. Current
assets are those assets which are converted into cash in the ordinary course of business.
Thus, Gross working capital = Book value of current assets
What is Gross Working Capital? (2015) 2 Marks

Net Working Capital: It means the excess of current assets over current liabilities. Current assets 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 one year) and acquired expenses.
Thus, Net working capital = Current assets – Current liabilities
Distinguish Between Gross & Net Working Capital (2014) 2 Marks
HINT: Give Meaning & Formula in the Difference
TYPES OF WORKING CAPITAL
Explain any 4 types of Working Capital (2018) 4 Marks

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THE FACTORS AFFECTING WORKING CAPITAL REQUIREMENTS:
Explain any 4 factors affecting working capital requirements (2002/2010) 4 Marks
Mention any 2 factors affecting working capital requirements (2006) 2 Marks

1. Nature of Business: Manufacturing firms require considerable working capital as they have to build up stock of raw
materials and finished products. On the other hand, public utility undertakings require less working capital as they do not
have to maintain inventory.
2. Size of Business: Firms carrying on large-scale operations and undertaking high volume of production require more
working capital than small-scale firms. For example, a departmental store needs greater amount of working capital as
compared to a hawker.
3. Manufacturing Cycle: It means the time involved in the production of goods. Longer is the time gap between the
purchase of raw materials and production of finished goods, higher is the need for working capital.
4. Rapidity of Turnover: Turnover means the speed with which the amount of working capital is recovered by the sale of
goods. When the turnover is rapid, the amount of working capital required is small. This is because working capital is
locked up in business for a short period.
5. Terms of Purchase and Sale: A business firm requires comparatively small amount of working capital if it buys goods and
services on credit and sells them in cash. On the other hand, if it purchases in cash and sells on credit, larger amount of
working capital will be required.
6. Credit Policy: When a liberal credit policy is followed, more working capital is required. On the contrary, smaller working
capital is needed in case of a tight credit policy.
7. Operating Efficiency: Better utilisation of resources leads to reduction in costs and improves profitability. As a result
need for working capital is reduced. High profit margins and flow of regular income from sales also reduce the amount of
working capital required in business.
8. Goodwill of Business: An enterprise enjoying good reputation in the market can easily and quickly obtain short-term
loans from commercial banks. It requires a less amount of working capital.

Give difference between Fixed and Working Capital (2014/2019) 3 Marks

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