Business Finance Xii Sp New Syllabus

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BUSINESS FINANCE XII SP NEW SYLLABUS

1.1 Introduction1.2 Meaning, role and objectives of financial management1.3 Financial planning - Meaning and Importance1.4 Capital structure - Meaning and factors influencing capital structure1.5.A Fixed capital - Meaning and factors affecting their requirement1.5.B Working capitalMeaning and factors affecting their requirement1.6 Distinction between

1.1 INTRODUCTIONBusiness finance is a broad concept. It deals with all financial activities of business. Theterm business covers both commerce and industry. In simple words, business financeapplies to all financial activities of agriculture, industry, banking, transport insurance,

etc. Thus, the scope of business finance includes commercial finance, industrial finance,property finance, corporate finance and even agriculture Business finance.

Business finance deals with raising, administering and disbursing funds by abusiness firm or an organization. In business finance importance of capital, financialplanning and financial management are highlighted.

In actual practice business finance refers to corporation finance. In this era ofmultinationals, the business finance is almost identified with 'corporation finance'.Corporation finance deals with financial matters of corporate enterprise.

In an academic world, the term 'corporation finance' is now known as 'financialmanagement'.

Unit objective :After shidying this chapter you should be able to know-Meaning, role and objectives of financial managementMeaning and importance of financial planningMeaning and factors affecting capital structureMeaning and factors affecting fixed capitalMeaning and factors affecting working capital

1.2 MEANING OF FINANCIAL MANAGEMENTFinancial Management is a specialised function of general management. It refers

to management of business funds. It is mainly concerned with raising of finance and itseffective untilization for achievement of goals of the organization.

DefinitionThe term 'financial management' has been defined by different authors. A few

definitions given by eminent authors are given below:


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1. Ezra Soloman : "Financial Management is concerned with effective use of animportant economic resource, namely capital, funds."

2. Kuchal S.C.: "Financial Management deals with procurement of funds and their

effective utilization in business.

From the above definitions it is clear that there are two basic aspects of financialmanagement.

(a) Raising of funds(b) Effective utilization of funds.

Thus, we can see that financial management is an operational function. It deals withplanning, organizing, directing, co-ordinating and controlling financial activities. It isrightly called as 'Resource Management'. Since most, of the business activities involveuse of finance, the financial management has acquired a vitalplace in modem business

world.

Role of Financial ManagementFinancial Management is essential for all types of organizations i.e. profit making

organizations or non-profit making organizations. It plays a crucial role in making bestuse of financial resources.

There has been significant development in Indian economy since the introduction ofnew economic policy in July 1991. Free market economy and free access to globalinvestment have made financial management more complex than what it was earlier.Today it is the most important area of corporate management. The subject matter of

financial management is changing at a rapid pace. It has become more significantbecause of developments at national and international levels. All this has a direct impacton 'corporate financial policies.'

The financial, management has become a subject of considerable importance indeveloping countries like India. All business entities arise out of the savings of thesociety. The savings in developing countries are meagre. These scarce resource ofsavings have to be used in many developmental activities. It is very essential that thefunds which are used in business activities are well managed.

The role of financial management can be considered with detailed study of

each activity i.e. functions of financial management.

Functions of Financial ManagementThe functions of financial management can be divided into two (A) Routine functions(B) Executive functions

(A) Routine functions
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1. Record keeping and reporting2. Preparation of various financial statements

3. Cash planning4. Credit management5. Providing information to Board of Directors on current financial position for

making decisions of purchases, marketing, pricing, etc.

(B) Executive Functions:1. Forecasting financial requirements : Financial needs have to be carefullyestimated m business. Money may be required for long term purpose i.e. fixed capitaland for short term purpose i.e. working capital. A careful forecasting of such fundsmust be made.

Forecasting of finance means projection of financial needs of business for some timeahead. It is nothing but budgeting financial needs of the expected programmes.

Forecasting is not only concerned with amount of money required for aprogramme but also includes.

a) Durations of funds (5 years, 10 years, etc)b) Timing of supply of funds

c) Kinds of funds (owned or borrowed, etc.)

2. Deciding sources of funds : Once the need of finance is revealed, varioussources of funds must be considered. Different type of securities like shares,debentures etc. can be issued to raise funds. Funds may also be borrowed fromfinancial institutions and lenders. An utmost care is to be taken while selecting thesources of funds. There should be a proper balance between long term funds and short

term funds. The funds raised from owners and outsiders have to be in certainproportion If a firm has committed to finance from lenders the terms and conditions ofcredit should be borne in mind. Thus, financial decisions should be exercised with greatcare and caution.

3. Investment decisions: Investment decisions refer to the decisions regardingutilization of funds raised by the firm. It relates to the selection of assets in which fundsare to be invested. The funds can be invested in two types of assets, namely

a) Long term assets or fixed assetsb) Short term assets or current assets.

A large portion of initial funds invested in fixed assets such as land, building, machinery,equipments and furniture, etc. This decision making is popularly known as 'capitalbudgeting'.

The aspect of investment decisions relating to current assets is known as 'workingcapital management'. Cash, account receivables; and inventory form the element of


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current assets. A finance manager has to ensure efficient utilization of every currentasset to maintain control on cash inflow and cash outflow.

4. Dividend policy :A business firm is basically a profit earning organization. Theearnings, of a firm depend upon efficient utilization of funds. Financial management is

also concerned with the decision to declare dividend. A finance manager has to decidewhat portion of profit is to be retained in the business and balance is to be distributedamong shareholders. The shareholders are generally more interested in getting higherrate of dividend while Board of Directors wants to retain earnings for future expansion.The finance manager balances the expectations of investors and use of retainedearnings to acquire additional assets.

5. Checking and analysis of financial performance :The checking andanalyzing financial performance is very essential to carry out financial functionssmoothly For this various financial statements are prepared and analyzed. This is ofgreat value in improving techniques of financial control.

6. Advising Board of Directors: A finance manager provides advice to Board ofDirectors in respect of financial matters. He suggests various solutions for any financialdifficulty. Normally finance manager gives advice on important matters such as pricing,expansion, acquisition, dividend policy etc.

Objectives of Financial ManagementBusiness firms are profit oriented organizations. Their objectives are expressed in termsof money. The basic objectives of financial management are as follows -

a) Profit maximisationb) Wealth maximisation

Let us learn this in detail.

A. Profit maximisationProfit maximisation is a basic principle of any business activity. According to thisprinciple, all functions of business aim at profit. The principle of 'profit maximisation' isa traditional concept. It is based on assumption that 'profit is a tool of measuring thesuccess of business firm'. In simple words, the, business firm should undertake onlysuch activities that increase profit. The business activities which decrease profit shouldbe avoided.

Profit maximization is considered to be the most important business objective

because of the following reasons -1. It is difficult for business to survive without profit.2. Profit is a tool of measuring the success of a business firm.3. High level profitability results in better returns (dividend) to the

shareholders.4. High level profitability can generate fluids, which can 6e used for future

expansion of business.


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5. Profit maximization has to be achieved for socio-economic welfare.

B. Wealth maximisation :According to Prof. Soloman Ezra the ultimate goal offinancial management should be the maximization of owners' wealth.

According to him, maximization of profit is unreal and half motive. The proper aim offinancial management is wealth maximization of equity shareholders.

Wealth maximization is also known as 'value maximization.' It means maximising netpresent value of a firm.

The focus of financial management-is on wealth maximization of its owners' i.e.suppliers of equity capital. The wealth of shareholders is reflected in market value ofthe shares. So wealth maximization means the maximization of market price of shares.The wealth of equity shareholders is maximized only when market value of equityshares is maximized.

Equity shares are traded in share market. The share price of a company, quoted inshare market. index, is a reflection of its earning capacity, dividend and retention policy.Financial decision making should aim at maximizing market value of equity shares ofcompany.

Additional information :

Besides the above objectives let us consider the most recent and important aspect of afirm's objective i.e. social satisfaction objective.

The business firms in recent time not only think about investors but also welfare of allpeople in general. The social satisfaction and social welfare are now given equalimportance. A business firm operates in society. Therefore, it has certain responsibilitiestowards society. The interests of suppliers, customers, creditors,employees of companyand government are to be protected. The shareholders expect high rate of dividend,customers want products of good quality at reasonable prices, society requires effectiveand efficient use of scarce resources of production and government insists on obeyanceof rules and regulations and payment of taxes regularly. Thus, business firm has tomake fulfilment of all such social responsibilities. The profit rnaximization or wealthmaximization cannot be the only objective of 6usiness firm. Frorn social point of viewthe business firms should recognize their social obligations too.

1.3 FINANCIAL PLANNINGMeaning :Financial planning is an important function of financial. management.

It is a continuous process in day-to-day administration of business. It is not. possiblefor finance manager to go ahead unless he prepares 'financial plan'. Financial planningis not only required for profit making but even for survival of a firm. The term financialplanning refers to assessment of financial requirements and arranging the sources ofcapital.
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Modern management lays a great emphasis on detailed 'financial plan'. The financialplan must include information about economic environment in which business operates,It , establishes targets of sales and profit. It promotes co-ordination, of resourcesandefforts to reach these targets. Thus, financial planning is 'an advance programming

of all plans of financial management'.

Definition :J. H. Boneville"The financial plan of a corporation has two fold, aspects, it refers not only to

capital structure of the corporation, but also to the financial policies which corporation.has adopted or intends to adopt."

Thus, Boneville has considered two important things for financial planning i.e.(1) capitalstructure and (2) financial policies. This will ensure best possible use of funds.

Importance of financial planning :The finance manager gets entireinformation about the firms activities. On this basis he prepares financial plan. In hisefforts to construct financial plan, he is able to build up information. This information isuseful for other functions for decision making. An excellent management informationsystem is an asset which serves as 'guide' for overall activities of firm.

Let us discuss significance of financial planning with the following points

1. Elimination of waste :Due to financial planning, it is possible to eliminate thewasteful expenditure. There are several factors such as change in government policy ontaxes, fluctuating interest rates, etc. which can be anticipated and tackled with the help

of financial planning. Many organizations have suffered irreversible damage due towasteful expenditure because of lack of financial planning.

2. Co-ordination : Co-ordination is the most vital part of management Financeholds the key to a11 activities of organization such as production, distribution,marketing and personnel. These activities will hamper if not supported by properfinancial planning. It is responsibility of finance manager to bring about co-ordinationamong all departmental heads of organization. In other words, financial planning shouldmatch production planning, distribution planning, personnel planning and overallcorporate planning.

3. Dynamism :Financial planning is a demanding exercise, which requiresdynamism on the part of finance manager It means finance manager must takeinitiative and face various changing financial situations as and when they arise Accurateforecast of future trends are required for effective planning. Unprofitable ventures canbe avoided while profitable projects can be undertaken when such forecasts areavailable. Thus, dynamism becomes an integral part of effective financial planning.
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4. Communication :Communication is an effective tool of management. Financialplanning enables the finance manager to communicate various aspects of financial planto, the executives of other departments. Detailed policies and procedures must bemade known to every one in the organization, so that there is no wastage of time,goodwill and financial resources. Effective financial planning helps finance manager to

communicate easily with others in the organization.

5. Decision making : It is necessary for a firm to take appropriate and timelydecisions to achieve its objectives. Financial planning prepares, itself for attainment ofthese objectives. Any scheme, how so ever effective, cannot go through unlessbudgetary provision is made in the financial planning.

6. Integration : Financial planning gives a fairly good idea to the firm about itsavailable resources. Financial planning is to be completed in all consultation and co-operation of other departments. This promotes team spirit among all executives. Thefinancial planning assists in integration of firm's activities.

7. Futuristic :Financial planning is effective when it foresees events. It means, itmust take into account not only present but also future developments. This futuristicelement of financial plan helps for advance programming.

Sound financial planning is the key to successful business operations.- Comment.

1.4 CAPITAL STRUCTURE

Meaning :Capital structure constitutes two words i.e. capital arid structureCapital refers to investment of funds in the business while structure means

arrangement of different components in proper proportion. Thus capital structuremeans 'mix-up of various sources offunds in desired proportion'.

Once the capital requirement of firm, is decided, attention is given to the kind ofcapital sources which can be raised to meet this need.

A company can raise its capital from different sources i.e. owned capital or borrowedcapital or both. The owned capital consists of equity share capital, preference sharecapital, reserves and surplus. On the other hand, borrowed sources are debentures,loans, etc. Proportion of different sources are used in capital structure.

To decide capital structure means, to decide upon the ratio of different securitiesin total capital. It is nothing but 'composition of capital'. Definition :

Weston and Bringham"Capital structure is the permanent financing of firm represented by long term

debt, preferred stock and net worth."
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R. H. Wessel"The long term sources of funds employed in a business enterprise."

John H. Hampton"A firm's capital structure is the relation,between the debt and equity securities

that makes up the firm's financing of its assets."Thus, the term capital structure means 'financing mix'. It refers to the proportion ofdifferent securities raised by a firm for long term finance.

Components / parts of capital structure

There are four basic components of capital structure. They are as follows :

1) Equity share capital :It is the basic source of financing activities of business.Equity share capital is provided by equity shareholders. They buy equity shares andhelp a business_ firm to raise necessary funds. They bear ultimate risk associated with

ownership. Equity shares carry dividend at fluctuating rate, depending upon profit.

2) Preference share capital :Preference shares carry preferential right as topayment of dividend and have priority over, equity shares for return of capital when thecompany is liquidated. These shares carry dividend at a fixed rate. They have limitedvoting rights.

3) Retained earnings :It is an internal source of financing. It is nothing butploughing back of profit.

4) Borrowed capital :It comprises of the following -

a) Debentures: A debenture is an acknowledgement of loan raised bycompany. Company has to pay interest at an agreed rate.

b) Term loan: Term loans are provided by bank and other financialinstitutions. They carry fixed rate of interest .To understand above concept thoroughly, we shall consider following balance sheet

Example :Balance sheet of Sunrise Company Limited as on 31st March 2012,

Liabilities AmountRs

Assets AmountRs.

Share Capital5000 Equity Sharesof Rs. 10 each fully paid1000, 10% PreferenceShares of 100 each fullypaid

50,000

1,00,000

Fixed AssetsBuildingPlant & Machinery

Current AssetsCash in hand

2,00,00080,000

14,000


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Reserves & SurplusGeneral & SurplusLiabilities1000, 12% Debentures ofRs. 100 each fully paid

Sunday CreditorsBank OverdraftBills Payable

20,000

1,00,000

40,00020,00010,000

Cash at BankSunday DebtorsInventories

24,00012,00010,000

3,40,000 3,40,000

Capital Structure = Equity shares + Preference Shares + Reserves + Debentures= 50,000 + 1,00000 + 20,000 + 1,00,000= 2,70,000

Factors influencing capital structure:Factors

Internal Factors External Factors1. Requirement of capital 1. Market conditions2. Size and nature of business 2. Attitude of investors3. Growth of business firm 3. Cost of capital4. Adequate and stable earning 4. Government regulations5. Cash position . 5. Attitude of financial institutions6. Period of finance 6. Rate of interest7. Future plan 7. Taxation8. Trading on equity 8. Competition9. Capital gearing10. Attitude of management

The pattern of capital structure of various firms varies widely. There is no hard and fast

rule for the proportion of owned funds and borrowed funds. So to determine the bestpatternof capital structure many factors are to be borne in mind. The factors whichplay vital role in capital structure determination are divided into two -

A) Internal factorsB) External Factors

A. Internal Factors

1. Requirement of capital : When a new business is. started, it cannot issuevariety of securities. This is because there is considerable risk involved, at initial stagesof new company. The, ideal structure for new company is to raise capital through equityshares.


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Other types of securities may be issued by company in future. The company mayrequire additional funds for expansion or modernization, etc.

2. Size and nature of business : The size of business has great impact on itscapital structure. Large manufacturing companies have huge investments in fixed assets

such as land, machinery, building etc. Further these fixed assets can be offered assecurities against issue of debentures. Hence, these firms may raise funds by issue ofequity shares along with debentures.

On the other hand trading concerns require more working capital. They can raisefunds by issue of equity as well as preference shares.

In case of small companies capital requirement is less They have less capacity toraise funds from external sources.

3. Growth of business firm: Different capital structures may be required at

various stages of development of company.

At initial stages of development, equity capital and short term loans are the mainsources of finance. When a company grows in size, it can utilize sources of finance suchas preference shares, debt capital etc.

The well established concerns with goodwill and reputation can acquire fundsfrom varioussources..

4. Adequate and stable earning : The business firms with stable earning willhave 'stable earnings per share' (i.e. EPS). Such companies can utilize source of debtcapital as they can easily pay a fixed rate of interest. Therefore, developed companiesusually employ more amount of loan capital.

The business firm with unstable earning should not opt debt in their capitalstructure, as they may face difficulty in meeting fixed amount of interest.

5. Cash position: The companies.expecting large and stable cash inflow infuture, can utilize large amount of debt capital in their capital structure.

It is quite risky for those companies whose cash inflow is unstable andunpredictable to have debt capital. It is because when company raises loan capital itbecomes compulsory to pay interest on that. If company fails to pay interest, this maycause situation of financial insolvency for the company.

6. Period of finance: While framing capital structure the 'period for which financeis needed', should also be considered.


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If funds are required on regular basis, the company should raise funds throughissue of equity shares.

If funds are required for short period of time the firm should raise funds throughissue of debentures or redeemable preference shares.

7. Future plan and development: While designing capital structure,management should keep in mind the future development and expansion plans. Equitycapital can be issued in the beginning. The debentures and preference shares may beissued in future to finance developmental plans.

8. Trading on equity: The use of borrowed capital for financing a firm is knownas Trading on equity. The policy of 'Trading on equity' is based on premise that, if therate of interest on debt is lower than rate of companies earning, the equity shareholderwill enjoy advantage in the form of additional profit. Higher rate of dividend to equityshareholders improves goodwill of the company. It increases market value of shares.

This improves creditworthiness of the company and company will be able to raisefurther loan at. lower rate of interest.

But if company earnings are not sufficient, it may face financial crises. Theinterest on debt has to be paid even in case of loss. The whole earnings may exhaust inpayment of interest.

No dividend would be declared to shareholders. This will affect goodwill andcreditworthiness of the company. It will not be able to raise further loans.

Thus, trading on equity is double edged sword. It may increase income ofshareholders if the things go right. On the other hand, it increases risk of loss under

adverse conditions.

9. Capital gearing: It is a ratio between debt capital (fixed interest) and equitycapital (variable dividend). If the proportion of debt capital is high as compared toequity share capital, it is high gearing. On the other hand, if the proportion of debtcapital is less as compared to equity share capital, it is a state of low gearing. A propermix of various types of finance should be maintained in capital structure, so that theinterest of equity shareholders is protected.

10. Attitude of Management: The capital structure is influenced by the attitudeof persons in the management. The management's attitude towards 'control of firm',

should be noted minutely. If the management has strong will of exclusive control, thenpreference shares and debt capital are used as source of finance.

B. External Factors1. Market conditions: The pattern of capital is also influenced by prevailingmarket conditions. Readiness of investors to purchase shares, interest rate, stages ofbusiness cycle, tax, risk of investment, etc together form market conditions.


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The various methods of financing should be considered in the prevailing marketconditions. For eg: If share market is in a declining situation, a company should notissue equity shares but issue debt. On the other hand, during the period of boom inshare market, it should issue equity shares to raise capital.

2. Attitude of investors: Attitude of investors also plays an importantrole.indetermination of capital structure. The investors who are ready to take risk andexpect higher returns prefer equity shares for investment. On the contrary, cautiousinvestors, who are interested in safe and assured income, invest in debentures.

3. Cost of capital: Cost of capital is one of the important factors while designingcapital structure. The cost of capital is the minimum return expected by its supplier. Theexpected return depends upon the degree of risk. The high degree of risk is assumedby shareholders than debt holders. In case of debt holder, rate of interest is fixed, whilerate of dividend given to shareholders is not fixed. The loan of debt holder is repaidwithin the prescribed period whereas shareholders get back their capital only when

company is liquidated. Thus 'debt' is a cheaper source of capital than equity. Thepreference share capital is also cheaper but not cheap as debt. However, it should berealized that company cannot minimize cost of capital by employing only debt.

At a particular point beyond which, debt becomes more expensive because ofincreased risk of excessive debt.

4. Government rules and regulations: Statutory obligations play important rolein capital structure decision. The SEBI has prescribed debt : equity ratio norm of 2:1. Ahigher debt-equity ratio of 3:1 has been permitted for large capital intensive project.The small-industrial projects are given concession and aid by government to avail more

debt capital as compared to equity capital.

5. Attitude of financial institutions: It is another factor which is to beconsidered while determining capital structure.

If financial institutions prescribe high terms of lending, then management has tomove to other source of financing.

If financial institutions prescribe easy terms of lending, it would be advantageousto obtain funds at cheaper rate.

6. Rate of interest: The prevailing rate of interest plays vital role in determining,capital structure: If prevailing interest rates are higher, firms will delay debt financing.On the other hand, if prevailing interest rates, are lower, firm will opt for debtfinancing.

7. Taxation: Interest paid against debt is tax deductable expenditure. Dividend isnot considered as tax deductable expenditure for the company. As such, issue of debtcapital is more advantageous than issue of share capital.
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The companies with higher taxes employ debt capital as it is tax deductable expense.

8. Competition: The firms which are facing cut-throat competition prefer to issueequity shares, because their earnings are not certain and adequate. But the companies

which have monopolies may issue debt capital because of certainty of earnings.

Sound or appropriate Capital Structure

There is no ideal pattern of capital structure. An appropriate mix of securities in capitalstructure help in maximization of 'earning per share' i.e. EPS.

Example :

A Sunrise Company Ltd. has share capital of Rs. 2,00,000 divided in 20,000 equityshares. This company has an expansion programme requiring an investment of anotherRs. 1,00,000. The management is considering alternatives as follows

a) Issue of 10,000 equity shares of Rs. 10/- eachb) Issue of 10,000 12% preference shares of Rs. 10 /- each.c) Issue of 1000 10% debentures of Rs. 100/- each

Let us calculate EPS assuming the earning of company is Rs. 50,000 before interest andtax (i.e. EBIT) and tax rate at 50%.

Present and Projected Earning per share

Particular

Present capitalstructure

Proposed capital structure

All Equity All EquityEquity +

PreferenceEquity +

Debt.

Earning before interest 50,000 50,000 50,000 50,000

Less Interest - - - 10,000

Less Tax @ 50% 50,00025,000

50,00025,000

50,00025,000

40,00020,000

Less Pref. Dividend - - 12,000 -

Profit 25,000 30,000 20,000 20,000

No. of Equity share 20,000 30,000 20,000 20,000

EPS 1.25 -0.83 -0.65 1.00

The above table indicates that use a debenture in capital structure is desirable:

1.5.A. FIXED CAPITAL

MeaningThe concept of 'fixed capital' was first theoretically analysed by economist DavidRecardo. It refers to any kind of real or physical capital i.e. fixed assets. It is not used


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for the production of goods. Fixed capital is that portion of total capital which isinvested in fixed assets such as land, building, equipment, etc.

According to Karl Mark"Fixed capital also circulates, except that the, circulation time is much longer".

A fixed asset may be held for 5, 10 or 20 years and more. Thereafter it may be sold orre-used.

In National Accounts, it is defined as "the stock of tangible, durable fixed assetsowned or used by resident enterprises for more than one year.

This includes building plant, machinery, vehicle, equipment, etc." The European system of National and Regional Accounts includes intangible

assets such as computer software, copyright etc within the definition of fixed assets.

An owner can obtain funds for purchase of fixed assets from capital market.Funding can come from selling shares, issuing debentures, bonds or even long termloans.

A person who invests money in fixed capital, is tying up his money in fixed assets, withhopes to make a future profit. Such an investment goes along with risk.

Factors affecting requirement of Fixed Capital

Factors affecting fixed capital requirementNature of businessSize of businessGrowth and expansion of businessStage of development of businessBusiness cycle

1. Nature of business : The nature of business certainly plays a vital role indetermining fixed capital requirement. For e.g. Rail, Road and other public utilityservices have large fixed investment. They need to invest in huge sum in fixed assets.Their working capital requirements are nominal, because they supply services and notproduct. They deal in cash sales only.

2. Size of business : The size of business also affects fixed capital needs. Ageneral rule applies that the bigger the business, the higher the need of fixed capital.Size of firm, either in terms of its assets or sales, affects the need of fixed capital.

3. Growth and expansion: A growing firm may need to invest money in fixedassets in order to sustain its growing production and turnover.


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4. Stage of development of business: The requirement of fixed capital for anew undertaking is greater than that of an established business.

5. Business cycle: When there is boom period in the economy, additionalinvestment in permanent assets may be made by firm to increase their production

capacity. Hence the need of fixed capital increases .

1.5.B. WORKING CAPITAL

MeaningThere is no universally accepted definition of working capital. Various financial expertshave used this term in different ways.

Some explain it in a narrow sense while some in a wide sense. In the narrow sense, it isthe "difference between current assets and current liabilities".

Gerstenbergh defines it as follows"The excess of current assets over current liabilities".

The current assets minus current liabilities approach refers to 'net working capital'.Gerstenbergh does not call it as working capital. He prefers to call it as circulatingcapital.

In broad sense, the term working capital is defined as follows1. Mead, Baker & Mallot

"Working Capital means current assets:"

2. J. S. Mill"The sum of current assets is working capital of a business."

3. Western and Brigham"Working capital refers to a firm's investment in short term assets - cash, short termsecurities, account receivable and inventories".

This approach has broader application. It takes into consideration all current resourcesof the company. It refers to 'gross working capital.'

Factors affecting the requirement of working capital

Factors affecting working capital requirementNature of businessSize of business

Volume of saleProduction cycleBusiness cycleFactors affectingTerms of purchase and Sale


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Credit capitalGrowth and expansionManagement abilityExternal factorsRequirement of cash

Seasonal fluctuation

1. Nature of business: The working capital requirements are highly influenced by thenature of business. Industrial and manufacturing enterprises, trading firms require largesum of working capital. Big retail stores need a large amount of working capital as theyhave to maintain large stock of variety of goods. .It is because they have to satisfyvaried and continuous demand of consumers.

2. Size of business: The size of business also affects the requirement of working capital.Size of the firm may be estimated in terms of scale of operation. A firm with large scaleoperation will require more working capital.

3. Volume of sale : This is the most important factor affecting size of working capital.The volume of sale and the size of working capital are directly related with each other.If the volume of sales increases, there is an increase in amount of working capital.

4. Production cycle: The process of converting raw material into finished goods iscalled. 'production cycle.'

If the production cycle period is longer, the firm needs more, amount of workingcapital. If the manufacturing cycle is short, it requires less working capital.

5. Business cycle: When there is upward-swing in economy, sales will increase. This willlead to increase in investment in stock. This act will require additional working capital.

During recession, period, sales-will decline and consequently the need of workingcapital will also decrease.

6. Terms of purchase and sales: If credit terms of purchases are favourable and termsof sales are less liberal, then requirement of cash will be less. Thug working capitalrequirement will be reduced. A firm gets more time for payment to suppliers. A firmwhich enjoys more credit facilities needs less working capital.

On the other hand, if firm does not get proper credit for purchases and adopts liberalcredit policy for sales, requires more working capital. .

7. Credit control: Credit control includes the factors such as volume of credit sales, theterms of credit sales, the collection policy, etc. If credit control policy is sound, it ispossible for the company to improve its cash flow. If credit policy is liberal, it creates aproblem of collection of funds. It can increase possibility of bad debt. A firm selling on


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easy credit terms require more working capital. The firm making cash sales requiresless working capital.

8. Growth and expansion activities : The working capital requirement of a firm willincrease with growth of firm. The growth of firm is in terms of sales or even fixed

assets.A growing company needs funds continuously to support large scale operation.

9. Management ability: The requirement of working capital is reduced if there is propercoordination in production and distribution of goods.

A firm stocking on heavy inventory calls for higher level of working capital.10. External factors: If the financial institutions and banks provide funds to the firm as

and when required, the need of working capital is reduced.

11. Requirement of cash : The working capital requirement is also influenced by theamount of cash required by firm for various purposes.

If the requirement of cash is more then company needs higher amount of workingcapital.

12. Seasonal fluctuations: The demand for products may be of seasonal nature. Duringcertain season the size of working capital may be bigger than that in another period fore.g. Before rainy season umbrella and raincoat manufacturing companies need moreworking capital to manufacture above goods so that they can put these goods beforemansoon starts.

1:6 DISTINCTION BETWEEN

Sr.NO.

Points Fixed Capital Working Capital

1. Meaning Fixed capital refers to anykind of physical capital i.e.fixed assets.

Working capital refers tocurrent assets minus currentliabilities.

2. Nature It stays in business almostpermanently i.e. for morethan one accounting year.

Working capital is circulatingcapital

3. Purpose It is not used up in productionof product but invested infixed assets such as landbuilding, equipment, etc.

Working capital is invested inshort term assets such ascash, account receivable,inventory, etc.

4. Sources Fixed capital funding cancome from selling shares,debentures, long term loans,bonds, etc.

Working capital can be fundedwith short term loans,deposits, trade credit, etc.

5. Objective ofinvestor

Investor invests money infixed capital hoping to make

Investor invests money inworking capital for getting


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future profit. immediate return.

6. Risk involved Investment in fixed capitalimplies a risk.

Investment in working capitalis less risky.

SUMMARY

Business finance deals with all financial activities of business. Business finance is almostidentified with corporation finance and now it is known as financial management.

Financial management is concerned with raising of funds and their effective utilisationin business. Financial planning is an advance programming of all plans of financialmanagement.

Capital structure refers to the proportion of different securities raised by a firmfor long term finance.

Fixed capital is that portion of capital which is invested in fixed assets such as land,building, equipments, etc.

Working capital refers to a firm's investment in short term assets such as cash,account receivable and inventories.

Key Terms

Business finance : Corporation finance or financial management .

Financial Management : Management of business funds.Forecasting of finance : Budgeting financial needs

: Principle of business that aims at making maximum profit.Wealth maximization : The maximization of market price of shares.Financial planning : Advance programming of financial plan.Capital Structure : Composition of capitalTrading on equity : Use of borrowed funds for financing business.Capital Gearing : Ratio between debt capital and equitycapital.

Fixed Capital : Funds invested in fixed assets.

Working capital : Sum of current assets.

EXERCISE

Q.1 A. Select the correct answer from the possible choices given belowand rewrite the statements .1. Business finance deals with . activities of business.

a) manufacturing b) selling c) financial


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2. A business firm is basically organizationa) profit - oriented b) service oriented ' c) Non-profit.

3. Normally gives advice to Board of Directors in respect of financial matters. a) Auditor b) Secretary c) Finance Manager

4. Wealth maximization of owner means maximization of of shares. a) face value b) market value c) issue value

5. Due to ............... planning it is possible-to eliminate wasteful expenditure.a) Financial b) Sales c) Production

6. The ............... means mix-up of various sources of funds in desired proportion.a) Capital structure b) Term loan c) Retained profit

7. Large manufacturing companies have investment in fixed assets.

a) huge b) small c) moderate

8. Big retail stores require large amount of .. capital.a) fixed b) working c) loan

9. The concerns can acquire funds from various sources.a) well established b) newly established c) small trading

10. Trading on equity means use of ............... capital for financing a firma) Equity b) Preference c) Borrowed

11. During the period of boom in share market . are issued to raise capital. a) bonds b) debentures c) equity shares,.

12. The investors who are ready to take risk prefer . shares far investment. a) Preference b) equity c) bonus.

13. If share market is depressed a company should issue . capital.a) debt b) owned c) mix

14. The is considered as tax deductable expenditure.

a) dividend b) bonus c) interest

15. The ............... capital stay in business almost permanently.a) fixed b) working c) debt

16. The difference between current assets and current liabilities is ............... capital.a) debt b) fixed c) working

17. A firm selling on credit terms require . working capital.a) more b) medium c) less


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18. A firm making cash sales requires ............... working capital.a) less b) more c) no

19. If volume of sales increases, there is in amount of working capital.

a) an increase b) a decrease c) no change .

20. The SEBI has prescribed debt - equity ratio norm of ..............a) 1:1 b) 2:1 c) 2:2

Q.1 B. Match the pairs.

Group A Group B

a. Financial management 1. Minimise market value of equity sharesb. Wealth maximization 2. Investment in fixed assetsc. Financial plan 3. Ratio of buying and sellingd. Capital structure 4. Management of business funds

e. Fixed capital 5. Ad hoc programming of finance6. Investment in current assets7. Management of business activities8. Maximise market value of equity shares9. Ratio of different securities in capital10. Advance programming of financial management

C Write a word or a term or a phrase which can substitute each of the followingstatements .

1. A function concerned with raising of finance and its effective utilization in business.2. The basic principle of business activities that aims at profit.

3. The principle which means maximization of market price of equity shares.4. An advance programming of all plans of financial management.5. A mix up of various sources of funds in desired proportion.6. The ratio between debt capital (fixed interest) and equity capital (variable dividend).7. The use of borrowed capital for financing business firm.8. The portion of total capital which is. invested in fixed assets.9. The sum of current assets of the business.

10. The difference between current assets and current liabilities.

Q.2 Distinguish between the following.1. Fixed capital and Working capital

Q.3 Write notes on.1. Role of financial management .2. Objectives of financial planning3. Importance of financial planning4. Capital structure and its components


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Q.4 State, with reasons, whether the following statements are True or False.1. Financial management is essential for all types organization2. The proper aim of financial management is wealth maximization.3. Maximisation of profit is real and complete motive.4. It is not possible to go ahead without financial plan.

5. There is hard and fast rule for the proportion of owned funds and borrowed funds.6. Trading on equity is double edged sword.

7. Requirement of working capital does not depend upon any factor.

Q.5 Answer in brief.1. What is. financial management? State itsrole in the organisation.2. What are the objectives of financial management?3. What is financial planning? State importance of financial planning.4. What is fixed capital? State factors affecting requirement of fixed capital.

Answer the following questions.

1. What is capital structure? What are the internal and external factors influencing capitalstructure.

2. What is working capital? State the factors affecting requirement of working capital.Labels:BUSINESS FINANCE XII SP NEW SYLLABUS
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Business Finance Xii Sp New Syllabus

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