NCERT Notes for Class 12 business studies Chapter 9 Financial Management

Class 12 business studies Chapter 9 Financial Management

Table of Contents

NCERT Notes for Class 12 business studies Chapter 9 Financial Management, (business studies) exam are Students are taught thru NCERT books in some state boards and CBSE Schools.  As the chapter involves an end, there is an exercise provided to assist students to prepare for evaluation.  Students need to clear up those exercises very well because the questions inside the very last asked from those.

Sometimes, students get stuck inside the exercises and are not able to clear up all of the questions.  To assist students, solve all of the questions, and maintain their studies without a doubt, we have provided step-by-step NCERT Notes for the students for all classes.  These answers will similarly help students in scoring better marks with the assist of properly illustrated Notes as a way to similarly assist the students and answer the questions right.

NCERT Notes for Class 12 business studies Chapter 9 Financial Management

Class 12 business studies Chapter 9 Financial Management

Meaning of Business Finance

Money required for carrying out business activities is called business finance. Almost all business activities require some finance. Finance is needed to establish a business, to run it, to modernise it, to expand, or diversify it. Finance is required to buy various assets, to meet the day-to-day expenses of the business etc. Availability of adequate finance is essential for the smooth functioning of the business. Without finance neither any business can be started nor successfully run. That is why finance is called the life blood of the business.

Financial Management

Financial management may be defined as planning,organizing,directing and controlling the financial activities of an organization. It is concerned management of flow of funds and involves decisions related to procurement of funds, investment of funds in long term and short term assets and distribution of earnings to owners. It is a science of money management. The primary aim of financial management is to maximise shareholders’ wealth.

Financial Management

Importance of Financial Management

All the financial activities of a business directly or indirectly affected through financial management decisions. Some of them are:

Estimate size of the total financial requirements

It is the duty of the financial manager to decide how much fund needed to start a business. Over and under estimation will adversely affect the working of a firm.

Decide the size and composition of fixed assets.

The amount and type of fixed asset investment is decided by the financial manager. These decisions involve huge amount of investment, affect the earning capacity and are irreversible except at a huge loss.

Decide the size and composition of current assets.

The quantum of current assets and its breakup into cash, inventory and receivables are also influenced by financial management decisions.

Decide the sources of funds

Companies raise adequate finance from different sources. Some of them are owners fund and others are borrowed funds. Debt and equity differ significantly in terms of their cost and risk for the firm. It is the duty of the financial management to take appropriate decision in this regard.

Objectives of Financial Management

1- Wealth maximization:

The primary aim of modern financial management is to maximize shareholders’ wealth. Wealth maximization means to increase company’s share price and thereby increase the wealth of shareholders. The market price of a company’s shares is closely related to three important financial decision namely, investment decision, financing decision and dividend decision. All financial decisons aim at ensuring that each decision is efficient and adds some value. Such value additions tend to increase the market price of shares.

2- Profit Maximisation:

As against the wealth maximization objective, some financial experts are of the view that the objective of financial management should be to maximize profit. It implies that every decision relating to business is evaluated in the light of profits. It focuses on maximum return on investment. The company should earn sufficient profit to meet its expenses and also to pay dividend at competitive rates.

Facts about Reliance Industries Ltd (RIL)

Number of equity shares

633,46,51,022(Out of which 46.32% in Ambani family

Face value of share

Rs.10

Equity share capital

6334.65 Cr.

Share Price

Rs.976 (on 6-07-2018)

 

Rs.1426 (on 29-04-2020)

(Appreciation of wealth of shareholders in 21 months

  

is Rs.2.85 lakhs crores

Market capitalization

6.18 Lakhs Crores (on 6-07-2018)

(number of shares in the

9.03 Lakhs Crores (on 29-04-20)

[9.03 lakhs-6.18 lakhs])

market X market price of

  
 

share)

Finance Function/ Financial Decisions

Financial management is concerned with taking three important financial decisions namely, investment decision, financing decision and dividend decision. The market price of a company’s shares is closely related with these three decisions.

Investment decision

  1. Financing decision
  2. Dividend decision

FINANCIAL DECISIONS

Investment Decisions

Financing Decisions

Dividend decisions

  • Capital Budgeting Decisions
  • Working Capital decisions
  • Decision about amount of owners fund to be raised
  • Decision about amount of borrowed fund to be raised
  • Decision about the amount of profit to be retained in the business
  • Decision about the amount of profit to be distributed as dividend.
  1. Investment Decisions

This decision relates to careful selection of assets in which funds will be invested by the firm. The investment decision, therefore, relates to how the firm’s funds are invested in different assets. The decision may relate to investment in assets which are long term or short term.

Working Capital Management

1. Decisions about the level of cash,stock,debtors,bills receivables etc

Capital Budgeting Examples-

  1. Purchase of fixed asset
  2. Opening new branch
  3. Launching a new product line
  4. Major expenditure on advertising

The decision of investing funds in the long term assets or fixed assets like plant and machinery, land and building etc is known as Capital Budgeting.

These decisions involve huge amount of investment, affect the earning capacity and are irreversible except at a high cost. Thus, Capital Budgeting is the process of selecting the asset or an investment proposal that will yield returns over a long period.

The decision of investing fund in current assets or short term assets is termed as Working Capital Management. It represents the funds available to the enterprise to finance regular operations, i.e. day to day business activities, effectively. In case a firm has an inadequate working capital i.e. less funds invested in the short term assets, then the firm may not be able to pay off its current liabilities and may result in bankruptcy. Or in case the firm has more current assets than required, it can have an adverse effect on the profitability of the firm. Through working capital management, a firm tries to maintain a trade-off between the profitability and the liquidity.

Investment decisions are considered very important because:

  1. They are long term decision and irreversible except at a high cost.
  2. It involve huge amount of funds.
  3. It affects the future earning capacity of the company.

Capital Budgeting

A long-term investment decision is known as Capital Budgeting. It involves long term investment decision such as purchase of new machinery, replacement of machinery, new plants, introduction of new products, and research development projects. These decisions involve huge amount of investment, affect the earning capacity and are irreversible except at a high cost. These decisions are very crucial for any business since they affect its earning capacity in the long run. Capital budgeting is the process through which business undertakes to evaluate various long term investment proposals and capital budgeting before they are approved or rejected.

Features of capital budgeting:

  • Huge Funds
  • High Degree of Risk
  • Difficult Decision
  • Long Term Effect
  • Irreversible Decision

Factors affecting capital budgeting / long term investment decisions

There are certain factors which will affect capital budgeting decisions:

Cash flow of the project

Investment in fixed assets generates cash inflows (receipts) over a period. These cash flows should be carefully analysed and evaluated before making a capital budgeting decision.

The rate of return

The most important criterion is the rate of return of the project. These calculations are based on the expected returns from each proposal and the assessment of the risk involved. Suppose, there are two projects, A and B (with the same risk involved), with a rate of return of 10 per cent and 12 per cent, respectively, then under normal circumstance, project B should be selected.

Risk Involved

The degree of risk involved in each project should be assessed before making a long term investment.

Investment criteria involved

There are different capital budgeting decisions techniques to evaluate investment proposals. These techniques are Net Present Value, Discounted Cash Flow, Payback Period Method etc.

Competitive Strategy

If a competitor is going for new machinery of high capacity and cost effective, we may have to follow that.

Demand Forecast

Analysis of demand for a long period must be undertaken before capital budgeting decision.

Financing Decision

Financing decision relates to the quantum of finance to be raised from various sources. Mainly there are two sources of funds-Owners Fund and Borrowed Funds. Owners’ funds consists of equity capital and retained earnings. Borrowed funds are in the form of debentures and other forms of debts like loans, bonds etc. The financial manager has to decide the proportion of funds to be raised from either sources, based on their basic characteristics. The cost of each type of finance has to be estimated. Interest on borrowed funds has to be paid regardless of whether or not a firm has earned a profit. Likewise, the borrowed funds have to be repaid at a fixed time. The risk of default on payment is known as financial risk. Shareholders’ funds, on the other hand, involve no commitment regarding the payment of returns or the repayment of capital.

A firm, therefore, needs to have a judicious mix of both debt and equity in making financing decisions, which may be debt, equity, preference share capital, and retained earnings.

Financial risk: Financial risk is the chance that a firm would fail to in meeting the payment obligations. Doing business with more debt increases the financial risk of a company

Factors Affecting Financing Decisions

The financing decisions are affected by various factors. Important among them are as follows:

Cost

The costs of raising funds through different sources are different. The finance manager always prefers the source with minimum cost.

Risk

The risk associated with each of the sources is different. More risk is associated with borrowed fund as compared to owners fund. Finance manager compares the risk with the cost involved and will take wise decision.

Floatation Cost

Higher the floatation cost, less attractive the source. Floatation cost involves brokers commission, underwriters commission, expenses on prospectus etc.

Cash Flow Position of the Company

A stronger cash flow position may make debt financing more viable than funding through equity.

Fixed Operating Costs

If a business has high fixed operating costs (e.g., building rent, Insurance premium, Salaries, etc.), It must reduce fixed financing costs. Hence, lower debt financing is better. Similarly, if fixed operating cost is less, more of debt financing may be preferred.

Control Considerations

Issues of more equity may lead to dilution of management’s control over the business. Debt financing has no such implication. Companies afraid of a takeover bid would prefer debt to equity.

Floatation Cost

Flotation cost is the cost involved in the issue of shares or debentures. Floatation cost involves broker’s commission, underwriter’s commission, expenses on prospectus etc. Higher the floatation cost, less attractive the source.

Dividend Decision

Dividend decision is related with the distribution of dividend. Dividend is that portion of profit which is distributed to shareholders. The decision involved here is how much of the profit earned by company (after paying tax) is to be distributed to the shareholders as dividend and how much of it should be retained in the business. While the dividend constitutes the current income re-investment as retained earnings increases the firm’s future earning capacity. The decision regarding dividend should be taken keeping in view the overall objective of maximising shareholder’s wealth.

Factors Affecting Dividend Decision

How much of the profits earned by a company will be distributed as profit and how much will be retained in the business is affected by many factors. Some of the important factors are discussed as follows:

Amount of Earnings

Dividend is paid out of current and past earning. Therefore, earnings are a major determinant of the decision about dividend.

Stability Earnings

If a company has stable earnings, it will provide high dividends to its shareholders.

Growth Opportunities

Companies having good growth opportunities retain more money out of their earnings so as to finance the required investment. The dividend in growth companies is, therefore, smaller, than that in the non– growth companies.

Cash Flow Position

The payment of dividend involves an outflow of cash. Companies declare high rate of dividend only when they have surplus cash. In situation of shortage of cash companies declare no or very low dividend

Shareholders’ Preference

While declaring dividends, managements must keep in mind the preferences of the shareholders in this regard. If the shareholders in general desire that at least a certain amount is paid as dividend, the companies are likely to declare the same. There are always some shareholders who depend upon a regular income from their investments.

Taxation Policy

If tax on dividend is higher, it is better to pay less dividend. So taxation policy of government also influences dividend decision.

Stock Market Reaction

Rate of dividend and stock market reaction are directly related. A higher rate of dividend has a positive impact on stock price and vice versa. Therefore, management should take into account the impact of dividend policy on the equity shareprice,while taking a decision about it

Access to Capital Market

Large and reputed companies generally have easy access to the capital market and, therefore, may depend less on retained earnings to finance their growth. These companies tend to pay higher dividends than the smaller companies which have relatively low access to the market.

Legal Constraints

Certain provisions of the Companies Act place restrictions on payouts as dividend. Such provisions must be adhere to while declaring the dividend.

Contractual Constraints

While granting loans to a company, sometimes the lender may impose certain restrictions on the payment of dividends in future. The companies are required to ensure that the dividend does not violate the terms of the loan agreement in this regard.

FINANCIAL PLANNING

Financial Planning is a vital part of Financial Management. Financial Planning is the process of planning your finance for future. Financial planning is the plan needed for estimating the fund requirements of a business and determining the sources for the same. It essentially includes generating a financial blueprint for company’s future activities. Financial planning takes into consideration the growth, performance, investments and requirement of funds for a given period. Financial planning includes both short-term as well as long-term planning. The objective of financial planning is to ensure that enough funds are available at right time. If adequate funds are not available the firm will not be able to honor its commitments and carry out its plans. On the other hand, if excess funds are available, it will unnecessarily add to the cost and may encourage wasteful expenditure.

  • Financial planning is done for three to five years. For longer periods it becomes more difficult and less useful.
  • Plans made for periods of one year or less are termed as budgets.

Financial planning usually begins with the preparation of a sales forecast. Let us suppose a company is making a financial plan for the next five years. It will start with an estimate of the sales which are likely to happen in the next five years. Based on these, the financial statements are prepared keeping in mind the requirement of funds for investment in the fixed capital and working capital. Then the expected profits during the period are estimated so that an idea can be made of how much of the fund requirements can be met internally i.e., through retained earnings (after dividend payouts). This results in an estimation of the requirement for external funds. Further, the sources from which the external funds requirement can be met are identified and cash budgets are made, incorporating these factors.

Objectives of Financial Planning

Objective of financial planning is to ensure availability of sufficient funds at reasonable cost. It has twin objectives:

To ensure availability of funds whenever required

This includes estimation of the funds required for different purposes, which are, long- term assets and working capital requirements. Apart from this, there is a need to estimate the time at which these funds are to be made available. Financial planning also tries to specify possible sources of these funds.

To see that the firm does not raise resources unnecessarily:

It is an important objective of the company to make sure that the firm does not raise unnecessary resources. Shortage of funds and the firm cannot meet its payment obligations. Whereas with a surplus of funds, the firm does not earn returns but adds to costs.

Importance of financial planning

Financial planning is an important part of overall planning of any business enterprise. It aims at enabling the company to tackle the uncertainty in respect of the availability and timing of the funds and helps in smooth functioning of an organisation. The importance of financial planning can be explained as follows:

It helps the company to prepare for the future

Financial planning forecast what may happen in future under different business situations. In other words, it makes the firm better prepared to face the future. For example, a growth of 20% in sales is predicted. However, it may happen that the growth rate eventually turns out to be 10% or 30%. Many items of expenses shall be different in these three situations. By preparing a blueprint of these three situations

Helps in coordination

If helps in coordinating various business functions, e.g., sales and production functions, by providing clear policies and procedures. Financial planning makes possible a closer cooperation between various departments of the firm.

Helps in avoiding business shocks and surprises

By anticipating the financial requirements financial planning helps to avoid shock or surprises which otherwise firms have to face in uncertain situations.

Base for Financial control

Financial planning act as base for checking the financial activities. It compare the actual revenue with estimated revenue and actual cost with estimated cost.

Reduce wastage

Detailed plans of action prepared under financial planning reduce waste, duplication of efforts, and gaps in planning.

Ensuring Liquidity

Financial planning maintains the balance between inflow and outflow of funds makes it liquid funds available throughout the year.

Difference between financial management and financial planning

Basis

Financial Management

Financial Planning

Meaning

It refers to efficient acquisition, utilization and disposal of surplus for the smooth flow of organization.

It refers to estimation of capital and deciding the sources of funds and optimum utilization of funds.

Scope

It is wider in scope, it includes financial planning also

It is narrow in scope; it is a part of financial management.

Money

There is actual money to mange

There is no money to manage, only planning

Objective

Objective is to manage all the activities related to finance

Objective is to ensure availability of funds and to see that firm does not raise the funds unnecessarily

CAPITAL STRUCTURE

One of the important decisions under financial management relates to design the capital structure. Financial management of a company decides the proportion of the use of different sources in raising required funds.

Capital Structure is the mixture of long-term sources of funds in a firm’s capital. It represents the proportion of debt capital and equity capital in the total capital of a firm. On the basis of ownership, the sources of business finance can be broadly classified into two categories viz., ‘owners’ funds’ and ‘borrowed funds’. Owners’ funds consist of equity share capital, preference share capital and reserves and surpluses or retained earnings. Borrowed funds can be in the form of loans, debentures, public deposits etc. Debt and equity differ in cost and risk. As debt involves less cost but it is very risky securities whereas equity is expensive securities but these are safe securities from company’s point of view.

The cost of debt is lower than the cost of equity for a firm because the lender’s risk is lower than the equity shareholder’s risk, since the lender earns an assured return and repayment of capital and, therefore, they should require a lower rate of return.

Risk in case of Debt and Equity –A comparison

Debt

Equity

Debt is more risky because payment of regular interest on debt is a legal obligation of the business. Any failure with reference to the payment of interest or repayment of principal amount may lead to the liquidation of the company. Eg.Kingfisher Airlines Ltd

Equity shares are safe securities from company’s point of view as company has no legal obligation to pay dividend on to equity share holders if it is running in loss but these are expensive securities

Capital structure affects both the profitability and the financial risk. That proportion of debt and equity, which results in an increase in the value of equity share may be called the optimal capital structure. In other words, capital structure decisions should emphasis on increasing shareholders wealth

Financial Leverage

The proportion of debt in the overall capital of a firm is called Financial Leverage or Capital Gearing. When the proportion of debt in the total capital is high then the firm is called highly levered firm but when the proportion of debts in the total capital is less, then the firm will be called low levered firm.

When financial leverage increase (highly geared) the cost of fund will decline due to increased use of low-cost debts. But at the same time financial risk increases. Normally, in highly geared situation earning per share will increase (If company’s rate of return on investment (RoI) is higher than the cost of debts)t due to the use of low cost securities in the capital structure. This technique of using fixed cost securities like preference shares and debentures etc in capital structure so as to increase the return on equity share capital is called Trading on equity.

Low Leverage

Assets 1000 crores

Debt

250 crores

Equity 750 crores

High Leverage

Assets 1000 crores

Debt 750 crores

Equity

250 crores

Financial leverage is computed as Debt/ Equity or Debt / Debt+ Equity.

Financial leverage is called favourable if Return On Investment (ROI) is higher than the cost of debt.

Trading on Equity

In favorable financial leverage situation (Return On Investment (ROI) is higher than the cost of debt)company’s often employ fixed cost securities such as debentures and preference shares in the capital structure so as to increase the return on equity capital. Such practice is called Trading on Equity. If the cost of borrowed fund is lower than company’s rate of earnings, the equity shareholders get additional profits. However, leverage or trading on equity can operate adversely if the rate of interest on fixed interest bearing securities is higher than the Return on Investment.

Simple example to explain Trading on equity phenomenon

Suppose B Ltd raised its entire capital Rs.8,00,000 through the issue of equity shares alone and earns a profit of 80,000, i.e.,the rate of return is 10% [ (80000/800000)100]

On the otherhand,if the same company B Ltd raise Rs.3,00,000 through issue of equity shares and Rs.5,00,000 by way of 7% debentures, the rate of return to equity share holders will increase to 15%.

Factors Affecting Capital Structure

Capital structure of an organization is affected by several factors. Some of the factors affecting capital structure are:

Trading on equity/ financial leverage factor

Trading on equity factor is the most important factor that will influence the decision of capital structure. In a favorable financial leverage situation, where ROI is higher than the cost of debts, companies often employ more debts to its capital structure to enhance the EPS. Such practice is called Trading on Equity.

Cash Flow Position

A firm’s ability to pay expenses and loans determines debt capacity. The Company may raise funds by issuing debts if it has a fluent cash flow position, as they are to be paid back after some time.

At the time of considering cash flow,finanacial manager must be kept in mind that a company has cash payment obligations for (i) normal business operations; (ii) for investment in fixed assets; and (iii) for meeting the debt service commitments i.e., payment of interest and repayment of principal

Interest Coverage Ratio

Interest Coverage Ratio is the number of times earnings before interest and taxes of a company cover the interest obligation. High-Interest coverage ratio indicates that company can have more of borrowed funds.

Interest Coverage Ratio (ICR) = Earnings Before Interest and Tax (EBIT) / Interest.

Interest Coverage Ratio (ICR): The interest coverage ratio refers to the number of times earnings before

Interest and taxes of a company covers the interest obligation. The higher the ratio, lower shall be the risk of company failing to meet its interest payment obligations.

Control

Debt never dilutes the control of existing equity share holders. Further issue of equity share may dilute the control of existing equity share holders.

Return on Investment

It will be beneficial for a firm to raise finance through borrowed funds if the return on investment is higher than the rate of interest on the debt. But if the return is uncertain and the company is not sure if it can cover the fixed cost of interest, they should opt for equity.

Floatation Cost

Floatation cost is the cost involved in the issue of shares or debentures. These cost include the cost of advertisement, underwriting statutory fees, brokers commission etc. Cost of the Public issue is more than the floatation cost of taking a loan.

Flexibility

Issuing debenture and preference shares introduce flexibility. A good financial structure is flexible and sound enough to have scope for expansion or contraction of capitalization whenever the need arises.

Cost of debt/capital

Cost of debt means the minimum return expected by the suppliers of capital.A firm’s ability to borrow at a lower rate increases its capacity to employ higher debt. Thus, more debt can be used if debt can be raised at a lower rate.

Stock Market Conditions

Conditions of the stock market influence the determination of securities. During the depression, people do not like to take a risk and do not take interest in the equity shares. During the boom, investors are ready to take a risk and invest in equity shares.

Tax Rate

Since interest is a deductible expense, cost of debt is affected by the tax rate. A higher tax rate, thus, makes debt relatively cheaper and increases its attraction than equity. Suppose, rate of borrowing is 10% and the tax rate is 30%, the after tax cost of debt is only 7%.

Regulatory framework

Provisions of the Companies Act, SEBI guidelines etc are to be followed while designing capital structure. Therefore, choice of sources of finance is depends on various regulations framed by authorities from time to time.

 

Knowledge Box

  

Capitalisation: Capital means total fund invested in the business and includes owner’s

funds and borrowed funds.Capitalisation is the valuation of this capital and will include owner’s funds, borrowed funds, long term loans, reserves and any other surplus earnings.

Over Capitalisation: It is a situation where business employs more capital than warranted.

Under Capitalisation: It is a situation where Business employs less capital than warranted

Fixed Capital and Working Capital

Fixed Capital

The capital invested in fixed assets like land and building, plant and machinery, furniture and fixtures etc is known as fixed capital or block capital. Fixed assets are those assets which are required for permanent use and are not meant for resale. Managing fixed capital is related to investment decision and it is also called capital budgeting.

Capital budgeting decisions will affect the growth, profitability and risk of the business in the long run. These long term assets last for more than one year. It must be financed through long-term sources of capital such as equity or preference shares, debentures, long-term loans and retained earnings of the business. Fixed Assets should never be financed through short- term sources. Investment in these assets would also include expenditure on acquisition, expansion, modernization and their replacement

Importance of Fixed Capital Management/ Capital Budgeting

Capital budgeting decisions are very important because of the following reasons:

Large amount of fund involved

Purchase of fixed assets involve huge amount of fund. Therefore detailed analysis should be undertaken before such decisions.

Long Term Investment

Investment in fixed assets is for a long period and brings return in future.Thus, this investment is also known as block capital.

Irreversible in nature

These decisions once taken are not reversible without incurring heavy losses.

Risk involved

Fixed capital decisions are full of risk because of two reasons-these refer to a long period and secondly involve huge investment. As such expected profits for several years are to be anticipated and these estimates may turn out to be wrong.

Factors affecting the Requirement of Fixed Capital

Some of the factors affecting the requirement of fixed capital are as follows:

Nature of business

The nature of business determine how much fixed capital is required.eg,a manufacturing concern needs more fixed capital as compared to a trading concer,as trading company does not need plant, machinery etc.

Scale of operations

A larger organization operating at a higher scale needs bigger plant, more space etc.and therefore requires more fixed capital as compared to small organization.

Technique of production

Companies using capital intensive techniques require more fixed capital whereas companies using labour intensive techniques require less capital. In capital intensive organization they require more fixed capital to purchase machinery, construct building etc.

Growth prospects

Higher growth of an organization at present as well as anticipated future requires higher investment in fixed assets and they require larger fixed capital.

Diversification

When a firm diversifies its activities, requirements of fixed capital will increase. It requires more investment in fixed assets for the new project.

Technology up gradation

In certain industries, assets become obsolete very soon, eg, computers.So their replacement also becomes due faster. So they require more fixed capital to replace old fixed assets like machinery, computers etc.

Financing alternatives

An enterprise which procures fixed assets on lease requires lesser fixed capital than on outright purchase.

Level of collaboration

By collaborating with others, a firm uses another’s facility or jointly establishes a facility for common use. Such collaboration reduces the investment in fixed assets for each one of the participants.

Eg..Banks share ATM facility, Telecom companies mobile tower sharing etc

Working Capital

The capital invested in current assets like stock, debtors, bills receivables, short term securities, cash and bank balance for meeting day to day expenses is known as working capital. It represents investment for a short period and changes its form from time to time. These assets are expected to get converted into cash or cash equivalents within a period of one year. These provide liquidity to the business. Insufficient investment in current assets may make it more difficult for an organisation to meet its payment obligations.

The term ‘working capital’ is used in two senses, namely gross working capital and net working capital. Gross working capital is the total value of current assets. On the other hand net working capital is the excess of current assets over current liabilities

Net working Capital=Current Asset – Current Liability

Current liabilities are those payment obligations which are due for payment within one year; such as bills payable, creditors, outstanding expenses and advances received from customers, etc.

Factors affecting the Requirement of working capital

Main factors affecting the requirements of working capital are as follows:

Nature of business

The basic nature of a business influences the amount of working capital required. The trading concern usually needs a small amount of working capital as compared to a manufacturing concern. This is because there is no production process in trading concern.Similarly, service industries which have no inventory requires less amount of working capital.

Scale of operations

There is direct link between the working capital and scale of operations. In other words more working capital is required in case of big organizations while less working capital is needed in case of small organizations.

Business cycle

Different phases of business cycle influence the requirement of working capital. In boom period, sales as well as production shoot up which call for larger amount of working capital. But during depression the demand declines and it affects both production and sales. Therefore in depression less working capital is required.

Operating Cycle/Production Cycle

The amount of working capital directly depends upon the length of operating cycle. Operating cycle in a manufacturing concern refers to the time period involved in production. If operating cycle is long then more working capital is required whereas for companies having short operating cycle, the working capital requirement is less.

 

Knowledge Box

Operating Cycle: Operating cycle is the time period between acquisition of raw materials and the collection of cash from receivables. In trading concern operating cycle begins with procurement of goods to be sold and ends with realising cash from debtors after sale of these goods. In manufacturing concern the operating cycle begins with purchase of raw materials, converting raw materials into finished goods and ends when finished goods are sold in the market and revenue is realized by the company.

Seasonal factors

Some business is seasonal in their operations. In peak season, due to higher level of activity more amount of working capital will be required. But during off season, they require only less amount of working capital.

Credit allowed

Those enterprises which sell goods on cash basis need little working capital but those who provide credit facilities to the customers need more working capital.

Credit availed

A business may get credit facility from suppliers of goods. More the credit facility, lesser would be the requirement of working capital.

Availability of raw materials

If raw materials required for the business are available freely and regularly, a firm needs to maintain only lesser amount of working capital.

Reorder period

Time gap between placement of order and receipt of raw materials is relevant. Longer the reorder period, larger shall be the amount of working capital requirements.

Level of competition

High level of competition increases the need for more working capital. In order to face competition, more stock is required for quick delivery. Credit sales also required at this situation.

Inflation

Inflation leads to rise in price. In such a situation more capital is required than before in order to maintain the previous scale of production and sales

Liquidity means ability of an asset to convert into cash quicker and without reduction in value Marshalling in the order of liquidity-Assets are arranged in order of liquidity i.e. they can be converted to cash easily. Most liquid assets, such as cash, will come first and least liquid assets, such as building, will come last. Liabilities are arranged in the order they are to be discharged.

Marshalling of Assets– Assets and liabilities can be arranged either in the order of liquidity or permanence.

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