Class 12 Business Studies

Business
Finance
The fund required
to carry out the
activities of the
Business is called
Business Finance.
 Financial Management
Financial management refers to the efficient acquisition of
finance, efficient utilization of finance and efficient distribution
and disposal of surplus for the smooth working of the company.
In other words, it is concerned with the flow of
funds and involves decisions related to :

Procurement of Funds
Investment of Funds
Distribution of Earnings
 Role of Financial Management
The overall financial health of a business and its future depends a
great deal on the quality of its financial management.
Financial Management is concerned with optimal procurement as
well as the usage of finance.
Good financial management aims at procuring funds at a lower
cost, keeping the risk under control and achieving effective
deployment of such funds in the most productive activities, so
that they can earn the highest possible return for their investors.
It also aims at ensuring the availability of enough funds
whenever required as well as avoiding idle finance.
The financial statements, such as Balance Sheet and Statement of
Profit and Loss Account, of a business are largely determined by
financial management decisions taken earlier.
 Objectives of Financial Management
 The objective of financial management is to maximize the current price of equity shares of the
company or to maximize the wealth of owners of the company, that is, the shareholders.
 Therefore, when a decision is taken about investment in a new machine, the aim of financial
management is to ensure that benefits from the investment exceed the cost so that some value
addition takes place. Similarly, when finance is procured, the aim is to reduce the cost so that the
value addition is even higher.

The objective of maximization of

shareholder’s wealth is achieved by :
Ensuring the availability of sufficient funds
at a reasonable cost.

Ensuring effective utilization of funds.

Ensuring safety of funds procured by

creating reserves, reinvesting profits, etc.
 Financial Decisions
The finance functions relate to three major decisions which
every finance manager has to take :
Financial Decisions

Investment Financial Dividend

Decision Decision Decision
Capital
Debt Profit
Budgeting

Working Retained
Capital
Equity Earnings
Investment Decision
(Capital Budgeting This decision relates to the careful selection of
Decision) assets in which funds will be invested by the firms.

An investment decision can be long-term or short-

term. A firm has to select the most appropriate
investment option out of the various options
which will bring maximum benefit to the firm.

The firm invests its funds in acquiring fixed assets

as well as current assets. When a decision
regarding fixed assets is taken it is also called a
Capital Budgeting Decision.

The size of assets, profitability and

competitiveness are all affected by Capital
Budgeting Decisions.
 Factors Affecting Investment / Capital Budgeting Decisions
 Whenever a company is investing huge funds in an investment
proposal it expects some regular amount of cash flow to meet
Cash flow of
the day-to-day requirement.
the Project  The amount of cash flow an investment proposal will be able
to generate must be analyzed properly before investing in the proposal.

 The most important criteria to decide the investment proposal is the rate of
Return on return it will be able to bring back for the company in the form of income.
Investment  For example : If project A is bringing 10% return and project B is bringing 15%
return then we should prefer project B.
 With every investment proposal, there is some degree of risk is also involved.
Risk Involved  The company must try to calculate the risk involved in every proposal and
should prefer the investment proposal with a moderate degree of risk only.
 Along with the rate of investment return, risk, and cash flow, there are
Investment
various other criteria which help in selecting an investment proposal such as
Criteria the availability of labour, technologies, input, machinery, etc.
 Importance or Scope of Capital Budgeting Decision
Long-term Growth
 Capital budgeting decisions affect the long-term growth of the company.
 As funds invested in long-term assets bring return in future and future prospects and growth of the company depends upon
these decisions only.

Large Number of Funds Involved

 Investment in long-term projects or buying of fixed assets involves huge amounts of funds.
 If the wrong proposal is selected it may result in the wastage of huge amounts of funds that is why
capital budgeting decisions are taken after considering various factors and planning.

Risk
 The fixed capital decisions involve huge funds which carry high risk also.
 The return comes in the long run and the company has to bear the risk for a long period till the return start coming.

Irreversible Decision
 Capital Budgeting Decisions cannot be reversed or changed overnight.
 As these decisions involve huge funds and heavy costs and going back or reversing the decision
may result in heavy loss and wastage of funds.

Conclusion : Therefore, the Finance Manager must compare all the available alternatives very
carefully and then only decide where to invest the most valuable resource of the firm i.e. finance.
 Financing Decision
(Quantum of finance to be raised from various long-term sources.)
 The second most important decision that a finance
manager has to take is deciding the source of finance.
 A company can raise finance from various sources but
the main sources of finance are divided into two categories :
a) Owner’s Funds : It includes share capital and retained earnings.
b) Borrowed Funds : These include debentures, loans, bonds etc.
 Deciding how much to raise from which source is a
concern of the financing decision.
 The borrowed funds involve some degree of risk whereas in the
owner's fund, there is no fixed commitment of repayment and there is
no risk involved. But the finance manager prefers a mix of both types.
 Factors Affecting Financing Decisions
 The cost of raising finance from various sources are different and finance
Cost manager always prefer the source with minimum cost.
 The cash flow position of the company also helps in selecting the securities.
 A strong cash flow position may make debt financing more viable than funding through equity.
Cash Flow Position  With smooth and steady cash flow companies can easily afford borrowed funds securities but when
companies have a shortage of cash flow, then they must go for owner's fund securities only.
 If existing shareholders want to retain complete control of the business then they prefer borrowed fund
Control Considerations securities to raise further funds.
 On the other hand, if they do not mind losing control then they may go for owner's fund securities.

 It refers to the cost involved in the issue of securities such as broker's commission, underwriter's fees,
Flotation Cost expenses on the prospectus, etc.
 The firm prefers securities which involve the least floatation cost.
 If a company is having high fixed operating cost then it must prefer an owner's fund because due to high
fixed operational costs. For example: Building rent, Insurance premium, salaries etc.
Fixed Operating Cost  The company may not be able to pay interest on debt securities which can cause
serious troubles for the company.

 More risk is associated with the borrowed fund as compared to owner's fund securities.
Risk  The finance manager compares the risk with the cost involved and prefers securities
with a moderate risk factor.

 The conditions of the capital market also help in deciding the type of securities to be raised.
State of Capital Market  During the boom period, it is easy to sell equity shares as people are ready to take risks whereas, during
the depression period, there is more demand for debt securities in the capital market.
Dividend Decision /
Residual Decision
 This decision is concerned with the distribution of
surplus funds. The profit of the firm is distributed
among various parties such as creditors,
employees, debenture holders, shareholders, etc.
 After the payment of fixed liabilities, a finance
manager has to decide what to do with the
residual profit of the company.
 The surplus profit is either distributed to equity
shareholders or kept aside in the form of
retained earnings.
 Therefore, under dividend decision, the finance
manager decides how much to be distributed in
the form of dividend and how much to keep
aside as retained earnings.
 Factors Affecting Dividend Decisions
The Finance Manager analyses the following factors before dividing the net
earnings between dividends and retained earnings :
1) Earning :
 Dividends are paid out of the current and previous year's earnings.
 If there are more earnings then the company declares a high rate of dividend
whereas, during a low earning period, the rate of dividend is also low.
2) Stability of Earnings :
 Companies having stable or smooth earnings prefer to give
a high rate of dividend whereas companies with unstable
earnings prefer to give a low rate of dividend.
3) Cash Flow Position :
 Paying dividend means an outflow of cash.
 Companies declare a high rate of dividend only when they have surplus cash.
In a situation of shortage of cash, companies declare no or very low dividend.
4) Growth Opportunities :
 If a company has a number of investment plans then it should reinvest the earnings of the company.
 Hence, a company with no growth plans will distribute more in the form of
dividends whereas growing companies will be kept aside more as retained earnings.
5) Preference of Shareholders :
 If a company is having a large number of retired and middle class shareholders
then it will declare more dividend.
 Whereas if company is having a large number of young and wealthy shareholders then it will prefer
to keep aside more in the form of retained earnings and declare a low rate of dividend.
6) Taxation Policy :
 The rate of dividend also depends upon the taxation policy of the government.
 Under the present taxation system, dividend income is tax-free for shareholders but a
company has to pay tax on dividends given to shareholders.
 If the tax rate is higher, then the company prefers to pay less in the form of
dividend whereas if the tax rate is low then the company may declare higher dividend.
7) Access to Capital Market Consideration :
 If the capital market can easily be accessed or approached and there is enough demand for securities
of the company then the company can give more dividends and raise capital by approaching the
capital market.
 But if it is difficult for the company to approach the capital market then companies declare a low
rate of dividend and use reserves for reinvestment.
8) Legal Restrictions / Constraints :
 Companies Act has given certain provisions regarding the payment of dividends.
 Apart from the company's act, there are certain internal provisions of the
company like whether the company has enough cash flow to pay a dividend or not.
 The payment of dividend should not affect the liquidity of the company.

9) Contractual Constraints :
 When companies take long-term loans then financier may put some restrictions or constraints
on the distribution of dividend and companies have to abide by these constraints.

10) Stock Market Reactions :

 The declaration of dividend has impact on stock market as the increase in dividend is taken as
good news in the stock market and prices of securities rise.
 Whereas a decrease in dividend may have negative impact on the share price
in the stock market. Hence equity share price also affects dividend decision.

11) Stability of Dividend :

 Some companies follow a stable dividend policy as it has a better impact
on shareholder and improves the reputation of the company in the share market.
 The stable dividend policy also satisfies the investor. When the company is confident then their
earning potential has improved then they increase the dividend.
 Financial Planning
 Financial planning means deciding in advance how much to spend, on what to spend according to the funds
at your disposal.

In the words of Gerestenbug financial planning includes :

Determination of the amount of finance needed by an enterprise to carry out
its operations smoothly.

Determination of sources of funds, i.e., the pattern of securities to be issued.

Determination of suitable policies for proper utilization and administration of

funds.

 Financial planning begins with the determination of the total capital requirement. For this, the finance
manager does the sales forecast.
 If the prospects appear to be bright and then the firm needs to increase its production capacity which means
more requirement of long-term funds i.e., fixed capital as well as working capital.
 Financial planning does not end by raising estimated finance. It includes long-term investment decisions. The
finance manager analyses various investment plans and selects the most appropriate one. The finance
manager also makes a short-term financial plan called budget.
 Objectives of Financial Planning
To ensure the availability of funds
whenever these are required
 The main objective of financial
planning is that sufficient funds
should be available in the
company for different purposes
such as for the purchase of long-
term assets, to meet day-to-day
expenses, etc.
 It ensures the timely availability
of finance and also tries to
specify the sources of finance.
To see that firm does not raise
resources unnecessarily
 Excess funding is as bad as a
shortage of funds. It may result
in the wastage of resources.
 If there is surplus money it must invest in
the best possible manner as keeping
financial resources idle is a great loss for
an organization.
 Financial planning includes both short-
term as well as long-term planning.
 Long-term planning focuses on capital
expenditure plan whereas short-term
financial plans are called budgets which
include a detailed plan of action for one
year or less.
 Importance of Financial Planning
It Makes the Firm Well-prepared to Face the Future
 Financial planning helps in forecasting what may happen in future under different business situations. It helps the firm to face the
eventual situations.
 For example : If a company is expecting 20% growth in sales there are chances that it may be 10% or
maybe 30%. The planners prepare the blueprint of all three situations so that the company can be
well known of all the possible situations and the planning for those particular situations.

It Helps in Avoiding Business Shocks and Surprises

 By preparing the blueprint of various possible situations the firm can avoid business shocks and
surprises and feel better prepared to face different types of situations.

Helps in Proper Utilization of Finance

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

Helps in Coordination
 It helps in coordinating various business functions such as production, sales function etc. by providing clear policies and procedures.

The Link Between Investment and Financing Decisions

 Financial planning helps in deciding the debt/equity ratio and deciding where to invest this fund.
 It creates a link between both decisions.

It Links the Present with the Future

 Financial planning relates present financial requirements with future requirements by anticipating the
sales and growth plans of the company.
 Stage 1 : Preparation
of a sales forecast

Step 2 : Preparation
Step 5 : Preparation
of financial
of a cash budget.
statements

Step 4 : Estimation Step 3 : Estimation

of sources of of expected profits
external funds
 Various Steps Involved in the Process of Financial Planning
1) Preparation of a Sales Forecast :
 Financial planning usually begins with the preparation of a sales forecast.
 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.

2) Preparation of Financial Statements :

 Based on the sales forecast, the financial statements are prepared to keep in
mind the requirement of funds for investment in the fixed capital and working capital.

3) Estimation of Expected Profits :

 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.
 This results in an estimation of the requirement for external funds.

4) Estimation of Sources of External Funds :

 The sources from which the external fund's requirement can be met are identified.

5) Preparation of Cash Budget :

 Cash budgets are made incorporating the above factors.
 Capital Structure
 Capital structure means the proportion of debt and equity used for financing the operations of
the business.
𝐃𝐞𝐛𝐭
Capital Structure =
𝐄𝐪𝐮𝐢𝐭𝐲
 An ideal capital structure is very difficult to define but it should be such that it increases the value
of equity shares or maximizes the wealth of equity shareholders.

Debt and Equity differ in Cost and Risk :

Debt involves less cost but it is very risky because of the payment of regular
interest which is the legal obligation of the business. If the company fails to pay
its obligation the security holders can claim over the assets of the company.
Equity securities are expensive securities but these are safe securities from the
company's point of view as a company has no legal obligation to pay a dividend
to equity shareholders if it is running into losses.

Conclusion : A capital structure of the business affects the profitability and financial
risk. Generally, companies use the concept of financial leverage to set up the capital
structure.
 Financial Leverage / Trading on Equity
 Financial leverage refers to the proportion of debt in the overall capital.
𝐃𝐞𝐛𝐭
Financial leverage =
𝐄𝐪𝐮𝐢𝐭𝐲
 With debt funds company's funds and earnings increase because debt is a
cheaper source of finance but it involves a high degree of risk.
More debt will increase by earning only when the return on
investment is more than the rate of interest on the debt.
Return on Investment > Rate of Interest = Favourable
Situation.
Return on Investment < Rate of Interest = Unfavourable
Situation.
 If the Rate of Interest is more than the earnings then more debt means a loss for
the company.
 Total Capital = Rs 50 Lakhs
Situation Equity Capital = Rs 50 Lakhs (5,00,000 shares @ Rs 10
1 each)
Debt = Nil
Tax Rate = 30% p.a.
Earning before Interest and Tax (EBIT) = Rs 7, 00,000
Total Capital = Rs 50 Lakhs
Situation Equity Capital = Rs 40 Lakhs (4,00,000 shares @ Rs 10 each)
2 Debt = Rs 10 Lakhs
Tax Rate = 30% p.a.
Interest on Debt = 10%
Earning before Interest and Tax (EBIT) = Rs 7,00,000

Total Capital = Rs 50 Lakhs

Situation Equity Capital = Rs 30 Lakhs (3,00,000 shares @ Rs 10 each)
3 Debt = Rs 20 Lakhs
Tax Rate = 30% p.a.
Interest on Debt = 10%
Earning before Interest and Tax (EBIT) = Rs 7,00,000
 Situation - 1 Situation - 2 Situation – 3
EBIT (Earning before 7,00,000 7,00,000 7,00,000
interest and tax paid)
Less : Interest 0 -1,00,000 -2,00,000
(10% of 10 Lakhs) (10% of 20 Lakhs)
EBT 7,00,000 6,00,000 5,00,000
(Earning before tax)
Less : Tax (30% of EBT) -2,10,000 -1,80,000 -1,50,000
(30% of 7 Lakhs) (30% of 6 Lakhs) (30% of 5 Lakhs)

EAT (Earning after tax) 4,90,000 4,20,000 3,50,000

EPS 0.98 1.05 1.16

𝐄𝐀𝐓 𝟒, 𝟗𝟎, 𝟎𝟎𝟎 𝟒, 𝟐𝟎, 𝟎𝟎𝟎 𝟑, 𝟓𝟎, 𝟎𝟎𝟎
𝐍𝐨. 𝐨𝐟 𝐄𝐪𝐮𝐢𝐭𝐲 𝐒𝐡𝐚𝐫𝐞𝐬 𝟓, 𝟎𝟎, 𝟎𝟎𝟎 𝟒, 𝟎𝟎, 𝟎𝟎𝟎 𝟑, 𝟎𝟎, 𝟎𝟎𝟎
 Capital
Structure = ? Maximization of the wealth of equity shareholder
(EPS = maximize)
 If we compare all the situations then we can see the situation – 3 equity shareholders can
get maximum return followed by the situation – 2 and least earning in the situation – 1.
 Hence, it is proof that more debt brings more income for the owners in capital structure.
 But this statement holds only till rate of earning of capital, i.e., return on investment of
the company is more than the rate of interest charged on debt.
 In this example, the return is 14%
EBIT
= X 100
Total Investment
7,00,000
= X 100 = 14%
50,00,000

The Rate of Interest is 10% hence 14% > 10%.

I.e. ROI > Rate of Interest.
 Total Capital = Rs 50,00,000
Equity Capital = Rs 50,00,000 (5,00,000 shares @ Rs 10 each)
Situation Debt = Nil
Tax Rate = 30% p.a.
1 Interest Rate = 10% p.a.
Earning before Interest and Tax (EBIT) = Rs 3, 00,000
3,00,000
ROI = 6,00,000× 100 = 6%

Total Capital = Rs 50,00,000

Situation Equity Capital = Rs 40,00,000 (4,00,000 shares @ Rs 10 each)
Debt = Rs 10,00,000
2 Tax Rate = 30% p.a.
Interest on Debt = 10% p.a.
Earning before Interest and Tax (EBIT) = Rs 3, 00,000
3,00,000
ROI = × 100 = 6%
50,00,000

Total Capital = Rs 50,00,000

Situation Equity Capital = Rs 30,00,000 (3,00,000 shares @ Rs 10 each)
Debt = Rs 20,00,000
3 Tax Rate = 30% p.a.
Interest on Debt = 10% p.a.
Earning before Interest and Tax (EBIT) = Rs 3, 00,000
3,00,000
ROI = 50,00,000× 100 = 6%
 Situation - 1 Situation - 2 Situation – 3
EBIT (Earning before 3,00,000 3,00,000 3,00,000
interest and tax paid)
Less : Interest 0 -1,00,000 -2,00,000
(10% of 10 lakhs) (10% of 20 lakhs)
EBT(Earning before tax) 3,00,000 2,00,000 1,00,000
Less : tax (30% of EBT)
-90,000 -60,000 -30,000
(30% of 3 lakhs) (30% of 2 lakhs) (30% of 1 lakh)

EAT (Earning after tax) 2,10,000 1,40,000 70,000

EPS 0.42 0.35 0.23

𝐄𝐀𝐓 𝟐, 𝟏𝟎, 𝟎𝟎𝟎 𝟏, 𝟒𝟎, 𝟎𝟎𝟎 𝟕𝟎, 𝟎𝟎𝟎
𝐍𝐨. 𝐨𝐟 𝐄𝐪𝐮𝐢𝐭𝐲 𝐒𝐡𝐚𝐫𝐞𝐬 𝟓, 𝟎𝟎, 𝟎𝟎𝟎 𝟒, 𝟎𝟎, 𝟎𝟎𝟎 𝟑, 𝟎𝟎, 𝟎𝟎𝟎
 Factors which Influence the Decision on Capital Structure
1) Cash Flow Position :
 The decision related to the composition of capital structure also depends upon
the ability of a business to generate enough cash flow.
 Sometimes company makes sufficient profit but it is not able to generate
cash inflow for making payments.
 Hence if the company fails to make fixed payment it may face insolvency.
 The company must analyze properly the liquidity of its working capital before
including the debt in the capital structure.
2) Interest Coverage Ratio :
 It refers to the number of times companies Earn before Interest and Taxes (EBIT) cover the interest
payment obligation.
𝐄𝐁𝐈𝐓
 ICR = 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭
 A high ICR means companies can have more of borrowed fund securities whereas a lower ICR means less
borrowed fund securities.
3) Return on Investment (ROI) :
 If the return on investment is more than the rate of interest then the company
must prefer debt in its capital structure.
 Whereas if the return on investment is less than the rate of interest to be paid
on debt, then the company should avoid debt and rely on equity capital.
4) Cost of Debt :
 If a firm can arrange borrowed funds at a low rate of interest then it will prefer more debt
as compared to equity.
5) Tax Rate :
 High tax rates make debt cheaper as interest paid to debt security
holders is subtracted from income before calculating tax whereas
companies have to pay tax on dividends paid to shareholders.
 So high tax rate means prefer debt whereas, at a low tax rate,
we can prefer equity in capital structure.
6) Cost of Equity :
 Owners or equity shareholders expect a return on their investment i.e., earning per share.
As far as debt is increasing earnings per share (EPS) then we can include it in the capital
structure when EPS start decreasing will the inclusion of debt then we must depend upon
equity share capital only.
7) Floatation Costs :
 Floatation cost is the cost involved in the issue of shares or debentures.
 These costs include the cost of advertisement, underwriting statutory fees etc.
 The issue of shares and debentures requires more formalities as well as more floatation
cost. Whereas there is less cost involved in raising capital through loans or advances.
8) Risk Consideration :
 Financial risk refers to a position when a company is unable to meet its fixed financial
charges such as interest, preference dividend, payment to creditors etc.
 If a firm's business risk is low then it can raise more capital by issue of debt securities
whereas, at a time of high business risk, it should depend upon equity.
9) Flexibility :
 Excess of debt may restrict the firm’s capacity to borrow further.
 To maintain flexibility, it must maintain some borrowing power
to take care of unforeseen circumstances.
10) Control :
 Equity shareholders are considered as the owners of the company and they have complete
control over the company. Whereas Debt does not cause a dilution of control.
11) Regulatory Framework :
 The issue of shares and debentures has to be done according to the
SEBI guidelines and for taking loans.
 Companies have to follow the regulations of monetary policies.
 If SEBI guidelines are easy then companies may prefer the issue of securities for additional
capital whereas monetary policies are more flexible than they may go for more loans.
12) Debt Service Coverage Ratio :
 It is one step ahead of ICR, i.e., ICR covers the obligation to pay back interest on
debt but DSCR takes care of the return of interest as well as principal repayment.
Profit after tax + Interest + Non−Cash Expense (Depreciation)
 DSCR =
Preference dividend + Interest + Repayment Obligation
 If DSCR is high then the company can have more debt in the capital
structure as a high DSCR indicates the ability of the company to repay its debt.
 If DSCR is less than the company must avoid debt and depend upon equity capital only.
13) Stock Market Condition :
 There are two main conditions of the market, i.e., boom condition and recession or depression
condition.
 During the depression period (Bearish Phase) in the market, business is slow and investors also
hesitate to take a risk so at this time it is advisable to issue borrowed fund securities as these are
less risky and ensure regular payment of interest.
 If there is a boom period (Bullish Phase), business is flourishing and investors also take
a risk and prefer to invest in equity shares to earn more in the form of a dividend.

14) Capital Structure of the Company :

 Some companies frame their capital structure according to industrial norms.
 But proper care must be taken as blindly following industrial norms may lead to financial risk.
 If firm cannot afford high risk it should not raise more debt only because other firms are raising.
 Fixed  Fixed Capital involves the allocation of
firm's capital to long-term assets or
Capital projects.
 Managing fixed capital is related to
investment decisions and it is also called
Capital Budgeting.
 The capital budgeting decision affects the
growth and profitability of the company.
 This decision includes the purchase of
land, building, plant and machinery,
change of technology, expenditure of
advertising campaign, research and
development etc.
 Factors Affecting the Requirement of Fixed Capital
 The type of business company is involved in is the first factor
Nature of which helps in deciding the requirement of fixed capital.
Business  A manufacturing company needs more fixed capital as compared
to a trading company and does not need a plant, machinery, etc.

 Companies which are operating at large scale require more fixed capital.
Scale of
 Whereas companies operating on a small scale need less amount of fixed capital as
Operation they need less amount of machinery and other assets.

 Companies using capital-intensive techniques require more fixed capital.

Technique of  Whereas companies using labour-intensive techniques require less fixed capital.
Production  Capital-intensive techniques make use of plant and machinery and the company
needs more fixed capital to buy plant and machinery.

 Industries in which technology upgradation is fast need more amount

of fixed capital as when new technology is invented old machines
Technology
become obsolete and they need to buy new plants and machinery.
Upgradation  Whereas companies, where technological Upgradation is slow,
require less fixed capital as they can manage with old machines.
  Companies which are expanding and have higher growth
Growth
plans require more fixed capital as to expand their production
Prospects
capacity they need more plant and machinery so more fixed capital.

 Companies which have plans to diversify their activities by including more range
Diversification of products require more fixed capital. As to produce more products they require
more plants and machinery which means more fixed capital.

 If companies can arrange financial and leasing facilities easily

Availability of then they require less fixed capital as they can acquire assets in
Finance and easy installments instead of paying a huge amount at one time.
Leasing  If easy loans and leasing facilities are not available then
Facility companies will have to buy plants and machinery by paying
huge amounts together. Hence the requirement for fixed capital is more.

 If companies are performing collaborations, joint venture then companies

Level of
will need less fixed capital as they can share plant and machinery.
Collaboration /
 But if a company prefers to operate as an independent unit
Joint Ventures
then there is more requirement for fixed capital.
 Meaning and Types of Working Capital
Capital required for smooth day-to-day operations of the business is called Working
Capital. Working capital refers to an excess of current assets over current liabilities.

It has two types :

Gross Working Capital Net Working Capital / Working of Capital
 This refers to the investment in all the current assets  This refers to the excess of current assets over current
such as cash, bills receivables, prepaid expenses, liabilities.
inventories, etc.  Current liabilities are to be paid within an
 These current assets get converted into cash within accounting year, For example : Bills payables,
an accounting year. creditors, etc.
 Examples of current assets in order of liquidity are :  Current liabilities are sources of funds for acquiring
a) Cash in Hand / Cash at the Bank current assets.
b) Debtors  It can be positive as well as negative.
c) Marketable Securities  Positive working capital means a positive liquidity
d) Finished Goods Inventory position as current assets are more than current
e) Bills Receivables liabilities.
f) Work in Progress  Negative working capital means a weak and poor
g) Raw Materials liquidity position as current liabilities exceed current
h) Prepaid Expense assets.
 Factors Affecting the Working Capital
The Scale of Operation
 The firms operating at large scale need to maintain more inventory,
debtors, etc. so they generally require large working capital.
 On the other hand, firms operating at a small scale require less working capital.

Nature of Business
 The type of business, the firm is involved in, is the next consideration while deciding the working capital.
 In the case of retail shops, the requirement for working capital is less because the length of the operating
cycle is small.
 The wholesalers as compared to retail shops require more capital as they have to maintain a large stock and
the length of the operating cycle is large.
 The manufacturing company requires a huge amount of working capital because they have to convert raw
materials into finished goods, sell on credit, and maintain the inventory of raw materials as well as finished
goods.

Business Cycle Fluctuations

 During the boom period, the market is flourishing which means more demand, more production,
more stock, and more debtors which means more amount of working capital is required.
 Whereas during the depression period low demand less inventories to be maintained,
and less debtors, so less working capital will be required.
 Seasonal Factors
 The working capital requirement is constant for companies which are selling goods throughout the season.
 The companies which are selling seasonal goods require huge amounts during the season
as more demand, more stock has to be maintained and fast supply is needed.
 Whereas during the off-season demand is very low, so less working capital is required.

Credit Allowed
 If a company is following a liberal credit policy results in a higher number of debtors, Hence needs more
working capital.
 If a company is following a strict credit policy then it can manage with less working capital also.

Credit Availed
 Another factor related to credit policy is how much and for how long a period
a company is getting credit from its suppliers.
 If suppliers of raw materials are giving long-term credit then the company
can manage with less amount of working capital.
 Whereas if suppliers are giving only short-period credit then the company
will require more working capital to make payments to creditors.

Operating Efficiency
 A firm having a high degree of operating efficiency requires less amount of working capital.
 Whereas the firm has a low degree of efficiency which requires more working capital.
 Availability of Raw Materials
 If raw materials are easily available and there is a ready supply of raw materials and inputs then firms can manage the
amount of working capital also as they need not maintain any stock of raw materials.
 Whereas if the supply of raw materials is not smooth then firms need to maintain a large
inventory to carry on the operating cycle smoothly. So, they require more working capital.

Level of Competition
 If the market is competitive then the company will have to adopt a liberal credit policy and supply goods on time.
 Higher inventories have to be maintained so more working capital is required.
 A business with less competition will require less working capital as it can dictate terms according to its requirements.

Inflation
 If there is an increase or rise in price then the price of raw materials and cost of labour will rise, it will increase by working
capital requirement.
 But if the company can increase the price of its goods as well, then there will be fewer problems with working capital.

Growth Prospects
 Firms planning to expand their activities will require more amount of working capital.
 As for expansion, they need to increase the scale of production which means more raw materials, more inputs etc. so more
working capital also.

Technology and Production Cycle

 Production Cycle : It is long then more working capital will be required because it will take
a long time for converting raw material into finished goods.
 Whereas when the production cycle is small lesser funds are tied up in inventory and raw
materials so less working capital is required.