What is Fixed Capital and Working Capital?
We all know that finance is essential for running a business. Business enterprises require careful financial planning and understanding of the resultant capital structure, risks, and profitability that they may have. All these have an effect on shareholders as well as the employees. They require an understanding of business finance, major financial decision areas, financial risk, and the business’s working capital requirements. The success of a business depends on how well finance is invested in assets and operations and how timely and cheaply the finance is arranged from different sources. Financial Management is concerned with the management of the flow of funds and involves decisions related to the acquisition and application of funds in long-term and short-term assets. It is concerned with two aspects: procurement of funds as well as usage of finance.
The assets which remain in the business for a period of more than one year are known as Fixed Assets. For example, plant, machinery, building, land, furniture, equipment, etc. These assets are not meant for sale. Fixed Capital is the money invested by a company in its fixed assets, which are to be used over a long period of time. Hence, it can be said that fixed capital is used for meeting the permanent or long-term needs of the business.
Management of Fixed Capital
Raising fixed capital required by the firm at minimum cost and using it effectively sums up the management of fixed capital. The decision taken by a firm to invest in fixed assets is known as Capital Budgeting Decision. A firm must take capital budgeting decisions carefully as it affects the profitability, growth, and risk of business in the long run. It consists of decisions related to the purchase of land, plant and machinery, building, investing in advanced techniques of production, or launching a new product line.
A firm must always finance its fixed assets through long-term sources like shares, debentures, long-term loans, etc., and not through short-term sources.
Factors Affecting Requirement of Fixed Capital
Fixed Capital refers to investment in fixed assets for a longer period. The fixed capital of an organisation gets its funds through long-term sources of finance like preference shares, equity shares, debentures, etc. The requirement of fixed capital in an organisation depends upon various factors. These factors are as follows:
1. Nature of Business
The first factor which helps in determining the requirement of fixed capital is the type of business in which the company is involved. A manufacturing company requires more fixed capital, as compared to a trading company. It is because a trading company does not need plant, machinery, equipment, etc.
2. Scale of Operation
The companies operating at a large scale require more fixed capital as compared to the companies operating at a small scale. It is because the former requires more machinery and other assets; however, the latter requires less machinery.
3. Technique of Production
The companies that use capital-intensive techniques require more fixed capital; however, the companies that use labour-intensive techniques require less fixed capital. It is because the capital-intensive techniques use plant and machinery, which requires more fixed capital.
4. Growth Prospects
Companies aiming at expanding their business and having higher growth plans require more fixed capital for expansion of business, they have to expand their production capacity and to do so they need more plant and machinery. Hence, the companies aiming at expanding their business require more fixed capital.
5. Technology Upgradation
Industries, where technology upgradation is fast, requires more fixed capital as whenever new technology is invented, the old machines become obsolete and the firm has to purchase new plant and machinery. However, the companies where technological upgradation is slow, need less fixed capital as they can easily manage with old machines.
The companies which are planning to diversify their activities by including more range of products require more fixed capital. It is because, for diversification of the business, they have to produce more products for which more plants and machinery are required, ultimately increasing the need for more fixed capital.
7. Level of Collaboration/Joint Ventures
The companies that prefer collaborations or joint ventures need less fixed capital as these companies can share plant and machinery with the collaborators. However, if a company prefers to operate its business as an independent unit, then it will require more fixed capital.
8. Availability of Finance and Leasing Facility
If a company can easily arrange financial and leasing facilities, then it will require less fixed capital, as it can acquire the required assets in easy instalments and won’t have to pay a huge amount at one time. Whereas, if a company cannot find financial and leasing facilities easily, then it will require more fixed capital, as it has to purchase plant and machinery by paying a huge amount at once.
Excess of current assets of an organisation over its current liabilities is known as Working Capital. It can also be defined as that part of total capital, which is required for holding current assets.
i) Gross Working Capital
The investment in all the current assets like prepaid expenses, cash, inventories, bills receivables, etc. is known as Gross Working Capital. The gross working capital of an organisation gets converted into cash within an accounting year.
The list of current assets in order of their liquidity is as follows:
- Cash in hand/Cash at bank
- Marketable Securities
- Finished goods inventory
- Bills Receivable
- Work in progress
- Raw Materials
- Prepaid Expense
ii) Net Working Capital/Working Capital
Excess of current assets over current liabilities is known as Net Working Capital. Current liabilities are a source of funds for acquiring current assets and are to be paid within an accounting year. For example. Tanya gets credit for maintaining stock. Now, the stock (which is a current asset) is created by her through credit purchase (which is her current liability). When the current liabilities of an organisation exceed its current assets, then the net working capital of the firm will be negative. The net working capital of an organisation depicts its liquidity position. The negative net working capital of an organisation indicates a poor and weak liquidity position; however, a positive net working capital indicates a positive liquidity position.
Factors Affecting the Working Capital
1. Nature of Business
The first factor which helps in determining the requirement of working capital is the type of business in which the company is involved. A trading company or a retail shop requires less working capital as the length of the operating cycle of these types of businesses is small. However, the wholesalers require more working capital as they have to maintain a large stock and generally sell goods on credit, increasing the length of the operating cycle. Besides, a manufacturing company requires a huge amount of working capital as it has to convert its raw material into finished goods, sell the goods on credit, maintain the inventory of raw materials and finished goods.
2. Scale of Operation
The firms that are operating at a large scale need to maintain more debtors, inventory, etc. Hence, these firms generally require a large amount of working capital. However, the firms that are operating at a small scale require less working capital.
3. Business Cycle Fluctuation
A market flourishes during the boom period which results in more demand, more stock, more debtors, more production, etc., ultimately leading to the requirement for more working capital. However, the depression period results in less demand, less stock, fewer debtors, less production, etc., which means that less working capital is required.
4. Seasonal Factors
The companies which sell goods throughout the season require constant working capital. However, the companies selling seasonal goods require a huge amount of working capital during the season as at that time there is more demand and the firm has to maintain more stock and supply the goods at a fast speed, and during the off-season, it requires less working capital as the demand is low.
5. Technology and Production Cycle
A company using labour-intensive techniques requires more working capital because it has to maintain enough cash flow for making payments to labour. However, a company using capital-intensive techniques requires less working capital because the investment made by the company in machinery is a fixed capital requirement and also there will be less operating expenses.
6. Credit Allowed
The average period for collection of the sale proceeds is known as the Credit Policy. The credit policy of a company depends on various factors like the client’s creditworthiness, industry norms, etc. A company following a liberal credit policy will require more working capital, as it is giving more time to the creditors to pay for the sale made by the company. However, if a company follows a strict or short-term credit policy, then it will require less working capital.
7. Credit Avail
The time period that a company is getting credit from its suppliers also affects the requirement for working capital. If a company is getting long-term credit on raw materials from its supplier, then it can manage well with less working capital. However, if a company is getting short period of credit from its suppliers, then it will require more working capital.
8. Operating Efficiency
If a company has a high degree of operating efficiency then it will require less working capital; however, if a company has a low degree of operating efficiency, then it will require more working capital. (Operating cycle of a firm is the time period from the purchase of raw material to the realisation from debtors). Hence, it can be said that the length of the operating cycle directly affects the requirements of the working capital of an organisation.
9. Availability of Raw Materials
If the raw material is easily available to the firm and there is a ready supply of inputs and raw material then the firm can easily manage with less working capital. Also, as the firm does not need to maintain any stock of raw materials, they can manage with less stock, and hence less working capital. However, if there is a rough supply of raw materials, then the firm will have to maintain a large inventory to carry on the operating cycle smoothly. Therefore, the firm will require more working capital.
10. Level of Competition
If there is competition in the market, then the company will have to follow a liberal credit policy for supplying goods on time. For this, it will have to maintain higher inventories, resulting in more working capital requirements. However, if there is less competition in the market or a company is in a monopoly position, then it will require less working capital as it can dictate its own terms according to its requirements.
A rise in the price increases the price of raw materials and the cost of labour, resulting in the increasing requirement for working capital. However, if a company is able to increase the price of its goods also, then it will face less problem with working capital. A rise in price has a different effect on the working capital of different businesses.
12. Growth Prospects
If a firm is planning on expanding its activities, then it will require more working capital as it needs to increase the scale of production for expansion, resulting in the requirement of more inputs, raw materials, etc., ultimately increasing the need for more working capital.
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