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When in long run a firm shift from a smaller to a larger plant size then what the firm will have to
do to made such shift, changeover to a bigger plant size requires investment in new capacity.
Even keeping to the same plant size over time, requires replacement of worn-out plant. All these
require investment of resources.
Investment is defined as the acquisition of durable productive facilities in the expectation of a
future gain. It normally consists of physical capital like plant, equipment, building, machinery
etc. it may also include non- physical capital like training of personnel etc.
Investment or capital expenditure usually involves a large sum of money (although the amount
need not be huge) incurred at a point of time where as benefit are realized at different point of
time in future but it is very natural, investment decision becomes vital to almost organization.
So how well this activity is planned and implemented. The value of investment lies on potential
profit. If a firm acquires a capital asset which gives less revenue than its cost the business will
definitely suffer setback. Hence a correct estimation of the worth of investment is essential
before the investment is undertaken.
1) Investment selection :It involves decision regarding both the amount of investment in the planning period and selection
of project.
It consist of
Expansion of firm production facilities (to meet growing demand for the product of the
company)
Replacement decision :
(Replacing damaged or obsolete plant and machinery by more efficient one.
New improved product decision (to bring new or changed product in the market, certain
investment are needed like expenditure on R & D, market research, advertisement etc.
Make or buy decision :To produce the product or to purchase it from vendor (supplier)
Lease or buy decision :A firm may decide to lease equipment rather than invest sizeable funds for buying
equipment.
2) Financing investment :There are certain norms against which the benefits are to be judged from the long term
investment.
E.g.:- minimum rate of return, required rate of return.
Sources of capital to the firm are presumed to be:
a) External sources (the capital market)
b) Internal sources (retained earning)
Each specific sources of capital has its own cost, which becomes a component part of overall
cost of capital to the firm.
3) Allocation of fund among project :-
then
innovation is encouraged.
e) Fiscal policy:- various tax policies of the government have favorable or unfavorable
influence on capital investment.
E.g. excise duties, method of allowing depreciation.
f) Cash flow:- every firm makes a cash flow budget. Its analysis influence capital
investment decision. With its help the firms plans funds for acquiring the capital asset.
g) Return expected from the investment:- in most of the cases, investment decision are
made in anticipation of increased return in future. While evaluating investment proposal,
it is therefore essential for the firm to estimate future return or benefit accruing from the
investment.
Steps in capital project evaluation:In order to evaluate a project we need to have three kind of information:
1. List of investment proposals (developing investment proposals)
2. Estimate cash flow of each of these proposals.
3. Knowledge about the various criteria used for project evaluation.
1)
2) Estimating cash inflow:In capital expenditure proposal analysis the most important and difficult step is to
estimate cash flow associated with the project.
Cash flow is of two kinds: Cash outflows
(Associated with building and equipment the new production facility)
Cash inflow
The annual cash inflows the project will generate after it goes into operation.
A large no. of variables are involved in the cash flow forecast and many
individual and departments participate is developing them.
Guidelines for estimation of cash flows:a) Cash flow must be constructed on incremental basis. ( only the difference of cash
flow due to acceptance of the project are relevant for inclusion in investment
analysis).
b) Indirect cash flow must be taken.
e.g. the impact of a new product on the sales revenue of the existing product.
c) Cash flow should be constructed on an after tax basis (because that represents net
Flow from the point of view of the firm).
3) Evaluation of project:Capital project have a finite life over which the project yield a stream(flow) of annual
receipt.
A fundamental concept that must be understood while taking as out stream of
annual receipt is the notion of time
value of money.
The investment in projects occurs only in initial years of the project. The net return from
the project comes in stream of annual receipt.So net return from the project can be
scientifically calculated only when the cash inflow and outflow are expressed in terms of
common denominator.
I.e. when the stream of annual cash flows is disconnected to find the present value.
Evaluation of project
Traditional method
ARR
P B Period
NPV
PI
ARR
Average profit
Average investment
* 100
Where,
Average profit is = total profit during the life of the project
Number of years
Pay back period means period required to get back initial investment.
Less the pay back period better the project.
IRR
1) Net present value: This method is based on the economic reasoning of discounting future cash flow
to make comparable.
NPV is calculated by discounting all future flows to present and subtracting. The
present value of all cash out flow from the present value of all inflows.
If NPV of project is positive, this indicates that project add more to revenue than
it adds to cost. Therefore accepted.
NPV (+) = accepted
nt=1
Rt
Co
(1 + r )t
t = time period ( 0 to n year)
Rt = cash inflow in period t
Co = initial investment or cash outflow
R = discount rate (cost of capital)
N = last period of project
1) TIME VALUE OF MONEY: - Time value of money means that value of a unit of money is
different in different time periods. The concept of time value of money refers to fact that the
money received today is different in its worth from the money receivable at some other time in
future. In other words, the same principal can be stated as that the money receivable in future is
less valuable than the money received today.
The main reason for the time preference of money is to found in the reinvestment opportunities
for funds which are received early. The funds so invested will earn a rate of return; this would
not be possible if the fund is received at a later time.
Example: Suppose a firm is selling a machine for RS. 20,000 .The buyer offers to pay Rs.20,
000 either now or after one year. The seller firm naturally accepts the first choice. i.e. to receive
Rs. 20000 now. In this case firm reinvest the amount in fixed deposit account for one year and
get return 2000 @10%. So in first case co. net income is 22,000 where as in second option co.
income is 20,000. In this case interest amount is time value of money.
So we can say that T.V.M. for the money is its rate of return which the firm can earn by
reinvesting its present money. This rate of return can also be expressed as a required rate of
return to make equal the worth of money of two different time periods.
CHAPTER NO.:-3
CAPITALIZATION
Meaning: - Capital Structure ordinarily implies the proportion of debt and equity
in the total capital of a company. Since company can tap any one or more source of
funds to meet its total financial requirement .The total capital of a company may
thus be composed of all such tapped sources.
Capital may be defined as long term funds of the firm.
Capital is the aggregation of the items appearing on the left hand side of balance
sheet minus current liabilities (total liabilities current liabilities).
Capital is also be expressed as total asset minus current liabilities. (Total asset
Current liabilities).
Types of Capital:-
Equity Capital:-
The operating profit (i.e. EBIT) of the firm is mainly divided into three
claimants
A. Debt Holders (debenture, banks loan .Others loan,) :- By way of interest.
B. Government
: - By way of taxes.
C. Shareholders
: - By way of dividend.
If we talk about size of EBIT, it is depend on investment decision of the firm.
While capital structure of the firm determine how EBIT is to be sliced among three
above claimants.
The total value of the firm is sum of its value to the debt holder and to its
shareholders and is determine by the amount of EBIT going to them respectively.
Therefore the investment decision can increase the value of the firm by increasing
the size of the EBIT where as the capital structure mix can affect the value only by
reducing the share of the EBIT going to the Government in the form taxes.
Capital structure or financial leverage or financing mix of the firm does not
affect the total earning of firm. However earnings available to the
shareholders may be influenced by capital structure of the firm. For a given
level of earnings lower the cost of capital, the higher would be the value of firm.
But, what is the relationship between financing mix, cost of capital and the value
of the firm? Is there any optimal capital structure? Can value of the firm be
maximized by affecting the financing mix or by affecting the cost of capital? If
leverage affects the cost of capital and the value of the firm, then the firm should
try to achieve an optimal capital structure or optimal financing mix and minimizing
the cost of capital .is there really a capital structure which may be called the
optimal capital structure?
Factors Determining Capital Structure
1) Control: - The mgt. control over the firm is one of the major determinants of
capital structure decision.
The equity shareholders are considered as the real owner of the company, since
they can participate in decision making through the elected body of representatives
called Boards of Director.
The preference shareholders and debenture holder cannot participate in decision
making.
When the promoters do not wish to dilute their control, the company will rely more
on debt fund. Any fresh issue of shares will dilute the control of the existing
shareholders.
2) Risk: - Mainly two risks are involved in capital structure decision
(a) Business Risk (BR) (it is influenced by demand, price, input, competition in
market, fixed cost, etc.)
(b) Financial Risk (FR represents the risk from financial leverage )
FR is least if the project is financed by equity capital, since equity dividend is
payable only when there is sufficient fund for appropriation and equity capital need
not to refunded during the life time of the company.
FR is high if the proportion of debt fund is more in capital structure, since the
interest is to be paid to the financer even if profit is low and borrowed fund is to be
paid off to them after certain period or at the time of maturity.
11) Profitability: - A co. with higher profitability will have low reliance on
outside debt fund and it will meet its additional requirement through internal
generation.
12) Growth rate: - The growing co. requires more and more funds for its
expansion schemes which will meet through raising debt. The fast growing co.
will rely more on debt fund than equity or internal earning.
13) Government policy: - Increase in lending rate by govt. may cause the
companies to raise finance from capital market.
Meaning of optimal capital structure:The optimal capital structure is the capital structure at which the weighted average
cost of capital is minimum and there by maximum value of the firm. It also may be
defined as the capital structure or combination of debt and equity that leads to the
maximum value of the firm.
Over capitalization & under capitalization
Over capitalization:Generally over-capitalization implies that the capital of the company exceeds its
requirements. A company is overcapitalized when its earning capacity does not
justify the amount of capitalization. In other words, a company is said to be
overcapitalized when its actual profits are not sufficient to pay interest (on
debentures and borrowings) and dividends (on share capital) at fair rates.
A concern is said to be over-capitalized if its earnings are not sufficient to justify
a fair return on the amount of share capital and debentures that have been issued.
It is said to be over capitalized when total of owned and borrowed capital exceeds
its fixed and current assets i.e. when it shows accumulated losses on the assets side
of the balance sheet.
A company is said to be overcapitalized, when its total capital (both equity and
debt) exceeds the true value of its assets. It is wrong to identify overcapitalization
with excess of capital because most of the overcapitalized firms suffer from the
problems of liquidity.
3)
4)
5)
6)
7)
Increase in unemployment
Encouragement to reckless speculation
Misutilization and wastage of resources
Reduced efficiency of the management
Loss of public confidence in investment etc.
Under capitalization:-
Leverage
Meaning (dictionary) : an increased means of accomplishing some
purpose (Leverage allows us to accomplish certain things which are
otherwise not possible ,viz; lifting of heavy object with the help of
leverage).
Meaning (in financial mgt.): the term leverage is used to describe the
firm ability to use fixed cost asset or funds to increase the return to its
owners. The fixed cost (also called fixed operating cost) and fixed
charges (called financial cost) remaining constant irrespective of change
in volume of output of sales. Thus employment of an asset or source of
fund for which the firm has to pay a fixed cost or return has considerable
influence on the earning available for equity shareholders.
Example: As per the Income statement of XYZ Ltd. Sales is
Rs.4, 00,000 .Variable cost is60%.Fixed cost is Rs.50,
000
Then
EBIT is
Sales
= 4,
00,000
Less:
Variable cost = 2,
40,000
Contribution = 1,
60,000
Less:
Fixed cost
50,000
(Operating profit) EBIT 1
10,000
If due to some reason sales is increased by 100% (doubled)
=1,
Then
EBIT will be
Sales
= 8,
00,000
Less:
Variable cost = 4,
80,000
Contribution = 3,
20,000
Less:
Fixed cost
50,000
(Operating profit)
EBIT 2
= 2,
70,000
In above income statement you see the advantage of fixed cost in total cost is that,
if the sales are double than operating profit will be more than double .this is
happening due to sales work as lever to carry fixed cost, by increase in sales the
distribution of fixed cost per unit start declining and it increases profit. That is
known as leverage effect.
The first effect due to fixed cost is known as operating leverages &the second
effect due to fixed interest is known as financial leverages the formulas are as
below
1. Operating leverage
Contribution
EBIT
2. Financial leverage
EBIT
EBT
3. Combined leverages =
Contribution
EBT
Cost of capital: We are raising long term fund from various sources and we have to return these
principal amount as per term and condition. In addition to this we are also paying
some periodical payments to the supplier of funds these periodical payments we
are paying because we are using these funds.
Cost of capital is nothing but the periodical payments (other than principal amount)
to the supplier of capital on account of use of capital.
I. Cost of Debt capital (Kd)
Kd =
I (1- T)
Amount Received
= (i)
E.P.S.
M.P.S.
(ii)
D.P.S
M.P.S.
(iii)
D.P.S.
M.P.S
Trading on equity :-
CHAPTER NO.:-1
FINANANCE MANAGEMENT
Traditional View
Traditional View of finance, management looks into the following function, that
finance manager of business firm will perform.
(i) Arrangement of short term and long term fund for financial institution.
(ii) Mobilization of funds through financial instrument like equity shares,
preference shares, debenture, bonds.etc.
(iii) Orientation of finance functions with accounting function and
compliance of legal provisions relating to funds procurement, use
distribution.
Modern View
Due to globalization & liberalization of economy the function of finance manager
in any organization becomes vary diversified.
In today scenario finance manger is expected to do
(i) The total funds requirement of the firm.
(ii) The assets to be required and
(iii) The pattern of financing the asset.
Thus finance manager of modern business firm role is divided among three basic
claimants.
(1) Investment Decision
(2) Finance Decision
Objectives
It is necessary to set objective or goals for measuring performance and control. The
setting of physical targets to be achieved within a set of time period provides the
basis of conversion of the targets into financial objectives.
The primary financial objectives of a firm are as follows:
(i) Return to capital employed
(ii) Value addition and profitability
(iii) Growth in earning per share and price / earnings ratio
(iv) Growth in the market value of the shares
(v) Growth in dividends to share holders
(vi) Optimum level of leverage
(vii) Survival & growth of the firm
(viii) Minimization of financial charges
(ix) Efficient utilization of short, medium, long term sources of fund.
Profit Maximization Objective
Traditionally the size of firms are small, owned managed and they are
competing with same size of firm, thats why profit maximization was rational
objective of firm.
The profit of the firm became the income of the owner. Maximizing profit the
ensured the self interest of the owner/manager, who both decide actions of the
firm and ensured that these are carried out.
The force of competition imposed profit maximization upon the firm to survive
in business.
The profit maximization objective of firm is criticized for the following reason
(1) The concept of profit maximization is vague and narrow
(2) It ignores the risk factor, as well as timing of return.
(3) It may allow decision to be taken at the cost of long run stability and
profitability of the concern
(4) It emphasize the short run profitability and short term project
(5) It may cause decrease in share price
(6) It only thinks for owner where as other stake holder also participates for
growth of organization. (Stake holder such as, share holder, creditors,
debtors, debenture holder, government, banks, etc.)
Acquiring
temporary working
capital
Service Department
Obligation
Generate Cash
inflows from
Operation
Dividend
Distribution
Retained Earnings
available for re
investment
----------------------------------------------------------------------------------------------------
Ratio Analysis
Financial Statement analysis means study of relationship among various factors in a business
disclosed in financial statement of firm
The basic objective of financial statement is as follows
To judge financial health of the firm
To evaluate the profitability of the enterprises
To gauge the debt servicing capacity of firm
To understand long term and short term solvency of the firm
To know the return on capital employed or invested
Methods of Analyzing Financial Statement
The method of analyzing of financial statement
Ratio are the mathematical tool for comparing the two relative figures .One absolute figure is not
much informative but when compare one figure with other we get more information.
Ratio Analysis is defined as systematic use of ratio to analyse and interprate the financial
statements that the strength and weakness of the firm is clearly known.
Similarly by using the ratio we can do the comparative study. A single figure by itself has no
meaning but when we expressed in term of related figure we get the significant figure.
Four types of comparison are done:
i) Trend Analysis: It is comparing the present ratio with the past ratio
ii) Inter firm Comparison: It is comparing our ratio with the competitors ratio.
iii) Comparison with standards:
iv) Comparison with plans:
Advantages of Ratio Analysis
The importance of ratio Analysis is the fact that it presents the information on comparative
basis and helps the decision maker to decide the future plans.
Following is the list of certain advantages
1) Liquidity position of the company is clearly known.(by using current ratio ,liquid ratio)
2) Long term Solvency is clearly shown by ratio analysis.
3) Operational efficiency is in clearly known i.e. how efficiently you are using your stocks,
debtors. etc.
4) Profitability of the organization is known by using Gross profit, net profit ratio.
5) Inter firm comparison is possible
6) Comparison with plan and standard is possible
7) Investment decision or disinvestment decision can be taken by using ratio analysis.
8) Ratio analysis highlights the weakness and strength of the organization.
Types of ratios
For the sake of facilitation of Calculations and interpretation, ratios may be classified
according to different basis. One of the ways of classification is according to the financial
statements. In this method, ratios are calculated on the following basis.
(i) Trading A/C ratios
(ii) Profit and Loss A/C ratios
(iii)Balance Sheet ratios
However, the classification according to the following basis will be more effective for
analyzing and interpreting the financial statements.
(i) Profitability ratios
(ii) Turnover ratios
(iii)Financial ratios
(iv) Leverage ratios
Profitability Ratios:
These ratios give an idea about the profitability of a business firm. Profit and profitability
differ from each other as profit is the difference between income and expenditure. While
profitability is measured by comparing the profit with some other parameter like sales, capital
employed the total assets etc. The ratios are falling under this category are usually expressed in
percentage. The following are the ratios under this category:
(i) Gross Profit Ratio:
Gross profit is the difference between the net sales [sales less
sales returns] and the cost of goods sold. This ratio is calculated with the help of the following
formula:
This ratio shows the margin left after meeting the purchases and manufacturing costs. It
measures the efficiency of production as well as pricing. A high gross profit ratio means a high
margin for covering other expenses like administrative, selling and distribution expenses. I.e.
other than the cost of goods sold therefore, higher the ratio, the better it is. It is important for a
business to maintain this ratio on a higher side, otherwise it will be difficult to cover other
expenses. A firm should compare its gross profit ratio with the industry average to find out
where it stands. A firm can also compare its own ratio of the past with the current years, ratio to
find out its performance. This is known as intra-firm comparison.
Alternatively, this profit can also be calculated by deducting only operating expenses
from gross profit. This ratio is calculated with the help of the following
Thus, higher this ratio, the lower is the margin of operating profit .this ratio can be further
analyzed to find out the percentage of each type of expenses to sales.
(iv) Return On capital Employed :
This ratio indicates the percentage of net
profits before interest and tax total capital employed .the capital employed is calculated as
follows
Capital employed =equity capital + preference capital +Reserves and surplus
+Long term debt fictitious Assets
This ratio is considered to be a very important one because it reflects the overall efficiency
with which capital is used the ratio of a particular business should be compared with other
business firms in the same industry to find out the exact position.
(vii)
company. Earning capital per share indicates the amount of profits available for distributions
amongst the equity shareholders. This ratio is calculated as shown below:
As mentioned above, EPS is one of the important criteria for measuring the performance
of a company. If EPS increases, the possibility of a higher dividend per share also increases.
However, the Dividend payment depends on the policy of the company. Market price of shares
of a company may also show an upward trend if the EPS is showing a rising trend. However, it
should be remembered that EPS of different companies may vary from company to company due
to the following different practices by different companies regarding stock in trade, depreciation,
source of rising finance, tax-planning measures etc.
(viii)
This ratio is price of the shares. The formula for calculation is a follows very important for
investors who purchase their shares in a open market. They will evaluate their return against their
investment, i.e. the market price paid by them. The higher the ratio, the more attractive are their
investment.
Turnover ratios:
These ratios are also known as activity ratios or asset management ratios. These ratios are
very important for a business concern to find out how will the facilities at the disposal of the
concern are being used. These ratios are usually calculated on the basis sales or cost of goods
sold. High turnover ratios indicate better utilization of resources. The important turnover ratios
are discussed below.
(i)
working capital of the business firm. The indication given by this ratio is the number of times
working capital is turned around in a particular period. The ratio is calculated with the help of the
following formula.
(ii)
management is about the credit to be granted to the customers. There should be a well-defined
credit policy, which should be followed carefully by the firm. The credit policy followed by a
firm is indicated by this ratio. This ratio is calculated with the help of the following formula.
the credit period allowed by the firm to its customers. Creditors turnover Ratio indicates the
credit period allowed by the creditors to the firm. In other words, it is exactly apposite the above
ratio. Formula is below:
(iv)
cost of goods sold during given period And the average amount of inventory held during that
period. The indication given by this ratio is the number of times the finished stock is turned over
during a given accounting period. The formula is given bellow:
.
(v)
Fixed Asset Turnover Ratio:This ratio indicates the amount of sales realized per
rupee of investment in fixed assets. Fixed assets are those assets, which are not acquired for resale. In other words, they are meant for utilization in the business for the purpose of improving
its earning capacity. Whether this purpose is being fulfilled or not is indicated by this ratio. The
formula is given bellow;
and indicates sales per rupee of capital employed. The formula is bellow
Financial Ratios:As the name suggest, these ratios are calculated to judge
financial position firm from the long term as well as short term angle. The Following
ratios are included in this category.
(i) Current ratio: This ratio is calculated by dividing current assets by current
liability. Current ratio is also known as Solvency ratio as it indicates how the expected current
claims are covered by current assets. The formula is bellow
Current asset means assets, which have been purchased in order to convert them into cash or
into other current assets within a period of normally one year.
(ii) Liquid / Quick / Acid Test Ratio: This ratio is a better tool to measure the ability
to honor day to day commitments. It is the ratio between the liquid assets and liquid liabilities.
From The balance sheet, liquid assets are calculated by deducting inventories and prepaid
expenses from current assets. liquid liabilities are current liabilities less Bank overdrafts. The
formula is bellow.
(iv) Proprietary Ratio:It is primarily the ratio between the proprietors funds and total
assets. The formula is bellow
Working Capital management is the management of assets that are current in nature. Current
assets, by accounting definition are the assets normally converted in to cash in a period of one
year. Hence working capital management can be considered as the management of cash, market
securities receivable, inventories and current liabilities. In fact, the management of current assets
is similar to that of fixed assets in the sense that is both in cases the firm analyses their effect on
its profitability and risk factors, hence they differ on three major aspects:
1.
2.
The large holdings of current assets, especially cash, may strengthen the firms liquidity
position, but is bound to reduce profitability of the firm as ideal car yield nothing.
3.
The level of fixed assets as well as current assets depends upon the expected sales, but it
is only current assets that add fluctuation in the short run to a business.
To understand working capital better we should have basic knowledge about the various aspects
of working capital. To start with, there are two concepts of working capital:
Gross Working Capital
Net Working Capital
1. Working capital, sometimes called gross working capital, simply refers to current assets used
in operations.
2. Net working capital is defined as current assets minus current liabilities.
3. Net operating working capital (NOWC) is defined as operating current assets
minus operating current liabilities. Generally, NOWC is equal to cash, accounts
Receivable, and inventories, fewer accounts payable and accruals.
The term working capital originated with the old Yankee peddler, who would load
up his wagon with goods and then go off on his route to peddle his wares.
WORKING
CAPITAL MANAGEMENT
Working Capital
Capital required for a business can be classified under two main categories via,
1)
Fixed Capital
2)
Working Capital
Every business needs funds for two purposes for its establishment and to carry out
its day- to-day operations. Long terms funds are required to create production facilities
through purchase of fixed assets such as p&m, land, building, furniture, etc.
Investments in these assets represent that part of firms capital which is blocked on
permanent or fixed basis and is called fixed capital. Funds are also needed for shortterm purposes for the purchase of raw material, payment of wages and other day today expenses etc.
These funds are known as working capital. In simple words, working capital
refers to that part of the firms capital which is required for financing short- term or
current assets such as cash, marketable securities, debtors & inventories. Funds, thus,
invested in current assts keep revolving fast and are being constantly converted in to
cash and this cash flows out again in exchange for other current assets. Hence, it is also
known as revolving or circulating capital or short term capital.
2.
The gross working capital is the capital invested in the total current assets of the
enterprises current assets are those
Assets which can convert in to cash within a short period normally one accounting
year.
CONSTITUENTS OF CURRENT ASSETS
1)
2)
Bills receivables
3)
Sundry debtors
4)
5)
a.
Raw material
b.
Work in process
c.
d.
Finished goods
In a narrow sense, the term working capital refers to the net working. Net working
capital is the excess of current assets over current liability, or, say:
NET WORKING CAPITAL = CURRENT ASSETS CURRENT LIABILITIES.
Net working capital can be positive or negative. When the current assets exceeds the
current liabilities are more than the current assets. Current liabilities are those
liabilities, which are intended to be paid in the ordinary course of business within a
short period of normally one accounting year out of the current assts or the income
business
CONSTITUENTS OF CURRENT LIABILITIES
1.
2.
3.
Dividends payable.
4.
Bank overdraft.
5.
6.
Bills payable.
7.
Sundry creditors.
The gross working capital concept is financial or going concern concept whereas net
working capital is an accounting concept of working capital. Both the concepts have
their own merits.
The gross concept is sometimes preferred to the concept of working capital for the
following reasons:
1.
It enables the enterprise to provide correct amount of working capital at correct time.
2.
Every management is more interested in total current assets with which it has to
operate then the source from where it is made available.
3.
It take into consideration of the fact every increase in the funds of the enterprise
would increase its working capital.
4.
It is qualitative concept, which indicates the firms ability to meet to its operating
expenses and short-term liabilities.
IT indicates the margin of protection available to the short term creditors.
It is an indicator of the financial soundness of enterprises.
It suggests the need of financing a part of working capital requirement out of the
permanent sources of funds
Every business concern should have adequate amount of working capital to run its
business operations. It should have neither redundant or excess working capital nor
inadequate nor shortages of working capital. Both excess as well as short working
capital positions are bad for any business. However, it is the inadequate working
capital which is more dangerous from the point of view of the firm.
DISADVANTAGES OF REDUNDANT OR EXCESSIVE WORKING CAPITAL
1.
Excessive working capital means ideal funds which earn no profit for the firm and
business cannot earn the required rate of return on its investments.
2.
3.
Excessive working capital implies excessive debtors and defective credit policy
which causes higher incidence of bad debts.
4.
5.
If a firm is having excessive working capital then the relations with banks and other
financial institution may not be maintained.
6.
Due to lower rate of return n investments, the values of shares may also fall.
7.
is an operating cycle involved in sales and realization of cash. There are time gaps in
purchase of raw material and production; production and sales; and realization of cash.
Thus working capital is needed for the following purposes:
For the purpose of raw material, components and spares.
To pay wages and salaries
To incur day-to-day expenses and overload costs such as office expenses.
To meet the selling costs as packing, advertising, etc.
To provide credit facilities to the customer.
To maintain the inventories of the raw material, work-in-progress, stores and spares
and finished stock.
For studying the need of working capital in a business, one has to study the business
under varying circumstances such as a new concern requires a lot of funds to meet its
initial requirements such as promotion and formation etc. These expenses are called
preliminary expenses and are capitalized. The amount needed for working capital
depends upon the size of the company and ambitions of its promoters. Greater the size
of the business unit, generally larger will be the requirements of the working capital.
The requirement of the working capital goes on increasing with the growth and
expensing of the business till it gains maturity. At maturity the amount of working
capital required is called normal working capital.
There are others factors also influence the need of working capital in a business.
fig no-
1.1(Operating Cycle)
the
question of working capital and the velocity or speed with which the sales are affected.
A firm having a high rate of stock turnover will needs lower amount of working capital
as compared to a firm having a low rate of turnover.
8. CREDIT POLICY: A concern that purchases its requirements on credit and
sales
its product / services on cash requires lesser amt. of working capital and vice-versa.
9. BUSINESS CYCLE: In period of boom, when the business is prosperous, there is
need for larger amt. of working capital due to rise in sales, rise in prices, optimistic
expansion of business, etc. On the contrary in time of depression, the business
contracts, sales decline, difficulties are faced in collection from debtor and the firm may
have a large amt. of working capital.
12.
PRICE LEVEL CHANGES: Changes in the price level also affect the working
capital requirements. Generally rise in prices leads to increase in working capital.
2.
It is concerned with the decision about the composition and level of current assets.
3.
It is concerned with the decision about the composition and level of current
liabilities.