Business Studies Part I
Business Studies Part II

Fixed & Working Capital

FIXED AND WORKING CAPITAL

 Every business needs funds to finance its assets and activities. Investment is required to be made in fixed assets and current assets. Fixed assets are those which remains in the business for more than one year, usually for much longer e.g., plant and machinery, furniture and fixture, land and building, vehicles etc. Decision to invest in fixed assets must be taken very carefully as the investment is usually quite large. Such decisions once taken are irrevocable except at a huge loss. Such decisions are called capital budgeting decisions. Current assets are those assets which, in the normal routine of the business, get converted into cash or cash equivalents with in one year e.g., inventories, debtors, bills receivable etc. Management of Fixed Capital Fixed capital refers to investment in long-term assets. Management of fixed capital involves around allocation of firm’s capital to different projects or assets with long-term implications for the business. These decisions are called investment decisions or capital  budgeting decisions and affect the growth, profitability and risk of the business in the long run. These longterm 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, modernisation and their replacement. These decisions include purchase of land, building, plant and machinery, launching a new product line or investing in advanced techniques of production. Major expenditures such as those on advertising campaign or research and development programme having long term implications for the firm are also examples of capital budgeting decisions.

The management of fixed capital or investment or capital budgeting decisions are important for the following reasons:

  • Long-term growth and effects: These decisions have bearing on the long-term growth. The funds invested in long-term assets are likely to yield returns in the future. These affect future possibilities and prospects of the business.
  • Large amount of funds involved: These decisions result in a substantial portion of capital funds being blocked in long-term projects. Therefore, these investment programmes are planned after a detailed analysis is undertaken. This may involve decisions like where to procure funds from and at what rate of interest.
  • Risk involved: Fixed capital involves investment of huge amounts. It affects the returns of the firm as a whole in the longterm. Therefore, investment decisions involving fixed capital influence the overall business risk complexion of the firm.
  • Irreversible decisions: These decisions once taken, are not reversible without incurring heavy losses. Abandoning a project after heavy investment is made is quite costly in terms of waste of funds. Therefore, these decisions should be taken only after carefully evaluating each detail or else the adverse financial consequences may be very heavy.

Factors affecting the Requirement of Fixed Capital:

  1. Nature of Business: The type of business has a bearing upon the fixed capital requirements. For example, a trading concern needs lower investment in fixed assets compared with a manufacturing organisation; since it does not require to purchase plant and machinery etc.
  2. Scale of Operations: A larger organisation operating at a higher scale needs bigger plant, more space etc. and therefore, requires higher investment in fixed assets when compared with the small organisation.  and starting a cement manufacturing plant. Obviously, its investment in fixed capital will increase.
  3. Financing Alternatives: A developed financial market may provide leasing facilities as an alternative to outright purchase. When an asset is taken on lease, the firm pays lease rentals and uses it. By doing so, it avoids huge sums required to purchase it. Availability of leasing facilities, thus, may reduce the funds required to be invested in fixed assets, thereby reducing the fixed capital requirements. Such a strategy is specially suitable in high risk lines of business.
  4. Level of Collaboration: At times, certain business organisations share each other’s facilities. For example, a bank may use another’s ATM or some of them may jointly establish a particular facility. This is feasible if the scale of operations of each one of them is not sufficient to make full use of the facility. Such collaboration reduces the level of investment in fixed assets for each one of the participating organisations. Apart from the investment in fixed assets every business organisation needs to invest in current assets. This investment facilitates smooth day-today operations of the business. Current assets are usually more liquid but contribute less to the profits than fixed assets. Examples of current assets, in order of their liquidity, are as under.
  5. Choice of Technique: Some organisations are capital intensive whereas others are labour intensive. A capital-intensive organisation requires higher investment in plant and machinery as it relies less on manual labour. The requirement of fixed capital for such organisations would be higher. Labour intensive organisations on the other hand require less investment in fixed assets. Hence, their fixed capital requirement is lower. 4. Technology Upgradation: In certain industries, assets become obsolete sooner. Consequently, their replacements become due faster. Higher investment in fixed assets may, therefore, be required in such cases. For example, computers become obsolete faster and are replaced much sooner than say, furniture. Thus, such organisations which use assets which are prone to obsolescence require higher fixed capital to purchase such assets. 5. Growth Prospects: Higher growth of an organisation generally requires higher investment in fixed assets. Even when such growth is expected, a business may choose to create higher capacity in order to meet the anticipated higher demand quicker. This entails higher investment in fixed assets and consequently higher fixed capital.
  6. Diversification: A firm may choose to diversify its operations for various reasons, With diversification, fixed capital requirements increase e.g., a textile company is diversifying 1. Cash in hand/Cash at Bank 2. Marketable securities 3. Bills receivable 4. Debtors 5. Finished goods inventory 6. Work in progress 7. Raw materials 8. Prepaid expenses These assets, as noted earlier, are expected to get converted into cash or cash equivalents within a period of one year. These provide liquidity to the business. An asset is more liquid if it can be converted into cash quicker and without reduction in value. Insufficient investment in current assets may make it more difficult for an organisation to meet its payment obligations. However, these assets provide little or low return. Hence, a balance needs to be struck between liquidity and profitability. Current liabilities are those payment obligations which, when they arise, are due for payment within one year; such as bills payable, creditors, outstanding expenses, advances received from customers etc. Some part of current assets is usually financed through short-term sources, i.e., current liabilities. The rest is financed through long-term sources and is called net working capital. Thus, NWC = CA – CL i.e. Current Assets – Current Liabilities.

Factors Affecting the Working Capital Requirements:

  1. Nature of Business: The basic nature of a business influences the amount of working capital required. A trading organisation usually needs a lower amount of working capital compared to a manufacturing organisation. This is because there is, usually no processing, therefore, there is no distinction between raw materials and finished goods. Sales can be effected immediately upon the receipt of materials, sometimes even before that. In a manufacturing business, however, raw material needs to be converted into finished goods before any sales become possible. Other factors remaining the same, trading business requires less working capital. Similarly, service industries which usually do not have to maintain inventory require less working capital.
  2. Scale of Operations: For organisations which operate on a higher scale of operation, the quantum of inventory, debtors required is generally high. Such organisations, therefore, require large amount of working capital as compared to the organisations which operate on a lower scale.
  3. Business Cycle: Different phases of business cycles affect the requirement of working capital by a firm. In case of a boom, the sales as well as production are likely to be higher and therefore, higher amount of working capital is required. As against this the requirement for working capital will be lower during period of depression as the sales as well as production will be low.
  4. Seasonal Factors: Most business have some seasonality in their operations. In peak season, because of higher level of activity, higher amount of working capital is required. As against this, the level of activity as well as the requirement for working capital will be lower during the lean season.
  5. Production Cycle: Production cycle is the time span between the receipt of raw material and their conversion into finished goods. Some businesses have a longer production cycle while some have a shorter one. Duration and the length of production cycle, affects the amount of funds required for raw materials and expenses. Consequently, working capital requirement is higher in firms with longer processing cycle and lower in firms with shorter processing cycle.
  6. Credit Allowed: Different firms allow different credit terms to their customers. These depend upon the level of competition that a firm faces as well as the credit worthiness of their clientele. A liberal credit policy results in higher amount of debtors, increasing the requirement of working capital.
  7. Credit Availed: Just as a firm allows credit to its customers it also may get credit from its suppliers. To the extent, it avails the credit on its purchases, the working capital requirement is reduced.
  8. Operating Efficiency: Firms manage their operations with varied degrees of efficiency. For example, a firm managing its raw materials efficiently may be able to manage with a smaller balance. This is reflected in a higher inventory turnover ratio. Similarly, a better debtors turnover ratio may be achieved reducing the amount tied up in receivable. Better sales effort may reduce the average time for which finished goods inventory is held. Such efficiencies may reduce the level of raw materials, finished goods and debtors resulting in lower requirement of working capital.
  9. Availability of Raw Material: If the raw materials and other required materials are available freely and continuously, lower stock levels may suffice. If, however, raw materials do not have a record of un-interrupted availability, higher stock levels may be required. In addition, the time lag between the placement of order and actual receipt of the materials (also called lead time) is also relevant. Higher the lead time, higher the quantity of material to be stored and higher is the amount of working capital requirement.
  10. Growth Prospects: If the growth potential of a concern is perceived to be higher, it will require higher amount of working capital so that is able to meet higher production and sales target whenever required.
  11. Level of Competition: Higher level of competitiveness may necessitate higher stocks of finished goods to meet urgent orders from customers. This increases the working capital requirement. Competition may also force the firm to extend liberal credit terms discussed earlier.
  12. Inflation: With rising prices, higher amounts are required even to maintain a constant volume of production and sales. The working capital requirement of a business thus, become higher with higher rate of inflation. It must, however, be noted that an inflation rate of 5%, does not mean that every component of working capital will change by the same percentage. The actual requirement shall depend upon the rates of price change of different components (e.g., raw material, finished goods, labour cost,) Finished goods as well as their proportion in the total requirement.

The four factors that affect the fixed capital requirements of a company are explained below:

  • Nature of business:The kind of activities a business is engaged in has an important bearing on its fixed capital requirements. On one hand a trading concern does not require to purchase plant and machinery etc. and needs lower investment in fixed assets. Whereas on the other hand a manufacturing organisation is likely to invest heavily in fixed assets like land, building, machinery and needs more fixed capital.
  • Scale of operations:The amount of fixed capital required by a business varies directly in proportion to its scale of businessA larger organisation operating at a higher scale needs bigger plant, more space etc. and therefore, requires higher investment in fixed assets when compared with the small organisation.
  • Diversification:If a business enterprise plans to diversify into new product lines, its requirement of fixed capital will increase as compared to an organisation which does not have any such plans.

Growth prospects: If a business enterprise plans to expand its current business operations in the anticipation of higher demand, its requirement of fixed capital will be more as compared to an organisation which doesn’t plan to persue any such plans.