This article throws light upon the top two categories for the classification of finance required for a business. The categories are: 1. Fixed Capital 2. Working Capital.
Classification of Finance: Category # 1. Fixed Capital:
Meaning and Definition of Fixed Capital:
The term ‘fixed capital’ stands for that amount of capital which is required for long-term to create production facilities through purchase of fixed assets such as plant, machinery, land, building, furniture, etc. These assets represent that part of firm’s capital which is blocked on a permanent or fixed basis. The business does not intend to dispose off these assets and for this reason fixed capital is also known as ‘Block Capital’.
The fixed assets are neither fixed or attached, in all cases, to a particular place nor are they fixed in value. There may be increase or decrease in their value in the course of time; yet, they are regarded as fixed assets as they are to be retained in business for carrying out regular operations and without them the business of the concern cannot be carried out.
Investment in non-current assets such as long-term receivables, advance to subsidiary or affiliate concerns, goodwill, patents, copyrights, long-term investments etc. also form part of fixed capital. Fixed capital is required not only for the acquisition of fixed and non-current assets at the start of the business, but is also required for development, expansion and permanent working capital.
Some important definitions of fixed capital are as follows:
In the words of P.M. Chiuminatoo, “Fixed capital comprises of fixed assets and other non- current assets.”
Shubin has defined fixed capital as, “The funds required for the acquisition of those assets that are to be used over and over for a long period- such assets as land, building, machinery, equipment and tools.”
According to Hoagland, “Fixed capital is comparatively easily defined to include land, building machinery and other assets having a relatively permanent existence.”
In the words of Wheeler, “Fixed Capital is invested in the fixed or long-term assets. The amount of fixed capital needs, therefore, varies directly with the amount of fixed assets owned or used by a business.”
From the above definitions, it is clear that fixed capital is the amount invested in various fixed or permanent assets which are necessary for conducting the operations of a business.
Importance of Fixed Capital:
Capital is the life blood and nerve centre of a business. Just as circulation of blood is essential in the human body for maintaining life, capital is very essential to maintain the smooth running of the business. The need for fixed capital cannot be over-emphasised. Every business needs some amount of capital to be invested in fixed or non-current assets so as to create production or business facilities.
No business can be started without an adequate amount of fixed capital.
Right from the very beginning, i.e.; conceiving an idea to business, capital is needed to promote or establish the business, acquire fixed assets, make investigations such as market surveys, etc. Even an existing concern may require fixed capital for making improvements or expanding the business, thus, it is very essential to have adequate fixed capital in a business.
Assessment of Fixed Capital Requirements:
Fixed capital is required to finance the cost of acquisition of permanent assets such as land, building, plant and machinery, etc.; and to fund the cost of intangible assets like promotion expenses, organisation expenses, operating losses, costs of financing, patents, copyrights and goodwill, etc.
Hence, the assessment of the total amount of fixed capital required in a business involves:
A. Estimation of Fixed Assets Requirements
B. Estimation of Intangible Assets Requirements.
A. Estimation of Fixed Assets Requirements:
Fixed assets requirements are estimated usually at the time of promotion of a new enterprise. However, existing firms may also need it at the time of expansion, growth, replacement and improvement of the existing facilities. It is important not only to estimate the investments needed for these assets but also the time at which these amounts are required.
The promoters and managers of the business can determine various fixed ^assets required by them from their own experience in the business or by making a study of similar units or by taking advice from technical experts in that line of business. The estimation of the cost of these assets could be made by them by making enquiries with the manufactures or suppliers of these assets.
Estimation of the cost of land usually poses no problems and the cost of building can be estimated by taking help from building engineers and contractors. Further, the cost of installation of plant and machinery and other equipment’s should also be made. A sufficient margin for non-firm costs should, however, be made to meet the exigencies.
The requirement of fixed assets varies from business to business. There are a number of factors that determine the requirements of fixed assets in a business.
Factors Affecting the Estimation of Fixed Assets Requirements:
Various factors which affect the estimation of fixed assets requirements in a business can be studied under two heads:
(i) Internal Factors; and
(ii) External Factors.
1. Internal Factors:
(a) Nature or Character of Business:
The fixed assets requirements of a business basically depend upon the nature of its business. Public utility undertakings such as electricity, water supply and railways require huge funds to be invested in fixed assets. On the other hand, trading and financial firms have very less requirements for fixed assets but have to invest large amounts in current assets.
Manufacturing concerns also require sizeable fixed capital as they have to set up production facilities and invest large funds in fixed assets such a land and building, plant and machinery, etc. Thus, the nature of business determines the requirements of fixed assets/capital to a large extent.
(b) Size of Business:
The fixed assets /capital requirements of concern are also influenced by the size of its business which may be determined in terms of scale of operations. Generally, larger the size of a business unit, greater is the requirement of fixed assets needed to set up the business operations.
(c) Activities Undertaken by the Enterprise or Scope of Business:
The requirement of fixed capital also depends upon the number of activities undertaken by the enterprise. For example, if a concern manufactures and markets its products itself, it needs more fixed capital as compared to a concern that undertakes only manufacturing activities or only marketing activities.
Similarly, if a concern is engaged in production of all parts of a product, it will require more capital than a concern which is engaged in assembling parts manufactured by other units.
(d) Production Techniques:
Another factor that influences the requirements of fixed capital in a business is the production technique that is to be adopted in the enterprise. For example, use of automatic machinery calls for larger investment in the fixed assets. On the other hand, if production methods are simple, which do not require such equipment’s, lesser amount of fixed capital shall be needed.
(e) Mode of Acquisition of Fixed Assets (Extent of Lease or Hire):
Fixed assets may be purchased out-rightly or acquired on lease or hire basis. If an outright purchase of fixed assets is to be made, larger amount of fixed capital shall be required in comparison to the acquisition of fixed assets on leasehold basis or on hire.
It is, therefore, essential to decide in advance as to which assets are to be acquired on leasehold basis and which are to be purchased out rightly. In the same manner, if some of the fixed assets are available on hire or rent, decision has to be taken in regard to the purchase of these assets on outright or hire basis.
(f) Acquisition of old Equipment and Plant:
In certain industries, old plant and machinery or equipment’s may be available at prices much below the prices of the new plant and machinery. If old plant and machinery could be satisfactorily used in the business, especially in the areas where the technological change in production method is moderate or slow, it would substantially reduce the required investment in fixed assets.
(g) Decision as Regards Ancillary Units:
In certain industries; there may be a possibility of carrying out certain processes through ancillary units or sub-contracts without compromising with the quality and cost of the product. If it is so, the requirements of fixed assets can be decreased.
(h) Availability of Fixed Assets at Concessional Rates:
In some areas, the Government provides land and other materials/ facilities at concessional rates to promote balanced industrial growth and regional development of industries. Further, plant and machinery may be made available on installment basis. Such concessions induce the promoters to establish business in these areas reducing their investment in fixed assets.
2. External Factors:
The decisions relating to investment in fixed assets involve large amount of funds and are of irreversible nature. Such decisions have a long-term and significant effect on the profitability of a concern.
Thus, such decisions have to be carefully taken after considering the various factors affecting future requirements of fixed assets, as discussed below:
(a) International conditions and Economic Outlook:
While taking decision relating to investment in fixed assets, particularly in a large concern, the general economic and international conditions also play an important role.
For example, if the level of business activity is expected to increase, the needs for fixed assets and funds to finance their acquisition will also grow. In the same manner, companies expecting war may commit large investment in fixed assets before there is a shortage of such material.
(b) Population Trends and its Composition:
If a firm is planning for national market for its products, national population trends must be evaluated while forecasting for fixed assets requirements. In India, certain promoters are encouraged to expand business because the population is increasing at a fast rate. The age and sex composition of the population may also be important for certain businesses.
(c) Shift in Consumer Preferences:
Another factor that affects the future requirements of fixed assets is shift in consumer preferences. Fixed assets requirements should be planned in a manner so as to provide goods or services that consumers will accept.
(d) Competitive Factors:
The decision making process on planning future requirements of fixed assets is also influenced by competitive factors. For example, if an existing company shifts to a particular line of business, then others may also follow the lead.
(e) Shift in Technology:
Future improvements and shifts in technology have also to be considered while deciding about the future requirements of fixed assets. The financial plan should allow a scope for adjustments as and when new situations emerge.
(f) Government Regulations:
There may be certain government regulations affecting the size and the direction of a business enterprise. Hence, these should also be considered while assessing requirements of fixed assets. Although, it may not be possible to forecast changes in the Govt. policy, a margin should be provided to absorb the impact of such changes.
B. Estimation of Intangible Assets Requirements:
The expenses of promotion, incorporation, organisation or establishment of business, cost of financing and the amount to be invested in intangible assets such as goodwill, patents, copyrights, etc. also form part of fixed capital and hence influence the requirements of fixed capital of a concern.
The estimation of fund requirements for intangible assets, except for organisation expanses such as legal fees and taxes, etc. is a difficult task.
However, these are discussed below:
1. Promotion Expenses:
The expenses incurred by the promoter to make preliminary investigation, study marketing possibilities, enquiries about the technical aspects of production processes and assembling the elements of business are called promotion expenses. These are to be paid to the promoter as compensation for the services rendered by him in promoting the business.
Although, it is very difficult to determine the remuneration of the promoter for his personal efforts, time and skill in promoting the business, sufficient provision should be made for the same while estimating the requirements of intangible assets for the purpose of assessing the fixed capital requirements of a business.
2. Incorporation and Organisation Expenses:
Expenses incurred in setting up the business such as legal counseling, stamp duty, registration fees, filing fees, incorporation taxes, printing, etc. form part of incorporation or organisational cost. It is very essential to make an estimate of such expenses while determining the requirements of fixed capital in a business.
3. Costs of Financing:
The expenses incurred for arranging the funds required for a business are called costs of financing. These include the remuneration of underwriters, brokers, investment bankers as well as the expenses to be incurred in preparation of a registration statement and prospectus for making capital issues.
These costs would also be estimated while assessing the requirements of intangible assets forming part of the fixed capital.
4. Initial Operating Losses:
Every enterprise needs some time to stabilise the production and reach the self-supporting stage. Until that time, it incurs certain cash losses and funds drain out of the business. Such losses are most prolonged in business requiring huge initial investment, complex production techniques and marketing or developing a novel product.
While planning for capital, it is very essential to estimate and provide for such operating initial losses.
5. Cost of Acquisition of Patents Copyrights, Goodwill, etc.:
If a company is considering to purchase patents, copyrights, goodwill, etc. then it is very essential to make an estimate of the cost of these intangible assets and include the same in the fixed capital requirements of a business.
After preparing estimates of fixed assets and intangible assets requirements separately, we can determine the total fixed capital requirements of an enterprise by simply adding the funds needed for fixed assets and intangible assets.
Management of Fixed Assets/Capital:
We may say at the outset that the selection of various fixed assets required to create the desired production facilities and the decision as regards determination of the level of fixed assets is primarily the task of the production/technical people. However, there are certain financial considerations also involved in the same.
As the decisions relating to fixed assets involve huge funds for a long-period of time and are generally of irreversible nature affecting the long-term profitability of a concern, an unsound investment decision may prove to be fatal to the very existence of the organisation. Thus, management of fixed assets is of vital importance to any organisation.
The process of fixed assets management involves:
(i) Selection of most worthy projects or alternatives of fixed assets, and
(ii) Arranging the requisite funds/capital for the same.
The first important consideration to be kept in mind is to acquire only that much amount of fixed assets which will be just sufficient to ensure smooth and efficient running of the business. However, in some cases it may be economical to buy certain assets in a lot size.
Another important consideration to be kept in mind is the possible increase in demand of the firm’s products necessitating expansion of its activities. Hence, a firm should have that much amount of fixed assets which could adjust to the increased demand.
The third aspect of fixed assets management is that a firm must ensure buffer stocks of certain essential equipment/services to ensure un-interrupted production in the event of emergencies. Sometimes, there may be a break-down in some of the equipment’s or services affecting the entire production.
It is always better to have some alternative arrangement to deal with such situations. But at the same time the cost of carrying such buffer stocks should also be evaluated. Efforts should also be made to minimise the level of buffer stocks of fixed assets by encouraging their maximum utilisation during lean periods, transferring a part of peak period and hiring additional capacity.
The fourth aspect of management of fixed assets is to consider the cost of capital to be invested.
Principles of Fixed Capital Management:
The main objective of fixed capital management is to make sound investment and to retain intact the investment in fixed assets such as land, building, plant, machinery, etc.
The following are the main principles in the fixed capital management:
(i) Selection of most appropriate and suitable fixed assets.
(ii) Financing and acquisition of fixed assets.
(iii) Proper accounting of fixed assets.
(iv) Sound depreciation policy.
(v) Proper upkeep and maintenance of fixed investments.
(vi) Periodical appraisal of fixed investments.
Classification of Finance: Category # 2. Working Capital:
Working capital refers to that part of the firm’s capital which is required for financing short-term or current assets such as cash, marketable securities, debtors and inventories. Funds thus invested in current assets keep revolving fast and are being constantly converted into 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.
The working capital requirements of a concern depend upon a large number of factors such as:
1. Nature or character of business.
2. Size of business/ scale of operations.
3. Production policy.
4. Manufacturing process/length of production cycle.
5. Seasonal variations.
6. Working capital cycle.
7. Rate of stock turnover.
8. Credit policy.
9. Business cycles
10. Rate of growth of business
11. Earning capacity and dividend policy.
12. Price level changes
13. Other factors
To avoid the shortage of working capital at once, an estimate of working capital requirements should be made in advance so that arrangements can be made to procure adequate working capital. The working capital should be determined by estimating the investment in current assets minus moneys expected from current liabilities.
The following factors should be taken into consideration while making an estimate of working capital requirements:
1. Total costs incurred on material, wages and overheads.
2. The length of time for which raw materials are to remain in stores before they are issued for production.
3. The time taken for conversion of raw material into finished goods.
4. The length of sales cycle during which finished goods are to be kept waiting for sales.
5. The average period of credit allowed to customers.
6. The amount of cash required to pay day-to-day expenses of the business.
7. The average amount of cash required to make advance payments, it any.
8. The average credit period expected to be allowed by suppliers.
9. Time lag in payment of wages and other expenses.
From the total amount blocked in current assets estimated on the basis of the first seven items given above, the total of the current liabilities, i.e. the last two items is deducted to find out the requirements of working capital.