Fundamentals of Accounting Business Finance 16. Fixed and Working Capital – Meaning & Sources This lesson introduces you to the concept of fixed and working capital, why it is required and where it can be sourced from. This when tied up with what you have learnt in the previous lessons in this unit will give you a comprehensive overview of the business financing.
16.0 Objectives After going through this lesson you will be able to: • •
understand what fixed and working capital are understand where these can be sourced from
16.1 Introduction Oranisations are usually faced with two types of financing decisions: • •
Long-term Short-term Long-term decisions such as capital budgeting are called such because they involve long-live assets or liabilities. Also these are not easily reversible and the organisation may be committed to these decisions for several years. Short-term decisions on the other hand involve short-term assets and liabilities e.g. a 6 month bank loan which can be easily repaid at the end of the period without any major impact on the organization. This forms the background of this lesson. Some points which form a part of this lesson have already been covered in the three previous lessons which form part of this unit. These will only be mentioned here and covered very briefly.
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16.2 Fundamentals of Fixed Capital 16.2.1 Meaning Fixed Capital (also called Fixed Investment) can be defined as the amount of capital permanently invested in the business. It refers to any kind of real or physical capital (fixed asset) that is not used up in the production of goods. Thus, investment in physical assets such as machinery, land, buildings, installations, vehicles, or technology forms part of the fixed capital. Normally, a company balance sheet will state both the amount of expenditure on fixed assets during the quarter or year, and the total value of the stock of fixed assets owned. The use of the term "fixed" refers not so much to the asset being invested in "staying in one place", but to the circulation of flows of capital. Normally, for the purpose of accounting, fixed investment refers to physical assets held for one year or more. 16.2.2 Sources The various sources for fixed capital are: • • • •
• • •
Long-term loans Bonds & Debentures Retained Earnings Share Capital o Equity Shares o Preference Shares Venture capital funding / seed capital funding Deferred credit Asset securitization These have already been discussed in detail in Lesson 14 of this unit.
Self-Check Questions Fill in the Blanks 1. Fixed Capital is also called Fixed _______________ 2. Normally, for the purpose of accounting, fixed investment refers to physical assets held for more than ____________ 3. List two possible sources of fixed capital
16.3 Fundamentals of Working Capital 2
16.3.1 Meaning Working capital for any manufacturing unit means the total amount of circulating funds required for the continuous operations of the unit on a going basis. The working capital comprises of: • • • • •
Amount for raw material of various kinds Amount for stock in process Amount for all finished goods in stores and in transit Amount for receivables or sundry debtors Other routine expenses
16.3.2 Sources The key means to finance the Working capital are: • • •
Credit available on purchases; Short term Bank borrowing; Surplus of long term funds over the long term uses – Net Working Capital (NWC)
16.3.3 Difference between Working Capital requirement and Net Working Capital Working capital requirement means the requirement of funds for financing the minimum total current assets. Net working capital or liquid surplus means the difference between current assets and current liabilities. The desired level of net working capital should be higher than 1:1 to ensure sufficient liquidity and availability of working funds. Factors which determine the working capital: 1. 2. 3. 4. 5.
Policies for production Manufacturing process Credit policy of the unit Pace of turnover Seasonality
16.3.4 Assessment of Working Capital Requirement Turnover Method This is applicable to all borrowers enjoying fund based working capital limits up to and inclusive of Rs. 5 Crores (including non-fund based Acceptance L/C) with the Banking system. Under this method, the working capital requirement will be computed on the basis of the 25% of the Annual Projected Turnover /Sales of the borrowers. Out of this 25%, a minimum of 20% of the -projected turnover is to provided by the bank/financial institution as working capital limit and the rest 5%
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is to be contributed by the borrowers as their margin towards the working capital. Let us consider an example to understand this better: Projected turnover
300 lacs
Working capital requirement (25% of projected turnover)
300 X 25/100
= 75 lacs
Bank finance for working capital (20% of projected turnover)
300 X 20/100
= 60 lacs
Margin money for working capital from long term sources
300 X 5/100
= 15 lacs
Further, these workings are subject to the assumption of an operating / business cycle of a period of 3 months, although in reality the operating cycle may be shorter or longer. It is, therefore, necessary to assess the borrower’s requirements of working capital on the basis of traditional method and where the operating/production cycle is longer to provide the finance in excess of 20% of the projected annual turnover. However, in case of shorter operating cycle, working capital should be provided at 20% of the projected annual turnover. Of course, the actual’ drawings should be permitted on the basis of the drawing power after excluding unpaid stocks/stocks received under D/A L/C. The Method of Lending on Basis of Inventory and Receivables Banks have the freedom to determine the level of holding for inventory and receivables for various industries. They may continue to accept those levels which are in conformity with the past levels of holding of the borrower on the basis of actual for last 2/3 years and also keeping in view the industry levels in general as advised by the RBI from time to time. Cash Budget System of Lending Banks may give option to the borrowers to choose the method of Cash budget System. In such cases, the borrowers will have to satisfy the bank that they have the necessary infrastructure to submit the required periodical information in time. The borrower must have a finance professional and computerized environment. Under this system, the peak level cash deficit will be the level of total working capital finance to be provided to the borrower by the Bank. The peak level cash deficit will be ascertained from the Projected Cash Budget Statement submitted by the borrower. This statement would comprise of projected receipts and payments for the next 12 months on account of • • • •
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Business operations; Non-business operations Cash flow from capital accounts; and Sundry items.
16.3.5 Dangers of inadequate Working Capital: 1. It may not be possible for the company to utilize production capacity fully for want of working capital 2. A company may not be able to take advantage of cash discount facilities 3. A company may not be able to take advantage of profitable business opportunities 4. A company may not increase its cash sales and may have to restrict its activities to credit sales only 5. A company may have to borrow funds at exorbitant rates of interest 6. Low liquidity would positively threaten the solvency of business. The credit worthiness of the company is likely to be jeopardized because of lack of liquidity
Self-Check Questions Fill in the Blank 4. Net working capital or liquid surplus means the difference between current ___________ and current ___________ 5. List two factors which determine working capital requirement 6. Under the Turnover Method of assessment of Working Capital Requirement the working capital is computed on the basis of what percentage of the Annual Projected Turnover /Sales of the borrowers
16.4 Summing Up In this lesson you have learnt about the following: • • • • •
Long-term & Short-term financing decisions Meaning & sources of Fixed Capital Meaning and sources of Working Capital Difference betweem Working Capital & Net Working Capital Methods for assessing Working Capital requirement
16.5 Answers to Self-Check Questions 1. Investment 2. One Year 3. Long-term loans, Bonds & Debentures, Retained Earnings, Share Capital, Venture capital funding / seed capital funding, Deferred credit, Asset securitization 4. assets, liabilities
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5. Policies for production, Manufacturing process, Credit policy of the unit, Pace of turnover, Seasonality 6. 25%
16.6 Terminal Questions 1. Take up the annual report of a company and assess the working capital requirement for the company based on its results using the Turnover Method 2. Which are more expensive – long-term bank loans or short-term bank loans and why?
16.7 Glossary • •
• • •
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Fixed Capital: Fixed Capital (also called Fixed Investment) can be defined as the amount of capital permanently invested in the business Working Capital: Working capital for any manufacturing unit means the total amount of circulating funds required for the continuous operations of the unit on a going basis L/C: Letter of Credit D/A: Documents against Acceptance RBI: Reserve Bank of India