Long Answer Questions | Business Studies (BST) Class 12 - Commerce PDF Download

Q1: Explain the various determinants of the financial needs of a business?
Determination of Financial Needs of a Business
or
Assessing Funds Requirements
Ans: Estimating or determining the financial requirements of the business is one of the main objectives of financial planning. Before raising funds, it is essential that the requirement of funds be correctly estimated. In the absence of correct estimates, the firm may suffer either from inadequate or surplus funds. If the funds are short of its requirements, the firm will not be able to meet its day-to-day expenses and pay the short-term and long-term liabilities on time.
On the other hand, if the funds are in excess of the requirements of the business, they will remain idle and will reduce the profitability of the business. Hence, the estimates should be made in a way that all financial requirements are properly satisfied.
Funds requirements of a business can broadly be classified into two main categories. They are:
Fixed Capital Requirements, and Working Capital Requirements.
Assessment of Fixed Capital Requirements: Fixed capital is the capital that is meant for fulfilling the permanent or long-term needs of the business. In the words of Shubin, “Fixed capital is the funds required for the acquisition of those assets that are to be used over and over for a long period.”
Fixed capital is required for acquiring fixed assets. Fixed assets may include the following:

• Tangible assets such as land, buildings, plant and machinery, furniture, etc.
• Intangible assets such as goodwill, patents, copyrights, etc.

A certain amount of fixed capital is also required for meeting certain expenditures not leading to the creation of an asset like research expenses, promotional expenditure incurred for the establishment of business, share issue expenses, underwriting commission, etc. The requirement of funds for these expenditures is long-term and hence the funds required in respect thereof are also included under fixed capital.
Every business needs a fair amount of fixed capital to be invested in fixed assets so as to create production or business facilities. For a new business, the fixed capital is needed in the beginning because fixed assets are needed at the time of promoting or establishing the business. For an existing business fixed capital is required for the development and expansion of the business. Hence, it is essential to have an adequate amount of fixed capital in the business.
The assessment of fixed capital requirements for a new business can be made by preparing a list of fixed assets needed by the business.
The list is prepared by the promoters by studying similar units and by taking advice from technical experts. The estimation of cost of land can be made from property dealers, estimation regarding the cost of building can be made with the help of building contractors and the cost of machinery can be ascertained from the suppliers of the machinery. Similarly, the amount to be paid for goodwill, patents, trade-marks, etc. can also be estimated.
Factors Affecting the Estimation of Fixed Capital/Fixed Assets Requirements: Factors that affect the estimation of Fixed Capital or Fixed assets requirements can be studied under two heads
(a) Internal Factors and
(b) External Factors.
(a) Internal Factors:

• Nature of Business: Certain types of businesses require heavy investment in fixed assets, while others do not. Usually, the manufacturing concerns require more fixed assets than trading concerns. Similarly, public utility undertakings like railway, electricity, water supply, etc. require huge funds to be invested in fixed assets.
• Size of Business: Larger the size of a concern, the greater will be the requirement of fixed capital. Also, in larger concerns, most of the activities are performed with the help of automatic machines. As such, they require a huge investment in fixed assets.
• Types of Products: A concern that manufactures simple consumer products such as soap, oil, etc. will need a lesser amount of fixed capital in comparison to a concern that manufactures complicated products such as motorcycles, cars, etc.
• Activities Undertaken by the Enterprise: A concern that is engaged in the manufacturing of all parts of a product by itself will require a greater amount of fixed capital as compared to a concern that gets most of the parts manufactured from outside and merely assembles them. Similarly, if a concern itself manufactures and markets its products, it will require more amount of fixed capital as compared to a concern that is engaged only in the manufacturing or only in marketing activities.
• Mode of Acquisition of Fixed Assets: If some of the fixed assets are available on the lease or on hire, a lesser amount of fixed capital will be required. On the contrary, if all the fixed assets are to be purchased on immediate cash payment, a larger amount of fixed capital will be needed.
• Acquisition of Old Assets: In certain industries, old plant and machinery may be available at sufficiently reduced prices and which can be used ‘satisfactorily. It would reduce the requirement of fixed capital to a great capital to a great extent. But the old plant and machinery should be used in the industries where the technological changes are moderate or slow.
• Availability of Fixed Assets of Concessional Rate: In some areas, the Government provides land and other equipment at concessional rates to promote balanced industrial growth. In such a case, the requirement of fixed capital is reduced.

(b) External Factors:

• General Economic Outlook: If the economy is recovering from depression and the level of business activity is expected to rise, the requirement for fixed assets will also rise and hence the need for fixed capital will also rise.
• Technological Changes: If rapid technological innovations are taking place in an industry, the need for fixed capital will be larger because the old and out-dated machinery will have to be replaced by new ones.
• Degree of Competition: The degree of Competition also affects the Fixed Capital-requirements. If there is a lot of competition in some industries, the need for fixed capital will be more because if some firms go on adopting the new technology, the others have to follow them.
• Shift in Consumer Preferences: If the consumer preferences go on changing in some industries, the need for fixed capital will be more because the firm will have to produce new varieties accordingly, which require more investment in fixed assets.
• Assessment of Working Capital Requirements: After the assessment of fixed Capital, funds required for working capital are assessed. The term ‘Working Capital’ is used in two ways.

In one sense it denotes the ‘total current assets’ whereas in another sense it is regarded as the excess of current assets over current liabilities. Current assets include cash, receivables (i.e., debtors and bills receivables), stock, etc. The amount required to be invested in current assets differs from one business to another. The amount depends on various factors such as nature and size of the business, duration of the production cycle, rapidity of turnover, credit policy, the quantity of stock, seasonal fluctuations, rate of growth, etc.
Working capital may be fixed or fluctuating. Fixed working capital refers to the minimum amount which would always be invested in raw materials, work-in-progress, finished goods, receivables, and cash balance. This amount is absolutely essential throughout the year on a continuous basis to maintain a desirable level of business activity. The amount required for fixed working capital mainly depends on the duration of the production cycle.
The cycle starts from the purchase of raw material; then the raw material is converted into finished goods by incurring labor and other costs. On sale, these finished goods are converted into debtors and lastly, the firm will again have cash when the debtors pay. The length of the production cycle (i.e., the length of time between the purchase of raw material and receiving cash from debtors) will determine the quantum or requirements of fixed working capital. The longer the cycle, the higher will be the requirements of fixed working capital.
The requirement of working capital over and above the fixed working capital is known as fluctuating working capital. It keeps on fluctuating from time to time according to the change in the level of business activities. For instance, during peak season, due to intensive sales, more funds are blocked in stocks and debtors and thus more amount will be required for fluctuating working capital.
The total amount of working capital can be estimated by estimating the needs of working capital for the following:

• For maintaining adequate stock
• For receivables.
• For paying day-to-day expenses
• For contingencies

For maintaining adequate stock: Every industrial undertaking is required to maintain a minimum stock of raw materials, work in progress, and finished goods. The requirement of the stock is determined by various factors like volume of production, the length of the production cycle, and the period for which the finished goods have to remain in a warehouse before they are sold.
For receivables: Finished goods may be sold for cash or on credit. Credit sales take the form of receivables (i.e., debtors and bills receivables). The amount is tied up in receivables until cash is realized from them. The amount tied up in receivables depends upon a number of factors such as quantum of credit sales, credit period allowed, the efficiency of the debt collection system, etc. For example, if a firm changes its credit period from 30 days to 60 days, the amount tied up in debtors will go up, and consequently, the need for working capital will also increase by a similar amount.
For paying day-to-day expenses: A firm has to carry some minimum cash balance to make payment for wages, salaries, and other expenses throughout the year. A proper cash balance is also maintained to avail of the cash discounts facilities offered by proper cash balance is also maintained to avail of the cash discounts facilities offered by the suppliers.
For contingencies: A minimum cash balance is also maintained for meeting unseen contingencies so that the business successfully sails through the period of crisis.
Thus, the overall financial needs of a business can be determined, by assessing the needs for fixed capital and working capital separately and then by adding the two.

Q2: Define the term ‘Over-Capitalisation’ and ‘Under Capitalisation’ and their causes?
Ans: Over Capitalisation: Quiet often, the term ‘Over-Capitalisation’ is misunderstood to mean the excess of capital. But in actual practice, over-capitalized concerns have been found short of funds.
In fact, over-capitalization refers to that state of affairs where a company earns less than what should have earned at a fair rate of return on the capital invested in it. In other words, if a company is continuously unable to earn a fair rate of return on its capital, it is termed an over-capitalized company.
In the words of Bonneville Dewey, ” When a business is unable to earn a fair rate of return on its outstanding securities, it is over¬capitalised.”
According to Gerstenberg, “A corporation is over-capitalized when its earnings are not large enough to yield a fair return on the number of stocks and bonds that have been issued or when the amount of securities outstanding exceeds the current value of assets.”
The same view has been expressed by Harold Gilbert in these words, “When a company has consistently been unable to earn the prevailing rate of return o.n its outstanding securities (considering the earning of similar companies in the same industry and the degree of risk involved) it is said to be over-capitalized.”
It is clear from the above definitions that the situation of over¬capitalisation arises due to a fall in the earning capacity of the business. On account of this, the earnings will not be sufficient to give a reasonable return on capital employed in it. For example, a company is earning a profit of Rs. 8,00,000 on a total capital investment of Rs. 80,0, 000. In case the normal, rate of return prevailing in the market is 10%, this company will be said to be fairly capitalized. However, if it earns only Rs. 2,20,000 while the normal rate is 10%, the company will be said to be over-capitalized because it will be able to give a return of only 6% on the total capital employed.
In order to ascertain whether a company is earning a fair return or not, the rate of return earned by the company should be compared with similar firms in that industry. If the company’s rate of return is t .substantially less than the average rate earned by other firms, will indicate that the company is unable to earn a fair return on the capital 1 employed in it. It may also be noteworthy that a company will be said to be over-capitalized only when it is continuously unable to earn fair income over a long period of time. If its earning is reduced temporarily, owing to the occurrence of abnormal events like strikes, lockouts, etc. the company will not be called over-capitalized.
Causes of Over-Capitalisation:
Following are some of the important causes of over-capitalization:-

• Over-Issue of Capital: If a company raises more capital than it can profitably use, there will be a large number of idle funds will the company. Because of idle funds, the earning capacity of the company will be reduced. This leads – to the situation of over-capitalization because the company will have to pay dividends on idle capital too. Hence, the rate of dividend will fall which in turn leads to a fall in the market price of its shares.
• Promotion of the Company with Inflated Assets: A company will fall prey to over-capitalization if it is promoted with assets purchased at excessive prices, the reason is that such prices of the assets do not fear any relation to their earning capacity. Such a situation arises particularly when a partnership firm or private company is converted into a public company and in that process, their assets may be transferred to the public company at price higher than their real values. Sometimes, the promoters also transfer their property to the new company at inflated prices.
• Promotion or Expansion of the Company during Boom Period: If a company is formed or expanded during the boom period, it; may becomes a victim of over-capitalization. The reason is that the price paid for assets will be quite high. When the boom disappears the real value of such assets will decline to a great extent whereas they will be shown in the books at their original values. Such a company is over-capitalized because its earning will fall due to depression but the assets and capital will be shown in the books in previous figures.
• High Promotion Expenses: A certain degree of over-capitalization may be caused due to the. fact that the promoters have incurred heavy expenses on the promotion. of the company, a huge amount may have been spent on issue and underwriting of shares and the promoters may have taken a fabulous. remuneration for the services rendered by them. A major part of the earnings of the company will be utilized to write off these expenses and consequently, the company will not be able to pay fair dividends on its shares.
• Over-estimation of Earnings at the Time of promotion: In case of a new concern,-the amount of capitalization is determined on the basis of estimates of future earnings. However, if it is found that the actual earning is less than the estimated earning, it will lead to a situation of over-capitalization. For example, if a company’s annual earnings were estimated at Rs, 50,000 and its current rate of return (or N capitalization rate) is 10% its, capitalization will be fixed at Rs. 5,00,000. Subsequently, it was found that the company actually earned (Rs. 40,000. On this basis, the company’s capitalization should have been: fixed at Rs. 4,00,000. Thus, the company will be over-capitalized by 4 Rs. 1,00,000.
• Under-estimation of Rate of Return at the Time of Promotion: A concern may have correctly estimated the number of its earnings, but it may have under-estimated its rate of return (i.e., capitalization, rate). For example, a company’s annual earnings were estimated at ‘ Rs. 50,000 and the rate of return were fixed at 10%. By applying this rate the company’s capitalization was worked out at Rs. 5,00,000. Subsequently, it was found that the actual rate of return was 12.5%, and hence the amount of capitalization should have been fixed at Rs. i.e., Rs. 50,000 × 100. 12.5 Obviously, there is over-capitalization to the extent of Rs.1,00,000.
• Shortage of Capital: Sometimes, the shortage of capital may also lead to over-capitalization. It may happen when the promoters underestimate the requirements of capital and raise less capital in relation to the needs of the business. In such a case the company will be forced to borrow a large sum of money at an unreasonably high rate of interest. A major part of the earnings will be absorbed by the amount of interest, leaving little for the shareholders. This will bring down the value of shares leading to over-capitalization.
• Inadequate Depreciation: If a company does not make sufficient provisions for depreciation and replacement of assets, it will find after some time that the earning capacity of the assets is diminished leading to a fall in its earnings. This is yet another case of over-capitalization.
• Under-capitalization: The term ‘under-capitalization’ does not mean a shortage or inadequacy of capital. The term is just reverse to over-capitalization. In the words of Greenberg:

“A corporation may be under-capitalized when the rate of profits, it is making on total Capital, is exceptionally high in relation to the return enjoyed by similarly situated companies in the same industry, or when it has too little capital with which to conduct its business.”
In simple words, under-capitalization is a state of affairs when the capital or resources of the company are being utilized more efficiently. As a result, the company succeeds in continuously earning an abnormally high rate of return on the capital employed in it. Such a company declares a high rate of dividend in comparison to the prevailing rate and the market value of its shares exceeds their book value. Thus under-capitalization refers to the sound financial position and good management of the company.
Causes of Under-Capitalisation:
The following are the important causes of under-capitalization:

• Under-Estimation of Capital Requirements: At the time of promotion, the promoters may under-estimate the capital requirements of the company. This results in a situation of under-capitalization at later stages when more capital is required.
• Under-Estimation of Earnings: Sometimes at the time of promotion, the future earnings of the company are under-estimated and the company is capitalized accordingly. If afterward it is found that the actual earnings are far in excess of the estimates, the company may find itself in a situation of under-capitalization.
• Over-Estimation of Rate of Return at the Time of Promotion: Sometimes a concern estimates its income correctly but it over-estimates its rate of return (i.e„ capitalization rate). For example if a company’s earnings were estimated at Rs. 60,000 and the rate of earnings were fixed at 15%. By applying this rate the capitalization was fixed at‘Rs. 4,00,000 (i.e., Rs. 60,000 × 10015). Subsequently, it was ascertained that the actual rate was 10% and hence the amount of capitalization should have been Rs, 6,00,000 (i.e., Rs. 60,000 × 10010). Thus, the company is under-capitalized by Rs. 2,00,000.
• Promotion of Company During Deflation: Companies that are floated under recessionary conditions often experience under-capitalization after the recession is over. This is because of two reasons. Firstly, during recession assets are purchased at a price that is must lower in comparison to their earning capacity. Secondly, companies established during a recession are capitalized at a low figure anticipating low earnings but when the recession is over earnings increase and the company becomes under-capitalized.
• Conservative Dividend Policy: Certain companies follow a policy of declaring low dividends and plowing back a major part of their earnings. They build up large funds for replacement, renovation, and expansion. The result of such a policy is reflected in high earnings which is a situation of under-capitalization.
• High Level of Efficiency: In a company where the management is very efficient, the company may operate on a high efficiency even with a meager amount of capital. Over a period, earning the position of the company will improve and it will become under-capitalized.