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:
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:
(b) External Factors:
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: 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:-
“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:
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