Long Answer Questions: Financial Management

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 a business is a central aim of financial planning. Before raising funds, the requirement should be estimated correctly. If estimates are too low, the firm may face a shortage of funds and be unable to meet day-to-day expenses or meet short-term and long-term liabilities on time. If estimates are too high, funds may remain idle and reduce the firm's profitability. Therefore, estimates should be made so that financial requirements are met without under-utilisation or excess idle funds.
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 refers to funds meant for 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 to acquire fixed assets such as:

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

Certain long-term expenditures that do not create an asset-for example, research expenses, promotional expenditure at the time of establishing the business, share issue expenses, underwriting commission-are also financed from fixed capital. New businesses need a substantial amount of fixed capital at the start for acquiring fixed assets, while existing businesses may require fixed capital for expansion and development. Assessment of fixed capital for a new business can be prepared by listing required fixed assets, studying similar units and consulting technical experts. Costs of land, buildings and machinery can be estimated from property dealers, building contractors and machinery suppliers respectively. Costs of goodwill, patents and trademarks can be estimated similarly.
Factors Affecting the Estimation of Fixed Capital/Fixed Assets Requirements: These factors can be classified as internal and external.

(a) Internal Factors:

• Nature of Business: Manufacturing concerns generally require more fixed assets than trading concerns. Public utility undertakings (railways, electricity, water supply) need very large investments in fixed assets.
• Size of Business: Larger units usually require greater fixed capital because they use more and often more automated equipment.
• Types of Products: Firms that make simple consumer products (soap, oil) require less fixed capital than firms producing complex goods (cars, motorcycles).
• Activities Undertaken by the Enterprise: A firm that manufactures all components itself will need more fixed capital than one that outsources many parts and simply assembles them. Similarly, firms that both manufacture and market their products require more fixed capital than those engaged only in manufacturing or only in marketing.
• Mode of Acquisition of Fixed Assets: Availability of assets on lease or hire reduces the need for fixed capital. Conversely, immediate purchase of assets increases fixed capital requirements.
• Acquisition of Old Assets: Purchasing used plant and machinery at lower cost can reduce fixed capital needs, provided the industry does not face rapid technological changes that would make such assets obsolete quickly.
• Availability of Concessional Rates: Government concessions on land or equipment in certain regions lower the requirement of fixed capital.

(b) External Factors:

• General Economic Outlook: When the economy is recovering and business activity is expected to rise, fixed capital requirements generally increase.
• Technological Changes: Rapid technological innovation increases the need for replacement and modernisation of machinery, thus raising fixed capital needs.
• Degree of Competition: High competition may force firms to adopt new technologies and expand capacity, increasing fixed capital requirements.
• Shift in Consumer Preferences: Frequent changes in consumer tastes may require investment in new types of machinery or production lines, raising fixed capital needs.

Assessment of Working Capital Requirements: After estimating fixed capital, a firm must assess funds required for working capital. The term working capital is used in two senses: (i) total current assets, and (ii) the excess of current assets over current liabilities. Current assets include cash, receivables (debtors and bills receivable), inventories, etc. The amount needed in current assets varies by nature and size of business, duration of the production cycle, turnover speed, credit policy, stock levels, seasonal fluctuations, growth rate, and other factors.

Working capital may be classified as fixed or fluctuating. Fixed working capital is the minimum amount that must always be invested in current assets (raw materials, work-in-progress, finished goods, receivables and cash) to maintain a desirable level of activity. The quantum of fixed working capital depends mainly on the duration of the production cycle-the time between purchasing raw material and receiving cash from customers. The longer this cycle, the higher the fixed working capital required.

Fluctuating working capital is the additional amount required over the fixed working capital. It varies with the level of business activity-for example, during peak seasons more funds are tied up in inventories and receivables, so fluctuating working capital increases.

The total working capital requirement can be estimated by analysing needs for:

• Maintaining adequate stock;
• Receivables;
• Paying day-to-day expenses; and
• Contingencies.

For maintaining adequate stock: Firms must hold minimum levels of raw materials, work-in-progress and finished goods. Stock requirements depend on production volume, length of the production cycle and the period goods remain in warehouse before sale.
For receivables: Credit sales create receivables that tie up funds until cash is received. The amount tied up depends on the volume of credit sales, credit period granted and efficiency of collection. For example, extending credit terms from 30 days to 60 days will roughly double the funds tied up in debtors and increase working capital needs accordingly.
For paying day-to-day expenses: A firm must maintain a minimum cash balance to pay wages, salaries and routine expenses and to avail of cash discounts from suppliers.
For contingencies: A small cash reserve is kept to meet unforeseen contingencies so the business can continue during short crises.
Thus, the overall financial needs of a business are determined by separately assessing fixed capital and working capital requirements and then adding the two.

Q2: Define the term 'Over-Capitalisation' and 'Under Capitalisation' and their causes?
Ans: Over-Capitalisation: The term is often misunderstood to mean simply an excess of capital. In practice, an over-capitalised company is one that earns less than a fair rate of return on the capital invested. In other words, when a company is continuously unable to earn a fair return on its capital, it is said to be over-capitalised.

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."
According to Harold Gilbert: "When a company has consistently been unable to earn the prevailing rate of return on its outstanding securities (considering the earnings of similar companies in the same industry and the degree of risk involved) it is said to be over-capitalized."

These definitions show that over-capitalisation arises when a firm's earning capacity falls so that earnings cannot provide a reasonable return on capital employed. For example, if a company earns a profit of Rs. 80,000 on total capital of Rs. 8,00,000, and the normal market rate of return is 10%, the company is fairly capitalised. If the company earns only Rs. 22,000 while the normal rate is 10%, it would be over-capitalised since it earns only 2.75% on capital (i.e., far below the expected 10%).

Causes of Over-Capitalisation:
Following are some important causes of over-capitalisation:

• Over-Issue of Capital: Raising more capital than the business can profitably use leads to idle funds. Idle funds depress the firm's earning capacity, reduce dividends and push down the market price of shares.
• Promotion of the Company with Inflated Asset Values: If a company is promoted with assets shown at inflated prices (for example, when a private concern is converted into a public company and assets are overvalued), the capital base will be larger than justified by earnings.
• Promotion or Expansion During a Boom: Assets bought at high prices during a boom may lose real value when the boom ends. Earnings decline while capital remains recorded at higher values, causing over-capitalisation.
• High Promotion Expenses: Heavy spending on promotion, underwriting and excessive remuneration to promoters reduces distributable earnings and contributes to over-capitalisation.
• Over-Estimation of Earnings at Promotion: If projected earnings used to fix capital are higher than actual future earnings, the company becomes over-capitalised.
• Under-Estimation of Rate of Return at Promotion: If the capitalization rate is set too low when the company is formed, the resulting capitalisation will be excessive relative to actual returns.
• Shortage of Capital Leading to High-Cost Borrowing: Ironically, under-raising capital initially can force the firm to borrow at high interest rates; large interest payments reduce earnings available to shareholders and can create an over-capitalised appearance.
• Inadequate Depreciation: Failure to provide adequate depreciation and replacement reserves reduces long-term earning capacity of assets, leading to lower earnings against recorded capital.

Under-Capitalisation: Under-capitalisation is the reverse situation. Greenberg defines it as a corporation being under-capitalized when its profits and rate of return are unusually high relative to similarly situated companies, or when it has too little capital to conduct its business comfortably. In simple terms, under-capitalisation arises when a firm earns an abnormally high rate of return on a relatively small capital base. Such firms often declare high dividends and have market values of shares above book values.

Causes of Under-Capitalisation:
The important causes are:

• Under-Estimation of Capital Requirements: Promoters may under-estimate the capital needed and raise insufficient funds, producing under-capitalisation later.
• Under-Estimation of Earnings: If future earnings were under-estimated and actual earnings turn out much higher, the firm becomes under-capitalised.
• Over-Estimation of Rate of Return at Promotion: If the capitalization rate is set too high initially, the calculated capital will be low; when actual rates of return turn out lower, the company may be under-capitalised. For example, estimating earnings at Rs. 60,000 and fixing a rate at 15% gives capitalization of Rs. 4,00,000; if the correct rate should have been 10%, the proper capitalization would be Rs. 6,00,000 and the company is under-capitalised by Rs. 2,00,000.
• Promotion During Deflation/Recession: Firms floated during recession may buy assets at low prices and be capitalised conservatively; when the economy recovers and earnings rise, such firms become under-capitalised.
• Conservative Dividend Policy and Retained Earnings: Firms that declare low dividends and plough back earnings accumulate funds and strengthen their position, which may lead to under-capitalisation as earnings rise relative to originally fixed capital.
• High Management Efficiency: Efficient management and operations can produce high returns on limited capital, resulting in under-capitalisation.