Fixed and Working Capital
Fixed And Working Capital
The financial requirements of a business can be broadly categorised into two types: the capital needed for long-term assets and the capital needed for short-term operations. These are known as Fixed Capital and Working Capital, respectively.
Meaning
Fixed Capital refers to the investment in long-term assets (also called fixed assets or block capital) that are used in the business for a long period and are not meant for resale. These assets provide the base for business operations.
Examples: Land and building, plant and machinery, furniture and fixtures, vehicles, patents, trademarks.
Working Capital refers to the capital required to finance the day-to-day operations of a business. It is the capital needed for meeting the short-term requirements of the business.
It represents the investment in current assets.
Examples: Raw materials, work-in-progress, finished goods inventory, receivables (debtors), cash and bank balances, prepaid expenses.
Management Of Fixed Capital
Management of fixed capital is essentially the Investment Decision or Capital Budgeting Decision. It involves deciding how the firm's funds are invested in long-term assets. These decisions are crucial because they are:
1. Long-term: They affect the company's profitability and performance for many years.
2. Large Outlay: They usually involve significant amounts of funds.
3. Irreversible: Once invested in specific fixed assets, it is difficult and costly to reverse the decision.
Sound fixed capital management involves evaluating various investment proposals (e.g., buying a new machine, setting up a new factory, acquiring another company) based on their expected returns, risk, and financial feasibility, and selecting the most profitable ones.
Techniques like Payback Period, Net Present Value (NPV), and Internal Rate of Return (IRR) are used to evaluate long-term investment proposals.
Example 1. A printing press owner in Delhi is deciding whether to purchase a new high-speed printing machine costing ₹50 Lakhs or continue using the older machine and outsource some large orders. What kind of capital management decision is this, and what factors should he consider?
Answer:
This is a Fixed Capital Management decision (specifically, a long-term investment decision). The owner should consider factors like the cost of the new machine, the expected increase in revenue and reduction in operating costs due to the new machine, the lifespan of the machine, the returns expected from alternative options (outsourcing), and the availability of funds.
Factors Affecting The Requirement Of Fixed Capital
The amount of fixed capital required by a business depends on several factors:
1. Nature of Business: Manufacturing businesses generally require more fixed capital (for plant and machinery, factory building) compared to trading businesses which primarily need funds for inventory and receivables.
2. Scale of Operations: Large scale businesses require more fixed assets and hence more fixed capital compared to small scale businesses.
3. Technique of Production: Businesses using capital-intensive techniques (relying heavily on machinery) require more fixed capital than those using labour-intensive techniques.
4. Technology Upgradation: Businesses in industries with rapid technological changes may need to invest frequently in new, updated machinery, requiring more fixed capital.
5. Growth Prospects: Companies planning for rapid growth and expansion will need to invest heavily in fixed assets, increasing their fixed capital requirement.
6. Diversification: Businesses planning to diversify into new product lines or markets may need to acquire new types of fixed assets, increasing fixed capital needs.
7. Availability of Lease Financing: If assets can be easily acquired on lease, the requirement for owned fixed capital may be lower.
8. Collaboration/Joint Ventures: Forming partnerships or joint ventures can reduce the need for sole investment in fixed assets.
Example 2. Compare the fixed capital requirement of a software development firm and a steel manufacturing plant, both of similar size in terms of revenue. Explain the factors causing the difference.
Answer:
A steel manufacturing plant would require significantly more fixed capital than a software development firm. This difference is mainly due to the Nature of Business (manufacturing requires heavy machinery, land, building, etc.) and the Technique of Production (steel manufacturing is capital-intensive). A software firm's primary assets are human resources, computers, and office space, requiring relatively less investment in fixed assets.
Working Capital
Working Capital is the capital required to finance the short-term assets and meet the day-to-day operational needs of a business. It is the funds invested in current assets.
$$ \text{Working Capital} = \text{Current Assets} - \text{Current Liabilities} $$
Where Current Assets include cash, bank balance, inventory (raw materials, work-in-progress, finished goods), receivables (debtors, bills receivable), prepaid expenses, short-term investments. Current Liabilities include creditors, bills payable, outstanding expenses, short-term loans, advances from customers.
This is known as Net Working Capital. Gross Working Capital refers to the total investment in current assets.
Management of working capital involves managing each component of current assets (cash, inventory, receivables) and current liabilities efficiently to ensure sufficient liquidity while maintaining profitability.
Working capital is crucial for maintaining the liquidity of the business, enabling it to meet its short-term obligations as they fall due.
Factors Affecting The Working Capital Requirements
The amount of working capital needed by a business varies depending on several factors:
1. Nature of Business: Trading firms (retailers, wholesalers) need more working capital for inventory and receivables compared to manufacturing firms that might have longer production cycles but also have work-in-progress and finished goods inventory.
2. Scale of Operations: Larger businesses with higher volumes of sales and purchases require more working capital for managing inventory, receivables, and payables compared to smaller businesses.
3. Business Cycle: During a boom period, sales and production increase, leading to higher requirements for working capital (more inventory, receivables). During a recession, the need for working capital decreases.
4. Seasonal Factors: Businesses with seasonal operations require more working capital during the peak season to stock up inventory and manage higher sales volumes.
5. Production Cycle: The time taken to convert raw materials into finished goods affects working capital. A longer production cycle means more funds tied up in work-in-progress, increasing working capital needs.
6. Credit Allowed: If a business provides credit to its customers, it increases the level of receivables, thus increasing the need for working capital.
7. Credit Availed: If a business receives favourable credit terms from its suppliers, it reduces the need for working capital as part of the purchases are financed by trade credit (a form of current liability).
8. Operating Efficiency: High operating efficiency (e.g., faster inventory turnover, quick collection of receivables) reduces the need for working capital.
9. Availability of Raw Material: Consistent and timely availability of raw materials reduces the need to maintain large inventories, lowering working capital requirements.
10. Growth Prospects: A growing company will need more working capital to support increased sales and production activities.
11. Level of Competition: Higher competition might necessitate offering liberal credit terms to customers or maintaining larger stocks, increasing working capital needs.
12. Inflation: Rising prices require more funds to maintain the same level of inventory and manage expenses, increasing working capital requirements.
Example 3. A sweet shop in Kolkata that experiences a huge surge in sales during festivals like Diwali and Durga Puja needs significant funds to buy extra raw materials (milk, sugar, etc.) and pay temporary staff during these periods. Why does the working capital requirement increase during festivals?
Answer:
The working capital requirement increases during festivals due to Seasonal Factors and Scale of Operations (temporarily increased). The shop needs to stock up more inventory (raw materials and finished sweets) and meet higher short-term expenses (wages for temporary staff), all of which are components of working capital.