The Shri Ram School Moulsari Campus

Subject: COMMERCE
Class: XII
Notes: Fixed and Working capital

The term "finance" refers to the funds or capital required to carry out business
activities. It involves planning, acquiring, managing, and utilizing funds to meet the
various needs of the business, such as starting operations, expanding, purchasing assets,
paying liabilities, and ensuring smooth day-to-day functioning.
Importance of finance to a business concern
i. A firm can meet its liabilities in time and raise its credit standing.
ii. It can take advantage of business opportunities.
iii. Finance helps to bridge the gap between production and sales.
iv. The firm can face recession, trade cycles and other crisis easily.
v. The firm can carry on its business smoothly and without interruptions.
vi. It can replace plant and machinery in time and improve efficiency.
Meaning of financial planning:
Financial planning is the process of ensuring that enough funds are available at the right time.
It involves:
• Estimating the financial requirements of an organisation,
• choosing the sources of funds and
• deciding how the funds are to be utilised.
Importance of Financial Planning
1. Helps a business enterprise to avoid the problem of shortage and surplus of funds
2. Serves as a guide in developing a sound capital structure (proper balance between
equity and debt) so as to maximise returns to the shareholders.
3. Helps in effective utilisation of funds.
4. It enables the management to exercise effective control over the financial activities of
an enterprise.
5. Helps to prepare the company to face business shocks and surprises in future.
Features of financial planning
i. Financial planning decides the when, how and why of financial activities.
ii. It is future oriented and involves forecasting.
iii. It decides the objectives, policies, procedure and methods concerning funds.
iv. Financial planning has a wide scope and includes.
• Estimating the financial requirements of an organisation,
• choosing the Sources of funds and
• deciding how the funds are to be Utilised.
List of sources of finance for a sole proprietorship business.
i. Owner’s own contribution of capital
ii. Retained profits
iii. Loans from friends and relatives
iv. Short term loans from commercial banks and long-term loans from financial
institutions
v. Trade credit from suppliers
List of sources of finance for a Partnership business
i. Partners’ contribution of capital in an agreed ratio
ii. Retained profits
iii. Loans advanced by partners to the firm
iv. Short term loans from commercial banks and long-term loans from financial
institutions
v. Trade credit from suppliers
vi. Machinery and equipment can be bought on hire purchase or instalment credit
Capital structure
• Capital structure is the composition of the amount of long-term funds. It refers to the
specific mix of debt and equity used to finance the company’s assets and operations.
• Long term funds comprise of owner’s funds (equity share capital, preference share
capital and retained earnings and borrowed funds (debentures and long-term loans).
• When the proportion of debt and equity is such that it results in increase in
shareholders wealth, the capital structure may be called optimum.
Capital gearing ratio (financial leverage)
The ratio between equity (owned funds) and debt (borrowed funds) is called capital gearing
ratio. A company is considered highly geared or trading on thin equity when the proportion
of debt is high. A company is trading on thick equity when the proportion of equity is higher
than debt/low gearing.

Factors that affect the capital structure of a company

1. Exercise of control:
Equity shareholders have voting rights and the control of the company is in their
hands. If promoters want to retain control they must not issue further equity shares to
the public and should raise funds by issuing debentures or preference share capital.
2. Need for flexibility:
A good capital structure should have flexibility so that changes can be made to it
whenever required. Equity shares cannot be paid off during the lifetime of the
company. Debentures and preference shares can be paid off whenever the company
wishes. Companies should ensure minimum restrictions in loan agreements.
3. Nature of business:
• Companies enjoying regular and liberal earnings can use more debt.
• Companies with fluctuating demand and earnings would be better off by
raising funds through equity.
• New and stagnant companies find it easier to raise funds through equity while
established and growing companies are able to issue debentures and
preference share capital easily.
4. Cost of financing:
*In a good capital structure, cost of capital should be reasonably low.
* Normally, cost of debt is lower than cost of equity. Issue expenses or floatation costs of
shares are high.
* Higher rate of tax makes debt financing more attractive.
5. Capital Market Conditions:
During boom investors are willing to take risk and invest in equity shares. During a
down swing investors prefer safe investment with a fixed rate of return and would
invest in preference shares or debentures.
6.Period and purpose of financing:
* Modernisation and expansion programmes are better financed through preference shares
and debentures.
*Fir funds required for permanent investment, equity shares are appropriate choice.
7. Cash flow position:
It is possible that a company is earning profits yet not generating enough cash to meet
its fixed commitments. A projected cash flow statement can be prepared and analysed
for liquidity before deciding the debt equity ratio.
8.Need of investors:
*Enterprising investors who prefer capital gains and a say in the management of the company
may issue equity shares.
*Debentures and preference shares are issued to attract those investors who desire a regular
return and safety of investment.
9. Trading on Equity:
Trading on equity means using debt along with equity in the capital structure of a company to
increase the returns to the equity shareholders due to the presence of fixed financial charges
like interest.
Trading on Equity is advisable only when the ROI (Return on Investment) is higher than the
fixed charges paid on debt.

Fixed capital
• Fixed capital refers to the funds required for acquisition of fixed assets.
• They are permanently used in the business and are meant for generating income.
• Fixed capital is known as block capital because it is blocked permanently in the
business in the form of fixed assets and cannot be disposed off without breaking up
the business.
Factors to be considered while determining the fixed capital requirement for the
company.
1. Nature of Business:
• Manufacturing firms require heavy investment in fixed assets and hence more
fixed capital.
• Public utility undertakings like railways and electricity supply also require heavy
investment in fixed assets and hence more fixed capital.
• Trading concerns require less investment in fixed capital.
2. Size of Business:
Large scale organizations undertaking large scale operations will require more fixed
capital than small scale firms due to high volume of production.
3. Nature of products:
*A company manufacturing capital goods will require a large amount of fixed capital , for eg.
Machinery.
*A firm producing consumer products like soap, toothpaste would require less fixed capital .
4. Method of production:
A company employing capital-intensive techniques of production like automatic
machines will require more fixed capital as compared to companies employing
labour-intensive techniques of production.
5. Mode of acquiring fixed assets:
An organization purchasing fixed assets on cash down basis will require a huge
amount of fixed capital whereas; an organization acquiring assets on lease or hire
purchase will require much lesser fixed capital.
6. Diversity of product lines:
• A multi-product manufacturing company requires more fixed capital than a
single product manufacturing company.
• Firms manufacturing each part of the finished product need more capital as
compared to firms buying component parts and assembling them.
7.Investment in intangible assets-
*Amount invested in acquiring goodwill, patents, copyrights etc affects the amount of fixed
capital needed for business.
*Higher the need for intangible assets, more will be the requirement of fixed capital.

Meaning of working capital

Working capital refers to the capital invested in current or working assets such as stock of
material and finished goods, accounts receivable, bill receivable, cash or bank balance. It
represents liquid funds which are required for meeting day-to-day expenses of the business.
Working capital is also known as circulating capital or revolving capital because,
• it keeps on circulating or revolving in business as it is invested, recovered and
reinvested repeatedly during the operating cycle of business.
• The current assets change their form from one form to the other in the ordinary course
of the business. Example they change from cash to inventory , inventory to receivables, and
receivables to cash again.

Factors that affect the working capital requirement of a company.

1. Nature of Business:
• Manufacturing firms require considerable working capital to build stock of
raw material and finished goods.
• Public utility undertakings require less working capital as they do not have to
maintain inventory.
2. Size of Business:
*Large scale organizations undertaking large scale operations will require more
working capital than small scale firms.
3. Manufacturing Cycle:
* Manufacturing cycle is the time involved in production of goods. Longer the
manufacturing cycle, larger is the requirement of working capital.
4. Rapidity of turnover:
*Turnover means the speed with which the amount of working capital is recovered by sale of
goods.
*When the turnover is rapid, the amount of working capital required is small.
5. Terms of purchase and sale:
*If a business buys goods and services on credit, and sells them in cash , then small amount
of working capital is required.
6. Credit Policy:
• More working capital is required if a liberal credit policy is followed.
• Less working capital is required in case of a tight credit policy.
7.Operating efficiency:
*Better utilisation of resources leads to reduction in costs and improves profitability, as a
result need for working capital will be less.
8.Goodwill of Business:
An enterprise enjoying a good reputation in the market can easily get short term loans
from commercial banks so it requires less working capital.

Types of working capital required by a business concern.

1. Gross working capital is the total amount of funds invested in current assets.
2. Net working capital is the excess of current assets over current liabilities.
Current assets are those assets which are converted into cash in the ordinary course of
business. Example, cash in hand, cash at bank, debtors, inventory and prepaid expenses.
Current liabilities include sundry creditors, bills payable and short-term loans.
3. Permanent Working Capital: It refers to the minimum amount of working capital
required permanently to operate the minimum level of business activity. It is permanently
locked up in current assets. It is, raised through long-term sources of finance.
(a) Initial working capital: Initial working capital is the capital required at the time of
commencement of the business. In the initial stage, the business usually does not get
credit from suppliers. Therefore, all operating expenses have to be incurred in cash. It
is generally provided by the owners.
(b) Regular Working Capital: It means that part of permanent working capital which is
required for the continuous business operations. It represents the excess of current
assets over current liabilities. It consists of enough cash to meet short-term
obligations, to build up inventory and enough stock of finished goods to ensue quick
delivery to customers.
4. Temporary/Variable Working Capital: Capital required in addition to the permanent
working capital. It is required to meet seasonal and special needs of business. It is fluctuating
in nature and is therefore also known as variable working capital. It is generally raised from
short term sources of finance.
(a) Seasonal Working Capital: It refers to the extra working capital required during
the busy seasons for firms dealing in seasonal products. Additional working
capital is required to buy extra raw material and pay for extra labour in the busy
seasons.
(b) Special Working Capital:
Special working capital refers to the extra funds required to meet future
contingencies that may arise in business. A reserve working capital should be
maintained by the business firms to act as a cushion at the time of unforeseen
emergencies like:
• special operations to meet sudden spurt in demand,
• unusually stagnant periods or depression leading to piling up of inventory,
• strikes, lockouts and natural calamities.
Distinguish between fixed capital and working capital :