Business finance is a term that consists of a wide range of activities and works which revolve around the proper utilization of money and other various valuable assets. It also refers to money and credit which is employed in the business for earning profit to run a business in a better way, there are many basic requirements of a business that are plant and machinery, building, inventory, recruitment and wages to workers and salaries to employees etc.
Two categories of financial needs
- Fixed capital requirement
- Working capital requirement
Fixed Capital Requirement: To set up a well business, an organization requires a huge amount of funds which is very necessary as it consists of plant and machinery, building, furniture & fixture etc which is used for long time period i.e. more than 1 year. The value of these assets may increase or decrease with time. For example, the value of plant and machinery decreases due to wear and tear of machinery which is also termed depreciation, and the value of assets such as land & building could increase because of an increase in market rates or due to an increase in the growth rate of the economy. Generally, manufacturing companies require more amount of fixed capital as compared to companies engaged in tertiary sector.
Working capital requirement: A business also requires a large amount of working capital to run its day-to-day activities smoothly. These activities consist of the money spent on inventories, electricity expenses, carriage inward/ outward etc. Generally, working capital requirements are required less at the point of time as these are required for less than one year and the business continues to trade in it so it keeps on circulating. Whenever a company is engaged in a special type of business during that time required for working capital increases. For example, during the festive season, sweet shops require huge funds to meet the expenses raised due to the high demand of the customers.
Factors affecting Fixed capital requirement
Investment in fixed assets is for a longer duration which is why it is known as fixed capital requirement. Fixed capital is financed through long-term sources of finance such as equity shares, preference shares, debentures, long-term loans etc. The requirement for fixed capital depends upon various factors which are explained below:
- Nature of business: The type of business, the company is involved in is the first factor which helps in deciding the requirement of fixed capital. A manufacturing company needs more fixed capital as compared to the trading company or the companies involved in business related to the tertiary sector, as these companies do not require funds for the purchase of a fixed assets like plants and machinery, furniture etc.
- Scale of operation: The companies which are operating at a large scale require more fixed capital as they need more machines & many other assets for growth and expansion and to fulfil the demand of the market, whereas small-scale enterprises require less amount of fixed capital to invest in the assets as they do not have plans to expand in near future.
- The technique of production: Companies using capital-intensive techniques require more fixed capital as compared to companies using labour-intensive techniques because companies using capital-intensive techniques make more use of plants and machinery and the company needs more fixed capital to purchase it. Finance is also required for repairing these types of machinery, for wear and tear which occur during the operational time.
- Technology Upgradation: Industry in which technology upgradation is fast like the IT sector need more amount of fixed capital because when new technology is invented, old machines become obsolete or useless and they need to buy new plants and machinery according to the trend prevailing in the market, whereas the companies where the upgradation is slow they require less fixed capital.
- Growth Prospectus: Companies which are expanding and have higher growth plans require more fixed capital as compared to the companies that have smaller growth plans because to expand their business they need to expand & enlarge their production capacity and for this require more fixed capital.
- Diversification: Companies which have plans to diversify their activities by including more range of products in their product pipeline require more fixed capital, as to produce more products the requirement of plant and machinery increases which means more fixed capital and vice versa.
- Level of collaboration/ joint ventures: If companies are preferring collaborations/ joint ventures then companies will need less fixed capital as they can share plants and machinery with their collaborators but in this case, if companies prefer to operate as an independent unit then there is more requirement of fixed capital.
- Availability of Finance and leasing facility: If companies can arrange finance and leasing facility easily then in that case they require less fixed capital as they can acquire assets on easy instalments instead of paying huge amounts at one particular period of time whereas on the other hand if easy loans and leasing facility are not available then more fixed capital is needed because companies will have to purchase plant and machinery by paying huge amounts to vendors together.
Factors affecting Working capital requirement
The firm must estimate its working capital accurately because unnecessary working capital may result in useless accumulation of inventory and wastage of capital whereas on the other side shortage of working capital results to the inefficient flow of the operating cycle and the business also fails to meet its commitment.
- Length of operating cycle: The amount of the working capital directly depends upon the length of the operating cycle. If the time period involved in the production cycle is large, then more capital is required whereas for companies having a short operating cycle the working capital requirement is less.
- Seasonal factors: The working capital requirement is constant for the companies which are engaged in the selling of goods throughout the season like wheat rice etc, whereas the companies selling seasonal goods like AC, Refrigerator blowers etc require a huge amount of capital during the season time when the demand of these goods is more.
- Credit Allowed: Credit policy refers to the average period for collection of sale proceeds. It depends upon a number of the factors such as creditworthiness of clients, industry norms etc. If a company is following a liberal credit policy, then it will require more working capital whereas if the company is following a strict policy less working capital is required.
- Credit Availed: Another factor related to credit policy is how much and for how long a period a company is getting credit from its supplier. If they provide the raw material for long-term credit, then less working capital is required otherwise if the raw material is provided by them for short-term credit then the company will require more working capital for making regular payments.
- Availability of raw material: If the raw material is easily available and the supply of raw material is fast then less amount of working capital is required because there is no need to maintain stock and if the raw material is not available easily then for smooth flow of operating cycle large amount of working is required.
- Level of competition: If the market is competitive then the company will have to adopt a liberal credit policy to supply goods on time. Higher inventories have to be maintained so more working capital is required, otherwise less competition or monopoly position of business requires less working capital.
- Inflation: If there is an increase in price then the price of raw materials and cost of labour will also increase which will result in the requirement of more working capital but in case the company is able to increase the price of its own goods as well then there will be less problem of working capital.
- Business cycle fluctuation: During the boom period the market is flourishing with more demand, more production, more stock, and more debtors which means blockage of funds in this so more amount of working capital is required whereas during the depression period low demand, less inventory is maintained, fewer debtors which mean less blockage of funds so less working capital is required.