Financial Management

Chapter 9
Financial Management

Business finance refers to the money that is required by an organisation for carrying out its
various business activities.

Need for Business Finance

An organisation requires business finance for carrying out one or more of the following
business activities:
 To set up a new business
 To carry out the business
 For expanding and modernising the business
 For purchasing various assets required for the operation of business. These assets can be
tangible assets such as machinery, building, etc as well as intangible assets in the form of
patents and trademarks.
 For carrying out day-to-day operations of the business such as payment of salaries,
purchasing of raw material, etc.

Financial Management
 Refers to the efficient acquisition, allocation and usage of funds by the company.
 It is carried out with the primary aim of reducing the cost of the funds that are procured,
minimising the risk and effective distribution of funds to different opportunities.

Importance of Financial Management

OR
Financial Management and Health of Business
OR
Items in Financial Statements Affected by Financial Management Decisions
It is said that the financial management decisions directly affect the financial health of a
business. The impact of these decisions is reflected in various financial statements of the
company such as Trading and Profit & Loss Account and Balance Sheet. The following are

1
Financial Management

the four aspects of financial statements that are affected by financial management decisions:
i. The amount and structure of fixed assets: A decision to invest more in a particular type
of fixed asset would increase its share in the overall composition of fixed assets. For
instance, a financial management decision to invest more in fixed assets would directly
increase the size of the fixed assets held by the business.
ii. Items in the profit and loss account: Various items in the profit and loss account such as
interest rate, depreciation, etc. are directly affected by the financial decisions of the
company. For instance, a decision taken to increase the quantum of debt directly
increases the future interest liability of the company.
iii. The composition of funds used: The composition of funds used by a company refers to
the short-term and long-term financing sources used by that company. It is determined by
the company’s decisions regarding liquidity and profitability. For instance, a company
aiming at higher liquidity would rely more on long-term financing and vice versa.
iv. The proportion of debt, equity, etc. in long-term financing: What proportion of the long-
term finance is to be raised by the way of debt or equity is a financial decision, which in
itself is a part of financial management.
v. The quantum and composition of current assets: The amount of current assets (i.e.,
working capital) that the organisation holds depends on the financial decisions pertaining
to the amount of fixed assets to be held. A decision to increase the quantum of fixed
assets directly increases the working capital requirements of the business and vice versa.

Objectives of Financial Management

OR
Wealth Maximisation Concept
 Wealth maximisation concept refers to those financial decisions that aim at maximising
the shareholders’ wealth.
 The primary objective of wealth management for a company is to opt for those financial
decisions that prove gainful from the point of view of its shareholders.
 The shareholders are said to gain when the market value of the shares held by them rises,
which in turn takes place when the benefits from the financial decisions made by the
company exceeds the cost involved.

2
Financial Management

 When the financial decisions successfully fulfil the objective of wealth maximisation,
other objectives such as proper utilisation of funds, maintenance of liquidity,
maximisation of profits and meeting financial obligations are automatically fulfilled.

Financial Decisions / Issues Pertaining to Financial Operations

The following are the three broad categories of financial decisions to be taken by the
financial manager of an organisation:
 Investment Decision
 Financing Decision
 Dividend Decision

Investment Decision
They refer to the decisions regarding where to invest the funds so as to earn the highest
possible returns on investment. These decisions can further be bifurcated into two categories,
namely long-term investment decisions and short-term investment decisions.
 Long-term investment decisions: These are those decisions that affect a business’s long-
term earning capacity and profitability. For example, investment in a new machine and
purchase of a new building are such decisions. They are also known as ‘Capital
budgeting decisions’.

3
Financial Management

 Short-term investment decisions: These are those decisions that affect a business’s day-
to-day working operations. For example, decisions regarding cash or bill receivables are
two such decisions. These decisions are also known as ‘Working capital decisions’.

Factors Affecting Capital Budgeting Decisions

1) Expected cash flow: The amount of cash flow that is expected from investment in a large
project must be properly analysed before taking the investment decision. The amount of
cash flow should be such that it is sufficient to meet the daily requirements of the
business.
2) Expected return: This is the most important criteria for investment decision in any
project. Investment projects associated with a greater rate of return are preferred over
those that offer a less rate of return.
3) Degree of risk: Every investment project involves a certain degree of risk. The risks
associated with investment in a project must be calculated properly before taking the
investment decision. In this regard, those investment proposals that involve a moderate
degree of risk are preferred.
4) Criteria of investment: Various other criteria such as availability of raw materials,
availability of inputs and technology used also affect the investment decision. Various
alternatives for investment must be weighed properly on various grounds and
accordingly, an appropriate decision must be taken.

4
Financial Management

Financing Decision
They refer to the decisions regarding the identification of various sources of funds (as debt
and equity) and deciding the best combination among them. These decisions are taken on the
basis of risk and profitability of various alternatives.

Factors Affecting Financing Decision
1) Cost of raising funds: Those sources of funds are preferred that involve minimum cost.
2) Risk involved: Sources of funds that involve moderate risk are preferred over those that
involve high risk. For instance, debt or debentures involve the risk of default payment
which must be carefully analysed before taking the debt.
3) Floatation cost: These are the costs involved in the process of raising funds. They can be
in the form of broker’s commission, fees of underwriters, etc. Those sources of funds are
preferred that involve minimum floatation cost.
4) Position of the company in terms of cash flow: A company with a stronger cash flow
position may easily opt for borrowed funds. On the other hand, companies with shortage
of cash flow may opt for shareholders’ fund.
5) Operational cost: A company having high fixed operational cost such as rent of the
building and salaries must opt for owner’s fund. This is because high fixed operational
cost is generally associated with risk of default on payment of interest. On the other hand,
a company with low operational costs may opt for borrowed funds.
6) Capital market conditions: During the period of a rising capital market, it is easy to
obtain funds through equity. On the contrary, during depression, it becomes difficult to
raise funds through equity. Therefore, in such situations, it is preferable to raise funds
through debt.
7) Considerations of control: Issuing more of equity dilutes the control of management over
the operations of the company. On the other hand, debt has no such considerations. So,
companies that are apprehensive of the dilution of control opt for more of debt and less of
equity.

5
Financial Management


Dividend Decision
They refer to the decisions regarding the distribution of profit or surplus of the company. The
profits can either be distributed to the shareholders in the form of dividends or retained by the
company itself.

Factors Affecting the Dividend Decisions
1) Amount of earnings: As a firm pays dividends out of its own earnings (either current or
past), it can be said that companies with higher earnings are in a position to pay a higher
amount of dividend to its shareholders and vice versa.
2) Stable earnings: A company with stable and smooth earnings is in a position to distribute
higher dividend as compared to those that have an unstable earning.
3) Stable dividends: In general, companies try to avoid frequent fluctuations in dividend per
share and opt for increasing (or decreasing) their value only when there is a consistent
rise (or fall) in the earnings of the company.
4) Growth prospects: Companies aiming for a higher growth level or expansion of
operations retain a higher portion of the earnings with themselves for re-investment,
thereby distributing lesser dividends.
5) Cash flow position: As dividend payments involve cash outflow from the company,
companies low on cash/low on liquidity distribute lower dividends than those with high
cash and liquidity.

6
Financial Management

6) Preference of shareholders: While distributing the dividends, a company must also keep
in mind the preferences of its shareholders. For instance, if the shareholders prefer at least
a certain minimum amount of dividend, then the company is likely to declare the same.
7) Taxation policy: If the taxation policy is such that a high rate of tax is levied on dividend
distribution, then the companies are likely to distribute lower dividends and vice versa.
8) Stock market reactions: The amount of dividend that a company distributes directly
affects its stock market prices. An increase in dividend by a company is viewed as a
favourable sign by the investors and the stock price of the company goes up. On the other
hand, a fall in the dividends adversely affects its stock prices. These reactions must be
taken into account while taking the dividend decisions.
9) Contractual constraints: Sometimes, while giving out loans to a company, the lender
may impose some restrictions in the form of certain contractual agreements. One of these
restrictions can be related to the dividend paid in the future. In such cases, the company
has to abide by such agreements when distributing the dividends.
10) Access to capital market: The companies that have a greater access to the capital market
tend to pay higher dividends as their reliability on the retained earnings is less.
11) Legal constraints: Companies have to adhere to the rules and policies laid out by the
Companies Act while declaring the dividends.

7
Financial Management

Financial Planning
It involves designing the blueprint of the overall financial operations of a company such that
right amount of funds are available for various operations at the right time. That is, it tends to
forecast what amount of fund would be required at what time as per the growth and
performance of the company.
Objectives of Financial Planning
Proper financial planning is a prerequisite for the successful growth of any organisation,
regardless of whether they are new or existing ones. The two main objectives of financial
planning are as given below:
1) Ensure timely availability of funds: Financial planning involves estimating the
amount of funds required for various business operations and the time when these
funds would be required. It also involves identifying the probable sources from which
the funds can be obtained.
2) Proper utilisation of funds: It implies ensuring that situations of both inadequate
funds as well as surplus funds are avoided. While on the one hand, inadequate funds
hinder the smooth operations of the firm; on the other hand, excess funds add to the
cost of business and encourage unnecessary and wasteful expenditure. Thus, financial
planning ensures that the funds are properly and optimally utilised.
Types of Financial Planning
1) Long-term financial planning: It involves planning for long-term (i.e., more than one
year) investment and growth. It mainly comprises planning for capital expenditure of
the company.
2) Short-term financial planning: It involves planning for short-term (i.e., less than a
year). For example, preparing the budgets for the company.
Steps Involved in Financial Planning
Following are the steps involved in financial planning:
1) Preparation of sales forecast: As a first step, an estimate is made regarding the
amount of sales for the period for which planning is being performed.
2) Preparation of financial statements: Next, financial statements are prepared keeping
in mind the requirement of fixed capital and working capital.
3) Estimation of expected profits: After the preparation of financial statements, the

8
Financial Management

expected profits from the investment are estimated. This further helps in estimating
the proportion of required funds that can be financed internally and the proportion
that would require external funding.
4) Identifying sources of external funding: Once the estimation of the requirement is
done, various external sources from which funds can be raised are identified and
analysed.
5) Preparation of final budget: After performing all the above mentioned steps, the
final budgets or plans are made.

Importance of Financial Planning

Financial planning plays a crucial role in the success of an organisation. Its importance
can be highlighted from the following factors:
1) Helps in facing eventual situations: Financial planning helps in forecasting the
future situations. In this way, it prepares an organisation to cope with the adverse
situations in a better manner.
2) Helps in avoiding surprises and shocks: Through financial planning, an organisation
can detect situations of shortage or surplus of funds that may arise in future.
Therefore, it prepares the managers in advance for such situations.

9
Financial Management

3) Improves coordination: Through financial planning, various business activities such

as sales and production are coordinated in a better manner. Such coordination ensures
smooth functioning of the business.
4) Reduces wastages and duplicity: Financial planning clearly defines the policies and
procedures for working, which in turn helps to reduce duplication of work as well as
avoid wastage of time and efforts.
5) Helps in optimum utilisation of funds: It ensures that situations of inadequate as well
as excess funds are avoided, thereby ensuring the funds are properly and optimally
utilised.
6) Link between the present and the future: Financial planning acts as a link between
the present and the future. This is done by providing such information as future
availability and requirement of funds.
7) Evaluation of performance: Financial planning clearly determines the targets and
policies of an organisation. In this way, it helps in evaluating the current work
performances in a better manner.

Difference between Financial Planning and Financial Management

Basis of
Financial Planning
Difference
Refers to the process of estimating
the amount of funds that would be
Meaning required by the business as well as
determining the sources through
which these would be obtained.
Aims at ensuring smooth operations
by considering the requirement of
Aim
funds against their availability.
Has a narrow scope and is a part of
Scope
financial management
Primary objective is to manage
various activities related to finance
Primary Objective
in a company.
Financial Management
Refers to the efficient acquisition,
allocation and usage of funds of the
company.
Aims at determining the best
investment alternative by
considering the relative costs and
benefits.
Has a wider scope.
Primary objective is to ensure that
funds are available to the company
as and when required and that
unnecessary fund raising is avoided.

10
Financial Management

It refers to the combination of borrowed funds (such as loans and debentures) and owners’
funds (such as equity share capital and preference share capital) that a company uses for
financing its fund requirements.
Usually, capital structure is simply referred to as the combination of debt and equity used by
a company for financing its fund requirements. Algebraically,
Debt Debt
Capital Structure is or,
Equity Debt + Equity
Capital Structure- The Optimisation of Risk and Return
The two sources of funds, namely debt and equity involve both risks and returns.
 Debt- A cheaper source of finance than equity
The low cost associated with debt is attributed to the following two factors:
i. In case of debt, the lender’s risk is lower than that in case of equity shareholders.
This is because the lender of debt is assured a fixed return in terms of the interest
rate. As against this, the equity shareholders are not assured any fixed return on
their shareholdings. This guarantee of return in case of debt implies that it
requires a low rate of return which in turn suggests a low cost.
ii. Interest paid on debt is a tax-deductible item. On the other hand, tax deductions
cannot be availed on dividends paid.
The above mentioned factors suggest that the higher the use of debt, the lower is
the overall cost of capital for the firm.
 Debt- A high risk source
Although debt is a cheaper source of finance, it involves high risk. This is because in
case of debt, the repayment of principle amount along with the interest rate is
obligatory for the firm. In case the firm fails to make these payments, it may be
forced into liquidation. That is, higher use of debt increases the financial risk for a
firm. As against this, equity shareholding is not associated with any such risk.
Thus, the decision regarding the capital structure should be taken very carefully after
analysing both the cost as well as risk involved in various sources.




11
Financial Management

Financial Risk
It refers to the probability that the company would not be able to meet its fixed financial obligations
like interest payment, preference dividend and other such repayment obligations.
It arises when the proportion of debt in the capital structure increases to a large extent. This is
because it is obligatory for the company to pay the interest charges on debt along with the principle
amount; and in case of high debt, it is possible that the firm is not able to meet its obligations.
Higher debt  Higher payment obligations  Higher chances of default on payment
Higher financial risk for the company.

Financial Leverage
It refers to the proportion of debt in the total capital of a firm. Algebraically,
Debt Debt
Financial Leverage = or
Equity Debt + Equity
Note: A rise in the financial leverage reduces the cost of capital but increases the financial
risk. This is because a rise in the financial leverage implies a rise in the proportion of debt in
the overall capital, which is considered to be less costly but more risky.

Trading on Equity and its Advantages

 Trading on equity refers to the practice of raising the proportion of debt in the overall
capital structure of the company such that the earnings per share increase.
 A company benefits from Trading on Equity when
Rate of return on investment > Rate of interest on the borrowed fund
It should be noted that this simply indicates the situation of favourable financial leverage.
The higher the difference between the return on investment and the rate of interest on
debt, the higher is the earnings per share.
Where,
Earnings Before Tax (EBT)
Return on Investment =
Total Investment
Note: Reckless use of trading on equity is not advisable. This is because although
increase in the proportion of debt may increase the earnings per share, it may also
increase the financial risk for the firm.

12
Financial Management

Factors Affecting the Choice of Capital Structure

1) Position of cash flow: The cash flows (the inflows and outflows of cash) of a company
should be such that it is able to cover its various payment obligations (such as interest
payments and normal expenses of the business) and is left with some surplus as well. In
this regard, the company opts for debt capital only in a position of strong cash flow. This
is because in case of debt, cash is required to pay the interest as well as the principle
amount on the debt.
a. Strong Cash flow  More debt
b. Low Cash flow  More Equity
2) Debt-Service Coverage Ratio (DSCR): This ratio shows the cash payment obligations of
the company as against the availability of cash. That is, it reflects the cash flow position
of the company. Algebraically,
Profit After Tax + Depreciation +Interest +Non Cash - Expense
DSCR =
Preference Dividend +Interest +Repayment of Obligation

Higher DSCR  Higher cash flow  Company can increase the proportion of debt in its
capital structure.
3) Equity cost: The rate of return expected by the shareholders is directly related to the risk
associated with their investment. As the financial risk faced by the company increases,
the shareholders’ expectation of rate of return increases and vice versa.
Now, as the company increases the component of debt, the financial risk faced by it also
increases. Therefore, the shareholders’ expectation of rate of return increases. This
relationship suggests that a company cannot increase the component of debt in its capital
structure beyond a certain point.
a. Higher financial risk  Greater expectation of rate of return on equity High cost of
equity  Difficult to opt for equity
b. Lower financial risk  Lower expectation of rate of return on equityLow cost of
equity  Easy to opt for equity
4) Condition of stock market: In situations of a good stock market, a company can easily
opt for equity share capital. As against this, in case of poor stock conditions, it becomes
difficult for the company to opt for equity share.

13
Financial Management

a. Good stock market condition  Easy to opt for equity

b. Poor stock market condition  Difficult to opt for equity
5) Interest Coverage Ratio: It refers to the number of times the ‘earnings before interest and
tax’ (EBIT) is able to cover the interest obligations of the company. The higher this ratio,
the higher is the number of times that the company would be able to meet its interest
obligations and the lesser is the financial risk. Thus, the company can opt for a higher
proportion of debt in the capital structure and vice versa.
a. High interest coverage ratio Low financial risk  Higher proportion of debt
b. Low interest coverage ratio High financial risk  Lower proportion of debt
6) Floatation cost: It refers to the cost of raising funds such as broker’s commission and
underwriting commission. The higher the floatation cost involved in raising funds from a
particular source, the lower is its proportion in the capital structure. For instance, if public
issue of shares involves higher floatation cost than debt, then the company would opt for
more of debt and less of equity in the capital structure.
7) Financial and operating risk: Financial risk refers to the probability that the business
would not be able to meet its interest payment obligations. Operating risk (also known as
business risk), on the other hand, is the risk related to the operating cost of the business.
The higher the fixed operating costs of a business, the higher is the business risk for the
company. High financial risk and operating risk for a company suggest that the capacity
of a company to use debt is low.
a. Financial risk + Operating risk = Total risk
b. Higher total risk  Lower proportion of debt
c. Lower total risk  Higher proportion of debt
8) Regulatory guidelines: Every company has to operate as per the regulatory guidelines
framed by the law which determines procedures to be followed while raising the funds
from different sources. The more liberal the guidelines, the easier it is to obtain the funds
from a particular source and hence the greater is the proportion of that fund in the capital
structure.
9) Returns on investment: When a company expects higher returns on invested capital, it
can benefit from trading on equity. In such a case, its ability to use higher debt increases.

14
Financial Management

a. Higher return on investment  Benefit from trading on equity  Higher proportion

of debt
b. Lower return on investment  No benefit from trading on equity  Lower proportion
of debt
10) Rate of interest on debt: Rate of interest holds a direct relationship with cost of debt. The
lower the rate of interest on debt, the lower is the cost of debt and thereby, the easier it is
to increase the proportion of debt in the capital structure and vice versa.
a. Lower rate of interest  Low cost of debt Higher proportion of debt in capital
structure
b. Higher rate of interest  High cost of debt Lower proportion of debt in capital
structure
11) Tax rate: As interest paid on debt is a tax-deductible expense, this suggests that the
higher the tax rate, the lower is the cost of debt and therefore, the higher is the probability
for the firm to increase the proportion of debt in its capital structure.
a. High tax rate  Cheaper debt  Higher proportion of debt in capital structure
b. Low tax rate  Costly debt  Lower proportion of debt in capital structure
12) Maintenance of flexibility: As the company increases the proportion of debt, its ability to
further increase the debt in future decreases. This may hinder the company from meeting
even its emergency expenses. Thus, the company should maintain a balance between
equity and debt in the capital structure.
13) Considerations of control: Issue of equity dilutes the management’s control over the
company. On the other hand, debt has no such implications. These control considerations
must be kept in mind while raising funds through equity or debt. Those organisations that
are wary of losing the management’s control opt for less of equity and vice versa.
14) Capital structure adopted by other companies: The industry norms and the capital
structure opted by other companies act as guidelines for a company regarding the
proportion of debt and equity in its own capital structure.

15
Financial Management

Fixed Assets and Current Assets

Basis of Difference Fixed Assets Current Assets
Refer to those assets which are Refer to those assets which get
invested in a company for a converted in cash or cash
Meaning longer time period, generally equivalents within a short span
more than one year. of time (less than one year) and
provide liquidity to a business
They affect the growth and They affect the liquidity of the
Implication
profitability of the business. business.
They are financed through They are financed through both
long-term liabilities (such as long-term and short-term
Mode of Finance
long-term loans, preference liabilities.
shares)
Example Plant, machinery, furniture Inventories, debtors

Capital Budgeting Decisions/ Investment Decision

OR
Capital Budgeting Decision
 It refers to the decisions regarding the allocation of fixed capital to different projects.
 It comprises of such investment decisions as attainment of new assets, expansion and
modernisation.
 Such decisions directly affect a business’s long-term growth, profitability and risk.
Importance of Capital Budgeting Decision
i. Long-term implications on growth: As investment on capital assets (long-term
assets) yield returns in the future, they are said to have long-term implications for the
company in the sense that it affects its future growth prospects.
ii. Huge amount of funds involved: Investing in fixed capital involves a large amount of
funds. These funds remain blocked in the business for a longer period of time without
yielding any immediate returns. Therefore, such decisions once made are difficult to
change.

16
Financial Management

iii. High risk involved: As fixed assets involve huge amount of money, they also involve
huge risk (in terms of cost-return relationship) and have an impact on the long-term
existence of the company.
iv. Irreversible decisions: These decisions once made are irrevocable. This is because
reversing a capital budgeting decision involves huge cost. Once a huge investment is
made on a project, withdrawing it would mean huge losses.

Factors Affecting Requirement of Fixed Capital

i. Type of business: The amount of fixed capital required by a company depends, to a large
extent, on the type of business that it deals in. Organisations that deal in services or
trading (having a small operating cycle) require less fixed capital. In contrast, a
manufacturing firm involving a large operating cycle would require large amount of fixed
capital.
Service or trading organisations → Small fixed capital requirement
Manufacturing organisations → Large fixed capital requirement

17
Financial Management

ii. Scale of operations: Higher scale of operations implies that a larger amount needs to be
invested in plants, land, building, etc., and thereby it requires large fixed capital and vice
versa.
High scale of operation → Large fixed capital requirement
Small scale of operation → Small fixed capital requirement
iii. Alternative techniques of production: An organisation can opt for either capital-intensive
techniques or labour-intensive techniques of production. Organisations that follow
capital-intensive techniques require higher investment in plants and machineries.
Therefore, they require a larger amount of fixed capital. In contrast, organisations that
follow labour-intensive techniques require lower amount of fixed capital.
Capital-intensive techniques → Large fixed capital requirement
Labour-intensive techniques → Small fixed capital requirement
iv. Growth prospects: Higher growth and expansion of a company is associated with higher
production, more sales, more inputs, etc. This requires higher level of machinery and
equipments. Thus, organisations with high growth prospects require higher amount of
fixed capital and vice versa.
High growth prospects→ Large fixed capital requirement
Low growth prospects→ Low fixed capital requirement
v. Regular upgradation of technology: Organisations having machinery or equipments that
are prone to becoming obsolete frequently require higher investment in fixed capital. This
is because regular replacement of obsolete equipments requires large investment in fixed
capital.
vi. Available alternatives for financing: One of the alternatives for financing can be
obtaining the assets on lease. If leasing facilities are easily available in the financial
market, then it is more feasible for the company to obtain the assets on lease rather than
purchasing it. In this way, the need to invest a huge sum in fixed assets considerably
reduces, which in turn reduces the fixed capital requirements.
Easy availability of leasing facility → Low fixed capital requirement
Difficulty in obtaining assets on lease → High fixed capital requirement

18
Financial Management

vii. Possibility of collaboration: At times, business organisations undergo collaboration with

each other and jointly establish certain facilities. In such cases, an individual
organisation’s requirement for fixed capital reduces.

Working Capital
It refers to the investment of a company in current assets (such as cash in hand, debtors and
stock).
Working Capital Affects Both Liquidity and Profitability
As working capital increases, the liquidity of business also increases. However, increase
in working capital (due to increase in current assets) is associated with low returns,
thereby reducing profitability.
For example, an increase in the inventory of the business increases its liquidity, but since
the stock is kept idle, it does not have any profitability. However, low working capital is
also not suitable as it hinders the day-to-day operations of the business. Thus, the
working capital should be such that a balance is maintained between profitability and
liquidity.
High working capital  High liquidity, but low profitability
Net Working Capital
It refers to the difference between current assets and current liabilities. Algebraically,
Net Working Capital = Current Assets – Current Liabilities.

Factors Affecting the Requirements of Working Capital

i. Type of business: Organisations that deal in services or trading (having small operating
cycle) require less working capital than organisations dealing in manufacturing. This is
because in organisations such as service or trading, the raw materials are generally the
same as the final outputs and the sales transaction takes place immediately. In contrast, a
manufacturing firm involves a large operating cycle and the raw materials need to be
converted into finished goods before they are finally sold. Therefore, such firms require
large working capital.
Service or trading organisations → Small working capital requirement
Manufacturing organisations → La rge working capital requirement

19
Financial Management

ii. Extent of credit allowed by the firm: Credit implies allowing sale proceeds without
immediate receipt of the cash payment. If a company follows a liberal credit policy, then
its number of debtors increases. This in turn increases the requirement of working capital
for the business. On the other hand, a stringent credit policy reduces the requirement of
working capital.
Liberal credit policy → Large working capital requirement
Stringent credit policy → Small working capital requirement
iii. Extent of availability of raw material: If the raw materials required by the company are
such that they are easily available, then this suggests that the firm need not maintain a
large stock of inventories of raw material. In such situations, the company requires less
working capital. On the other hand, if the raw materials are not easily available or their
supply is not smooth, then the company must maintain a huge stock of raw material to
ensure uninterrupted operations, thereby requiring a large working capital.
Easy availability of raw material → Low working capital requirement
Difficulty in obtaining raw material → High working capital requirement
iv. Scale of operations: Companies operating on a large scale require large working capital.
This is because such companies need to maintain high stock of inventory and debtors. In
contrast, if the scale of operations is small, the requirement of working capital will be
less.
Large scale of operation → Large working capital requirement
Small scale of operation → Low working capital requirement
v. Fluctuations in business cycle: During a boom period, the market flourishes and thereby
there is higher sale, higher production, higher stock and debtors. Thus, during this period
the need for working capital by a company increases. As against this, in a period of
depression, there is low demand, lesser production and sale, etc. Therefore, the
requirement for working capital is also less.
Boom → Large working capital requirement
Depression→ Small working capital requirement
vi. Growth Prospects: Higher growth and expansion for a company is associated with higher
production, more sales, more inputs, etc. Thus, companies with higher growth prospects
require higher amount of working capital and vice versa.

20
Financial Management

High growth prospects→ Large working capital requirement

Low growth prospects→ Small working capital requirement
vii. Seasonal factors related to operation: During the peak season of their business activity,
organisations require high working capital and vice versa.
viii. Extent of credit availed: The higher the possibility of credit that can be availed from the
suppliers, the lower is the requirement of working capital and vice versa.
ix. Extent of competition: The higher the extent of competition in the market, the larger is
the amount of stock of goods that the firms must maintain to meet the demand, and
therefore the higher is the requirement of working capital.
x. Inflation: A rise in the rate of inflation implies that the prices of raw materials, labour,
etc. increase. This suggests that larger amount of funds would be required to maintain
even the existing volume of production and sales. This in turn increases the requirement
of working capital. On the other hand, a low rate of inflation implies less requirement of
working capital for a business.
High rate of inflation→ Large working capital requirement
Low rate of inflation→ Small working capital requirement
Note: The extent of effect of rate of inflation also depends on how far the firm is able to
increase the price of its own good. If the firm is simultaneously able to increase the price
of its own good, then it need not increase the working capital with the increase in rate of
inflation.
xi. Operating efficiency of the firm: A high degree of efficiency suggests that the firm
utilises its raw materials and other inputs optimally with minimum wastage. This
suggests that the firm can manage its operations even with low stock of inventory, and
thereby requires low working capital. (A rise in the efficiency of a firm is reflected in a
higher inventory turnover ratio and higher debtors turnover ratio.) On the contrary, firms
that are less efficient require more of inputs and raw materials, and thereby require large
working capital.
High operating efficiency→ Low working capital requirement
Low operating efficiency → High working capital requirement

21
Financial Management

Operating Cycle and the Requirement of Working Capital

Operating cycle refers to the time period between the conversion of raw materials into
finished goods. The following activities take place in a typical operating cycle.
i. Purchase of raw materials
ii. Making payments for other inputs such as labour and electricity.
iii. Using the various inputs in the production process and converting the raw materials into
finished products
iv. Selling the finished goods so produced, either for cash or for credit
v. In case sale takes place for credit, then converting the receivables into cash
The longer the operating cycle, the larger is the amount of working capital that is required
by the business and vice versa. In this regard, manufacturing firms with longer operating
cycles would require greater working capital than that required by trading firms which
have shorter operating cycles. This is because manufacturing firms are required to
maintain a certain stock of raw materials, semi-finished goods and finished goods for
their smooth functioning.

22