UNIT 1

MEANING OF FINANCE:
Finance may be defined as the art and science of managing money. It includes financial
service and financial instruments. Finance also is referred as the provision of money at the
time when it is needed. Finance function is the procurement of funds and their effective
utilization in business concerns
Definition:
According to GUTHMANN and DOUGALL, business finance may be broadly defined as
“the activity concerned with the planning, raising, controlling and administering the funds
used in the business.” Financial decisions refer to decisions concerning financial matters of a
business firm. There are many kinds of financial management decisions that the firm makers
in pursuit of maximizing shareholder‟s wealth, viz., kind of assets to be acquired, pattern of
capitalization, distribution of firm‟s income etc. We can classify these decisions into three
major groups:

• Investment decisions
• Financing decision.
• Dividend decisions.
• Working capital decisions.

NATURE OF FINANCE FUNCTION:

1. In most of the organizations, financial operations are centralized. This results in

economies.
2. Finance functions are performed in all business firms, irrespective of their sizes /legal
form of organization.
3. They contribute to the survival and growth of the firm.
4. Finance function is primarily involved with the data analysis for use in decision
making.
5. Finance functions are concerned with the basic business activities of a firm, in
addition to external environmental factors which affect basic business activities,
namely, production and marketing.
6. Finance functions comprise control functions also
7. The central focus of finance function is valuation of the firm. Finance makes use of
economic tools. From Micro economics it uses theories and assumptions. From
Macroeconomics it uses forecasting models. Even though finance is concerned with
individual firm and economics is concerned with forecasting of an industry.

SCOPE OF FINANCIAL MANAGEMENT:

The main objective of financial management is to arrange sufficient finance for meeting short
term and long term needs. A financial manager will have to concentrate on the following
areas of finance function.
[Link] financial requirements: The first task of a financial manager is to estimate
short term and long term financial requirements of his business. The amount required for
purchasing fixed assets as well as needs for working capital will have to be ascertained.

[Link] capital structure: Capital structure refers to kind and proportion of different
securities for raising funds. After deciding the quantum of funds required it should be decided
which type of securities should be raised. A decision about various sources for funds should
be linked to the cost of raising funds.

3. Selecting a source of finance: An appropriate source of finance is selected after preparing

a capital structure which includes share capital, debentures, financial institutions, public
deposits etc. If finance is needed for short term periods then banks, public deposits and
financial institutions may be the appropriate. On the other hand, if long term finance is
required then share capital and debentures may be the useful.

4. Selecting a pattern of investment: When funds have been procured then a decision about
investment pattern is to be taken. A decision will have to be taken as to which assets are to be
purchased? The funds will have to be spent first on fixed assets and then an appropriate
portion will be retained for working capital and for other requirements.

5. Proper cash management: Cash management is an important task of finance manager. He

has to assess various cash needs at different times and then make arrangements for arranging
cash. Cash may be required to purchase of raw materials, make payments to creditors, meet
wage bills and meet day to day expenses. The idle cash with the business will mean that it is
not properly used.

6. Implementing financial controls: An efficient system of financial management

necessitates the use of various control devices. They are ROI, break even analysis, cost
control, ratio analysis, cost and internal audit. ROI is the best control device in order to
evaluate the performance of various financial policies.

7. Proper use of surpluses: The utilization of profits or surpluses is also an important factor
in financial management. A judicious use of surpluses is essential for expansion and
diversification plans and also in protecting the interests of share holders. A balance should
be struck in using funds for paying dividend and retaining earnings for financing expansion
plans.

FINANCIAL MANAGEMENT DECISIONS OR FINANCE FUNCTION:

Finance functions are practices and activities focused on managing a business’s financial
resources to generate profits. They are critical in acquiring and managing financial resources
and contributing to the productivity of other business functions, planning, and decision-
making activities.
Effective financial management involves various functions, including investment, dividend,
financing, and liquidity decisions. Each of these finance functions plays a crucial role in
ensuring the financial success of a business.

➢ Investment Decision
Investment decision refers to evaluating different investment opportunities and choosing the
one most likely to generate the highest returns and meet the investor’s objectives. It involves
analyzing the potential risks and rewards of different investment options and deciding based
on expected return, time horizon, risk tolerance, and liquidity needs. Investment decisions can
be made by individuals, businesses, or financial institutions and may involve investments
in stocks, bonds, real estate, or other financial instruments. Making informed investment
decisions is important for achieving financial goals and building long-term wealth.

Purpose of Investment Decision

The goal of investment decisions is to allocate resources to maximize the return on
investment while minimizing the level of risk. In other words, the aim is to make informed
decisions about where to invest money so that it generates the highest possible return while
also considering the level of risk involved.

For making investment decisions, consider the following factors:

Risk Tolerance: Assess your ability and willingness to endure market fluctuations and
potential losses.
Investment Goals: Define your financial objectives, such as retirement, home buying, or
funding education.
Time Horizon: Determine the length of time you plan to hold the investment, which impacts
the type of assets suitable for your portfolio.

➢ Dividend Decision

Dividend decision refers to how a company’s management team determines the amount
and timing of dividends paid to shareholders. This decision involves considering various
factors, such as the company’s financial performance, cash flow, and growth opportunities.
Apart from this, debt levels and the needs and expectations of shareholders. The goal is to
balance rewarding shareholders with dividends and retaining sufficient funds to reinvest in
the company’s growth and future profitability. Ultimately, the dividend decision is an
important aspect of a company’s financial strategy. It can have significant implications for
both the company and its shareholders.
Purpose of Dividend Decision

Dividend decisions aim to determine how much of a company’s profits should be distributed
to shareholders as dividends. Dividend decisions involve a trade-off between retaining
earnings to reinvest in the company and paying out earnings to shareholders. The goal is to
balance these two objectives to maximize the company’s long-term value.
Companies must consider several factors when making dividend decisions. It includes:

Profitability: Ensure consistent and sufficient profits to support dividend payments without
compromising the company's financial stability and growth prospects.

Cash Flow: Evaluate the company's cash flow to ensure it can sustain regular dividend
payouts and meet operational needs and investment opportunities.

Future Growth Plans: Consider the company's investment and expansion plans, as retaining
earnings might be necessary to fund future projects and drive long-term growth

➢ Financing Decision

A financing decision determines how an organization will fund its operations and
investments. This decision involves choosing the sources of funds a company will use to
finance its activities, such as debt, equity, or a combination of both.
The financing decision is critical to financial management, affecting the company’s ability to
generate profits, expand operations, and pay off debts. The decision must consider various
factors, including the company’s financial goals, risk tolerance, and cost of capital.
Purpose of Financing Decision
The financing decisions aim to determine how a company will fund its operations and
investments. Financing decisions involve analyzing various funding sources and choosing the
most appropriate mix of debt and equity financing to meet the company’s needs.

When making financing decisions, companies must consider:

Cost of Capital: Evaluate the cost of different financing options, such as debt and equity, to
determine the most cost-effective means of raising funds.

Financial Flexibility: Assess the company's ability to maintain financial flexibility, ensuring
it can respond to unexpected opportunities or challenges without over-leveraging.

Risk Management: Consider the risk associated with each financing option, including
interest rate risk, repayment schedules, and the impact on the company’s financial stability
and credit rating.

➢ Liquidity Decision
Liquidity decision refers to managing a company’s current assets and liabilities. It is done to
ensure sufficient cash or liquid assets to meet its short-term financial obligations. This
decision involves determining the optimal level of liquidity that a company needs to
maintain. They must consider factors such as cash flow, financial risk, and operational needs.

Purpose of Liquidity Decision

The main goal of a liquidity decision is to ensure that a company has enough liquid assets to
meet its short-term obligations, such as paying bills, salaries, and other operating expenses as
they become due. At the same time, the company must ensure that it does not hold too much
cash or other liquid assets. This can lead to lower returns on investment and reduced
profitability.

When making liquidity decisions, companies must consider:

Current Ratio: Assess the company’s ability to meet short-term obligations by comparing
current assets to current liabilities, ensuring there are enough liquid assets to cover immediate
needs.

Cash Flow Management: Evaluate the cash flow to ensure sufficient cash is available to
handle daily operations, unexpected expenses, and opportunities without facing liquidity
shortages.

Asset Liquidity: Consider the liquidity of the company's assets, ensuring that assets can be
quickly converted to cash without significant loss in value if needed to meet short-term
obligations.

ROLES AND RESPONSIBILITIES OF A FINANCIAL MANAGER:

1. Forecasting and planning

The financial manager needs to be aware of the current market trends and should be able
to assume the future too. He needs to interact with other executives and lay the business
plans carefully, shaping the future of the business firm.
2. Coordination and control
He should exhibit proper coordination with other departments and control the overall
business enterprise financially. He needs to consider all the decisions and activities of the
organization and integrate them into his financial planning.

3. Raising of funds
A business will need enough cash and liquidity to meet all its obligations. It can raise
funds in the form of debt or equity. A financial manager needs to tactfully decide the ratio
between equity and debt. Maintaining this ratio is quite necessary.

4. Allocation of funds

After raising funds through various channels, it is necessary to allocate the funds
properly. While allocating the funds, the finance should be used in an optimum manner.
While the allocation of funds, the following points should be kept in mind:
1. Size of firm and growth capacity
2. Mode of fundraising
3. Long-term or short-term assets
 5. Planning for the profit:
Making a profit is the primary objective of any business enterprise. Profit earning is
necessary for the sustenance and survival of a business organization. Profit planning
basically means apt usage of the profit earned.

An organization generates profit because of multiple factors, for instance, industry

competition, pricing, state of the economy, cost and output, mechanism of demand and
supply, and so on. There should be a healthy mix of fixed and variable factors of
production. This helps in enhancing the profitability of the business organization.
Fixed costs get incurred by the usage of fixed factors, for instance, machinery and
land. Continuous evaluation of the depreciation cost of the fixed cost of production is
also necessary. Otherwise, all these expenses can create massive fluctuations in the
overall profit of the business organization.
6. Risk management:
Each and every business is vulnerable to risks. Natural disasters like floods, fire,
cyclone, or change in the rates of interests, uncertainties in the prices of commodities
and shares, fluctuation of foreign exchange rates, etc., all lead to risks for a business.
But it is possible to cope with these risks in the form of insurance purchases or by
hedging. A financial manager has the responsibility to take care of and tackle all the
business risks. He should undertake the risk management programs like identification
of risks, and then hedge the risks effectively.

OBJECTIVES OF FINANCIAL MANAGEMENT

1. Profit maximization:
It is commonly believed that a shareholder’s objective is to maximise profit. To
achieve the goal of profit maximisation, the financial manager takes only those
actions that are expected to make a major contribution to the firm's overall profits.
The total earnings available for the firm's shareholders is commonly measured in
terms of earnings per share (EPS). Hence the decisions and actions of finance
managers should result in higher earnings per share for shareholders.

Points in favour of profit maximisation:

• It is a parameter to measure the performance of a business
• It ensures maximum welfare to the shareholders, employees and prompt payment to
the creditors
• Increase the confidence of management in expansion and diversification.
• It indicates the efficient use of funds for different requirements.

Points against profit maximisation:

• It is not a clear term like accounting profit, before tax or after tax or net profit or
gross profit.
• It encourages corrupt practices
 • It does not consider the element of risk
• Time value of money is not reflected
• Attracts cut –throat competition
• Huge profits attract government intervention
• It invites problem from workers.
• It affects the long run liquidity of a company.

2. Wealth Maximisation:
The goal of the finance function is to maximise the wealth of the owners for whom
the firm is being carried on. The wealth of corporate owners is measured by the share
prices of the stock, which is turn is based on the timing of return, cash flows and risk.
While taking decisions, only that action that is expected to increase share price should
be taken. It considers:
(a) Time value of money on investment decision
(b) The risk or uncertainty of future earnings and
(c) effects of dividend policy on the market price of shares.
Points In favour of Wealth Maximisation:
• It is a clear term
• Net effect of investment and benefits can be measured clearly.
• It considers the time value for money.
• It should be accepted universally
• It guides the management in framing a consistent strong dividend policy to reach
maximum return to the equity holders. Points against wealth maximisation:
• This concept is useful for equity shareholders not for debenture holders
• The expectations of workers, consumers and various interest groups create a greater
influence that must be respected to achieve long run wealth maximization and also for
their survival.
DIFFERENCE BETWEEN PROFIT AND WEALTH MAXIMIZATION:

Basis Profit Maximization Wealth Maximization

Goal The main goal of profit The main objective is to maximise

maximisation is to maximise a the wealth of all shareholders. It
company’s profit by decreasing encourages strategic investments that
costs or increasing revenue. It may not pay off immediately, but will
prioritises cutting costs and in the future.
immediate profit generation.

Time Horizon Generally considered a short-term Focuses on the long term.

strategy.
 Time Value of Does not consider the time value Considers the time value of money.
Money of money.

Sustainability A company looking to maximise Uses sustainable practices.

profits may not always make
sustainable decisions.

Flexibility Not as flexible because the Allows easy readjustments to

company may not be able to adapt strategies based on the company’s
to short-term market conditions. long-term goals.

Risk It can be risky to earn immediate The strategies involved tend to be not
profits, so the company must have very risky as the company seeks
a high risk tolerance. long-term sustainability.

Environmental, Environmental, social and ESG can improve a company’s

social and governance factors may not be reputation, ensure regulatory
governance factors prioritised. compliance, and build stronger
(ESG) relationships with stakeholders so
they are prioritised.

Financial Ratios Focus is on metrics like Net Profit Focuses on metrics such as earnings
Used Margin, Return on Investment, per share, price to earnings (P/E)
turnover ratio, and accounts ratio, and price to book (P/B) ratio.
receivable turnover ratio.

Value Creation More emphasis is put on Emphasis is on increasing the overall

immediate earnings. value of the company.

Maximisation Increases the earning capacity of Increases the value of the company’s
Procedure the company. stock for shareholders.

SOURCES OF FINANCE

A] LONG TERM FINANCE:

Financing means providing money for investment in the form of fixed assets and also in the
form of working capital needed for day-to-day operations

EXTERNAL SOURCES:
1. Preference Shares: Preference shares have two preferential rights. One at the time of
payment of dividend and second repayment of capital at the time of liquidation of the
company The company has the following advantages by this way of source:
• No voting rights and normally has no control over the policies.
• Finance through preference shares is less costly as compared to the equity shares.
The disadvantages of raising funds by way of preference capital are:
• Compared to equity capital it is a very expensive source of financing.
• Though there is no legal obligation to pay preference dividends, skipping them can
adversely affect the image of the firm in the capital market.
2. Equity Shares: The equity shares are the main sources of finance and the owners of
the company contribute it. It is the source of permanent capital since it does not have
a maturity date. The holders of equity shares have a control over the working of the
company. These shares are issued without creating any charge over the assets of the
company. The major advantage to raise funds through equity shares is that it does not
involve any fixed obligation for payment of dividends. The disadvantage of raising
funds by way of equity capital is high cost of capital. The rate of return required by
equity shareholders is generally higher than the rate of return required by other
investors.
3. Debentures: Debentures are certificates issued by the company acknowledging the
debt due by to its holders with or without a charge on the assets of the company. A
fixed interest has to be paid regularly till the principal has been fully repaid by the
company.
4. Institutional Assistance: The Government has set up certain special financial
corporation with the object of stimulating industrial development in the country.
These include IFC, SFC, ICICI, IDBI etc
5. Public Deposits: Public deposits are the another important source for the firms.
Companies prefer public deposits because, these deposits carry lower rate of interest
6. Lease Finance: Lease financing involves the acquisition of the economic use of an
asset through a contractual commitment to make periodic payments called lease
rentals to the person who owns the asset. Thus this is a mode of financing to acquire
the use of assets.
7. Hire Purchase: Assets involving huge amounts if other sources of long-term finance
are too costly may be acquired through hire purchase.
8. Government Assistance: The government provides finance to companies in cash
grants and other forms of direct assistance, as part of its policy of helping to develop
the national economy, especially in high technology industries and in areas of high
unemployment. Government subsidies and concessions are other modes of financing
long-term requirement. Subject to the government regulations, subsidies and
concessions are granted to business enterprises.
9. Mortgage Bonds: It is a written promise given by the company to the investor to
repay a specified sum of money at a specified rate of interest at a specified time.
10. Venture capital: Venture capital is the Money provided by investors to startup firms
and small businesses with perceived long-term growth potential. This is a very
 important source of funding for startups that do not have access to capital markets. It
typically entails high risk for the investor, but it has the potential for above-average
returns.

INTERNAL SOURCES

1. Retained Earnings : A company out of its profits, a certain percentage is retained that
amount is reinvested into the business for its development. This is also known ploughing
back of profits

2. Provision for depreciation: Depreciation means decrease in the value of the asset due to
wear and tear, lapse of time and accident. Provision for depreciation considered as one of the
source of financing to business.

B] SHORT TERM SOURCES

The sources of short-term funds used for financing variable part of working capital mainly
include the following:

1. Loans from Commercial Banks: Small-scale enterprises can raise loans from the
commercial banks with or without security. This method of financing does not require any
legal formality except that of creating a mortgage on the assets. Loan can be paid in lump
sum or in parts
2. Public Deposits: Often companies find it easy and convenient to raise short- term funds by
inviting shareholders, employees and the general public to deposit their savings with the
company. It is a simple method of raising funds from public for which the company has only
to advertise and inform the public that it is authorised by the Companies Act 1956, to accept
public deposits.

3. Trade Credit: Just as the companies sell goods on credit, they also buy raw materials,
components and other goods on credit from their suppliers. Thus, outstanding amounts
payable to the suppliers i.e., trade creditors for credit purchases are regarded as sources of
finance. Generally, suppliers grant credit to their clients for a period of 3 to 6 months. Thus,
they provide, in a way, shortterm finance to the purchasing company.

4. Discounting Bills of Exchange: When goods are sold on credit, bills of exchange are
generally drawn for acceptance by the buyers of goods. The bills are generally drawn for a
period of 3 to 6 months. In practice, the writer of the bill, instead of holding the bill till the
date of maturity, prefers to discount them with commercial banks on payment of a charge
known as discount.
5. Factoring: Factoring is a financial service designed to help firms in managing their book
debts and 18 receivables in a better manner. The book debts and receivables are assigned to a
bank called the „factor‟ and cash is realised in advance from the bank. For rendering these
services, the fee or commission charged is usually a percentage of the value of the book
debts/receivables factored. This is a method of raising short-term capital and known as
„factoring‟.

6. Bank Overdraft: Overdraft is a facility extended by the banks to their current account
holders for a shortperiod generally a week. A current account holder is allowed to withdraw
from its current deposit account up to a certain limit over the balance with the bank. The
interest is charged only on the amount actually overdrawn. The overdraft facility is also
granted against securities.
7. Cash Credit: Cash credit is an arrangement whereby the commercial banks allow
borrowing money up to a specified-limit known as „cash credit limit.‟ The cash credit facility
is allowed against the security. The cash credit limit can be revised from time to time
according to the value of securities. The money so drawn can be repaid as and when possible.
The interest is charged on the actual amount drawn during the period rather on limit
sanctioned. Arranging overdraft and cash credit with the commercial banks has become a
common method adopted by companies for meeting their short- term financial, or say,
working capital requirements.

8. Advances from Customers: One way of raising funds for short-term requirement is to
demand for advance from one‟s own customers. Examples of advances from the customers
are advance paid at the time of booking a car, a telephone connection, a flat, etc. This has
become an increasingly popular source of short-term finance among the small business
enterprises mainly due to two reasons. The enterprises do not pay any interest on advances
from their customers. Thus, advances from customers become one of the cheapest sources of
raising funds for meeting working capital requirements of companies.

9. Accrual Accounts: Generally, there is a certain amount of time gap between incomes is
earned and is actually received or expenditure becomes due and is actually paid. Salaries,
wages and taxes, for 19 example, become due at the end of the month but are usually paid in
the first week of the next month. Thus, the outstanding salaries and wages as expenses for a
week helps the enterprise in meeting their working capital requirements. This source of
raising funds does not involve any cost.

UNIT 2
MEANING OF CAPITAL
The term capital refers to the total investment of the company in terms of money, and assets.
It is also called as total wealth of the company. When the company is going to invest large
amount of finance into the business, it is called as capital. Capital is the initial and integral
part of new and existing business concern.
The capital requirements of the business concern may be classified into two categories:
(a) Fixed capital
(b) Working capital.
Fixed Capital
Fixed capital is the capital, which is needed for meeting the permanent or long-term purpose
of the business concern. Fixed capital is required mainly for the purpose of meeting capital
expenditure of the business concern and it is used over a long period. It is the amount
invested in various fixed or permanent assets, which are necessary for a business concern.
Definition of Fixed Capital
According to the definition of Hoagland, “Fixed capital is comparatively easily defined to
include land, building, machinery and other assets having a relatively permanent existence”.
Character of Fixed Capital
➢ Fixed capital is used to acquire the fixed assets of the business concern.
➢ Fixed capital meets the capital expenditure of the business concern.
➢ Fixed capital normally consists of long period.
➢ Fixed capital expenditure is of nonrecurring nature.
➢ Fixed capital can be raised only with the help of long-term sources of finance.
Working Capital
Working capital is the capital which is needed to meet the day-to-day transaction of the
business concern. It may cross working capital and net working capital. Normally working
capital consists of various compositions of current assets such as inventories, bills,
receivable,
debtors, cash, and bank balance and prepaid expenses.
According to the definition of Bonneville, “any acquisition of funds which increases
the current assets increase the Working Capital also for they are one and the same”.
Working capital is needed to meet the following purpose:
➢ Purchase of raw material
➢ Payment of wages to workers
➢ Payment of day-to-day expenses
➢ Maintenance expenditure etc.
CAPITALIZATION

Capitalization is one of the most important parts of financial decision, which is related to the
total amount of capital employed in the business concern. Understanding the concept of
capitalization leads to solve many problems in the field of financial management. Because
there is a confusion among the capital, capitalization and capital structure.

Meaning of Capitalization
Capitalization refers to the process of determining the quantum of funds that a firm needs to
run its business. Capitalization is only the par value of share capital and debenture and it does
not include reserve and surplus.

TYPES OF CAPITALIZATION
Capitalization may be classified into the following three important types based on its nature:
• Over Capitalization
• Under Capitalization
• Water Capitalization

Over Capitalization
Over capitalization refers to the company which possesses an excess of capital in relation
to its activity level and requirements. In simple means, over capitalization is more capital
than actually required and the funds are not properly used.
According to Bonneville, Dewey and Kelly, over capitalization means, “when a
business is unable to earn fair rate on its outstanding securities”.

Causes of Over Capitalization

Over capitalization arise due to the following important causes:
• Over issue of capital by the company.
• Borrowing large amount of capital at a higher rate of interest.
• Providing inadequate depreciation to the fixed assets.
• Excessive payment for acquisition of goodwill.
• High rate of taxation.
• Under estimation of capitalization rate.

Effects of Over Capitalization

Over capitalization leads to the following important effects:
• Reduce the rate of earning capacity of the shares.
• Difficulties in obtaining necessary capital to the business concern.
• It leads to fall in the market price of the shares.
• It creates problems on re-organization.
• It leads under or misutilisation of available resources.

Remedies for Over Capitalization

Over capitalization can be reduced with the help of effective management and systematic
design of the capital structure. The following are the major steps to reduce over
capitalization.
• Efficient management can reduce over capitalization.
• Redemption of preference share capital which consists of high rate of dividend.
• Reorganization of equity share capital.
• Reduction of debt capital.

Under Capitalization
Under capitalization is the opposite concept of over capitalization and it will occur when the
company’s actual capitalization is lower than the capitalization as warranted by its earning
capacity. Under capitalization is not the so-called inadequate capital.
Under capitalization can be defined by Gerstenberg, “a corporation may be under
capitalized when the rate of profit is exceptionally high in the same industry”.
Hoagland defined under capitalization as “an excess of true assets value over the
aggregate of stocks and bonds outstanding”.

Causes of Under Capitalization

Under capitalization arises due to the following important causes:
• Under estimation of capital requirements.
• Under estimation of initial and future earnings.
• Maintaining high standards of efficiency.
• Conservative dividend policy.
• Desire of control and trading on equity.

Effects of Under Capitalization

Under Capitalization leads certain effects in the company and its shareholders.
• It leads to manipulate the market value of shares.
• It increases the marketability of the shares.

• It may lead to more government control and higher taxation.

• Consumers feel that they are exploited by the company.
• It leads to high competition.

Remedies of Under Capitalization

Under Capitalization may be corrected by taking the following remedial measures:
1. Under capitalization can be compensated with the help of fresh issue of shares.
2. Increasing the par value of share may help to reduce under capitalization.
3. Under capitalization may be corrected by the issue of bonus shares to the existing
shareholders.
4. Reducing the dividend per share by way of splitting up of shares.
Watered Capitalization
If the stock or capital of the company is not mentioned by assets of equivalent value, it is
called as watered stock. In simple words, watered capital means that the realizable value of
assets of the company is less than its book value.
According to Hoagland’s definition, “A stock is said to be watered when its true value
is less than its book value.”

Causes of Watered Capital

Generally watered capital arises at the time of incorporation of a company but it also arises
during the life time of the business. The following are the main causes of watered capital:
1. Acquiring the assets of the company at high price.
2. Adopting ineffective depreciation policy.
3. Worthless intangible assets are purchased at higher price.

CAPITAL STRUCTURE:

Capital structure refers to the kinds of securities and the proportionate amounts that make up
capitalization. It is the mix of different sources of long-term sources such as equity shares,
preference shares, debentures, long-term loans and retained earnings.
The term capital structure refers to the relationship between the various long-term source
financing such as equity capital, preference share capital and debt capital. Deciding the
suitable capital structure is the important decision of the financial management because it is
closely related to the value of the firm. Capital structure is the permanent financing of the
company represented primarily by
long-term debt and equity.

Definition of Capital Structure

The following definitions clearly initiate, the meaning and objective of the capital structures.
According to the definition of Gerestenbeg, “Capital Structure of a company refers
to the composition or make up of its capitalization and it includes all long-term capital
resources”.
According to the definition of James C. Van Horne, “The mix of a firm’s permanent
long-term financing represented by debt, preferred stock, and common stock equity”.
According to the definition of Presana Chandra, “The composition of a firm’s
financing consists of equity, preference, and debt”.

OPTIMUM CAPITAL STRUCTURE

Optimum capital structure is the capital structure at which the weighted average cost of
capital is minimum and thereby the value of the firm is maximum.
Optimum capital structure may be defined as the capital structure or combination of
debt and equity, that leads to the maximum value of the firm.

OBJECTIVES OF CAPITAL STRUCTURE

Decision of capital structure aims at the following two important objectives:
1. Maximize the value of the firm.
2. Minimize the overall cost of capital.

FORMS OF CAPITAL STRUCTURE

Capital structure pattern varies from company to company and the availability of finance.
Normally the following forms of capital structure are popular in practice.
• Equity shares only.
• Equity and preference share only.
• Equity and Debentures only.
• Equity shares, preference shares and debentures.

FACTORS DETERMINING CAPITAL STRUCTURE

The following factors are considered while deciding the capital structure of the firm.

Leverage
It is the basic and important factor, which affect the capital structure. It uses the fixed cost
financing such as debt, equity and preference share capital. It is closely related to the
overall cost of capital.

Cost of Capital
Cost of capital constitutes the major part for deciding the capital structure of a firm.
Normally long- term finance such as equity and debt consist of fixed cost while mobilization.
When the cost of capital increases, value of the firm will also decrease. Hence the firm
must take careful steps to reduce the cost of capital.

(a) Nature of the business: Use of fixed interest/dividend bearing finance depends
upon the nature of the business. If the business consists of long period of
operation, it will apply for equity than debt, and it will reduce the cost of capital.

(b) Size of the company: It also affects the capital structure of a firm. If the firm
belongs to large scale, it can manage the financial requirements with the help of
internal sources. But if it is small size, they will go for external finance. It consists
of high cost of capital.

(c) Legal requirements: Legal requirements are also one of the considerations while
dividing the capital structure of a firm. For example, banking companies are
restricted to raise funds from some sources.

(d) Requirement of investors: In order to collect funds from different type of

investors, it will be appropriate for the companies to issue different sources of
securities.

Government policy
Promoter contribution is fixed by the company Act. It restricts to mobilize large, long term
funds from external sources. Hence the company must consider government policy
regarding the capital structure.

CAPITAL STRUCTURE THEORIES

1. Net Income approach
2. Net Operating Income (NOI) approach
3. Modigliani -Miller Approach
4. Traditional Theory approach

1. Net Income approach:

According to this approach, the market value of equity shares is based on the earning
available for equity shareholders after the payment of interest on debt if it is included in
the Capital Structure. The earning of the firm after the payment of all other expenses
except interest on debt is called Net Operating Income (NOI) and the earning available for
equity shareholders after the payment of interest is called as “Net Income (NI). Therefore,
Net Income = Net Operating Income (NOI) - Interest on debt (I).
According to this approach, as the debt increases, overall or weighted average cost of
capital decreases and vice versa. Therefore increase in debt results in the increase in the
value of the firm and consequently increases the value of the equity shares of the
company.

Assumptions:
Net Income approach is based on the following assumptions:
(i) There are no corporate taxes.
(ii) The cost of debt is less than the cost of equity i.e. the capitalization rate of debt is less
than the rate of equity capitalization. This prompts the firm to borrow.
(iii) The debt capitalization rate and the equity capitalization rate remain constant.
(iv) The proportion of the debt does not affect the risk perception of the investors.
Investors are only concerned with their desired return.
(v) The cost of debt remains constant at any level of debt.
(vi) Dividend pay out ratio is 100%. As per this approach, the firms try to optimize the
capital structure by introducing more and more debt having less cost than equity in the
capital structure.
Therefore, when the financial leverage is increased the proportion of cheaper source of
funds i.e. debt increases and overall cost of capital declines which consequently increases
the market value of the firm and also the value of the equity share of the firm. Hence, the
optimum capital structure exists when the firm employs 100% debt or maximum debt in
the capital structure.
According to this approach, the value of the firm and the value of equity are determined as
under.

Optimum Capital Structure under NI Approach:

The capital structure is said to be optimum at that stage of debt-equity mix where the
overall cost of capital is minimum. As per this approach the cost of capital is minimum at
100% level of debt, therefore the capital structure is optimized at the 100% debt level.

Criticisms of NI Approach:
(i) The assumption of constant cost of debt at any level of debt is not correct. The funds
providers insist for more rate of interest above certain level of debt.
 (ii) The assumption of risk perception of equity share holders is also not correct. As the
debt increases the financial risk also increases and equity share holders will expect more
return on their investment and hence the rate equity capitalization also increases with the
increase in financial leverage.

(iii) 100% dividend payout and absence of corporate tax are not practically possible.

2. Net Operating Income approach:

As per this approach, the market value of the firm is based on the earning available for
fund providers after paying all other expenses except interest on debt. The profit available
for funds providers or for calculating the market value of the firm is called Net operating
Income (NOI). This theory is just opposite to NI approach. NI approach is relevant to
capital structure decision. It means decision of debt equity mix does affect the WACC and
value of the firm. As per NOI approach the capital structure decision is irrelevant and the
degree of financial leverage does not affect the WACC and market value of the firm. NOI
approach evaluates the cost of capital and therefore the optimal Capital Structure on the
basis of operating leverage by means of NOI approach.

Assumptions:
The NOI approach is based on following assumptions:

(i) There are no corporate taxes.

(ii) Cost of debt remains constant at all level of debt.

(iii) Overall cost of capital remains constant.

(iv) Value of the firm depends on expected net operating income and overall capitalization
rate or the opportunity cost of capital.
(v) Net operating income of the firm is not affected by the degree of financial leverage.
(vi) The operating risk or business risk does not change with the change in debt equity
mix.

(vii) WACC does not change with the change in financial leverage.

As per NOI approach, even if the firm uses more and more debt in the capital structure, the
overall cost does not change even though the debt is cheaper than equity. This is because
the equity shareholders increase their expectations of return on their investment with every
increase in debt resulting in increased business risk. Consequently, the benefit of cheaper
debt is offset by higher expected rate of return on equity and therefore overall cost of
capital remains constant.
Optimum capital structure

As per NOI approach the cost of debt, market value of the firm and the market value of the
equity shares remain constant irrespective of change in the financial leverage and the
benefit of low cost of debt is offset by the increased rate of return on equity with the
increase in debt in the capital structure. Therefore, the overall all cost of capital remains
 the same at any level of debt; hence, the capital structure is optimum at any level of debt-
equity mix.

Criticisms of NOI approach:

The NOI approach is criticized on the following grounds:

(i) The assumption of absence of corporate tax is not correct.

(ii) The cost of debt increases with the increase in the quantum of debt.

(iii) As the cost of debt increases with the increase in financial leverage, the overall cost of
capital also increases with increase in financial leverage.

(iv) An investor values differently the firm having higher level of debt in its capital
structure than the firm having less debt or no debt.
3. Traditional Theory Approach:
According to this approach weighted average cost of capital decreases only up to a certain
level of financial leverage and starts increasing beyond certain level of judicious mix of
debt and equity. Hence, a firm has an optimum capital structure when the weighted
average cost of capital is minimum and the market value of the firm is maximum. This
approach has main three stages.

First Stage: Increasing Value In the first stage the cost of equity (ke) either remains
constant or rises slightly with increase in debt. At this stage, the increase in cost of equity
is less than the advantage in cost due to lower cost of debt than equity. During this stage,
the cost of debt (kd) remains constant since, it is considered as a rational decision.
Consequently, the overall cost of capital (ko) decreases with increase in leverage and thus
the total value of the firm (V) also increases.

Second Stage: Optimum Value At this stage, the cost of equity increases faster than it
increases at the first stage when debt is increased. Further the benefit of low cost of debt is
wiped off by increase in cost of equity beyond certain level, hence, the firm reaches at a
stage of minimum weighted average cost of capital and maximum value of the firm at
certain level of debt equity mix where the optimum capital structure is attained.

Third Stage: Declining Value As the debt is increased beyond certain level, the increase in
cost of equity becomes greater than the advantage of low cost of debt and therefore
weighted average cost of capital increases and the market value of the firm decreases. At
this stage, the value of the firm goes on declining with every increase in debt replacing the
equity. This happens because investors perceive a higher degree of financial risk and
demand a higher rate of return on equity, which exceeds the advantage of low cost debt.

Optimum Capital Structure under Traditional Approach

The supporters of traditional theory believe that overall cost of capital declines when the
debt
 is used in capital structure and it is possible to attain optimum capital structure. The capital
structure is optimum at the stage of debt-equity mix where the cost the overall cost of
capital is minimum and the value of the firm is maximum.

Criticisms of traditional Approach:

The traditional theory is criticized on following grounds;

(i) The theory assumes that investors value the levered firms more than the unlevered firm
is not practically correct.

(ii) Risk for shareholders does not increase with additional debt for financially sound
firms.

(iii) Investor’s perception about risk of leverage does not change for the same firm at
different levels of leverage.

(iv) Optimum capital structure is affected by tax deductibility of interest and other capital
market factors, which are ignored.

4. MODIGLIANI AND MILLER APPROACH

This approach was devised by Modigliani and Miller during the 1950s. The fundamentals
of the Modigliani and Miller Approach resemble that of the Net Operating Income
Approach. Modigliani and Miller advocate capital structure irrelevancy theory, which
suggests that the valuation of a firm is irrelevant to the capital structure of a company.
Whether a firm is highly leveraged or has a lower debt component in the financing mix has
no bearing on the value of a firm. The Modigliani and Miller Approach further states that
the market value of a firm is affected by its operating income, apart from the risk involved
in the investment. The theory stated that the value of the firm is not dependent on the
choice of capital structure or financing decisions of the firm.

Assumptions:
• There are no taxes.
• Transaction cost for buying and selling securities, as well as the bankruptcy cost, is nil.
• There is a symmetry of information. This means that an investor will have access to the
same information that a corporation would and investors will thus behave rationally.
• The cost of borrowing is the same for investors and companies.
• There is no floatation cost, such as an underwriting commission, payment to merchant
bankers, advertisement expenses, etc.
• There is no corporate dividend tax.

The Modigliani and Miller Approach indicates that the value of a leveraged firm (a firm
that has a mix of debt and equity) is the same as the value of an unleveraged firm (a firm
that is wholly financed by equity) if the operating profits and future prospects are same.
That is, if an investor purchases shares of a leveraged firm, it would cost him the same as
buying the shares of an unleveraged firm.
The following propositions outline the MM argument about the relationship between
cost of capital, capital structure and the total value of the firm:

(i) The cost of capital and the total market value of the firm are independent of its capital
structure. The cost of capital is equal to the capitalisation rate of equity stream of operating
earnings for its class, and the market is determined by capitalizing its expected return at an
appropriate rate of discount for its risk class.

(ii) The second proposition includes that the expected yield on a share is equal to the
appropriate capitalisation rate for a pure equity stream for that class together with a
premium for financial risk equal to the difference between the pure-equity capitalisation
rate (K.) and yield on debt (Kd). In short, increased Ke is offset exactly by the use of
cheaper debt.
(iii) The cut-off point for investment is always the capitalisation rate which is completely
independent and unaffected by the securities that are invested.

LEVERAGE:
Meaning of Leverage:

The term leverage refers to an increased means of accomplishing some purpose. Leverage
is used to lifting heavy objects, which may not be otherwise possible. In the financial point
of view, leverage refers to furnish the ability to use fixed assets or funds to increase the
return to its shareholders.

Definition of Leverage

James Horne has defined leverage as, “the employment of an asset or fund for which the
firm pays a fixed cost or fixed return. Types of Leverage

Types:

Leverage can be classified into three major headings according to the nature of the finance
mix of the company.
The company may use finance or leverage or operating leverage, to increase the EBIT and
EPS.

OPERATING LEVERAGE:

The leverage associated with investment activities is called as operating leverage. It is caused
due to fixed operating expenses in the company. Operating leverage may be defined as the
company’s ability to use fixed operating costs to magnify the effects of changes in sales on its
earnings before interest and taxes. Operating leverage consists of two important costs viz.,
fixed cost and variable cost. When the company is said to have a high degree of operating
leverage if it employs a great amount of fixed cost and smaller amount of variable cost. Thus,
the degree of operating leverage depends upon the amount of various cost structure.
Operating leverage can be determined with the help of a break even analysis.
Operating leverage can be calculated with the help of the following formula:

C
OL= --------
OP
Where,

OL = Operating Leverage

C = Contribution
OP = Operating Profits

Degree of Operating Leverage

The degree of operating leverage may be defined as percentage change in the profits resulting
from a percentage change in the sales. It can be calculated with the help of the following
formula:
Percentage change in profits
DOL=----------------------------------------------
Percentage change in sales

Uses of Operating Leverage:

Operating leverage is one of the techniques to measure the impact of changes in sales which
lead for change in the profits of the company.

1. If any change in the sales, it will lead to corresponding changes in profit.

2. Operating leverage helps to identify the position of fixed cost and variable cost.
3. Operating leverage measures the relationship between the sales and revenue of the
company during a particular period.
4. Operating leverage helps to understand the level of fixed cost which is invested in the
operating expenses of business activities.
5. Operating leverage describes the overall position of the fixed operating cost
FINANCIAL LEVERAGE

Leverage activities with financing activities is called financial leverage. Financial leverage
represents the relationship between the company’s earnings before interest and taxes (EBIT)
or operating profit and the earning available to equity shareholders.
Financial leverage is defined as “the ability of a firm to use fixed financial charges to
magnify the effects of changes in EBIT on the earnings per share”. It involves the use of
funds obtained at a fixed cost in the hope of increasing the return to the shareholders. “The
use of long-term fixed interest-bearing debt and preference share capital along with share
capital is called financial leverage or trading on equity”.

Financial leverage may be favourable or unfavourable depends upon the use of fixed cost
funds.

Favourable financial leverage occurs when the company earns more on the assets purchased
with the funds, then the fixed cost of their use. Hence, it is also called as positive financial
leverage.

Unfavourable financial leverage occurs when the company does not earn as much as the
funds cost. Hence, it is also called as negative financial leverage.
Financial leverage can be calculated with the help of the following formula:

OP
FL = ---------
PBT
Where,

FL = Financial leverage

OP = Operating profit (EBIT)

PBT = Profit before tax.

Degree of Financial Leverage

Degree of financial leverage may be defined as the percentage change in taxable profit as a
result of percentage change in earning before interest and tax (EBIT).

This can be calculated by the following formula

Percentage change in taxable Income

DFL= -----------------------------------------------
Precentage change in EBIT

Alternative Definition of Financial Leverage According to Gitmar, “financial leverage is the

ability of a firm to use fixed financial changes to magnify the effects of change in EBIT and
EPS”.
 EBIT
FL=-------------
EPS
Where,

FL = Financial Leverage

EBIT= Earning Before Interest and Tax

EPS = Earning Per share.

Uses of Financial Leverage:

Financial leverage helps to examine the relationship between EBIT and EPS

1. Financial leverage measures the percentage of change in taxable income to the

percentage change in EBIT.
2. Financial leverage locates the correct profitable financial decision regarding capital
structure of the company.
3. Financial leverage is one of the important devices which is used to measure the fixed
cost proportion with the total capital of the company.
4. If the firm acquires fixed cost funds at a higher cost, then the earnings from those
assets, the earning per share and return on equity capital will decrease.

COMBINED LEVERAGE

When the company uses both financial and operating leverage to magnification of any change
in sales into a larger relative change in earning per share.
Combined leverage is also called as composite leverage or total leverage. Combined leverage
expresses the relationship between the revenue in the account of sales and the taxable
income.

Combined leverage can be calculated with the help of the following formulas:
CL =OL × FL

C OP C
CL= ------ x ------- = -------
OP PBT PBT
Where,

CL = Combined Leverage

OL = Operating Leverage
FL = Financial Leverage

C = Contribution

OP = Operating Profit (EBIT)

PBT= Profit Before Tax

Degree of Combined Leverage

The percentage change in a firm’s earning per share (EPS) results from one percent change in
sales. This is also equal to the firm’s degree of operating leverage (DOL) times its degree of
financial leverage (DFL) at a particular level of sales.
Percentage change in EPS
Degree of contributed coverage =----------------------------------------
Percentage change in sales
 UNIT 4
CONCEPT OF WORKING CAPITAL MANAGEMENT
There are two concepts of working capital viz .quantitative and qualitative. Some people also
define the two concepts as gross concept and net concept.
According to quantitative concept, the amount of working capital refers to ‘total of current
assets’. Current assets are considered to be gross working capital in this concept.
The qualitative concept gives an idea regarding source of financing capital. According to
qualitative concept the amount of working capital refers to “excess of current assets over
current liabilities.”

L.J. Guthmann defined working capital as “the portion of a firm’s current assets which are
financed from long–term funds.” The excess of current assets over current liabilities is termed
as ‘Net working capital’. In this concept “Net working capital” represents the amount of
current assets which would remain if all current liabilities were paid.
Both the concepts of working capital have their own points of importance. “If the objectives
is to measure the size and extent to which current assets are being used, ‘Gross concept’ is
useful; whereas in evaluating the liquidity position of an undertaking ‘Net concept’ becomes
pertinent and preferable. It is necessary to understand the meaning of current assets and
current liabilities for learning the meaning of working capital, which is explained below.
Current assets:

It is rightly observed that “Current assets have a short life span. These type of assets are
engaged in current operation of a business and normally used for short– term operations of
the firm during an accounting period i.e. within twelve months. The two important
characteristics of such assets are,

i) short life span, and

ii) swift transformation into other form of assets. Cash balance may be held idle for a week or
two; account receivable may have a life span of 30 to 60 days, and inventories may be held
for 30 to 100 days.

Current liabilities:

The firm creates a Current Liability towards creditors (sellers) from whom it has purchased
raw materials on credit. This liability is also known as accounts payable and shown in the
balance sheet till the payment has been made to the creditors. The claims or obligations
which are normally expected to mature for payment within an accounting cycle (1 year) are
known as current liabilities. These can be defined as “those liabilities where liquidation is
reasonably expected to require the use of existing resources properly classifiable as current
assets, or the creation of other current assets, or the creation of other current liabilities.”
TYPES OF WORKING CAPITAL:

According to the needs of business, the working capital may be classified into following two
basis:

1) On the basis of periodicity

2) On the basis of concept

On the basis of periodicity:

The requirements of working capital are continuous. More working capital is required in a
particular season or the peck period of business activity. On the basis of periodicity working
capital can be divided under two categories as under:

1. Permanent working capital

2. Variable working capital

(1) Permanent working capital:

This type of working capital is known as Fixed Working Capital. Permanent working capital
means the part of working capital which is permanently locked up in the current assets to
carry out the business smoothly. The minimum amount of current assets which is required to
conduct the business smoothly during the year is called permanent working capital. For
example, investments required to maintain the minimum stock of raw materials or to cash
balance. The amount of permanent working capital depends upon the size and growth of
company. Fixed working capital can further be divided into two categories as under:

1. Regular Working capital: Minimum amount of working capital required to keep the
primary circulation. Some amount of cash is necessary for the payment of wages, salaries etc.

2. Reserve Margin Working capital: Additional working capital may also be required for
contingencies that may arise any time. The reserve working capital is the excess of capital
over the needs of the regular working capital is kept aside as reserve for contingencies, such
as strike, business depression etc.

(2) Variable or Temporary Working Capital:

The term variable working capital refers that the level of working capital is temporary and
fluctuating. Variable working capital may change from one assets to another and changes
with the increase or decrease in the volume of business. The variable working capital may
also be subdivided into following two sub-groups.
1. Seasonal Variable Working capital: Seasonal working capital is the additional amount
which is required during the active business seasons of the year. Raw materials like raw-
cotton or jute or sugarcane are purchased in particular season. The industry has to borrow
funds for short period. It is particularly suited to a business of a seasonal nature. In short,
seasonal working capital is required to meet the seasonal liquidity of the business.
2. Special variable working capital: Additional working capital may also be needed to
provide additional current assets to meet the unexpected events or special operations such as
extensive marketing campaigns or carrying of special job etc.

2) On the basis of concept:

on the basis of concept working capital is divided into two categories as under:

(A) Gross Working Capital: Gross working capital refers to total investment in current
assets. The current assets employed in business give the idea about the utilization of working
capital and idea about the economic position of the company. Gross working capital concepts
is popular and acceptable concept in the field of finance.

(B) Net Working Capital: Net working capital means current assets minus current liabilities.
The difference between current assets and current liabilities is called the net working capital.
If the net working capital is positive, business is able to meet its current liabilities. Net
working capital concept provides the measurement for determining the creditworthiness of
company.

FACTORS DETERMINING WORKING CAPITAL

The following factor determines the amount of working capital

1. Nature of Companies: The composition of an asset is a function of the size of a

business and the companies to which it belongs. Small companies have smaller
proportions of cash, receivables and inventory than large corporation. This difference
becomes more marked in large corporations. A public utility, for example, mostly
employs fixed assets in its operations, while a merchandising department depends
generally on inventory and receivable. Needs for working capital are thus determined
by the nature of an enterprise.

2. Demand of Creditors: Creditors are interested in the security of loans. They want
their obligations to be sufficiently covered. They want the amount of security in assets
which are greater than the liability.

3. Cash Requirements: Cash is one of the current assets which are essential for the
successful operations of the production cycle. A minimum level of cash is always
required to keep the operations going. Adequate cash is also required to maintain good
credit relation.

4. Nature and Size of Business: The working capital requirements of a firm are
basically influenced by the nature of its business. Trading and financial firms have a
very less investment in fixed assets, but require a large sum of money to be invested
in working capital. Retail stores, for example, must carry large stocks of a variety of
goods to satisfy the varied and continues demand of their customers. Some
 manufacturing business, such as tobacco manufacturing and construction firms also
have to invest substantially in working capital and a nominal amount in the fixed
assets.

5. Time: The level of working capital depends upon the time required to manufacturing
goods. If the time is longer, the size of working capital is great. Moreover, the amount
of working capital depends upon inventory turnover and the unit cost of the goods that
are sold. The greater this cost, the bigger is the amount of working capital.

6. Volume of Sales: This is the most important factor affecting the size and components
of working capital. A firm maintains current assets because they are needed to support
the operational activities which result in sales. They volume of sales and the size of
the working capital are directly related to each other. As the volume of sales increase,
there is an increase in the investment of working capital-in the cost of operations, in
inventories and receivables.

7. Terms of Purchases and Sales: If the credit terms of purchases are more favourable
and those of sales liberal, less cash will be invested in inventory. With more
favourable credit terms, working capital requirements can be reduced. A firm gets
more time for payment to creditors or suppliers. A firm which enjoys greater credit
with banks needs less working capital.

8. Business Cycle: Business expands during periods of prosperity and declines during
the period of depression. Consequently, more working capital required during periods
of prosperity and less during the periods of depression.

9. Production Cycle: The time taken to convert raw materials into finished products is
referred to as the production cycle or operating cycle. The longer the production
cycle, the greater is the requirements of the working capital. An utmost care should be
taken to shorten the period of the production cycle in order to minimize working
capital requirements.

10. Liquidity and Profitability: If a firm desires to take a greater risk for bigger gains or
losses, it reduces the size of its working capital in relation to its sales. If it is interested
in improving its liquidity, it increase the level of its working capital. However, this
policy is likely to result in a reduction of the sales volume, and therefore, of
 profitability. A firm, therefore, should choose between liquidity and profitability and
decide about its working capital requirements accordingly.

11. Seasonal Fluctuations: Seasonal fluctuations in sales affect the level of variable
working capital. Often, the demand for products may be of a seasonal nature. Yet
inventories have got to be purchased during certain seasons only. The size of the
working capital in one period may, therefore, be bigger than that in another.

OPERATING CYCLE:

The duration of time required to complete the sequence of events right from purchase of raw
material / goods for cash to the realization of sales in cash is called the operating cycle,
working capital cycle or cash cycle.

Operating Cycle of Manufacturing Firms:

The above operating cycle in figure relates to a manufacturing firm where cash is needs to
purchase raw materials and convert raw materials into work-in-process is converted into
finished goods. Finished goods will be sold for cash or credit and ultimately debtors will be
realized.

Operating Cycle of Non-Manufacturing Firm:

The non-manufacturing firms, such as whole sellers and retailers, will not have the
manufacturing phase; they will have rather direct conversion of cash into finished stock, into
accounts receivables and then into cash. The operating cycle of a non-manufacturing firm is
shown as under.
Operating Cycle of Service and Financial Firms
In addition to this, some service and financial concerns may not have any inventory at all.
Such firm have the shorter operating cycle.