financial investment

Types of Financial Needs of a Business

Financial Needs of a Business may be Classified into two on the basis of the Extent of Permanence:

Fixed Capital:

The funds required to purchase fixed or durable assets are known as fixed capital or long term capital. The fixed or durable assets include land, buildings, machinery, equipment and furniture etc. The nature and size of the business generally determines the amount of fixed capital needed. For e.g. manufacturing activities require large investments in plant, machinery, warehouses and others. While, trading concerns need relatively lesser investment in such assets. These assets continue to generate income and profits over an extended period of time. Also, funds which are once invested in fixed assets cannot be withdrawn and put to some other use.

Working Capital:

Money invested in short term assets or current assets is known as working capital. It includes purchase of raw materials, payment of wages and salaries, rent, fuel, electricity and water, repairs and maintenance of machinery, advertising, etc. Besides, sale of goods on credit leads to the holding of debtors balance and bills receivable, which may also be regarded as current assets. The requirement of finance for all these purposes arises at short intervals. Working capital is also known as Circulating capital or Revolving capital because funds invested in such assets are continuously recovered through realisation of cash, and again reinvested in current assets. The amount of working capital required depends mainly on the nature of the business, the time required for completing the manufacturing process, and the terms on which materials are purchased and goods sold. For e.g. trading companies require more working capital than manufacturing companies.

On the Basis of Period of Use, the Financial Needs of the Business may be Classified into :-

Long-Term Capital:

Long-term capital is required for a longer period i.e. five years or more. The fixed assets as well as the permanent part of the working capital is financed by it.

The important sources of long-term finance are :-

  • Issue of shares
  • Issue of debentures
  • Loans from financial institutions
  • Reinvestment of profits

Short-Term Capital:

Short-term capital is required for a shorter period i.e. less than a year. It involves financing the current assets and meeting day-to-day expenses.

The important sources of short -term finance are :-

  • Banks
  • Trade credit
  • Installment credit

Medium-Term Capital:

Medium-term capital is required for a period of 2 to 5 years. It involves financing certain activities like renovation of buildings, modernisation of machinery, heavy expenditure on advertising, etc.

The important sources of short -term finance are :-

  • Issue of shares
  • Issue of debentures
  • Borrowing from banks and other financial institutions
  • Reinvestment of profits

The funds raised to meet both the long-term and short-term capital requirements may take the form of :-

Ownership Capital:

It is the amount of capital invested in a business by its owners. It is on the basis of the amount invested that the owners become entitled to the profits of the business. Under sole proprietorship, the individual owner normally invests capital from his own savings. In partnership, each partner contributes capital as mutually agreed among partners. While companies raise capital by issuing shares. The investors who contribute towards the share capital of a company become its owners by virtue of their share holdings. The rate of return on owners investment depends on the level of profits earned and are entitled to receive dividend out of these profits. Ownership capital is generally used as permanent capital or long-term capital.

Borrowed Capital:

The financial requirements of the business are often met by raising loans. Borrowed money involves a fixed obligation to pay interest and repay the principal amount as and when due. In a sole proprietary business the proprietor can borrow money on his personal security or on the security of his existing assets. A partnership firm can raise loans on the personal security of the individual partners. Companies can also borrow either by issuing debentures or bonds, or raise direct loans. Money may be borrowed for short-term and long-term i.e. to finance fixed assets as well as current assets.

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