What is the need and importance of finance? State the different types of financial needs.

 

NEED FOR AND IMPORTANCE OF FINANCE

We all know that every business activity requires money to run it. Take the case of manufacturers. They must have a place to produce goods. They must buy machinery and raw materials, engage workers and managers, pay for electricity and water supply, and incur expenses for delivery of goods to their customers. Similarly, take the case of traders. They must buy goods and have godown to keep them. They have to arrange for the delivery of the goods to their customers. They must employ people for loading and unloading of goods, for keeping accounts as well as for bill collection. Take another example of goods transportation business. The transporters must buy trucks, must engage drivers and helpers, incur expenses on diesel, repair, and servicing of the vehicle, and so on. All these can be undertaken only with the help of finance. Thus, money is required for all types of business activities be it manufacturing or trading or transportation or any other kind. It is true that income is earned by business when goods are sold and services have been rendered. But this takes place afterwards. Goods must be produced or purchased before they can he sold. Arrangement of finance is therefore necessary much before any income can he earned. It costs money to build a factory, to buy machinery and raw materials, to hire a place for the business office, to pay rent, wages and salaries, and to meet to day expenses. So, no one can run a business without first raising adequate finance, of course this is done in anticipation of future income, on the assumption that customers will buy the goods and services offered to them.

To run a business, besides finance, we also require men, materials, machinery and management. But finance may he regarded as the most important requirements of business. Men, materials, machinery and managers can he brought together and engaged in business when you have adequate finance. Many business firms are known to have failed mainly due to shortage of finance. The importance of finance has increased in modern times for two reasons. Firstly, the business activities are now undertaken on a much larger scale than in the past. Even if a business is started initially on a small scale, it grows in course of time. There is increasing need for finance with enlargement of business. Secondly. the manufacturing process have become more complex than in the past. Factory production requires expensive machinery, equipment and tools, and many men. It requires large quantities of materials to be procured and kept in stock. The products must he widely advertised. Distribution of the products must he arranged through wholesalers, dealers and salesmen. Thus, with the growth in size and volume of business and with the increasing complexity of production and trade, there is a growing need for finance. In an existing business on the one hand, money must be spent before money is realised from sales. On the other hand, cash realisation on account of sales over a certain period may not be equal to the amount of expenditure incurred during the same period. Finance should. therefore, he available in adequate amount as and when needed. To anticipate what amount of finance will have to he arranged am what point of time is not an easy task. This is because business condition, may change from time to time.

TYPES OF FINANCIAL NEEDS

Broadly speaking, there are two ways of classifying the financial needs of the business. i) On the basis of the extent of permanence, we can classify the financial needs into a) fixed capital. and b) working capital. ii) On the basis of the period of use. we can classify the financial needs into: a) long-term capital. and h) short-term capital.

1- Fixed Capital and Working Capital

Fixed Capital:

In every business concern money has to be invested in some fixed or durable assets like land, buildings, machinery, equipment, furniture. etc. These assets are required for permanent use, that is, for a long period of time Funds required to purchase these assets is known as fixed capital or long-term capital. The nature and size of the business generally determines the amount of fixed capital needed. Manufacturing activities, particularly those engaged in heavy engineering, electrical, transport, shipping and ship building, electric supply, iron and steel manufacture, automobiles, etc. require large investments in plant and machinery, equipment, factory buildings. warehouses, etc. On the other hand, trading concerns need relatively lesser investment in fixed assets.

Investment in fixed assets involves a commitment for a longer period of time. These fixed assets continue to generate income and profits over an extended period of time. Moreover, funds which are once invested in fixed assets cannot he withdrawn and put to some other use.

Working Capital:

In business you require finance for purchase of raw material. payment of wages and salaries, rent, fuel, electricity and water repairs and maintenance of machinery, advertising, etc. Requirements of finance for these purposes arise at short intervals. In course of business activities, it is also necessary to hold stocks of materials, spare parts, and finished goods. This involves investment in short-term assets or current assets in the form of stocks of raw materials, spare parts, stores, finished goods, etc. Besides, sale of goods on credit leads to the holding of debtors balances and bills receivable, which may also be regarded as current assets.

Money invested in current assets like stock of raw materials, finished goods, etc. and book debts (that is debtors balances as well as bills receivable) is known as Working Capital. It is sometimes known as Circulating Capital or Revolving Capital. That is because funds invested in current assets are continuously recovered through realisation of cash, and again reinvested in current assets. The amount keeps on circulating or revolving from cash to current assets and back again to cash. Although this takes place at short intervals, the amount is needed again and again. Hence part of the funds required for this purpose is of a permanent nature. It is known as the 'fixed or permanent' part of the working capital. The permanent part of working capital should accordingly be regarded as long-term capital. The other part of working capital may vary due to the rise or fall in the volume of business. Hence it is known as the 'fluctuating' or 'variable' part of the working capital. Therefore, strictly speaking, only the fluctuating part of the working capital is regarded as short-term capital. the funds required are for less than a year. 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 are sold. For instance, trading companies require more working capital than manufacturing companies. This is because the trading business requires large quantities of goods to be held in stock, and also carry large debtors' balances. Construction companies also require relatively larger amounts of working capital than manufacturing concerns. In both these types of business, the value of current assets is about 80% to 90% of the value of total assets. The investment in current assets is relatively smaller in the case of hotels and restaurants because they mostly have cash sales, and only small amounts of debtors balances.

Working capital requirements vary among manufacturing industries because of differences in the time involved in the production process i.e., time that passes between the purchase of raw materials and the production of finished goods. Longer the processing time, the more is the amount of working capital required. For example, heavy engineering industry needs relatively more working capital than a rice mill or a cotton spinning mill or a steel rolling mill.

Another factor that determines the amount of working capital relates to the term, of credit allowed to customers. For instance, a company may allow only 15 days credit. while another may allow 90 days' credit. One may extend credit facilities liberally to all customers, while another in the same business may grant credit Only to selected reliable customers. The amount of working capital required will naturally be more if the credit period is longer and credit facilities arc extended to all customers. In both these cases, there will be larger debtors' balance which will I. demand more working capital. On the other hand, it supplies of materials are available on favourable terms of credit (i.e., payments can be made at longer intervals), working capital needs will he correspondingly smaller.

2- Long-term Capital and Short-term Capital

As stated earlier fixed assets should be financed with permanent long-term cap' This is Mainly because fixed assets are meant for use over a fairly long period of time, generally for five years or more. Long term capital is also required to finance; the permanent part of the working capital. On the other hand, to finance current assets and meeting day-to-day expenses, capital is needed generally for a short period i.e., less than a year. This is because stocks of materials and finished goods are normally used for as sold within a year, and dues from customers are usually realised within three to six months. The main difference between long-term capital and short-term capital is that the former is required for a longer period, (five years or more) while the latter is required for a short period (less than a year). Besides these capital needs, business concerns often require funds for a period of 2 to 5 years known as medium-term capital. Medium-term capital is required for certain activities like renovation of building, modernisation of machinery, heavy expenditure on advertising, etc.