Financial Management

Definition: Working capital refers to the capital required for day-to-day operations of a business. It represents the difference between a company's current assets and current liabilities. It is also known as circulating capital or short-term capital. Types of Working Capital:

• Gross Working Capital:
  • Total investment in current assets
  • Current assets include: cash, inventory, debtors, bills receivable, marketable securities, prepaid expenses
• Net Working Capital:
  • Current Assets minus Current Liabilities
  • Current liabilities include: creditors, bills payable, outstanding expenses, short-term loans, bank overdraft
  • Positive net working capital indicates ability to meet short-term obligations

Formula: Components of Working Capital:

Types Based on Time:

• Permanent Working Capital: Minimum level of current assets required to continue operations
• Temporary/Variable Working Capital: Additional working capital needed during peak seasons or special circumstances

Importance of Working Capital:

• Ensures smooth and uninterrupted operations
• Helps in maintaining liquidity and solvency
• Enables timely payment to creditors and employees
• Allows business to take advantage of opportunities
• Helps in maintaining good credit rating
• Protects business during emergencies

Factors Affecting Working Capital Requirements:

Example: A company has current assets of ₹50 lakh (cash ₹5 lakh, inventory ₹25 lakh, debtors ₹20 lakh) and current liabilities of ₹30 lakh (creditors ₹20 lakh, bank overdraft ₹10 lakh). Its net working capital is ₹20 lakh (50 - 30). Thus, working capital is the lifeblood of a business that ensures its day-to-day survival and growth.

Definition: Capital structure refers to the mix or composition of different sources of long-term funds that a company uses to finance its overall operations and growth. It represents the proportion of debt (borrowed funds) and equity (owner's funds) in the total capitalization of the firm. Key Components of Capital Structure:

• Equity Capital:
  • Funds contributed by owners/shareholders
  • Includes equity share capital, preference share capital, retained earnings
  • Features: Permanent capital, no fixed obligation to pay returns, shareholders have voting rights
• Debt Capital:
  • Borrowed funds from various sources
  • Includes debentures, bonds, loans from financial institutions, term loans
  • Features: Fixed obligation to pay interest, repayment schedule, lenders have no voting rights

Factors Affecting Capital Structure:

Theories of Capital Structure:

• Net Income Approach: Change in capital structure affects value of firm
• Net Operating Income Approach: Capital structure does not affect value
• Modigliani-Miller Theory: In perfect markets, capital structure is irrelevant
• Trade-off Theory: Balance between tax benefits of debt and bankruptcy costs
• Pecking Order Theory: Firms prefer internal funds, then debt, then equity

Optimal Capital Structure: The optimal capital structure is the mix of debt and equity that maximizes the firm's value while minimizing its cost of capital. It balances risk and return. Importance of Capital Structure:

• Affects profitability and financial risk
• Influences cost of capital
• Impacts shareholder wealth
• Determines financial flexibility
• Affects credit rating and borrowing capacity

Example: If a company has total long-term funds of ₹10 crore, with ₹6 crore from equity and ₹4 crore from debt, its capital structure is 60% equity and 40% debt (debt-equity ratio of 2:3).