Unit -Five

Estimating Capital Requirement

Becoming a sucessful entreprenuer requires to become a skilled fund raiser, a job that usually reguires
more time and energy than most business founder thinks. In startup companies raising capital can easily
consume as much as ane half of the entreprenuers time and can take many methods to complete. Finding capital
to finance a small business owner should carefully estimate initial capital requirement that best suits their
particular needs.
Capital is any form of wealth employed to produce more wealth. It exist in many forms in a typical
business including cash, inventory, plant and machinery etc. The entreprenuers need three different types of
capital.
-Fixed capital
-Working capital
-Growth capital

Fixed Capital:
Fixed capital is needed to purchase a companies parmanent or fixed assets such as land and buildings ,
mplant and equiptment etc. Money invested in these fixed assets trends to be frozen because it cannot be used
for any other purpose. Typically large sums of money is involved in purchasing fixed assets and credit terms are
usually of lengthy process.

Working Capital:
Working capital represents a business’s temprorary funds it is the capital used to support a companies
normal short term operations. It can be defined as current assets - current liabilities. The need for working
capital arises because of the uneven flow of cash in and out of the business due to normal seasonal flucations.
Credit sales, seasonsal sales or unfavourable changes in demand will create fluctuation in any small companies
cash flow. working capital normally is used to buy inventory, pay bills, finance credit sales to buy inventory,
pay bills, finance credit sales, pay wages and salaries and takes care of any unexpected emergencies.

Growth Capital:
Growth capital, unlike working capital is not related to the seasonal fluctuation of the small business.
Instead growth capital requirement surface when an existing business is expanding or changing it’s primary
direction. During times of rapid expansion , a growing companies capital reqirements are similar to those of
business start ups.

Methods of estimating fixed capital

The first and perhaps the most important decisions that any firm has to make is to define the business
(nature, size). Once the entreprenur choose the business they want to be in, they have to develop a plan to invest
in building, machinery, equiptments research and development etc. This is the capital budgeting process.

Considerable managerial time, attention and energy is devoted to identify, evaluate and implement
investment projects because
-it involves heavy funds
-it is the long term ommitment of funds
-the benefits can be expected for the long periods.
In capital budgeting cash flow plays an important role. Cashflows include income or increase on an
income and saving an expenditures. According to the concept of capital budgeting it is necessary to estimate a
cashflow in the process of analysing investment proposal. The following three steps are included in the
cashflow estimation :
1) Determination of net investment on initial cash outlet.
2) Determination of annual net cashflow or cashflow after tax.
3) Deteermination of net cashflow for final year.
Working Capital
 The working must be arranged sufficiently to operate the business smoothly. But it is not an easy task to
estimate the requred amount of working capital. however to determine the amount of working capital the
following items are usually included.
i) The no. of manufacturing goods within a period
ii) Total cost include on material, wages and indirect expenses
iii) The day to day expenses to be charged for business operation
iv) Average amount of credit allowed by supplier
v) Time lag in the payment of wages, salary and other expenses.

Method of determining working Capital

1) Projected balance sheet method:

It is a traditional approach towards projection of the working capital requirement. Under this method the
amt and current liabilities contained in the balance sheet. The difference between estimated current assets and
liabilities can serve as a basis for forecasting working capital requirement.

2) Operating cycle method:

The balance sheet approach doesnot indicate the exact position of working capital hence a new method
called operating cycle method was developed. The operating cycle may be defined as the time duration starting
from the procrument of goods or raw materials and ending with sales realisation. The gap is called operating
cycle.

Sources of Fund
Two long term securities available to the company for raising capital are- shares and debenture. Shares
include ordinary(common) shares. Debenture provides loan capital to the company and investor gets the status
of lender. Loan capital is also directly availabe financial instution to the companies.

Ordinary (Equity) Shares:

Ordinary shares(Prefered to as equity) represent the ownership position in a company. Yhe holders of
the ordinary shares, called share holders and legal owners of the company. Ordinary shares are the source of
permanent capital since they do not have the maturity periodfor the capital contributed by the share holders by
purchasing ordinary shares, they are entitled for dividend. The amount or rate is not fixed the company’s BOD
decides it. Being the owner of company share holders bear the risk of ownership:they are entitled to dividend
after the income claims of other have been satisfied. Similarly when the company is liquidated, they can
exercise their claim on assets after the claims of other supplier of capital have been made.

Features:
It has number of features which distinguish it from other securities

1) Claims on Assets:
Ordinary shareholder have a residual claim on the companies assets inthe cao of liquidation.

2) Voting right:
Ordinary shareholders are require to vote on a number of important matters such as election of directors,
change in MOA, change in authorised share capital etc.

3) Right to control:
Control in the context of the company means the power to determine it’s policy. Ordinary share holders
are able to control management of the company thropugh their voting right and right to maintain proprotionate
ownership.

4) Limited liability:
 Ordinary share holders are the true owner of the company, but their liability is limited to the amount of
their investment in share. If the share holders has already fully paid the issue price of the share, he has nothing
more to cintribute in the event of a financial distress or liquidation.

Pros and cons of Equity financing

Equity capital is the most important long term source of financing. It offers following advantages to the
company:
1) Permanent Capital:
It is a permanent capital and is available for use as longas the company goes because it is not
reedemeable.
2) Borrowing base:
By issuing ordinary shares, the company increase it’s financial capability. Lender generally lend in
proportion to the companies equity capital.
3) Dvidend payment discretion:
A company is not legally obligated to pay dividend. In time of financial difficulties, it can reduce ar
suspend payment of dividend. Thus it can avoid outflow associated with ordinary shares.

Equity capital has some disadvantage too, the firm compare to other sources of finance which are as
follows:
1) Cost:
Share have a higher cost at least for two reasons: Dividend are not tax deductable as are interest payment
and floation costs on ordinary shares are higher than those on debt.
2) Risk:
Ordinary shares are riskier from investor’s point of view as there is uncertainity regarding dividend and
capital.
3) Ownership dilution:
The issuance of new ordinary shares may dilute the ownership and control of the existing shareholders.

Debentures
Adebenture is a long term promisory note for raising loan capital. The firm promises to pay interest and
principal as stipulated. The purchasor of debenture are called as debenture holders.
A debenture is a long term fixed income financial security. The par value of adebenture is the face value
appearing on the debenture certificate. Some of the important features are:
1) Interest rate:
The interest rate on debenture is fixed and known. It indicates the percentage o fthe par value of
debenture thet will be paid out annually or semi-annually or quaterly) in the form of interest.
2) Maturity:
Debenture are issued for a specific period of time. The maturity of a debenture indicates the length if
time until the company redeems the par value to debenture holders and terminates the debentures.
3) Redeemption:
Debenture are mostly redeemable. They are generally redeemed on maturity.
4) Claims on assets and income:
Debenture holders have a claim on the company’s earning to that of shareholders. Debenture’s interest
has to be paid before paying any dividends. In Liquidation, the debenture holders have a claim on assets prior to
that of shareholders.

Pros And Cons of Debenture

Debenture has a number of advantages as longterm source of finance.

1) Less costly:
It involves less cost to the firm than the equity financing because investors considers debentures as
arelatively less risky investment alternative and therefore requires a lower rate of return.
2) Fixed payment of interest:
The payments are limited to interests because debenture holders do not participate in extra-ordinary
earning of the company.
3) No ownership dilution:
Debenture holders do not have voting rights as well as to control. Therefore, debenture issue doesnot
cause dilution of ownership.

Limitation of the debenture:

1) Financial risk:
It may be particularly disadvantageous to those firms which have flucluating sales and earning.

2) Obligatory payment:
Debenture results in legal obligation of paying interest and principal, which, if not paid, can force the
company into liquidation.

3) Cash outflows:
Debentures must be paid on maturity and therefore, at same points, it involves substantial cash outflows.

Term loans
Term loans are source of long term debt which are obtained directly from the bank and financial
institutions.Term loan represent long term debt wuth a mateurity of more than one year. The purpose of term
loans is mostly to finance the company’s capital expenditure. It have number of basic features which are as
follows:

1) Direct negotation:
A firm negotiate term loans for project finance directly with a bank or financial instution. Thus, term
loan is private placement. The advantages of private placement are the ease of negotation and low cost raising
loan. Unlike in the case of public issue the firm need not under write term loans. Thus, it avoids underwriting
commission and other floatation cost.

2) Maturity:
Banks and especially created inancial istuition are the main sources of term loan which are generally for
the period of three to five years: this is the period during which the company has not to make any payments.

3) Security:
Term loans are always secure specifically the assets using term loan funds secure them this is called
primary security. The companies current and future assets also generally secure term loans. This is called
secondary or collateral security.

4) Repayment Schedule:
Repayment schedule or loan amortization specifies the time schsdule for paying interest and principal
payment of loan is a legal obligation. The payment schedule will include both interest and principal payment.
Interest will be calculated on opening balance on loan. Thus, interest payment will decline over the years, and
the total loan payment(interest + principal)will be equal in each period. Repayment of loan in installement saves
the company from repaying the huge amount at the end of loan maturity.
 NATURE OF CREDIT SELLING

1) Trade Credit (Business to business credit):-

Trade simply means the business on to engage in a commerce or in business transaction. A time allowed
to payment of debt is credit.
Trde credit arises when a firm sales it’s products or service on credit and doesnot receive cash
immediately. It is an essential marketing tool acting as a bridge for the
movements of goods through production and distribution stages to customer.
Trde credit creates accounts receivables or trade debtors that the firms is expected to collect in the near
future are called trade debtors. If the firms is unable to collect it’s account receivables, the firm have to incure
baddebts losses. So, the companyshould be selective while selling it’s products in credit. Credit should be
granted to those who are financially strong and credit wortheness.
The objective of trade credit are:-
* to increase the sales volume
* to protect it’s sales from competitors
* to attract the potential customer to buy its products at favourable term
Trade credit can be of following types:
i) Extended payment period:-
The payment period indicates the average period for paying debts related to inventory putchase. An
extended payment order is sent to instruct the orderedbank to debt an account. It is
advantegious because of lower monthly payment amount no prepayment penalty protect credit
rating etc.

ii) Consigment:-
Consigment ia an arrangement under which merchandise are delivered by consigner (supplier)
to a consignee. The consigner retains title to the goods until the consigner had sold them. It is
avantegious for the seller because they do not need to pay supplier infront.

iii) Seasonal dating:-

One of the advantages of seasonal dating to the buyer is that stock will be on hand when the
active sealing season begins and buyer may makes some sales from the merchandise long before the
due date of invoice.

iv) Credit lines:-

An arrangement in which a bank extends specified amount of unsecured credit to the specified
borrower for the specified time period is called line of credit. It is convinent and flexible.

2) Consumer Credit:-
Consumer crdit is the credit etended to the consumer, the ultimate users of the products and services, by
the business firms for the purchase of it’s products and services. The consumer feel convinent when their
demand is the avaibility to puchase goods and services on credit. Small business that fails to offer customers on
credit lose sale to competitors that do.

The advantages of giving credit are:

* credit customer are likely to becomerepeat customer
* credit customer pays less attention to prices
* credit customer tends to buy products of higher quality
* credit is the convinence to the customer who dislike carrying cash

The disadvantages of giving credit are:

* credit forces entreprenurs to finance their customers, thus tyingup money in account
receivables
 * credit refusal may cause illwill
Types of consumer credit
i) Open accounts:
This is one of the most convinent types of credit for the customer where the monthly
invoice are send to the customer for payments and there are no interest charges.
ii)Installement credit:
Small companies taht salle consumer durables such as household appliences,vehicles, and other
high cost products - frequently relly on installement credit. Because very few customers can
purchase such itens in a single lump-sum payment. Most firms requires customers to make and
initial downpayment for the merchandise and then finance the balance. The customer repays the
loan amount with intereston loan.
iii)Cedit card
Credit cards have become a popular method of payment among customers. accepting credit
cards broadens thecustomers base.

Credit Operation Procedure

Acollection policy is needed because all customers do not pay the firms bills in time. Some customers
are slow payer while some are non payers. the collection effort should, thereforeaim at accelerating collection to
slow payers and reducing baddebts losses. AQ collection policy should ensure prompt and regular collection for
fast turnover of working of working capital, baddebts within limits and maintaining collection efficiency.
regularity in collection keep debtors alert and they tend to pay their dues promptly.
For effective management of credit, the firms should lay down clear guidelines and procedure for
granting credit and collecting their accounts. the firms neednot follow the policy of treating all customer
equallyfor the purpose of extending credit.
The credit operation procedure should involve the following steps:-
1) Credit information:-
In extending credit to the customer, the firm should have credit information concering each customer to
whom the credit will be granted. The firm should be ensured taht the receivables will be collected in full and on
due date. So credit should be granted to those who have the ability to make the payment on time. The collection
of credit information consume time and incure cost as well. Moreover it involves the following Various
sources:-
Financial statement:-
It is one of the easiest way of obtaining information regarding the financial
condition and performance of the prspective customer.
Bank Reference:-
Another source of collecting information is the bank where the customer
maintains his account.
Trade Reference:-
A firm can ask the prospective customer to give trade reference with whom
the customer has current dealing.

2) Credit investigation and analysis:-

After collecting the credit iformation from various sources the firms must investigate and analysis with
due care, the various factors taht affect the extent and nature of credit. Such factors are:-
* Type of customer, whether new or Existing
* The customer businessline, background and the related trade risk.
* The nature of the product, perishable or seasonal
* Size of customer’s order and expected futher volume of business with him.
*Company’s credit policy and pactises:
Lebral credit and collection policy
Lebral credit and strict collection policy
Strict credit and individual collection policy
 i) Analysis of credit file:-
He firm should maintain a credit file for each customer witrh the updated information,
collection, from reports of salesman, bankers directly from the customers. The firm’s trde experience
with the customer and his performance report based on financial statement could also
beanalysed. A regular exmination of the credit file will reveal the credit standing of the
customer.

ii) Analysis of financial ratio:-

The evaluation of the customer’s financial condition should be made very carefully be
cause it helps to determine the customer’s liquidity position and ability to repay debts.

iii)Analysis of business and its management:-

The firms should consider the quality of management and nature of customers business. A
management audit should be conducted to identify the management weakness of the customer
business. An over centralised structure of the custmers without proper management system may
lead to mismanagement, business failure etc.

3) Credit limit:-
Acredit limit is a maximum amount of credit which a firm will extend at a point of time. It indicates the
extent of risk taken by the firm by supplying on goods on credit to a customer. once the firmhas taken a decision
to extend credit to the applicants, the amount and duration of the credit havw to be deided depending upon the
amount of sales and the customer’s financial stength.

4) Collection efforts:-
When the normal credit period granting to a customer is over yet not made payment the firms should
send a polite letter to him reminding that the account is over due. If the customer doesnot respond then, the firm
may send progressively strong worded letters followed by telephone calls, telegrams, personal visit of firms
representatives oe even a legal notice. The legal action must be taken after examining the customer’s financial
cindition. The firm can accept reduced payment in the settlement of account from the customer’s having
financial problems.