Fixed Capital: Meaning, Importance and Factors Affecting Requirement of Fixed Capital
We all know that finance is essential for running a business. Business enterprises require careful financial planning and understanding of the resultant capital structure, risks, and profitability that they may have. All these have an effect on shareholders as well as the employees. They require an understanding of business finance, major financial decision areas, financial risk, and the business’s working capital requirements. The success of a business depends on how well finance is invested in assets and operations and how timely and cheaply the finance is arranged from different sources. Financial Management is concerned with the management of the flow of funds and involves decisions related to the acquisition and application of funds in long-term and short-term assets. It is concerned with two aspects: procurement of funds as well as usage of finance.
The assets which remain in the business for a period of more than one year are known as Fixed Assets. For example, plant, machinery, building, land, furniture, equipment, etc. These assets are not meant for sale. Fixed Capital is the money invested by a company in its fixed assets, which are to be used over a long period of time. Hence, it can be said that fixed capital is used for meeting the permanent or long-term needs of the business.
Management of Fixed Capital
Raising fixed capital required by the firm at minimum cost and using it effectively sums up the management of fixed capital. The decision taken by a firm to invest in fixed assets is known as Capital Budgeting Decision. A firm must take capital budgeting decisions carefully as it affects the profitability, growth, and risk of business in the long run. It consists of decisions related to the purchase of land, plant and machinery, building, investing in advanced techniques of production, or launching a new product line.
A firm must always finance its fixed assets through long-term sources, like shares, debentures, long-term loans, etc., and not through short-term sources.
Importance of Fixed Capital or Capital Budgeting Decisions
A capital budgeting decision is one of the most crucial business decisions. It is important for a business because of the following reasons:
1. Long-term Growth and Effects
Decisions regarding the long-term growth and effects of a firm have long-term implications on its business. As the funds invested by the firm in the long-term assets are most likely to yield returns in the future, these decisions affect the growth and future prospects of the business.
2. Large Amount of Funds Involved
A huge outflow of funds is involved in capital budgeting decisions, because of which a substantial portion of capital funds are blocked in long-term projects. The funds will get wasted if the firms get any wrong investment programme. Therefore, decisions regarding the amount of funds are crucial for the firm and it must carefully plan its investment programme.
3. Risk Involved
The capital budgeting decisions of an organisation involve huge funds and a higher degree of risk. These decisions have an impact on long-term profitability as the company has to bear the risk for a long period.
4. Irreversible Decisions
It is not possible to reverse most of the capital budgeting decisions without incurring heavy losses. For instance, if an organisation abandons a project in the middle, it will have an adverse financial consequence on the business. Therefore, every firm should take these decisions after every small detail to avoid heavy losses.
Factors Affecting Requirement of Fixed Capital
Fixed Capital refers to investment in fixed assets for a longer period. The fixed capital of an organisation gets its funds through long-term sources of finance like preference shares, equity shares, debentures, etc. The requirement of fixed capital in an organisation depends upon various factors. These factors are as follows:
1. Nature of Business
The first factor which helps in determining the requirement of fixed capital is the type of business in which the company is involved. A manufacturing company requires more fixed capital as compared to a trading company. It is because a trading company does not need plant, machinery, equipment, etc.
2. Scale of Operation
The companies operating at a large scale require more fixed capital as compared to the companies operating at a small scale. It is because the former requires more machinery and other assets; however, the latter requires less machinery.
3. Technique of Production
The companies that use capital-intensive techniques require more fixed capital; however, the companies that use labour-intensive techniques require less fixed capital. It is because the capital-intensive techniques use plant and machinery for which requires more fixed capital.
4. Growth Prospects
Companies aiming at expanding their business and having higher growth plans require more fixed capital for expansion of business. They have to expand their production capacity and to do so they need more plants and machinery. Hence, the companies aiming at expanding their business require more fixed capital.
5. Technology Upgradation
Industries, where technology upgradation is fast, requires more fixed capital, as whenever new technology is invented, the old machines become obsolete and the firm has to purchase new plant and machinery. However, the companies where technological upgradation is slow, need less fixed capital, as they can easily manage with old machines.
The companies which are planning to diversify their activities by including more range of products require more fixed capital. It is because, for diversification of the business, they have to produce more products for which more plants and machinery are required, ultimately increasing the need for more fixed capital.
7. Level of Collaboration/Joint Ventures
The companies that prefer collaborations or joint ventures need less fixed capital as these companies can share plants and machinery with the collaborators. However, if a company prefers to operate its business as an independent unit, then it will require more fixed capital.
8. Availability of Finance and Leasing Facility
If a company can easily arrange financial and leasing facilities, then it will require less fixed capital, as it can acquire the required assets in easy instalments and won’t have to pay a huge amount at one time. Whereas, if a company cannot find financial and leasing facilities easily, then it will require more fixed capital, as it has to purchase plants and machinery by paying a huge amount at once.
Name of the factor
Requirement for More Fixed Capital
Requirement for More Working Capital
|Nature of Business||Manufacturing Company||Trading Company|
|Scale of Operation||Large Scale Operation||Small Scale Operation|
|Technique of Production||Capital Intensive Techniques||Labour Intensive Techniques|
|Technology Upgradation||Fast Technological Upgradation||Slow Technological Upgradation|
|Growth Prospects||Higher Growth Prospects||Lower Growth Prospects|
|Diversification||Companies Diversifying||Companies staying stable to one product/service|
|Availability of Finance and Leasing Facility||Difficulty in getting finance and leasing facility||Easy availability of finance and leasing facility|
|Level of Collaboration||Operating independent||Collaborating with other companies|
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