Question

Explain factors needed for employment and utilization of funds. Explain briefly?

Answer 1

Finance is required in order to maintain an adequate cash flow to keep the business operating and also for development. For the latter, the right amount is required at the right time and at the right cost. So the first question here is about deciding the capital structure of a company, which refers to the kind and proportion of different securities for raising long term finance. It involves decisions regarding the form of capitalization, the sum total of all long term securities issued by the company, equity as well as debt and the surplus not meant for distribution. It deals with some questions such as what is the total capital required? What should be the mix of equity i.e. owner’s capital and debt in the total capital. There should be a healthy mix of equity and debt in a company’s capital structure in order to maximize returns to its owners. At the same time it should neither be over capitalized nor under capitalized. A company is said to be over capitalized when its earnings are not large enough to yield a fair return on the amount of stocks and bonds that have been issued or when the amount of securities outstanding exceeds the current value of the assets. A company may be under capitalized when the rate of profit it is making is exceptionally high in relation to the return enjoyed by similarly situated companies in the same industry or when it has too little capital with which to conduct its business. If a business is under capitalized it may remain still born. On the other hand, if a business is over capitalized it runs the risk of being crushed under its own weight.

A company has many alternatives while raising funds such as equity shares, term loans from financial institutions, debentures, fixed deposits and bank finance for working capital requirements. All these funds carry a cost either explicit interest on loans, debentures, deposits etc. or implicit as in the case of dividend on equity. The weighted average cost of all the funds garnered should be kept as low as possible. If the cost of financing becomes very high, the company’s profitability and hence growth prospects suffer. The time factor while mobilizing funds should also be kept in mind. A business should not be started for want of timely infusions of required cash. Capital markets as a rule go through a cyclical pattern – boom, recession and recovery. During a boom period, investors passionately embrace equity. During a recession, bond markets outperform equity markets. The right timing of capital issue, therefore becomes crucial while raising funds from various sources.

The company should normally, strike a fine balance between paying reasonable amounts to investors who are looking for a steady income on their equity investment and those investors who would want the company to invest the surplus generated by the company in projects having great growth potential. Every company should have a healthy dividend policy whether to pay dividends or retain the surplus for expansion, modernization etc. to satisfy the need for cash within the company as also to satisfy the expectations of the investors. Experts, generally arrange for a stable dividend policy wherein dividends are declared every year as a sort of reward for loyal shareholders. The reason is that some shareholders rely on dividend income and are willing to pay a higher price for less risky shares. Earning and dividends often affect the readiness of shareholders to offer funds in times of necessity.

Utilization of funds:

The amounts raised through various sources, at the right cost, at the right time should be put to good use. A proper balance should be maintained while investing in fixed assets and current assets. Fixed assets involve investment of funds (in land and buildings, plant and machinery, furniture and fittings, office equipment etc.) over a fairly long period of time. Such investment costs- money either in the form of interest on borrowed funds or imputed cost on own funds (depreciation, operating expenses etc.). To the extent of possible investment in fixed assets should be minimized in tune with business requirements. One should also carefully evaluate whether fixed assets should be owned or leased. Leasing would be advantageous when the assets in question are sparingly used balancing material handling and drilling equipment , diesel generating sets, and the assets are subjected to rapid technological obsolescence (computing, electronic, telecom hardware) . On the negative side, lease rentals are generally high and the leased assets are not available for use whenever the company requires them ( especially during a boom phase). When fixed assets are bought on the other hand there is an assurance of their uninterrupted availability for use by the company. When assets are purchased one should look at crucial issues such as wear and tear, obsolescence rate, ability, for company to earmark sums for major capital expenditure (without impacting profitability during a period), the depreciation policy that provides for timely replacement of worn out assets etc. Also, proper schedules for preventive maintenance and breakdown maintenance should be drawn up in advance. All spares should be stocked in sufficient quantities. Looking after fixed capital requirements is only part of the story. The other important issue is that of managing working capital requirements.