Profit vs. Wealth Maximization in Business Finance

Posted on Dec 10, 2024 in Economy

Profit Maximization vs. Wealth Maximization

Sources of Short-Term Financing of Working Capital

1. Indigenous Bankers: Private money lenders are called indigenous bankers. Business enterprises obtain loans from indigenous bankers to meet their requirements of working capital.

2. Customers’ Advance: Companies may take advances from their customers to meet their short-term financial requirements. Sometimes, enterprises may ask for some advance money from customers at the time of receiving orders for the supply of goods to them.

3. Trade Credit: It is a credit granted by the seller to the buyer for a short period. It is made available to companies that have sufficient financial reputation and goodwill, i.e., creditworthiness. Trade credit is granted on an open account basis, i.e., the supplier sends the goods to the buyer for the payment to be received in the future as per the terms of the sales invoice.

4. Bank Credit: Commercial banks provide short-term finance to business concerns by way of:

• Advancing loans
• Cash credit
• Overdraft
• Discounting and purchase of bills of exchange, promissory notes, and hundies

(a) Cash Credit: It is an arrangement in which the customer is allowed to borrow money up to a certain limit. Usually, the bank opens a separate account and credits the sanctioned loan. For such cash credit, the banker charges interest on the actual amount utilized by the borrower.

(b) Overdraft: It is a temporary loan given by the banker to the customer against the already existing current account. Overdraft means the current account holder can withdraw an amount more than the credit balance maintained in the account. Interest is charged on the actual amount withdrawn.

(c) Bills Discounted: The banker can give advances to their customers by discounting their bills. Bills discounted means taking the bills of exchange receivable by a customer and paying him the amount of the bill before maturity after deducting their discount charges. When the bill matures, the banker, as its holder, presents it to its acceptor and receives the amount. The bank may discount the bills with or without any security from the debtor in addition to the personal security of one or more persons liable on the bills.

5. Loans and Advances: Loans and advances are broadly classified into two classes: (1) Secured loans (2) Unsecured loans.

(1) Secured Loans: These are the loans granted by the banker by obtaining security by creating a charge of lien, pledge, hypothecation, or a mortgage on assets. If the borrower fails to pay the loan, the security can be confiscated and sold in the market to recover his dues.

(2) Unsecured Loans: These are the loans granted by the banker without taking any security.

6. Deferred Incomes: These are the incomes received in advance before supplying goods or services. These funds increase the liquidity of a firm.

7. Commercial Paper: Commercial paper represents unsecured promissory notes issued by firms to raise short-term funds. It may be issued even at a discount.

Explicit Cost vs. Implicit Cost

Working Capital Management Explained

Working Capital Management refers to the administration of a company’s short-term financial resources, focusing on managing and optimizing:

1. Current Assets (CA): Cash, Accounts Receivable, Inventory, and Prepaid Expenses.
2. Current Liabilities (CL): Accounts Payable, Short-term Loans, and Accrued Expenses.

Effective Working Capital Management ensures a company’s liquidity, profitability, and financial stability.

Key Concepts of Working Capital

1. Gross Working Capital (GWC): Total Current Assets.
2. Net Working Capital (NWC): Current Assets – Current Liabilities.
3. Working Capital Cycle (WCC): Time between purchasing raw materials and receiving payment from customers.
4. Working Capital Turnover: Revenue / Average Working Capital.

Factors Determining Working Capital Requirement

1. Business Cycle: Seasonal fluctuations, economic trends.
2. Industry Characteristics: Growth rate, profitability, and competition.
3. Company Size and Growth: Larger companies require more working capital.
4. Production and Sales Patterns: Just-in-time inventory, cash sales.
5. Credit Policy: Liberal or conservative credit terms.
6. Inventory Management: Raw materials, work-in-progress, finished goods.
7. Accounts Receivable and Payable: Payment terms, discounts.
8. Taxation and Regulatory Environment: Tax rates, compliance requirements.
9. Inflation and Interest Rates: Impact on working capital requirements.
10. Risk Management: Mitigating potential losses.

Components of Working Capital Requirement

1. Permanent Working Capital (PWC): Minimum working capital required throughout the year.
2. Temporary Working Capital (TWC): Additional working capital needed during peak periods.
3. Variable Working Capital (VWC): Fluctuating working capital requirements due to changes in sales or production.

Objectives of Working Capital Management

1. Maintain liquidity and financial stability.
2. Optimize working capital turnover.
3. Minimize costs and maximize returns.
4. Ensure timely payment of debts.
5. Invest surplus funds efficiently.

Techniques for Managing Working Capital

1. Cash Flow Forecasting
2. Inventory Management (Just-in-Time, Economic Order Quantity)
3. Accounts Receivable and Payable Management
4. Short-term Financing (Loans, Credit Lines)
5. Cash Conversion Cycle Optimization

Effective Working Capital Management is crucial for a company’s financial health, profitability, and competitiveness. By understanding the key concepts and factors influencing working capital requirements, businesses can make informed decisions to optimize their working capital.

Characteristics of Debentures

1. Type of Instrument: Debentures are a type of debt instrument issued by companies to raise capital.
2. Fixed Income: Debentures offer a fixed rate of interest, usually semi-annually or annually.
3. Redeemable: Debentures are redeemable after a specified period, usually 5-10 years.
4. Secured or Unsecured: Debentures can be secured by assets or unsecured.
5. Transferable: Debentures are transferable, allowing investors to sell them on the market.
6. No Voting Rights: Debenture holders do not have voting rights in the company.

Benefits of Preference Capital

1. Fixed Dividend: Preference shareholders receive a fixed dividend, providing a regular income stream.
2. Priority over Equity: Preference shareholders have priority over equity shareholders in case of liquidation.
3. No Voting Rights: Issuing preference shares does not dilute the voting power of existing shareholders.
4. Tax Efficiency: Preference dividends are taxed at a lower rate than equity dividends in some jurisdictions.
5. Attractive to Risk-Averse Investors: Preference shares offer a relatively lower-risk investment option compared to equity shares.

Drawbacks of Preference Capital

1. Fixed Dividend: The fixed dividend payment can be a burden on the company, especially during periods of financial stress.
2. No Participation in Profits: Preference shareholders do not participate in the company’s profits beyond the fixed dividend.
3. No Voting Rights: Preference shareholders do not have voting rights, limiting their influence on company decisions.
4. Redemption Obligation: The company must redeem preference shares at par value, which can be a significant cash outflow.
5. Impact on Equity Shareholders: Issuing preference shares can lead to a decrease in the value of equity shares, as preference shareholders have priority in case of liquidation.

The Need for Working Capital

Working capital is essential for a business to operate smoothly and efficiently. It represents the amount of money required to finance the company’s day-to-day operations, such as:

1. Purchasing raw materials and inventory
2. Paying wages and salaries
3. Meeting short-term debts and obligations
4. Maintaining cash reserves for unexpected expenses

Adequate working capital ensures that a business can:

1. Take advantage of new opportunities
2. Respond to changes in the market
3. Maintain a positive cash flow
4. Avoid liquidity problems and bankruptcy

Permanent Working Capital (PWC)

Permanent working capital refers to the minimum amount of working capital required by a business to operate continuously, regardless of fluctuations in sales or production. It represents the core working capital needs of the business.

Characteristics of PWC

1. Required throughout the year
2. Not affected by seasonal fluctuations
3. Essential for maintaining business operations
4. Typically financed through long-term sources, such as equity or long-term debt

Fluctuating Working Capital (FWC)

Fluctuating working capital refers to the additional working capital required by a business to meet temporary or seasonal increases in sales or production. It represents the variable working capital needs of the business.

Characteristics of FWC

1. Required only during peak periods
2. Affected by seasonal fluctuations
3. Used to finance temporary increases in inventory, accounts receivable, or other current assets
4. Typically financed through short-term sources, such as bank loans or credit lines

Key Differences Between PWC and FWC

1. Duration: PWC is required throughout the year, while FWC is required only during peak periods.
2. Financing: PWC is typically financed through long-term sources, while FWC is typically financed through short-term sources.
3. Purpose: PWC is essential for maintaining business operations, while FWC is used to finance temporary increases in sales or production.

By understanding the differences between permanent and fluctuating working capital, businesses can better manage their working capital requirements and ensure they have sufficient funds to operate efficiently.