Tag: University of Mumbai BMS Notes

Hedging can be performed by using different derivatives. The first method is by using futures. Both producers and end-users can use futures to protect themselves against adverse price movements. They offset their price risk by obtaining a futures contract on a futures exchange, hereby securing themselves of a pre-determined price for their product.

An important factor in determining the eventual price, is the basis. The basis is calculated by deducting the futures price form the spot price. By successfully predicting the basis of a commodity, the eventual price of a commodity can be calculated at the moment the hedge is placed.

Long Hedge

End-users take a long position when they are hedging their price risks. By buying a futures contract, they agree to buy a commodity at some point in the future. These contracts are rarely executed, but are mostly offset before their maturity date. Offsetting a position is done by obtaining an equal opposite on the futures market on your current futures position. The profit or loss made on this transaction is then settled with the spot price, where the producer will buy his commodity.

A long hedge refers to a futures position that is entered into for the purpose of price stability on a purchase. Long hedges are often used by manufacturers and processors to remove price volatility from the purchase of required inputs. These input-dependent companies know they will require materials several times a year, so they enter futures positions to stabilize the purchase price throughout the year.

For this reason, a long hedge may also be referred to as an input hedge, a buyer’s hedge, a buy hedge, a purchaser’s hedge, or a purchasing hedge.

A long hedge represents a smart cost control strategy for a company that knows it needs to purchase a commodity in the future and wants to lock in the purchase price. The hedge itself is quite simple, with the purchaser of a commodity simply entering a long futures position. A long position means the buyer of the commodity is making a bet that the price of the commodity will rise in the future. If the good rises in price, the profit from the futures position helps to offset the greater cost of the commodity.

Futures price – Basis + broker commission = Net Purchasing price

Short Hedge

Producers of commodities take a short position when hedging their price risks. They sell their product using a futures contract, for a delivery somewhere later in the future. They hedge their price risk similar to long hedgers. They sell a futures contract, which they offset come the maturity date by buying an equal futures contract. The profit or loss made by offsetting the position is then settled with the price obtained at the spot market. This will be the actual price the producer has obtained for selling their product. Just like a long hedge, the prediction of the basis is a crucial factor for determining the price a producer will receive before hedging the commodity. This price can be calculated using the following formula

Futures price + basis – broker commission = net selling price

A short hedge is an investment strategy used to protect (hedge) against the risk of a declining asset price in the future. Companies typically use the strategy to mitigate risk on assets they produce and/or sell. A short hedge involves shorting an asset or using a derivative contract that hedges against potential losses in an owned investment by selling at a specified price.

A short hedge can be used to protect against losses and potentially earn a profit in the future. Agriculture businesses may use a short hedge, where “anticipatory hedging” is often prevalent.

Anticipatory hedging facilitates long and short contracts in the agriculture market. Entities producing a commodity can hedge by taking a short position. Firms in need of the commodity to manufacture a product will seek to take a long position.

Companies use anticipatory hedging strategies to manage their inventory prudently. Entities may also seek to add additional profit through anticipatory hedging. In a short-hedged position, the entity is seeking to sell a commodity in the future at a specified price. The firm seeking to buy the commodity takes the opposite position on the contract known as the long-hedged position. Companies use a short hedge in many commodity markets, including copper, silver, gold, oil, natural gas, corn, and wheat.

Commodity Price Hedging

Commodity producers can seek to lock in a preferred rate of sale in the future by taking a short position. In this case, a company enters into a derivative contract to sell a commodity at a specified price in the future. The company then determines the derivative contract price at which they seek to sell and the specific contract terms. The company typically monitors this position throughout the holding period for daily requirements.

A producer can use a forward hedge to lock in the current market price of the commodity that they are producing, by selling a forward or futures contract today, in order to negate price fluctuations that may occur between today and when the product is harvested or sold. At the time of sale, the hedger would close out their short position by buying back the forward or futures contract while selling their physical good.

• A short hedge protects investors or traders against price declines.
• It is a trading strategy that takes a short position in an asset where the investor or trader is already long.
• Commodity producers can similarly use a short hedge to lock in a known selling price today so that future price fluctuations will not matter for their operations.

Long Hedges vs. Short Hedges

Basis risk makes it very difficult to offset all pricing risk, but a high hedge ratio on a long hedge will remove a lot of it. The opposite of a long hedge is a short hedge, which protects the seller of a commodity or asset by locking in the sale price.

Hedges, both long and short, can be thought of as a form of insurance. There is a cost to setting them up, but they can save a company a large amount in an adverse situation.

Cash and carry arbitrage is a financial arbitrage strategy that involves the exploitation of the mispricing between an underlying asset and the financial derivative corresponding to it. Using the cash and carry arbitrage strategy, a trader aims to use market pricing discrepancies between the underlying(s) and the derivative to their advantage by exploiting the opportunity to generate profits via a correction in the mispricing. The strategy is sometimes also referred to as basis trading.

This is a term used often in cash and carry and reverse cash and carry arbitrages. The cost of carry or CoC is the cost that a trader or investor has to bear for holding a position in the underlying market till the future contract’s expiration date arrives. Typically, cost of carry is expressed as a percentage.

Contango and backwardation

• When a market is said to be in contango when the future price is higher than the spot price of the asset. It is when the market is in contango that cash and carry arbitrage occurs.
• The term contango is largely used in the commodities market while the term premium is used in the equity derivatives market.
• Backwardation happens in an exactly reverse scenario, and that’s when reverse cash and carry arbitrage comes into play. Backwardation is also termed discount in the equity derivatives market.
• When the premium widens, it is indicative of a bullish market and when the discount widens, it may be a sign of a bearish market.

Example of cash and carry arbitrage

Assume that an underlying asset is trading at Rs 102, with a cash or carry of Rs 3. The futures contract is at Rs 109. The trader buys the underlying and goes long while also shorting the future and selling it at Rs 109. The cost of the underlying is Rs 105 (cost of carry included) but the sale that the trader has locked is at Rs 109. Hence, the profit is Rs 4, and that has happened by making use of the pricing difference between the securities in the two markets.

In a nutshell

Cash & carry arbitrage occurs when the price of an asset in a future contract is greater than the price of the underlying in the spot or cash market. In such a scenario, the investor shorts the future and takes a long position in the cash market. Getting a fair understanding of how futures contracts work is important before you take the step towards arbitrage strategies.

Arbitrage strategies help traders benefit in a risk-free manner. Understanding cash and carry arbitrage definition helps you practice it, and get a better grip on the arbitrage strategy.

How It Works

A trader implements a cash and carry arbitrage strategy by identifying lucrative arbitrage opportunities in the market. They identify and invest in securities that they identify as mispriced in relation to each other. The trader opts to go long in a commodity, while, at the same time, taking a short position for the corresponding financial derivative and selling it off.

The commodity purchased is held until the expiration date, i.e., the delivery date of the corresponding contract. The trader then delivers the underlying against the corresponding contract and locks in a riskless profit. The profit earned by the trader is determined by the purchase price of the underlying plus its total carrying cost.

By shorting the corresponding contract, the investor locks in a sale at the price at which the contract is priced at. Hence, the investor will already have determined the sale price. If the purchase price of the underlying plus its carrying cost is less than the price at which the contract is sold, the trader makes a riskless profit by exploiting this mismatch of prices.

Risks Associated with Cash and Carry Arbitrage

In the cash and carry arbitrage strategy, the acquisition cost of the underlying is certain; however, there is no certainty with regards to its carrying costs. In the event that the carrying costs of the underlying increase and rise beyond the locked-in sale price of the corresponding contract, the investor incurs a loss instead of a profit. An example of an increase in carrying costs is the rising margin rates by brokerage firms.

Summary:

• Cash and carry arbitrage is a financial arbitrage strategy that involves the exploitation of the mispricing between an underlying asset and the financial derivative corresponding to it.
• Using the cash and carry arbitrage strategy, a trader aims to use market pricing discrepancies between the underlying(s) and the derivative to their advantage by exploiting the opportunity to generate profits via a correction in the mispricing.
• Traders secure a profit by taking a long position on the financial commodity and shorting the corresponding contract.

Reverse Cash and Carry arbitrage is a combination of short position in underlying asset (cash) and long position in underlying future. It is initiated when future is trading at a discount as compared to cash market price. In other words, the cash market price is trading higher as compared to future. The arbitrageur/ trader can take position by selling his delivery of stocks in cash and simultaneously buying futures of same underlying assets of equal quantity. A trader must have delivery in that particular stock when there is such an opportunity available in the market.

Reverse cash and carry arbitrage occurs when market is in “Backwardation”, which means future contracts are trading at a discount to the spot price.

Reverse cash and carry arbitrage is performed when the futures is trading at a discount to the cash market price.

Lets assume the following data:

Cash market price:         Rs.100

December futures price:  Rs.90

This reflects a negative cost of carry which is bound to reverse to positive at some point in time during contract’s life and this reversal is an opportunity for traders to execute reverse cash and carry arbitrage.

Lets assume a contract multiplier for futures contract on Stock A is 200 shares. To execute reverse cash and carry, arbitrageur will buy one Dec Fut at Rs.90 and sell 200 shares of Stock A at Rs.100 in cash market. This would result in the arbitrage profit of Rs. 2000 (200 X Rs.10). Position of the arbitrager in various scenarios of stock price would be as follows:

Case I: Stock rises to Rs. 110

Loss on underlying = (110 – 100) x 200 = Rs. 2000

Profit on futures = (110 – 90) x 200 = Rs. 4000

Net gain out of arbitrage = Rs. 2000

Case II: Stock falls to Rs. 85

Profit on underlying = (100 – 85) x 200 = Rs. 3000

Loss on futures = (90 – 85) x 200 = Rs. 1000

Net gain out of arbitrage = Rs. 2000

On maturity, when the futures price converges with the spot price of underlying, the arbitrageur is in a position to buy the stock back at the closing price/ settlement price of the day.

Before entering the world of futures trading, investors must take the time to understand how contracts in the sector work and how they differ from trading in other, more mainstream asset classes, such as stocks and bonds.

The contract legally obligates a buyer to acquire an asset, or a seller to sell an underlying asset, at a predetermined date and price in the future. The asset involved can be anything from physical commodities gold, oil, corn, etc. to financial instruments, such as stock indices, interest rates and currencies.

Now before entering into a futures contract known as taking a position an investor should be aware of the four main elements of a futures contract. These instruments are much different from buying shares in companies on stock exchanges. In that type of trade, an investor immediately takes ownership of the underlying asset.

The four elements in a futures contract are:

Asset Class

The contract will specify the asset that underlies the contract, which is crucial in measuring the value of the trade. Some of the most highly traded assets in futures trading include energy products, agricultural commodities, precious metals, equities indices, and forex.

Quantity

The quantity explains the size of the contract, which typically outlines the specific number of the units being bought or sold. For example, one contract in WTI crude oil futures gives the holder the right to acquire 1,000 barrels of oil. If trading gold futures, one contract would give a market player the right to buy 100 troy ounces of gold.

Expiration

Futures contracts must have an end date an expiration on a set day in the future. The expiry date is the final day the contract can be traded. After that date, the contract must be settled under the terms of the agreement.

Price

The price of a contract is ultimately determined by the open market, reflecting the value of the asset involved. A futures contract, however, will contain a specific price, usually tied to the spot or cash price of the underlying commodity. The contract will also make clear what currency is being used in the contract, such as whether the asset is priced in U.S. dollars or another denomination.

Other Considerations

There are details involved in futures contracts, including delivery terms. Although most futures contracts are closed out before expiration, it’s still important to know the contract’s delivery terms. This involves knowing whether delivery will be in the physical commodity or will involve a cash settlement. Trading in gold, soybeans or oil often means a physical delivery, while other instruments, such as contracts based on S&P 500 Futures, are settled in cash.

Over the last three decades, the derivatives market has seen a phenomenal growth. A large variety of derivative contracts have been launched at exchanges across the world. Some of the factors driving the growth of financial derivatives are:

• Increased volatility in asset prices in financial markets

A price is what one pays to acquire or use something of value. The objects having value maybe commodities, local currency or foreign currencies.   The concept of price is clear to almost everybody when we discuss commodities. There is a price to be paid for the purchase of food grain, oil, petrol, metal, etc. the price one pays for use of a unit of another persons money is called interest rate. And the price one pays in one’s own currency for a unit of another currency is called as an exchange rate.

The changes in demand and supply influencing factors culminate in market adjustments through price changes. These price changes expose individuals, producing firms and governments to significant risks. The break down of the BRETTON WOODS agreement brought and end to the stabilizing role of fixed exchange rates and the gold convertibility of the dollars. The globalization of the markets and rapid industrialization of many underdeveloped countries brought a new scale and dimension to the markets. Nations that were poor suddenly became a major source of supply of goods. The Mexican crisis in the south east-Asian currency crisis of 1990’s has also brought the price volatility factor on the surface. The advent of telecommunication and data processing bought information very quickly to the markets. Information which would have taken months to impact the market earlier can now be obtained in matter of moments. Even equity holders are exposed to price risk of corporate share fluctuates rapidly.

This price volatility risk pushed the use of derivatives like futures and options increasingly as these instruments can be used as hedge to protect against adverse price changes in commodity, foreign exchange, equity shares and bonds.

• Increased integration of national financial markets with the international markets

Earlier, managers had to deal with domestic economic concerns; what happened in other part of the world was mostly irrelevant. Now globalization has increased the size of markets and as greatly enhanced competition .it has benefited consumers who cannot obtain better quality goods at a lower cost. It has also exposed the modern business to significant risks and, in many cases, led to cut profit margins

In Indian context, south East Asian currencies crisis of 1997 had affected the competitiveness of our products vis-Ã -vis depreciated currencies. Export of certain goods from India declined because of this crisis. Steel industry in 1998 suffered its worst set back due to cheap import of steel from south East Asian countries. Suddenly blue chip companies had turned in to red. The fear of china devaluing its currency created instability in Indian exports. Thus, it is evident that globalization of industrial and financial activities necessitates use of derivatives to guard against future losses. This factor alone has contributed to the growth of derivatives to a significant extent.

• Marked improvement in communication facilities and sharp decline in their costs.
• Development of more sophisticated risk management tools, providing economic agents a wider choice of risk management strategies

A significant growth of derivative instruments has been driven by technological break through. Advances in this area include the development of high speed processors, network systems and enhanced method of data entry. Closely related to advances in computer technology are advances in telecommunications. Improvement in communications allow for instantaneous world wide conferencing, Data transmission by satellite. At the same time there were significant advances in software programmed without which computer and telecommunication advances would be meaningless. These facilitated the more rapid movement of information and consequently its instantaneous impact on market price.

Although price sensitivity to market forces is beneficial to the economy as a whole resources are rapidly relocated to more productive use and better rationed overtime the greater price volatility exposes producers and consumers to greater price risk. The effect of this risk can easily destroy a business which is otherwise well managed. Derivatives can help a firm manage the price risk inherent in a market economy. To the extent the technological developments increase volatility, derivatives and risk management products become that much more important.

• Innovations in the derivatives markets, which optimally combine the risks and returns over a large number of financial assets leading to higher returns, reduced risk as well as transactions costs as compared to individual financial assets.

A forward contract is a customized contractual agreement where two private parties agree to trade a particular asset with each other at an agreed specific price and time in the future. Forward contracts are traded privately over-the-counter, not on an exchange.

A futures contract often referred to as futures is a standardized version of a forward contract that is publicly traded on a futures exchange. Like a forward contract, a futures contract includes an agreed upon price and time in the future to buy or sell an asset usually stocks, bonds, or commodities, like gold.

The main differentiating feature between futures and forward contracts that futures are publicly traded on an exchange while forwards are privately traded results in several operational differences between them. This comparison examines differences like counterparty risk, daily centralized clearing and mark-to-market, price transparency, and efficiency.

Marketing is about-

Product Mix: Service, Brand, Package, Design, Warranty etc.

Price Mix: Price policy, Terms of credit, Discount etc.

Promotion Mix: Personal Selling, Advertisement, Publicity, Sales

Promotion etc.

Place Mix: Distribution channels: Wholesaler, retailers, agents,

transport, inventory, warehousing.

The success of marketing depends on well- established institutional set

up and financial, technical and organisation assistance in time.

NSIC (National Small Industries Corporation):

The National Small Industries Corporation Ltd. (NSIC) was set-up by the Government of India in 1955 with the objective of promoting and developing small scale industries in the country.

FUNCTIONS:

Supply and distribution of indigenous and improved raw materials. Supply of both indigenous and imported machine on easy hire-purchase terms. Marketing of Small Industries products within the country. Export of Small Industries products and developing export. Developing prototypes of machines, equipment and tools which are then passed on to Small-Scale Units for commercial production. Technical training in several industrial trades Development and up-gradation of technology and implementation of modernization programmes. Providing of Common Facilities through Prototype Development & Training Centres. Setting-up Small Scale Industries in other developing countries on turnkey basis. acilities are available to the Small-scale unites registered with NSIC under the Single Point Registration Scheme under the Government Store Purchase Programme.

State Financial Corporation (SFC):

State Financial Corporation (SFCs), operating at the State-level, function with the objective of financing and promoting small and medium enterprises for achieving balanced regional socio-economic growth, generating greater employment opportunities. At present, there are 18 SFCS in the country.

Functions

• To provide terms loans for the acquisition of land, building, plant and machinery, pre-ops and other assets.
• To promote self-employment.
• To promote industry by the rural and urban artisans.
• To encourage new and technically/professionally qualified women entrepreneurs in setting up industrial project.
• To finance expansion, modernisation and upgradation of technology in the existing units.
• To provide financial assistance for transport vehicles strictly for captive use, depending on the requirement of the projects.
• To provide Interest subsidy for self-employment of young persons, adoption of indigenous technology in small and medium sector.

State Industries Development Corporations (IDC)

The State Industries Development Corporations (SIDCs) were established

under the Company Act, 1956 in the sixties and early seventies as wholly owned State Government undertaking for promotion and development of medium and large industries. SIDCs act as catalysts for industrial development and provide impetus to further investment in their respective states; The SIDCs are agent of IDBI and SIDBI for operating its seed capital scheme.

Functions:

• Grant of financial assistance to industrial units by way of loans, and guarantees.
• Providing risk capital to entrepreneurs by way of equity participation and seed capital assistance.
• Administering incentive schemes of Central/State Governments;

Technical Consultancy Organisations (TCO):

Objective:

• Carrying out industrial potential surveys, identification of project ideas, project formulation;
• Evaluation of projects referred to them;
• Preparation of project profiles, feasibility studies;
• Preparation of project reports and where called upon, to render turn-key services in project implementation;
• Conduct Entrepreneurship Development Programmes, entrepreneurship awareness camps, SEEUY training programmes;
• Identifying the potential entrepreneurs and providing them with technical and management assistance.
• Undertaking market research and surveys, for specific products;
• Undertaking energy audit and energy conservation assistants;
• Project supervision;
• Undertaking export consultancy and export oriented projects based on modern technology.

National Institution of Design (NID,1970) along with Indian Institution Technology, Mumbai Industrial Design Centre developed courses for industrial design to serve the needs of industries. The candidates selected from backgrounds in engineering, architecture and applied art have become new cadre of fully trained Indian designers. Programme on khadi, Garment Design, cane, bamboo, leather, glass bell metal and wider range of plastics have reduced cost, saved on materials and increased productivity of enterprises.

Science and Technology Entrepreneurship Park (STEP)

Function:

• Conducts entrepreneurship Development programme (EDP).
• Sets up institute- Industry linkage scale.
• Sets up database and information Canter for needs of particular Industry or a cluster of units nearby.
• Provides infrastructure including Central work shop and nursery sheds e.g. Tiruchilapali NIT supported STEP.
• Develops Special process, computer added designs e.g. Harcoat
• Butler Technological institute, Kanpur developing fibre reinforced spun pipes made out cement

Marketing assistance scheme

Marketing, a strategic tool for business development, is critical for the growth and survival of micro, small & medium enterprises. Marketing is the most important factor for the success of any enterprise. Large enterprises have enough resources at their command to hire manpower to take care of marketing of their products and services. MSME sector does not have these resources at their command and thus needs institutional support for providing these inputs in the area of marketing. Ministry of Micro, Small & Medium Enterprises, inter-alia, through National Small Industries Corporation (NSIC), a Public Sector Enterprise of the Ministry, has been providing marketing support to Micro & Small Enterprises (MSEs) under Marketing Assistance Scheme. Emergence of a large and diverse services sector in the past years had created a situation in which it was no longer enough to address the concerns of the small scale industries (SSI) alone but essential to include the entire gamut of enterprises, covering both SSI Sector and related service entities, in a seamless web. There was a need to provide space for the small enterprises to grow into medium scale enterprises, for that is how they will be able to adopt better and higher levels of technology and remain competitive in a fast globalizing world. Thus, as in most developed and developing countries, it was necessary that in India too, the concerns of the entire range of enterprises – micro, small and medium, were

addressed and the sector was provided with a single legal framework. The Micro, Small and Medium Enterprises Development (MSMED) Act, 2006 addresses these issues and also other issues relating to credit, marketing, technology upgradation etc concerning the micro, small and medium enterprises. The enactment of MSMED Act 2006, w.e.f. from 2nd October, 2006 has brought medium scale industries and service-related enterprises also under the purview of the Ministry, accordingly the name of Ministry has also been changed.

The need of the hour presently is to provide sustenance and support to the whole MSME sector (including service sector), with special emphasis on rural and micro enterprises, through suitable measures to strengthen them for converting the challenges into opportunities and scaling new heights. Thus, although the medium

enterprises are also proposed to be included as the target beneficiaries in the scheme, special attention would be given to marketing of products and services of micro and small enterprises, in rural as well as urban areas.

Objectives:

The broad objectives of the scheme, inter-alia, include:

• To enhance marketing capabilities & competitiveness of the MSMEs.
• To showcase the competencies of MSMEs.
• To update MSMEs about the prevalent market scenario and its impact on their activities.
• To facilitate the formation of consortia of MSMEs for marketing of their products and services.
• To provide platform to MSMEs for interaction with large institutional buyers.
• To disseminate/ propagate various programmes of the Government.
• To enrich the marketing skills of the micro, small & medium entrepreneurs.

Marketing support to MSMES

Under the Scheme, it is proposed to provide marketing support to Micro, Small &

Medium Enterprises through National Small Industries Corporation (NSIC) and enhance competitiveness and marketability of their products, through following activities:

Organizing International Technology Exhibitions in Foreign Countries by NSIC and participation in International Exhibitions/Trade Fairs:

International Technology Expositions / exhibitions may be organized by NSIC with a view to providing broader exposure to Indian micro, small & medium enterprises to facilitate them in exploring new business opportunities in emerging and developing markets. These exhibitions may be organised in consultation with the concerned stakeholders and industry associations etc. The calendar for these events may be finalised well in advance and publicised widely amongst all participants/stakeholders. The calendar of events would also be displayed on the Web-site of NSIC. Such expositions showcase the diverse technologies, products and services produced/rendered by Indian MSMEs and provide them with excellent business opportunities, besides promoting trade, establishing joint ventures, technology transfers, marketing arrangements and image building of Indian MSMEs in foreign countries. In addition to the organisation of the international exhibitions, NSIC would also facilitate participation of Indian MSMEs in the select international exhibitions and trade fairs. Participation in such events exposes MSMEs to international practices and enhances their business prowess. These events provide a platform to MSMEs where they meet, discuss, and conclude agreements on technical and business collaborations.

Lack of Finances

Cash flow is essential for startups to survive. One of the key challenges that small businesses face today relates to finances. As income increases, the expenditures also increase and to top it all, startups rely heavily on investors who provide them strong financial support. When such situations arrive, startups are the first ones who lose on properly managing their finances, and eventually succumb to the pressure. While entrepreneurs have to make sure that they have enough funds to go around, in the meantime, they also have to pay their employees, contractors, mortgage, and grocery bills.

Poor Business Planning

Proper planning is the key for startups to get their businesses off the ground. In this technological landscape, writing a formal business plan based on a vague requirement of some institution is suicidal. Due to poor planning, many businesses fail in the very first year because they do not effectively factor in challenges and pitfalls. Even if the startups have innovative ideas and ambitions, but their business plans lack perspective, they are doomed to fail or they have to continuously devise and change them.

Lack of Proper Marketing Strategy

It is always a challenge for startups to figure out best ways to market their products or services. The fact that small businesses need to maximize their return on investment with efficient and result oriented targeted marketing also makes them vulnerable in terms of trust they have develop vis-à-vis customers. Without putting a comprehensive marketing strategy in place, companies’ profits take a steep plunge.

Lack of A Dedicated Team

Due to the lack of a proper team, any business will suffer immensely. Lack of commitment aggravates frustration in the organization which quickly escalates into an open conflict. If the team members start making under commitments due to the fear of being responsible or blamed for failure, businesses will never achieve their goals.

Fierce Competition

Competition is the most inevitable challenge that startups face. In fact, startups have to bear the brunt of facing two-way challenge: one coming from monopolistic businesses that have dominated the market and making difficult for newcomers to emerge. Second, there are countless startups that are launched regularly in the market having innovative ideas, so it is highly likely to get swallowed by the shadow of other startups.

Fixed capital requirements: In order to start the business, funds are required to purchase fixed assets like land and building, plant and machinery, and furniture and fixtures. This is known as fixed capital requirements of the enterprise. The funds required in fixed assets remain invested in the business for a long period of time.

Different business units need a varying amount of fixed capital depending on various factors such as the nature of the business, etc. A trading concern, for example, may require a small amount of fixed capital as compared to a manufacturing concern. Likewise, the need for fixed capital investment would be greater for a large enterprise, as compared to that of a small enterprise.

Fixed capital involves allocation of firm’s capital to long-term assets or projects. Managing fixed capital is related to the investment decision and it is also called Capital Budgeting. The capital budgeting decision affects the growth and profitability of the company.

Factors Affecting Requirement of Fixed Capital:

• Nature of Business
• Scale of Operation
• Technique of Production
• Technology Up-gradation
• Growth Prospects
• Availability of Finance and Leasing Facility
• Level of Collaboration/Joint Ventures

Working Capital

The quantum of working capital is depending upon a large number of factors. It is very difficult to pin point the factor which is highly responsible. The degree of influence of each factor varies from time to time. However, the following are considered some of the important factors that generally influence requirement for working capital.

Factors determining working capital requirements

1. Nature of business determines working capital requirement

In the case of trading concern, there is a need of maintaining large inventories, receivables and cash. Minimum fixed assets is enough. Hence, the trading concern requires more amount working capital. In the case of service organization, large number of fixed assets are required and the services are rendered only on cash basis.

Credit is allowed only to some extent and short period. Hence, the service organization requires less amount of working capital. In the case of manufacturing concern, sizable amount of working capital is required along with large number of fixed assets as in the form of investment.

In nutshell, trading concern requires more working capital and service organization requires less working capital whereas manufacturing concern requires the working capital between these ends.

2. Size of Business / Scale of Operation determines working capital requirement

Generally, more amount of working capital is required if the size of business concern is large and the scale of operation is also high and vice versa. Sometimes, small concerns need more working capital due to high overhead charges and inefficient in use of available resources.

3. Production Policy determines working capital requirement

If the production is carried on the basis of order, less amount of working capital is enough. Sometimes, the production is carried on in anticipation of demand in future. If so, more amount of working capital is required. Some products have seasonal demand. In this case, more amount of working capital is required.

4. Credit Policy determines working capital requirement

If the company follows liberal credit policy and allows more credit sales with long period for repayment, there is a need of more amount of working capital and vice versa.

5. Credit Period Allowed by the Suppliers determines working capital requirement

The credit period allowed by the suppliers may be either short or long. If the credit period is short, there is a need of more amount of working capital and vice versa.

6. Manufacturing Process determines working capital requirement

The manufacturing process may be two, three or four. Moreover, the time required in each process may differ from one process to another. If the number of manufacturing process is large and the time required for each process is short or more, there is a need of more amount of working capital.

On the other hand, if the number of manufacturing process is short and the time required in the process is also short, there is a need of less amount of working capital.

7. Working Capital Cycle determines working capital requirement

Working capital cycle refers to the time required to convert the raw materials into finished goods and up to the stage of conversion of finished goods into cash form. If the working capital cycle is long, there is a need of more amount of working capital and vice versa.

8. Seasonal Variation determines working capital requirement

Some raw materials are available only in season. But, the need of raw material is throughout the year. Hence, the company is forced to buy the raw materials in bulk and store them for one year. If so, more amount of working capital is required.

9. Season Business determines working capital requirement

Some products have marketability only in season. In this case, more amount of working capital is required during seasonable period and less amount of working capital is required for off season period.

10. Business Cycle determines working capital requirement

Business cycle means periods of prosperity, recession, depression and recovery. Whenever the demand for the product is high, prices of the products are also high during the period of prosperity. Therefore, the company requires more amount of working capital.

On the other hand, if the demand for the product is low, prices of the products are also low during the period of depression. Therefore, the company requires less amount of working capital. During the period of recession and recovery, demand for the product and price of the product are moderate. Therefore, the company requires moderate amount of working capital.

11. Rate of Stock Turnover determines working capital requirement

Rate of stock turnover refers to the speed at which the raw materials, work in progress and finished goods converted into cash form. Therefore, if the rate of stock turnover is high, the need of working capital amount is low and vice versa.

12. Speed of Growth of the Company determines working capital requirement

The need of amount of working capital is high if the speed of growth of the company is high and vice versa.

13. Earning Capacity of the Company determines working capital requirement

Some companies have more earning capacity than others due to better quality of the products, monopoly in market and the like. These companies are able to generate more cash inflows than other companies. Hence, these companies require less amount of working capital than others.

14. Dividend Policy determines working capital requirement

The dividend policy of a company influences the requirements of its working capital. If the company prefer to issue bonus shares in the place of cash dividend, the company requires less amount of working capital. In other words, if the company decided to give high rate of cash dividend, whatever be the generation of profits, the company requires more amount of working capital.

15. Changes in the Price of the Product determines working capital requirement

If the price of the product is highly fluctuating, the company requires more amount of working capital. If the price of the products is steady, then, the need of working capital is low.

16. Volume of Sales determines working capital requirement

The volume of sales and the size of the working capital are directly related to each other. If the volume of sales increases, the company requires more amount of working capital and vice versa.

17. Term of Purchases and Sales determines working capital requirement

If a company follows credit purchase and cash sales, the need of amount of working capital is less. On the other hand, if a company follows cash purchase and credit sales, the need of amount of working capital is high. Likewise, a company requires moderate amount of working capital whenever a company follows cash purchase and cash sales and credit purchase and credit sales.

18. Expansion of the company determines working capital requirement

If a company has the plan for expansion, such a company requires more amount of working capital. If a company has no plan for expansion, less amount of working capital is enough.

19. Operating efficiency of the company determines working capital requirement

This relates to the optimum utilization of resources at a minimum cost. If a company is effectively operated, there is a possibility of controlling of operating costs.

20. Profit Appropriation determines working capital requirement

The profits earned by a company is not fully available for working capital purposes. The way profits are appropriated directly affects the contribution towards working capital. If more amount of profits is appropriated, more amount of working capital is available and vice versa.

21. Credit Policies of Reserve Bank of India determines working capital requirement

If the Reserve Bank of India follows selective and restrictive credit policies, the company is not a position to get credit facility from its suppliers. In this case, the company requires more amount of working capital.

22. Capital Structure of the Company determines working capital requirement

If shareholders have provided some funds towards the working capital needs to some extent, the company can get adequate amount of working capital without any difficulty. If the company has to depend entirely upon outside sources for both permanent and temporary working capital needs, the company faces a lot of difficulties for getting adequate amount of working capital.

23. Proportion of the Cost of Raw Materials to Total Costs determines working capital requirement

In those industries where cost of material is a large proportion of the total cost of the goods produced or where costly raw materials are used, large amount of working capital is required. If the proportion of raw materials is small, the amount of working capital requirements is also low.

24. Other Factors determining working capital requirement

Some other factors are also affect the requirements of amount of working capital. They are management ability, involvement of employees, import policy, asset structure, utilization of resources, importance of labour, banking facilities and the like.