Capital used to purchase current assets are termed as circulating capital. Every type of business requires a certain amount of fixed capital to carry on its activities
Profit is the prime motto of a business. Therefore, the way in which capital is utilised has a lot to do with its success or failure. The policies relating to the use of capital concern almost every activity of a business. For example, plans for sales, i.e., for the products to be sold, the pricing and promotional strategy to be followed, and plans for production, i.e., decisions relating to manufacture or purchase, the adoption of new technology and plans for the recruitment of expertise, motivational programmes, investment in human resource development — all these dictate the way in which capital may be utilised. The policies relating to the use of capital do not, however, stipulate the specific use of capital; in fact, these are largely monitored by other management decisions.
Assets like plants, machinery, land and buildings purchased with permanent capital are kept in business for the purpose of earning a profit over a longer period of time. However, in addition to these, there are assets which are normally not retained for a longer period, for they usually change their forms over and again during the course of a year. These are known as current assets, and the capital used to purchase them is termed as circulating capital. In a business cash, inventory and accounts receivable constitute the circulating capital because this capital changes frequently its form. The original capital is typically in the form of cash. This is invested in inventories, general administration, and sales promotional expenses. After making investment inputs, the management sells the output in the market with an intention of recovering the money so spent. When the product is sold on cash, the capital is again made available to the business. And so the cycle goes on.
The circulating capital requirements of a business vary considerably over a period of time; for instance, fluctuations in the sales volume often bring about fluctuations in the size of the capital invest in accounts receivable. These fluctuations in sales may be reflected in purchasing and production programmes. Quite often, managers build up heavy inventories to meet market demands during peak periods. The unfavorable period of business cycles may result in the slow movements of goods and may call for higher credit to intermediaries, which may result in the blocking of circulating capital. As both external constraints and management decisions pertaining to the internal operations of the business affect the size of the circulating capital, sound policies and rigorous control standards must be followed to ensure that the total amount is profitably employed.
Use of Circulating Capital
The policies relating to circulating capital should include general restrictions on the amount of capital invested in inventories. The size of an inventory must be consistent with other possible uses of this capital. If a company experiences difficulty in maintaining an adequate cash flow, it should try to minimise investment in inventories in such a fashion that no undue strain is put on its financial resources, and at the same time, an economic order quantity is maintained to maintain the production schedule. As the creditworthiness of a company is assessed by its current ratio, most companies place financial restrictions on inventory building.
Though inventory management is certainly not the main problem of the finance people, it is necessary for them to see to it that the purchase of inventory does not lead to a dilution of the current ratio.
Every type of business requires a certain amount of fixed capital to carry on its activities. For example, a machine tool producing concern may require a huge amount of capital for the installation of plant, machinery, etc. A retail store may need it for investment in fixtures and furniture. Even a consulting firm has to invest in office decoration, computers and typewriters. The investment made in such form is referred to as fixed capital because these terms of expenditure typically render services over a period of time.
In the words of Betty: “All fixed assets, intangible assets (such as goodwill, patents and trade marks investment) and other assets which are retained permanently in the business are purchased from funds which may be regarded as the fixed or permanent capital”. The fixed capital employed in business turns back into cash more slowly than circulating capital.
At any instance, it should not be taken for granted that fixed capital represents the only long-term investment required in a business. Actually, a growing business needs a minimum amount of capital to be invested in account receivables, inventory and other circulating items. The cash from accounts receivable should again be invested in inventories. The requirements of circulating capital are as regular as those of fixed capital. The financial programme of an enterprise should therefore provide for long-term capital to cover both fixed and circulating capital requirements.