Capital Structure, Fixed Capital and Working Capital (ISC Class 12 Commerce)
Updated 18 October 2026 · Fact-checked
Capital structure is the proportion of owners' funds and borrowed funds in a company's long-term capital. Trading on equity uses debt to raise earnings per share when the return on investment exceeds the cost of debt. Fixed capital is invested in long-term assets; working capital finances day-to-day operations, and net working capital is current assets minus current liabilities.
Understand Capital Structure, Fixed Capital and Working Capital
1. Capital structure. The proportion of owners' funds (equity, preference capital, reserves) and borrowed funds (debentures, long-term loans) in the long-term capital of a company. A company with a large proportion of fixed-cost capital (debt and preference) relative to equity is highly geared; one with mostly equity is low geared.
2. Trading on equity. Using fixed-cost funds to increase the return to equity shareholders. It works when the return on investment exceeds the cost of debt.
*Illustration (imaginary):* total capital Rs 20,00,000, earning before interest and tax (EBIT) 16% = Rs 3,20,000, tax 30%, shares of Rs 100.
| Plan | Debt | Interest at 9% | Profit before tax | Tax 30% | Profit after tax | Equity shares | EPS |
|---|---|---|---|---|---|---|---|
| All equity | 0 | 0 | 3,20,000 | 96,000 | 2,24,000 | 20,000 | Rs 11.20 |
| Geared | 12,00,000 | 1,08,000 | 2,12,000 | 63,600 | 1,48,400 | 8,000 | Rs 18.55 |
3. Factors affecting capital structure. Trading on equity; cash flow position (can it service debt?); interest coverage and financial risk; control (an equity issue dilutes control, debt does not); cost of capital (debt is usually cheaper as interest is tax-deductible); flexibility; market conditions; legal requirements and floatation costs; nature and size of the business.
4. Fixed capital. Capital invested in long-term assets such as land, buildings, plant and machinery, furniture and vehicles, used for many years. Decisions are long-term, involve large sums and are hard to reverse.
Factors: nature of business (manufacturing needs more than trading); scale of operations; choice of technique (capital-intensive needs more); technology upgradation; growth prospects; diversification; financing alternatives such as leasing; level of collaboration.
5. Working capital. Capital needed for day-to-day operations: raw materials, wages and expenses, stock and credit given. Gross working capital = current assets. Net working capital = current assets - current liabilities.
Types: permanent (regular) working capital, the minimum always needed; temporary (variable) working capital, which includes seasonal and special (emergency) needs; initial working capital at the start.
Factors: nature of business (trading needs more); scale; length of the operating cycle; business cycle; seasonal factors; credit allowed and availed; growth; inflation; availability of raw materials.
6. Comparison
| Basis | Fixed capital | Working capital |
|---|---|---|
| Purpose | Buy long-term assets | Finance daily operations |
| Period | Long term | Short term |
| Sources | Shares, debentures, long-term loans | Trade credit, overdraft, short-term loans |
| Form | Assets held for use, not sale | Circulates: cash, stock, debtors, cash |
| Liquidity | Low | High |
Capital Structure, Fixed Capital and Working Capital: key facts
- Net working capital
- Current assets
- Minus
- Current liabilities
- Gross working capital = current assets.
- Earnings per share
- Profit after tax
- Divided by
- Number of equity shares
- Used to test trading on equity.
- Trading on equity works when
- Return on investment
- Greater than
- Cost of debt
- Otherwise EPS falls.
How to answer Capital Structure, Fixed Capital and Working Capital questions
Questions ask for meanings, factors, EPS under two plans, or net working capital, or a comparison of fixed and working capital.
- 1For EPS: EBIT less interest gives profit before tax; less tax gives profit after tax; divide by shares.
- 2Compare the EPS of the plans and state whether trading on equity helped.
- 3For working capital, separate current assets and current liabilities and subtract.
- 4For factors, keep fixed capital factors and working capital factors in separate lists.
Capital Structure, Fixed Capital and Working Capital in real life
The idea, met in an everyday situation. Answer the question in your own words, then compare with the model answer. The one-line hook is what to remember.
Seasonal working capital
Suppose a company that makes raincoats must buy extra cloth and pay extra workers for three months before the monsoon.
Identify the type of working capital needed for the extra stock.
Try it first, then show the solutionSolution
- The extra need arises in a particular season.
- It is temporary, not regular.
Answer: Seasonal (temporary) working capital.
Memory hook: Season brings extra funds.
Fixed capital factor
Imagine a food-delivery company chooses to lease its vehicles instead of buying them.
Which factor affecting fixed capital does this show?
Try it first, then show the solutionSolution
- Leasing reduces the amount needed to buy assets.
- It is a financing alternative.
Answer: Financing alternatives (leasing).
Memory hook: Lease lowers fixed capital.
Tricks to remember Capital Structure, Fixed Capital and Working Capital
Short memory aids. Say each one aloud once, then use it on a question the same day.
Fixed for years, working for weeks
Fixed capital is tied up for years in assets; working capital turns over within the operating cycle.
Use it when: Fixed versus working capital.
ROI above interest
Trading on equity helps only when return on investment is above the interest rate.
Use it when: Capital structure decisions.
Capital Structure, Fixed Capital and Working Capital: solved examples
Ordered from board level to HOTS. Try each one before you open the solution.
Example 1: Net working capital · 1 mark · MCQBoard level
A firm has current assets of Rs 7,50,000 and current liabilities of Rs 4,20,000. Its net working capital is:
(a) Rs 11,70,000
(b) Rs 3,30,000
(c) Rs 7,50,000
(d) Rs 4,20,000
Try it first, then show the solutionSolution
- Net working capital = 7,50,000 - 4,20,000 = Rs 3,30,000.
Answer: (b)
Example 2: Fixed versus working capital · 2 marks · Short answerBoard level
Distinguish between fixed capital and working capital on two bases.
Try it first, then show the solutionSolution
- Purpose: fixed capital buys long-term assets; working capital finances day-to-day operations.
- Period: fixed capital is invested for the long term; working capital is short term and circulates.
Answer: Differ in purpose and period.
Example 3: Trading on equity · 4 marks · Short answerHarder board level
Suppose a company has capital of Rs 20,00,000 earning 16% before interest and tax, with tax at 30% and shares of Rs 100. Plan A is all equity; Plan B has debt of Rs 12,00,000 at 9% and the rest in equity. Calculate the EPS for each plan and state whether trading on equity helps.
Try it first, then show the solutionSolution
- EBIT = 16% of 20,00,000 = Rs 3,20,000.
- Plan A: tax = 30% of 3,20,000 = 96,000; profit after tax = 2,24,000; shares = 20,00,000 / 100 = 20,000; EPS = 2,24,000 / 20,000 = Rs 11.20.
- Plan B: interest = 9% of 12,00,000 = 1,08,000; profit before tax = 2,12,000; tax = 63,600; profit after tax = 1,48,400; equity = 8,00,000, so shares = 8,000; EPS = 1,48,400 / 8,000 = Rs 18.55.
- EPS rises from Rs 11.20 to Rs 18.55 because return on investment (16%) exceeds the 9% cost of debt.
Answer: Rs 11.20 and Rs 18.55; trading on equity helps.
Example 4: When debt hurts · 4 marks · Short answerHOTS / competency
Suppose in the same company earnings fall so that EBIT is only 6% of capital, the interest rate remaining 9% and the tax rate 30%. Calculate the EPS under Plan B and compare with Plan A, and state the lesson.
Try it first, then show the solutionSolution
- EBIT = 6% of 20,00,000 = Rs 1,20,000.
- Plan A: tax = 36,000; profit after tax = 84,000; EPS = 84,000 / 20,000 = Rs 4.20.
- Plan B: interest = 1,08,000; profit before tax = 12,000; tax = 3,600; profit after tax = 8,400; EPS = 8,400 / 8,000 = Rs 1.05.
- Lesson: when return on investment (6%) is below the cost of debt (9%), debt reduces EPS and raises financial risk.
Answer: Plan A Rs 4.20; Plan B Rs 1.05; debt hurts when return is below the cost of debt.
Example 5: Plan the capital of a new factory · 8 marks · Long answerHOTS / competency
Suppose a company plans a new biscuit factory with plant costing Rs 60,00,000, a building costing Rs 40,00,000, and stock, wages and credit to customers needing Rs 25,00,000 in the first cycle. Identify the fixed and working capital, state suitable sources of each and discuss two factors affecting each requirement.
Try it first, then show the solutionSolution
- Fixed capital = 60,00,000 + 40,00,000 = Rs 1,00,00,000; working capital (initial) = Rs 25,00,000.
- Sources of fixed capital: equity and preference shares, debentures, long-term loans.
- Sources of working capital: trade credit, bank overdraft or short-term loans.
- Fixed capital factors: nature of business (manufacturing is heavy in plant) and scale of operations.
- Working capital factors: length of the operating cycle and credit allowed to customers.
- Also state that long-term assets should be financed by long-term funds.
Answer: Fixed Rs 1,00,00,000, working Rs 25,00,000, with sources and two factors each.
Where students lose marks in Capital Structure, Fixed Capital and Working Capital
The slips examiners see most often, and what to write instead.
Mistake: Mixing the factors of fixed and working capital
The chapter keeps the two sets separate.
Wrong working
Factor of fixed capital: length of the operating cycle.
Right working
Operating cycle affects working capital; fixed capital depends on nature and size of business and technology.
Do this: Two separate lists.
Usually costs: 2 marks.
Mistake: Dividing profit by the wrong number of shares
Shares change with the plan.
Wrong working
Plan B EPS = 1,48,400 / 20,000.
Right working
Plan B has equity of Rs 8,00,000, so 8,000 shares; EPS = 1,48,400 / 8,000 = Rs 18.55.
Do this: Recompute the share count for each plan.
Usually costs: 2 marks.
Mistake: Taxing before deducting interest
Interest is deducted before tax.
Wrong working
Tax on EBIT, then interest.
Right working
EBIT less interest gives profit before tax; tax is on that.
Do this: Follow the order EBIT, interest, tax.
Usually costs: 2 marks.
Exam tips
- Show the full EPS table: EBIT, interest, PBT, tax, PAT, shares, EPS.
- State the condition for trading on equity: return above cost of debt.
- Keep fixed capital and working capital factors in separate lists.
- Give net working capital with the subtraction shown.
Practice questions on Capital Structure, Fixed Capital and Working Capital
Write each answer on paper first. Open the hint only if you are stuck, and the answer only when you have finished.
Q1 · 1 mark · Very short answerBoard level
Define capital structure.
Hint
Mix of two kinds of funds.
Answer
The proportion of owners' funds and borrowed funds in the long-term capital of a company.
Q2 · 2 marks · Short answerBoard level
Name two factors affecting working capital.
Hint
Cycle and credit.
Answer
Length of the operating cycle and credit allowed to customers (also nature of business, seasonal factors, scale).
Q3 · 2 marks · Short answerHarder board level
Why does a manufacturing firm need more fixed capital than a trading firm?
Hint
Plant.
Answer
Manufacturing needs plant, machinery and buildings, whereas a trader mainly needs a shop and stock, so the nature of the business raises fixed capital needs.
Q4 · 4 marks · Short answerHarder board level
A company has capital of Rs 10,00,000 earning 18% before interest and tax; tax is 30%; shares are Rs 100. Plan X is all equity; Plan Y has Rs 6,00,000 debt at 10%. Calculate the EPS under each plan.
Hint
EBIT first.
Answer
EBIT = Rs 1,80,000. Plan X: tax 54,000; profit after tax 1,26,000; shares 10,000; EPS Rs 12.60. Plan Y: interest 60,000; profit before tax 1,20,000; tax 36,000; profit after tax 84,000; shares 4,000; EPS Rs 21.
Q5 · 4 marks · Short answerHOTS / competency
A firm's current assets are Rs 9,00,000 and its current liabilities Rs 5,50,000. A sudden strike forces it to hold extra stock costing Rs 1,00,000 financed by a short-term loan. Find net working capital before and after, and classify the extra amount.
Hint
Both sides rise.
Answer
Before: 9,00,000 - 5,50,000 = Rs 3,50,000. After: current assets 10,00,000 and current liabilities 6,50,000, so net working capital stays Rs 3,50,000. The extra Rs 1,00,000 is special (temporary) working capital.
Test your recall
Answer in your head or on paper first, then open the card. Pulling an answer out of memory makes it stick far better than re-reading.
1.What is trading on equity?Show answer
Using debt to raise returns to equity shareholders.
2.Define net working capital.Show answer
Current assets minus current liabilities.
3.Name one factor affecting fixed capital.Show answer
Nature of business, scale, technique, technology, growth or leasing.
4.What is permanent working capital?Show answer
The minimum working capital always needed.
Capital Structure, Fixed Capital and Working Capital: frequently asked questions
Is a highly geared company always risky?
It has higher financial risk, though it can earn higher EPS when returns exceed the cost of debt.
Is leasing a fixed capital factor?
Yes, as a financing alternative that reduces the need to buy assets.
Is special working capital permanent?
No, it is temporary, kept for emergencies or special events.