Working Capital Management

INTRODUCTION:
The term working capital is commonly used for the capital required for day-to-
day working in a business concern, such as for purchasing raw material, for
meeting day-to-day expenditure on salaries, wages, rents rates, advertising etc.

DEFINITION AND CLASSIFICATION OF WORKING CAPITAL:

Working capital refers to the circulating capital required to meet the day to day
operations of a business firm. Working capital may be defined by various authors
as follows:

1. According to Weston & Brigham - Working capital refers to a firms

investment in short term assets, such as cash amounts receivables, inventories
etc.

2. Working capital means current assets. Mead,

Baker and
Malt
3. The sum of the current assets is the working capital of the business
J.S.Mill

Working capital is defined as the excess of current assets over current liabilities
and provisions.
The term working capital is often referred to circulating capital which is
frequently used to denote those assets which are changed with relative speed
from one form to another i.e., starting from cash, changing to raw materials,
converting into work-in-progress and finished products, sale of finished products
and ending with realization of cash from debtors.

Working capital has been described as the life blood of any business which is
apt because it constitutes a cyclically flowing stream through the business.
Working Capital may be classified in two ways
a) Concept based working capital
b) Time based working capital

Concepts of working capital

1. Gross Working Capital: It refers to the firms investment in total current or
circulating assets.

2. Net Working Capital: The term Net Working Capital has been defined in
two different ways:
i. It is the excess of current assets over current liabilities. Working Capital is positive.
When current assets exceed current liabilities and negative when current liabilities exceed current
assets.
ii. It is that portion of a firms current assets which is financed by long-term
funds.

3. Permanent Working Capital: This refers to that minimum amount of

investment in all current assets which is required at all times to carry out
minimum level of business activities. In other words, it represents the current
assets required on a continuing basis over the entire year. Tandon Committee
has referred to this type of working capital as Core current assets.
The following are the characteristics of this type of working capital:
1. Amount of permanent working capital remains in the business in one form or
another. This is particularly important from the point of view of financing.
2. It also grows with the size of the business. In other words, greater the size of
the business, greater is the amount of such working capital and vice versa.

4. Temporary Working Capital: It is also known as Variable Working Capital or

fluctuating Working Capital. The firms working capital requirements vary depending
upon the seasonal and cyclical changes in demands for a firms products. The extra
Working Capital required as per the changing production and a sales level of a firm is
known as Temporary Working Capital. For example, extra inventory has to be
maintained to support sales during peak sales period. On the other
hand investment in inventories, receivables, etc., will decrease in periods of
depression. Temporary working capital is generally financed from short-term
sources of finance such as bank credit.

Components of Current Assets and Current Liabilities

1 Current Assets are: 1) Inventories 2) Sundry Debtors 3) Bills Receivables
4) Cash and Bank Balances 5) Short term investments 6) Advances such as advances
for purchase of raw materials, components and consumable stores, prepaid
expenses etc.
2 Current Liabilities are:1) Sundry Creditors 2) Bills Payable 3) Creditors for
outstanding expenses 4) Provision for tax 5) Other provisions against the liabilities
payable within a period of
12 months.

Working Capital Management is concerned with managing the different components

of current
assets and current liabilities. A firm must have adequate Working Capital neither
excess nor
shortage. Maintaining adequate Working Capital at the satisfactory level is crucial for
maintaining
the competitiveness of a firm. Any lapse of a firm on this account may lead a firm to
the state of insolvency.

Need for working Capital

The need for working capital arises on account of two reasons:
a. To finance operations during the time gap between sale of goods on credit and
realization of money from customers of the firm.
b. To finance investments in current assets for achieving the growth target in sales.
Therefore finance the operations in operating cycle of a firm working capital is
required.

DETERMINANTS OF WORKING CAPITAL:

A large number of factors influence Working Capital needs of a firm. The basic
objective of a
firms Working Capital management is to ensure that the firm has adequate working
capital for its
operations, neither too much not too little. Investing heavily in current assets will
drain the firms
earnings and inadequate investment in current assets will reduce the firms
credibility as it affects the firms liquidity. Therefore, the need to strike a balance
between liquidity and profitability cannot be ignored. The following factors determine
a firms working capital requirements.
1. Nature of business: Working Capital requirements are basically influenced by
the nature of
business of the firm. Trading organizations are forced to carry large stocks of finished
goods,
accounts receivables and accounts payables. Public utilities require lesser
investment in
working capital.

2. Size of Business Operation: Size is measured in terms of a scale of operation. A

firm with
large scale of operation normally requires more Working Capital than a firm with a
low scale of
operation.

3. Manufacturing Cycle: Capital intensive industries with longer manufacturing

process will
have higher requirements of Working Capital because of the need to run their
sophisticated
and long production process.
4. Volume of sales: There is a positive direct correlation between the volume of
sales and the
size of working capital of a firm.
5. Operating efficiency: Operating efficiency means the optimum utilisation of a
firms resources at minimum cost. The firm with high efficiency in operation can
bring down the total investment in working capital to lower levels. Here effective
utilization of resources helps the firm in bringing down the investment in working
capital.
6. Growth and expansion of business: Working capital requirement of a
business firm tend to increase in correspondence with growth in sales volume
and fixed assets. A growing firm may need funds to invest in fixed assets in order
to sustain its growing production and sales.
7. Import policy
Import policy of the Government may also affect the levels of working capital of
a firm since
they have to arrange funds for importing goods at specified times.
8. Processing technology: Longer the manufacturing cycle the larger the
investment in
working capital when raw material passes through several stages in the production
process
work in process inventory will increase correspondingly.

Estimation/ Measurement of Working Capital

There are 3 methods for assessing the working capital requirement as explained
below:
a) Percent of Sales Method
Based on the past experience, some percentage of sale may be taken for
determining the
quantum of working capital
b) Regression Analysis Method
The relationship between sales and working capital and its various components
may be
plotted on Scatter diagram and the average percentage of past 5 years may be
ascertained.
This average percentage of sales may be taken as working capital. Similar
exercise may
be carried out at the beginning of the year for assessing the working capital
requirement.
This method is suitable for simple as well as complex situations.
c) Operating Cycle Method
Operating cycle of a firm has the following elements.
1. Acquisition of resources from suppliers.
2. Making payments to suppliers.
3. Conversion of raw materials into finished products.
4. Sale of finished products to customers.
5. Collection of cash from customers for the goods sold.
The time gap between acquisition of resources and collection of cash from customers
is known as the operating cycle. These five phases occur on a continuous basis.

Chart for operating cycle or working capital cycle.

In case of trading concerns, the operating cycle will be:

In case of financial concerns, the operating cycle will be:

Length of Operating cycle = R + W + F+ D C

1. Raw Material Consumption period (R) = Average Inventory

Av. Raw Material consumed/
Purchase per day

2. Work in progress Conversion period (W) = Av. Work in progress

Average Cost of production per day

3. Finished goods Storage period (F) = Av. Finished Goods stock

Av. Cost of Sales/ Total Cost per day

4. Debtors Collection period (D) = Av. Debtors (customers)

Av. Credit sales per day

5. Creditors Payment period (C) = Av. Creditors (suppliers)

Av. Credit purchase per day

For the calculation of per day divide the amount by 365

Importance or Advantages of Adequate Working Capital

Working capital is the life blood and nerve centre of a business. Just as circulation
of blood is essential in the human body for maintaining life, working capital is
very essential to maintain the smooth running of a business. No business can run
successfully without an adequate amount of working capital. The main
advantages of maintaining adequate amount of working capital are as follows:
1. Solvency of the business: Adequate working capital helps in maintaining
solvency of the business by providing uninterrupted flow of production.

2. Goodwill: Sufficient working capital enables a business concern to make

prompt payments and hence helps in creating and maintaining goodwill.

3. Easy loans: A concern having adequate working capital, high solvency and
good credit standing can arrange loans from banks and other on easy and
favorable terms.

4. Cash Discounts: Adequate working capital also enables a concern to avail

cash discounts on the purchases and hence it reduces costs.

5. Regular supply of raw materials: Sufficient working capital ensures

regular supply of raw materials and continuous production.

6. Regular payment of salaries, wages and other day-to-day

commitments: A company which has ample working capital can make regular
payment of salaries, wages and other day-to-day commitments which raises the
morale of its employees, increases their efficiency, reduces wastages and costs
and enhances production and profits.