Unit-5: Working Capital

Concept & Components of working Capital


In an ordinary sense, working capital denotes the amount of funds needed for meeting day-to-day operations of a concern.

This is related to short-term assets and short-term sources of financing. Hence it deals with both, assets and liabilities—in the sense of managing working capital it is the excess of current assets over current liabilities

Concept of Working Capital:

The funds invested in current assets are termed as working capital. It is the fund that is needed to run the day-to-day operations. It circulates in the business like the blood circulates in a living body. Generally, working capital refers to the current assets of a company that are changed from one form to another in the ordinary course of business, i.e. from cash to inventory, inventory to work in progress (WIP), WIP to finished goods, finished goods to receivables and from receivables to cash.

There are two concepts in respect of working capital:

(i) Gross working capital and

(ii) Net working capital.

Gross Working Capital:

The sum total of all current assets of a business concern is termed as gross working capital. The term ‘gross working capital’ refers to the firm’s investment in current assets. According to this concept working capital refers to a firm’s investment in current assets. The amount of current liabilities is not deducted from the total of current assets.So,

Gross working capital = Stock + Debtors + Receivables + Cash.

Net Working Capital:

The difference between current assets and current liabilities of a business con­cern is termed as the Net working capital.Hence

Net working capital= Stock+debtors+recievables+Cash-Creditors-Payables

Components of Working Capital:

1. Current Assets:

Current assets are those assets which are convertible into cash within a period of one year and are those which are required to meet the day to day operations of the business. The working capital management, to be more precise the management of current assets. The current assets are cash or near cash resources.

These include:

(a) Cash and bank balances,

(b) Temporary investments,

(c) Short-term advances,

(d) Prepaid expenses,

(e) Receivables,

(f) Inventory of raw materials, stores and spares,

(g) Inventory of work-in-progress, and 

(h) Inventory of finished goods.

2. Current Liabilities:

Current liabilities are those claims of outsiders which are expected to mature for payment within an accounting year.

These include:

(1) Creditors for goods purchased,

(2) Outstanding expenses,

(3) Short-term borrowings,

(4) Advances received against sales,

(5) Taxes and dividends payable, and 

(6) Other liabilities maturing within a year.

Objectives of Working Capital Management:

The basic objectives of working capital management are as follows:

(a) By optimizing the investment in current assets and by reducing the level of current liabilities, the company can reduce the locking-up of funds in working capital thereby, it can improve the return on capital employed in the business.

(b) The second important objective of working capital management is that the company should always be in a position to meet its current obligations which should properly be supported by the current assets available with the firm. But maintaining excess funds in working capital means locking of funds without return.

(c) The firm should manage its current assets in such a way that the marginal return on investment in these assets is not less than the cost of capital employed to finance the current assets.

(d) The firm should maintain proper balance between current assets and current liabilities to enable the firm to meet its day to day financial obligations.

Factors Affecting the Composition of Working Capital

Availability of Raw Materials

Availability of raw materials affects the composition of the working capital. When your company is using readily available raw materials, minimal working capital will be needed, because there will be no need to stock such materials in large volumes. But if your company makes use of seasonal raw materials needed for production all year, then you need to hold large quantities; this requires more working capital.

Nature of Business

Working capital requirements vary by industry. For instance, businesses in the service industry require a low level of working capital because they do not pay cash for inventory. Companies in a manufacturing sector, however, require a higher level of working capital because it takes some time to produce and then sell their goods. Therefore, it is important for you to determine the best-fit working capital requirements based on the nature of your business.

Operation Efficiency

Operating efficiency entails how fast you can convert raw materials to finished goods, sell these finished products and claim your payments from customers. High-efficiency businesses require less working capital. However, in the case of lower operating efficiency, your company will require more working capital.

Rate of Growth and Expansion

A company that is in a period of growth and expansion requires more working capital than a company that is static. Growing companies face an increase in the cost of business operations in terms of production and sales. To meet the production and sales needs of the business, you need more working capital. Therefore, if you want to grow or expand your business, you should start by planning to increase the working capital reserves.

Business Cycle:

The need for the working capital is affected by various stages of the business cycle. During the boom period, the demand of a product increases and sales also increase. Therefore, more working capital is needed. On the contrary, during the period of depression, the demand declines and it affects both the production and sales of goods. Therefore, in such a situation less working capital is required.

Production cycle

Production cycle means the time involved in converting raw material into finished product. The longer this period, the more will be the time for which the capital remains blocked in raw material and semi-manufactured products.

Thus, more working capital will be needed. On the contrary, where period of production cycle is little, less working capital will be needed.

Credit Allowed:

Those enterprises which sell goods on cash payment basis need little working capital but those who provide credit facilities to the customers need more working capital.

Level of Competition:

High level of competition increases the need for more working capital. In order to face competition, more stock is required for quick delivery and credit facility for a long period has to be made available.

Liquidity vs Profitability

Meaning of Liquidity:

Liquidity means one’s ability to meet claims and obligations as and when they become due. In the context of an asset, it implies convertibility of the same ultimately into Cash and it has two dimensions in it, viz., time and risk.

The time dimension of liquidity is concerned the speed with which an asset can be convertedinto Cash Risk dimension is concerned with the degree of certainty with which an asset can be converted into Cash without any sacrifice in its book value.

Measurement of Liquidity:

The liquidity is normally measured with the help of the following financial ratios:

(a) Current Ratio;

(b) Liquid Ratio;

(c) Absolute Liquidity Ratio;

(a) Current Ratio:

It is the relation between the amount of current assets and the amount of current liabilities. It is essentially a tool for measuring short-term liquidity and solvency position of firms.Generally, a 2 : 1 ratio is considered as normal and it expresses the satisfactory liquidity position

(b) Liquid Ratio:

It is the ratio between total liquid assets to total liquid liabilities. The normal for such ratio is taken to be 1:1

(c) Absolute Liquidity Ratio:

Liquid ratio measures the relationship between cash and near cash items on the one hand and immediately maturing obligation on the other.

Meaning of Profitability:

Profitability of a firm is represented by the rate of return on its capital employed.

This is measured as:

It is clear from the above that the ratio between Net Profit and Sales, can be increased either by reducing the Cost of Sales or by increasing the volume of sales. Reduction in cost of sales is possible only when there is an effective management of working capital.

In the second alternative, increase in sales is associated with increase in variable cost. And therefore, only an optimum use of working capital can ensure increase in profitability due to increase in sales.