Concepts of Working Capital | Importance | Factors | Sources | Management

What is Working Capital?

Working capital is the amount of funds required by an organization to finance its day-to-day operations. It is the amount of funds required to cover the cost of running the enterprise. It is the portion of the total capital employed in short term assets such as inventories, raw materials, accounts receivable, etc.

In other words, working capital refers to the capital which is required by the firm for financing short term or current assets such as cash, marketable securities, debtors and inventories.

Working Capital is very essential for the smooth running of a business. A business can run successfully only when it has adequate amount of working capital.

Significance of Working capital

A firm should maintain right amount of working capital. The working capital should neither be surplus nor inadequate.

1. If an organization has excessive working capital, then it indicates funds are remaining idle without profits.

2. If an organization has inadequate working capital, then it indicates that the firm does not have sufficient funds to meet day-to-day expenses.

Gross and Net Working Capital

The term working capital is treated in two different senses:

1. Gross Working Capital

Gross Working Capital is the total value of current assets of the firm. Some of the current assets are cash in hand, cash at bank, inventories, bills receivable, short term investments.

2. Net Working Capital

It is the excess of current assets over current liabilities i.e. Current Assets-Current Liabilities. When current assets exceed current liabilities, net working capital is consider positive. On the other hand, when current liabilities exceed current assets net working capital is considered to be negative.

Current Assets are the assets which can be converted into cash within one year in the ordinary course of business. Current Liabilities are the claims of the outsiders. They are expected to be met in the ordinary course of business.

The concepts of gross working capital and net working capital can be understood with the help of the following example.

XYZ Ltd. presents the following balance sheet at 31st December 2017.

XYZ Ltd - Balance Sheet
XYZ Ltd – Balance Sheet

Now the gross working capital will be calculated as follows.

Gross Working Capital
Gross Working Capital

Now the net working capital will be calculated as follows.

Net Working Capital
Net Working Capital

Operating Cycle

Working capital is required by an organization to bridge the time gap between the production of goods and realization of cash through sale of goods. This time gap is also called operating cycle of the business.

Operating cycle is the time involved in the conversion of raw material / resources into finished goods or services including the credit period involved for selling products / services.

A simple operating capital cycle may undergo the following stages:

Operating Cycle
Operating Cycle

1. The chain begins with the firm buying raw materials.

2. In due course, this raw materials or stock will be used in production, and in process. It gets converted into work in progress (WIP).

3. Work will continue on the WIP and it turns out to be finished goods.

4. When the finished goods are sold on credit, debtors come into existence.

5. When the debtors make the payment, cash will flow into the Organization.

Between each stage of this working capital cycle there is a time delay. For some businesses this will be very long where it takes them a long time to make and sell the product. They will need a substantial amount of working capital to survive.

Types of Working Capital

Working capital can be classified into permanent working capital and variable working capital.

1. Permanent Working Capital

It is the minimum amount of investment in all current assets. The minimum amount is invested through the lifetime of the business. Since the investment is permanently required, it is called permanent working capital. Permanent working capital is financed out of long-term funds.

2. Variable Working Capital

This is the amount of working capital that keeps fluctuating from time to time. The amount of investment in current assets increases or decreases depending upon the operating cycle.

For example, more amount of goods/ inventory have to be stocked during the period of peak sales. Similarly, less amount of goods/ inventory have to be stocked during off season. Since the amount of working capital fluctuates according to the needs of the business, it is called variable working capital. It is financed out of short term funds.

Importance of Adequate Working Capital

Generally speaking, companies with higher amounts of working capital are better positioned for success. They have the liquid assets needed to meet their expenses and sufficient funds for expansion of their business. Every business needs some amount of working capital. Adequate working capital is required for the following reasons:

1. Smooth functioning of the business

A firm can utilize the plant effectively if there is no shortage of inventories. To continue uninterrupted operations and for smooth functioning, adequate working capital is required.

2. Liquidity

An organization can pay off its current liabilities only if it has adequate working capital. It can meet its short term obligation if there is sufficient working capital.

3. Goodwill

If an organization fails to meet its short term obligation in time, it will lose its reputation. Hence to earn good reputation in the society, an organization should have adequate working capital.

4. Lower Cost

An organization can purchase raw materials at competitive price only when it has got sufficient funds to buy the raw materials. Similarly, funds can be borrowed by the organization from financial institutions at lower rate of interest, only if it pays the liabilities in time. Hence adequate working capital is required.

5. Profitability

Having adequate working capital reduces the cost of operation. It improves the profit of the firm.

Factors determining Working Capital Requirement

The following factors should be taken into consideration for determining the working capital of an organization.

1. Size

The amount of working capital depends on the size of the firm. A large firm requires more working capital than a small firm. A large firm has to invest a huge sum of money in inventories. Hence more working capital is required by a large firm.

2. Nature of business

The working capital requirements depend on the nature of business. If a business is operated on cash basis then less amount of working capital is required. For example, Gas Agencies run business only on cash basis hence, less amount of working capital is required.

A trading concern has to invest a large sum in inventories. Hence, they require more working capital than a manufacturing concern.

3. Terms of Credit

If a firm follows strict credit policy then less working capital is required. If the firm is liberal in its credit policy then more working capital is required. If the debts are not collected quickly or the credit period given is longer, then more working capital is required.

4. Banking Factor

If the bank provides adequate credit facility to institutions for meeting their short-term finance obligation, then less working capital is required.

5. Seasonal Variation

The amount of working capital depends on the seasonal variation for seasonal goods. If goods are sold during the season more working capital is required during the peak period.

For example, the working capital requirements vary for a manufacturer of umbrellas and raincoats.

6. Contingencies

Demand for the goods, price of a product also cause fluctuations in the amount of working capital. If the inventory is quickly converted into cash, less working capital is required.

7. Type of Production Process

Labour intensive firms have to pay wages and salaries to employees promptly. If a firm is labor intensive in nature. then more working capital is required. Likewise, if a firm utilizes or spends a major portion of money or raw materials or in production process, then more working capital is required.

8. Length of Operating Cycle

If the time gap between the purchase of raw material and realization of cash from sale of goods is longer, then more working capital is required. Less working capital is required if the operating cycle is shorter.

For example, heavy engineering needs more working capital than a cotton spinning mill.

9. Inventory Turnover

It the Inventory turnover is slow and if the amount of Inventory is large, more working capital is required. Inventory turnover is the rate at which sales are made.

Sources of Working Capital

Variable working capital is funded through

1. Trade Credit

2. Short term Loans

3. Public Deposits

4. Accrual Accounts

5. Advances From Customers

6. Factoring

Permanent working capital is funded through Issues of shares

1. Issue of debentures

2. Long term loans and

3. Retained earnings

Working Capital Management

Sometimes, a company will have a large amount of assets, but have very little with which to meet their business operations. Hence, working capital management is essential. Working capital management involves the relationship between a firm’s short-term assets and its short-term liabilities.

The objective of working capital management is to ensure that a firm is able to continue its operations and that it has sufficient funds to meet both maturing short-term debt and upcoming operational expenses.

The management of working capital involves

  1. Managing Inventories,
  2. Managing Cash,
  3. Managing accounts receivable and
  4. Managing payable.

1. Management of inventories

Inventory management helps in identifying the level of inventory, which allows for uninterrupted production but reduces the investment in raw materials. It reduces reordering costs and hence increases cash flow.

2. Management of cash

Cash means liquid assets that a business owns. It includes cheques, Money orders & bank drafts. Cash Management involves efficient collection and disbursement of cash and temporary investment of cash. It refers to maintaining optimum level of cash in an organization. Cash Management helps in identifying the cash balance which allows for the business to meet day-to-day expenses, and reduces cash holding costs.

Cash management involves

  • Controlling the level of cash maintained in the organization through cash budgeting and cash flow statements.
  • Exercising control over cash inflows through decentralized collection of debts
  • Exercising control over cash outflows through centralized disbursements of cash
  • Investing the surplus cash in appropriate investments.

3. Management of Receivables

Receivables Management involves maintaining optimum level receivables in an organization. It is a level where there exists trade-off between Profitability & Cost. Selling goods on credit brings cash inflows. It also involves risk of bad debts. Debtors management or receivables management helps in identifying the appropriate credit policy. Appropriate credit terms will attract customers, in such a way that cash flows and the cash conversion cycle results in increased revenue.

Management of receivables helps the organization to exercise control on credit. It focuses on establishing clear credit practices as a matter of company policy. Management of receivables helps in avoiding poor collection of debts. It also tries to retain the customers through effective management of credit.

4. Management of Payable

Creditors are a vital part of effective cash management and should be managed carefully to enhance the cash position. Purchasing involves cash outflows and an over-zealous purchasing function can create liquidity problems. Management of creditors boosts the image of the organization’s management.