Working Capital Concepts

Definition
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. Mathematically, it is represented as follows:

Working Capital = Current Assets – Current Liabilities

Working capital management involves the relationship between a firm's short-term assets and
its short-term liabilities. The basic goal of working capital management is to ensure that a firm is able to
continue its operations and that it has sufficient ability to satisfy both maturing short-term debt and
upcoming operational expenses. The management of working capital involves managing cash,
inventories, accounts receivable and accounts payable.

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:

1. Gross working capital; and
2. Net working capital.

The gross working capital refers to the firm’s investment in current assets. Current assets are the assets,
which can be converted into cash within an accounting year or within an operating cycle. The
components are cash, marketable securities, accounts receivables, inventories and prepaid expenses.
Net working capital, on the other hand, refers to the difference between current assets and current
liabilities. Current liabilities are those claims of outsider, which are expected to mature for payment
within an accounting year & include creditors, bills payable & the outstanding expenses. In other words
you can say that this is the excess of current assets over current liabilities.
To put it simply, the gross working capital is the entity’s total current assets, while its net working capital
is its total current assets minus total current liabilities.

Nature of Working Capital

The nature of working capital are as follows:
a. It is used for purchase of raw materials, payment of wages and expenses.
b. It changes form constantly to keep the wheels of business moving.
c. Working capital enhances liquidity, solvency, creditworthiness and reputation of the enterprise.
d. It generates the elements of cost namely: Materials, wages and expenses.
e. It enables the enterprise to avail the cash discount facilities offered by its suppliers.
f. It helps improve the morale of business executives and their efficiency reaches at the highest
climax.
 g. It facilitates expansion programs of the enterprise and helps in maintaining operational effi-
ciency of fixed assets.

Need for Working Capital

Working capital plays a vital role in business. This capital remains blocked in raw materials, work in
progress, finished products and with customers.

The needs for working capital are as follows:

a. Adequate working capital is needed to maintain a regular supply of raw materials, which in turn
facilitates smoother running of production process.
b. Working capital ensures the regular and timely payment of wages and salaries, thereby
improving the morale and efficiency of employees.
c. Working capital is needed for the efficient use of fixed assets.
d. In order to enhance goodwill a healthy level of working capital is needed. It is necessary to build
a good reputation and to make payments to creditors in time.
e. Working capital helps avoid the possibility of under-capitalization.
f. It is needed to pick up stock of raw materials even during economic depression.
g. Working capital is needed in order to pay fair rate of dividend and interest in time, which
increases the confidence of the investors in the firm.

Importance of Working Capital

It is said that working capital is the lifeblood of a business. Every business needs funds in order to run its
day-to-day activities.

The importance of working capital can be better understood by the following:

a. It helps measure profitability of an enterprise. In its absence, there would be neither production
nor profit.
b. Without adequate working capital an entity cannot meet its short-term liabilities in time.
c. A firm having a healthy working capital position can get loans easily from the market due to its
high reputation or goodwill.
d. Sufficient working capital helps maintain an uninterrupted flow of production by supplying raw
materials and payment of wages.
e. Sound working capital helps maintain optimum level of investment in current assets.
f. It enhances liquidity, solvency, credit worthiness and reputation of enterprise.
g. It provides necessary funds to meet unforeseen contingencies and thus helps the enterprise run
successfully during periods of crisis.

Classifications of Working Capital

Working capital may be of different types as follows:

Gross Working Capital

Gross working capital refers to the amount of funds invested in various components of current assets. It
consists of raw materials, work in progress, debtors, finished goods, etc.

Net Working Capital

The excess of current assets over current liabilities is known as Net working capital. The principal
objective here is to learn the composition and magnitude of current assets required to meet current
liabilities.

Positive Working Capital

This refers to the surplus of current assets over current liabilities.

Negative Working Capital

Negative working capital refers to the excess of current liabilities over current assets.

Permanent Working Capital

The minimum amount of working capital which even required during the dullest season of the year is
known as Permanent working capital.

Temporary or Variable Working Capital

It represents the additional current assets required at different times during the operating year to meet
additional inventory, extra cash, etc.

It can be said that Permanent working capital represents minimum amount of the current assets
required throughout the year for normal production whereas Temporary working capital is the addi -
tional capital required at different time of the year to finance the fluctuations in production due to
seasonal change. A firm having constant annual production will also have constant Permanent working
capital and only Variable working capital changes due to change in production caused by seasonal
changes.
Similarly, a growth firm is the firm having unutilized capacity, however, production and operation
continues to grow naturally. As its volume of production rises with the passage of time so also does the
quantum of the Permanent working capital.

Components of Working Capital:

(A) Current Assets:
These assets are generally realized within a short period of time, i.e. within one year. Current assets
include:
(a) Inventories or Stocks
(i) Raw materials
(ii) Work in progress
(iii) Consumable Stores
(iv) Finished goods
(b) Sundry Debtors
(c) Bills Receivable
(d) Pre-payments
(e) Short-term Investments
(f) Accrued Income and
(g) Cash and Bank Balances

(B) Current Liabilities:

Current liabilities are those which are generally paid in the ordinary course of business within a short
period of time, i.e. one year. Current liabilities include:
(a) Sundry Creditors
(b) Bills Payable
(c) Accrued Expenses
(d) Bank Overdrafts
(e) Bank Loans (short-term)
(f) Proposed Dividends
(g) Short-term Loans
(h) Tax Payments Due
Determinants of Working Capital
1. nature of business
2. terms of sales and purchases
3. manufacturing cycle
4. rapidity of turnover
5. business cycle
6. changes in technology
7. seasonal variation
8. market conditions
9. seasonality of operation
10. dividend policy
11. working capital cycle

Working Capital Financing Policies

1. Conservative (Relaxed) Policy
A firm in practice may adopt a conservative approach in financing its working capital where it depends
on more of long-term funds. Operations are conducted with too much working capital.

As you can see in the diagram, the firm is financing its fixed /permanent working capital and also
a part of its fluctuating working capital with long-term financing. Only a small portion is being financed
through short-term financing.

2. Aggressive (Restrictive) Policy

When a firm uses more of short-term sources for financing working capital; it is said to be
followed aggressive policy. Operations are conducted on a minimum amount of working capital.
As it can be seen from the diagram, the fixed working capital and a portion of fluctuating working capital
is finance by short-term funds. Only a small portion of fluctuating working capital is being financed by
short-term funds.

3. Matching Approach
A firm can meet its financing needs by using a matching approach in which the maturity structure of the
firm’s liabilities is made to correspond exactly to the life of its assets.

Comparison of the three policies:

Assuming a constant level of fixed assets, a higher CA/FA ratio indicates conservative current
assets policy (greater liquidity & lower risk) and a lower CA/FA ratio means an aggressive current assets
policy assuming other factors to be constant (higher risk & poor liquidity). In the above diagram,
alternative A indicates the most conservative policy, where CA/FA ratio is greatest at every level of
output. In the same way, Alternative C is the most aggressive policy & alternative C lies between the
conservative & the aggressive and is the average one.
Conservative and Aggressive policies compared (trade-off between profitability and risk):
Conservative Aggressive
Long-term Financing Benefits  less worry in  financing long-term
refinancing short-term needs with a lower interest
obligations cost than short-term debt
 less uncertainty  borrowing only what is
regarding future interest necessary
cost
Short-term Financing Risks  borrowing more than  refinancing short-term
what is necessary obligations in the future
 borrowing at a higher  uncertain future interest
overall cost costs
Result  manager accepts less  manager accepts greater
expected profits in exchange expected profits in exchange
for taking less risk for taking greater risk

Optimal Amount (Level) of Current Asset Analysis

Amount of
Policy Liquidity Profitability Risk
Current Assets
A. Conservative high high low Low
B. Matching average average average average
C. Aggressive high low high high

Note:
 greater current asset levels generate more liquidity; all other factors held constant
 as current assets levels decline, total assets will decline and the ROI will rise
 profitability varies inversely with liquidity
 profitability moves together with risk
 decreasing cash reduces the firm’s ability to meet its financial obligations (more risk)
 stricter credit policies reduce receivables and possibly lose sales and customers (more risk)
 lower inventory levels increase stockouts and lost sales (more risk)
 risk increases as the level of current assets are reduced

References:
Principles of Managerial Finance, 14th edition by Gitman, L.J, and Zutter, C.J
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