Working Capital Management

A business enterprise requires not only fixed assets but also current assets for its efficient
functioning. Current assets are required to make éffective utilisation of fixed assets. The amount
fixed assets is called fixed capital (long term or block capital). The amount invested in
investedin
currentassets is known as working capital (short term capital). Thus a business enterprise requires
twotypes of capital, namely, fixed capital and working capital.
Meaning and Definition of Working Capital
Working capital is the capital required for the day-to-day working of an enterprise. It is
required for the purchase of raw materials and for meeting the day-to-day expenditure on salaries,
wages, rents, advertising etc. It is needed for holding some convertible assets (current assets)
such as stock, book debts, bills receivable and cash. The firm operates its business through these
assets. These assets are convertible in the sense that these change from one form of asset to
another. Cash is converted into raw materials, raw materials into work in progress, work in progress
intofinishedgoods, finished goods into book debts and bills receivable and then book debts and bills
receivable into cash. Thus the amount goes on circulating or revolving from cash to current assets
and current assets to cash. That is why working capital is also called circulating capital or

revolving capital or floating capital or liquid capital. It is also known as operating capital.
Theconcept of working capital was, perhaps, first evolved by Karl Marx. But he used the
term variable capital". Karl Marx defined working capital as variable capital consisting of wage
fund.
necessary to the cost of
According to Shubin, "working capital is the amount of funds cover

operating the enterprise".

funds. In other words, it is the
Working capital is the difference between inflow and outflow of
a business on day-to-day basis.
net cashinflow. It is the assets and liabilities required to operate
 Financial Managemeng

112
features:
Nature of Working Capital its following
capital may be
studied from
for the day
to dayworking ofan
ne nature
of working which is required
of total capital
1. Workingcapital is that part
are short Ilivied,
Current assets
enterprise. in current
assets.

is the a m o u n t
invested
from day day. to Therefore
2. Working capital current
assets varies

3 level of investment
in each ofthe managing
fixed assets.
.The
attention than
managing current assets rquire
more
However,
position. the working
determines its liquidity
in a firm
The level of working capital
less.
capital should be neither too large nor too short termsources. Howeve
are financed through
requirements
5.
5. Generally, the working capital sources.
a part of it may be financed through long term payables
receivables management,
involves cash management,
.6. Working capital management
management, and inventory management. current
the decision related to one
inter-related to each other.
That is,
7. Current assets are
assets.
assetwill also affect other current
namely, gross concept
and net concept
There are two major concepts
of working capital,
8.
Components of Working Capital and current liabilities
are current assets
There are two components ofworking capital. They
below:
These may be briefly discussed as
assets which canbe converted into cash in the normal
Current assets: Current assets are those
of current assets include cash, short tem
course of activity of a firm usually one year. Examples
stock of raw material, stock of work-in-progress,
stock of finished
investment, bank balance, B/R,
expenses, advance payment of
tax etc.
goods, sundry debtors, prepaid
are those liabilities which are repayable during short period
Current liabilities: Current liabilities
liabilities include short term borrowings, sundry creditors
usually within a year. Examples ofcurrent
for taxation, dividend
B/P, advance payments from customers, outstanding expenses, provision
payable etc.
Concepts of Working Capital
There are two concepts on working capital. These are briefly described as follows:
1. Gross Concept: According to gross concept working capital refers to the amount of funds
invested in current assets. Thus working capital is equal to total current assets. The workins
capital as per gross concept is called gross working capital. This concept is used by the managemeti
to evaluate the current working capital position and to ensure the optimum investment in individu
current assets. Gross concept is a quantitative concept.
The gross working capital concept has the following ddvantages (or preferred due toth
following reasons):
 Working Capital Management 113

1.1. This concept is helpful in determining the correct amount of working capital at the right time.
2.2. Ithelps in planning and control ofindividual current assets.
3 Ithelps to maximise return on investment.
4. Ithelps in fixation offinancial responsibility.
2. Net Concept: According to net concept, working capital refers to excess of current assets
minus
overcurrent liabilities. To be more clearly, working capital is equal to total current assets as
The working capital per
totalcurrent liabilities. Thus working capital refers to net current asset. because it
net concept is called net working capital. The net concept is a qualitative concept
establishes a relationship between current assets and current liabilities.
There is an alternative definition of net working capital. According to this, the networking
term funds.
capital is that portion of firm's current assets which is financed with long
assets exceeds current liabilities,
Net working capital can be positive or negative. When current
liabilities are in excess of current assets it is
it is called positive working capital. When current
callednegative working capital.
The net working capital concept has the following advantages (or preferred to gross concept
because ofthe following reasons):
1. It measures the firm's liquidity.
term solvency of the firm.
2. It enables the creditors and investors to assess the short
can be financed with long term funds.
3. It indicates the extent to which working capital
4 It is an indicator of the financial soundness of an enterprise.
while net concept is an accounting
The gross concept is financial or going concern concept,
be suitable only for sole trader or partnership
concept of working capital. The net concept may
suitable to the company form of organisation.
fims. But the gross concept is very
Field and Mil1. Net concept is
The gross concept is supported by Baker, Mead, Mallott,
and Saliers. Of the two, the concept of net
Supported by Lincoln, Stevens, Doris, Gerstenbergh
be noted that both the concepts of working capital are
Working capital is most widely used. It may
two facets of working capital management.
Types of Working Capital
into two-permanent working capital and variable working
Working capital is broadly classified
capital.
1. Permanent Working Capital
capital which is continuously required by the
There is always a minimum amount of working called as permanent or fixed
out its normal business operations. This is usually
enterprise carry
to is the minimum
fixed working capital (hard core element ofworking capital)
Working capital.Thus, to ensure effective
utilisation of fixed assets and support the

unount working capital

of required which is permanently blocked in current
of the business. It is that part of capital
omal operation divided into three- initial working capital, regular
aSsets. Permanent working capital is again
working capital and cushion working capital.
 114 Financial Managemen
a)Lnitial Horking Capital: The working capital which is needed in the initial stage of busines
ess
1S called initial working capital. It is the capital with which the project is commenced.

(0 Regular Working Capital: It is the amount needed for continuous operation ofthe business
the amount
t 1s
of working capital required after the project has been established as a going
concern. It is the minimum amount ofthe liquid capital to keep up the circulating capital fom
cash to inventories, to receivables and back again to cash.
(c) Reserve Margin Cushion Working Capital: It is the excess working capital
or
overthe
needs or regular working capital that should be kept in reserve for contingencies thatmay
arise at any time. These contingencies may be rising prices, business depression, strikes
special operations such as experiments with new products etcC.
2. Variable Working Capital
Any amount over and above the permanent working capital is variable or temporary
working
capital. It is the working capital which varies with volume of business. This is the additional
needed to meet seasonal and
capital
special needs. Variable working capital is again divided intotwo-
seasonalworking capital and special working capital.
(a) Seasonal working capital: It is the working capital which is needed to meet the
needs of the firm. It refers to the additional seasonal
working capital required during busy seasons.
(6) Special working capital: This refers to the extra
working capital to be maintained to
meet unforeseen contingencies or to finance
special operations. It may be requiredto
carry on a
special sales campaign or financing slow moving stock or financing a period
of strike or lockout etc.

Temporary or variable
Temporary or variable
working capital working capital

V
Permanent or Fixed Permanent or Fixed
Working capital Working capital

Time Time
Fig. 1 Fig. 2
In
Fig. 1, permanent working capital is fixed over time while the temporary working
fluctuates. In Fig. 2, permanent working capital is also
capital
increasing with the passage of time due to
expansion of business. But even then it does not fluctuate as variable
working capital.
Working capital sometimes increases and sometimes decreases.
Variable
Working Capital Management 115
Other Types of Working Capital
Apart from the above, there are some other types of working capital. They are balance
sheet working capital and cash
working capital.
Balance Sheet Working Capital: This is calculated from the items appearing in the balance
sheet. Both gross working capital and net working capital are the examples of the balance shecet
workingcapital.
Cash Working Capital: Cash working capital is
required to make payments to its suppliers, to
pay day to day expenses and to pay salaries, wages, interests and dividends. The items of cash
working capital appear in the P/LA/c. Cash working capital shows the impact of various transactions
oncash position of a firm.
Importance of Working Capital (Need/ Role)
Suppose, you have purchased a car but you don't have money for the petrol. Is it possible to
run the car without petrol ? No, that means it is essential that you must have some money for the
smooth running of the car. The same thing is with the business too. Suppose a business has been
established by investing money in the fixed assets, but for the running of the business, there is no
money (working capital). What will happen ? The business cannot function. Thus, working capital
is the life blood and nerve centre of business.
Working capital is just like heart of business. If the heart is weak, it cannot pump blood and
human beings cannot work and survive for long. Likewise, if the working capital position is weak, a
firm cannot work smoothly although there is large investment in fixed assets. Fixed assets can be
effectively utilised only if there is adequate working capital. The need for working capital arises
because sales do not convert into cash immediately. There is a time lag between the sale of goods
and receipt of cash. Therefore, there is a need for working capital in the form of current assets to
deal with the problem arising out of the lack of immediate realisation of cash against goods sold.
Without working capital, a firm cannot operate its business. It is a must for the purchase of raw
material, and for meeting the day-to-day expenditure on salaries, wages, rents, advetising, lighting
etc. The fate of large scale investment is determined by a relatively small amount of current assets.
Both excessive and inadequate working capital positions are harmful. Excessive working capital
results in idle funds on which no profit is earned. Meanwhile insufficiency ofworking capital results
in interruption of production and inefficiencies which adversely affect the profit ofthe firm.
Fixed assets once acquired, create no recurring problems except those relating to their proper
maintenance. But the managementof working capital is an endless process which involves constant
vigil and watch of flow of funds during an operating cycle. A company's profitability is in one way
determined by the management of its working capital. Hence financial managers spend a great
deal of time on working capital management. There is nothing wrong in saying that the working
capital management is a constant head ache of financial manager.
It should be noted that the working capital should be neither too large nor too small. It must be
adequate. It is said, "inadequate working capital is disastrous, whereas redundant working capital
 T6

means a good umbrella

for creditors againstrai
S a criminal waste". Too much working capital
financial planning or idle assets
presence of 1dle assets Or
day, but to the management, it reflects faulty
overcapitalisation.
Dangers of Deficiency of Working Capital
to the business. A fim shoula
Every business unit should have adequate working capital
run

or shortage of working capital

neither have excess or redundant working capital nor inadequate
for any business. However, outgt
Both excess as well as short working capital position are bad
tne two, it is the inadequacy ofworking capital which is more dangerous from the point ofviewof

the firm.
The following are the dangers of deficiency of working capital:
1. It may lead to business failure.
The firm cannot take advantage of new opportunities or adapt to changes.

3 Trade discounts will be lost.

Cash discounts will be lost.
Financial reputation is lost. Creditors may not co-operate in times of difficulty because ofthe
loss of creditworthiness.
6. Creditors may apply to court for winding up.
7. Rate of return on investment falls.
8. It affects dividend policy adversely.
9 The company cannot utilise its fixed assets properly.
Aspointed out by Ralph, Kennedy and Steward McMuller, the inadequacy or
of working capital is the leading cause of business failures.
mismanagemes
Dangers of Excessive Working Capital
1. Excessive working capital means idle funds which gives no profit. Thus the rate of retum
falls.
2. The value of shares may fall due to lower rate of return on investment.
3. Efficiency of management may deteriorate.
It may encourage speculation.
5. Liberal dividend policy may be encouraged.
6. Inefficiency may be encouraged. There may be increased waste and loss due to bad debis.
Advantages of Adequate Working Capital
Advantages of adequate working capital in the business are outlined as follows:
1. The firm can avail ofthecash discount facilities offered by the suppliers.
1.
I t enhances the liquidity, solvency and creditworthiness of the concern.
2.
Working Capital Management 117
3. It is possible to meet unseen contingencies and successfully sail through the periods of crisis.
4. It improves the morale of the executives.
5.
5. Good relations with banks can be maintained.
6. It is possible to utilise fixed assets fully
7. It enables to undertake research, innovation and expansion programmes.
8. It increases profitability of the business.
9. It ensures regular supply of rawmaterials and continuous production.
10. It can make regular payment of day to day expenses.
Just as circulation of blood is very necessary in the human body to maintain life, smooth flow
of fund is very necessary to maintain the health of the business enterprise. The importance of
working capital can be very well explained in the words of Kennedy and Mc Millan, "An adequate
workingcapitalenables an enterprise to conduct its affairs economically without financial stringency
andtoface losses and unforeseen emergencies without inviting any disaster"
Operating Cycle Concept
A new concept which is gaining more and more importance in recent years is the 'Operating
of working capital. Operating cycle refers to the average time elapses between
ycleconcept'
the purchase of rawmaterials and the final cash realisation. According to Hunt, William and
Donaldson, "The working capital is required becauseof the time gap between the sale and their
actual realisation in cash. This time gap is technically termed as Operating Cycle' of the
business.
Cash is used to buy raw materials and other stores. Then the raw materials and stores are
issued to the production department. Wages are paid and other expenses are incurred in the
process and work-in-progress comes into existence. After sometimes the work-in-process become
finished goods. Finished goods are sold to customers on credit. In the course of time these customers
pay cash. Cash is realised and the cycle is completed. Thus the cash is converted into raw
materials which are converted into work in progress. These work-in-progress become finished
goods which are converted into debtors and bills (when the goods are sold on credit). Finally cash
isrealised from debtors and bills. This time period is simply known as operating or cash or working
capital
cycle.
In case of a manufacturing company, the operating cycle is the length of time necessary to
complete the following cycle ofevents:
(a) Conversion of cash into raw materials.
(b) Conversion of raw materials into work in progress.
(c) Conversion of work in progress into finished goods.
and bills).
(d) Conversion of finished goods into accounts receivables (debtors
(e) Conversion of accounts receivable into cash.
 118 inancial Management

wKecovericeeries)
Cash
Outflol w (Purchase)
Receivables Raw materials
(Drs. B/R)
Manufacturin
-----
in
progr

Sales Finished goods

Work

Operating or Cash Cycle

Each cycle starts with a cash outflow and after a time-lag (involving processing, credit sales,
receivables etc.) it ends with a cash inflow.
Thiscycle is repeated again and again during a year. The length of the cycle depends upon
certain factors liké nature of business, manufacturing time, efficiency of
management, turnover etc.
Importance of Operating Cycle Concept
Operating cycle concept is mainly used to ascertain the requirement of cash working capital.
Cash working capital is needed to meet the operating expenses of a
going concern. This is an
important concept because the longer the operating cycle, the more is the working capital
reqiurement. Management must ensure that the operating cycle does not become too long. Operating
cycle concept measures the working capital requirement. It traces the changes in working
It also determines the optimum level of working capital capital
requirement.
The operating cycle concept measures the operating
efficiency of financial management.It
is a tool for proper monitoring of external environment of business. Changes in Government
policy
(taxation, import, credit policies etc.), price trend, technological advancement etc. havetheir own
impact on the length of the operating cycle. In short, operating cycle concept helps to
accurately the amount of woking capital needed for the continuous operation of the determine
business.
Factors Determining Working Capital Requirements
The requirement of working capital depends on the followig factors:
Nature of business: The manufacturing or trading concerns
require more amount of working
capital because they have to invest heavily in inventories and debtors. In the case
of
like transport, electricity undertaking etc, most of the transactions are on cash basis.public utilities
Further, these
concerns do not require large inventories. Hence they require less amount of working
capital.
2. Production Cyele : Another factor determining working capital is the production cycle.It
simply refers to the time required to manufacture a product. It covers the time span
theprocurement of material and production of goods. Thus time involved in the between
processis called production cycle. The longer the
manufacturing
prodiction cycle, the larger will be the
requirement of workingcapital.
Working Capital Management 119

3. Size of the business: Generally large business concerns are required to maintain nuge
inventories. Hence, bigger the size, the larger will be the working capital required and vice
versa.

Turnover: Turnover means the speed with which the working capital is recovered by the
sale of goods. If the turnover is higher, it will require less amount of working capital. For
example, a hotel which effects quick sales needs comparatively low working capital. But if
the sales are slow more working capital will be required.
Terms of trade: A concern which purchases on credit and sells on cash will require less
amount of working capital. If a concern buys everything on cash and sells on credit, it will
need a
largeamount of working capital.
. Business cycle fluctuations: There are different phases of business cycle- boom,
depression, recession, recovery etc. These phases affect the working capital requirements.
During the period of boom there is need for large àmount of working capital. This is due to
increase in sales, rise in price etc. On the other hand, in times of depression the business
contracts. As a result, sales decline, difficulties arise in collection from debtors, etc. Ultinmately,
firms may have large amount of working capital lying idle.
Nature and value of the produet: If the cost of raw material is a larger proportion ofthe
total cost ofthe finished product, working capital required will be large.
8. Seasonal fluctuation: Certain industries manufacture and sell goods only during certain
seasons. Such concern require large amount of working capital during the season.
9. Use of manual labour or machines: In labour intensive industries larger amount of working
capital will be needed than in the machanised industries.
10. Growth and expansion of business : A growing concern needs more working capital to
finance its increasing activities and expansion. But working capital requirements are low in
case of static concerns.
11. Company policies: Working capital requirements are also influenced by company policies
relating
such as those to depreciation, dividends etc.

Hard Core Working Capital (Core Current Assets)

This term was used for the first time by 1andon Committee in its report in 1974. It represents
finished goods, stores and
the minimum amount of investment in raw materials,anwork-in-progress,
spares, accounts receivable and cash balance which
industrial enterprise is required to carry on
minimum amount ofeurrent assets required throughout
a certain level of activity. It is the irreducible
of current assets. For example, every concern is required
the year for maintaining the circulation
work-in-process, Iinished goods, loose tools and
to maintain a minimum stock of raw material, some cash balance to make payment
invest in receivable and
accounts keep
spares etc. It has to
year.the Thus hard core working capital is the permanent
or wages, salaries etc. throughout
to produce goods and services necessary satisty their demand
to
Working capital which is required
assets that must be kept at all times. The
at the lowest point. It is the minimum
amount ofcurrent
 VarsagEmeht
minimum current assets that must be
kept at all times is called core current assets. In
current assets in which funds are
permanently blocked up are known short,
as core current
The amount of hard core assets.
working capital is determined by taking into consideration the
or
production policies, technology, financial policies sales
of the firm etc.
Management of Working Capital
Proper management is needed for working capital. Working
to capital management simply refers
management of working capital. In other words, it is the
current management of current assets and
liabilities.
It involves the problem of decision making regarding investment
in
assets for
current
maintaining the liquidity of funds. According to Smith, "Working various
management is concerned with the problems that arise in
capital
assets, current liabilities and the attempting manage the current to
interrelationships that exist between them". It involves
both
formulating working capital policy and carrying
out that policy in day-to day operations.
The objectives of
and ii)availability
workingcapital management are twofold: (i) maintenance of working capital
of sufficient funds at the time of need.
Importance of Working Capital Management
The importance of the sound and proper
from the following facts:
management of working capital may be studied
1. About 50% to 70% capital of a manufacturing firm is invested in its current assets. In capital
budgeting, we consider about fixed investment in very detail that is nearly 30% to 50% of the total
funds. Hence themanagement current assets should get proper attention of the
of
2. Fixed assets can be acquired even on lease but there is no alternative for
management.
current assets.
There is no way of avoiding the investment in
inventory and in receivable.
3 There is a positive correlation between the sale of a firm
and its current assets. With an
increase in sales a corresponding increase in current asset is also required. As a result, their
proper administration too becomes important.
4.
4. Working capital requirements are generally financed through outside sources. So a
continuous
effort is necessary to utilise them in the best way. Surveys indicate that most of the
part of
the finance manager's time is devoted to the management of current assets and
current
liabilities (i.e., working capital management).
5 Working capital management is
particularly important for small firms. A small firm has
relatively limited access to the long-term capital markets. Therefore, it must depend heavily
on short-term bank loans and trade credit (i.e., current liabilities)
PrinciplesofWorking Capital Management
The following are the important principles of working capital management:
1. Principle of risk variation: Here risk refers to the inability of a firm to maintain adequate
current assets to pay off its obligations. As the level of working capital in relation to sales
decreases, the degree of risk also increases. When the degree of risk increases, the opportunity
Working Capital Management
121
for gain and loss also
increases. If
the level of working
decreases. This affects the capital increases, the amount oI
opportunity for gain and loss. The size of the TISK
depends upon attitude of
the working capital
risk by holding a management. conservative management
A
higher level of working capital. But liberal prefers to minimis
risk by reducing this level. management assumes greater
However, the goal of a management should be that level ofworking
capital which would optimise a firm's rate of
return.
2. Principle of cost of capital: Different sources of finance have
be different costs of capital. It
can that the cost of capital moves
seen
lower and vice versa. Thus
inversely with risk. If the risk is higher, the cost is
additional risk capital results in the decline in the cost ofcapital.
3. Principle of equity
position: According to this principle, the amount of working capital
invested in each component should be
adequately justified by a firm's equity position. Every
rupee invested in the working capital should contribute to the worth or value of the firm.
4. Principle of maturity of payment: All efforts should be made to relate maturities of payment
to its flow of internally generated funds. There should be the least disparity between the
maturities of a firm's short-term debt instruments and its flow of internally generated funds.
This is so greater risk is generated when there is a greater disparity. A margin of
because a

safety should, however, be provided for short-term debt instruments.

anitol
Working Capital Management 123

Sources of Working Capital

Working capital is financed through the following sources:
Long term sources: These provide funds for a relatively long period. The main long term
urces are share capital, debentures, long term borrowings, retained earnings etc.
Short term sources: These usually provide funds for a short period say upto one year or so. The
main short term sources are bank credit (commercial banks and indigenous banks), public deposit,
commercial papers, factoring etc.
Transactionary sources: These provide funds toa business through the normal business operation.
or
These are automatic sources of short term funds. These are also called spontaneous sources
finance. These are cost free. Trade credit (credit allowed) by suppliers, outstanding expenses,
tax liabilities, depreciation etc. fall in this category.
Important sources are briefly discussed as follows:
Long Term or Permanent Sources
the permanent or long term
1. Shares: Issue of shares is the most important source for raising
shares and preference shares. Preference
Working capital. A company can issue equity at the time of
shares carry preferential rights with regard to dividend and repayment ofcapital
such preference. These are ordinary shares.
winding up. Equity shares do not carry any
term or permanent working
2. Debentures: Debenture is also an important method of raising long fixed
is a creditorship security.
Thus it is a part of borrowed capital. A
capital. Debentures
debenture is a charge against profit. It
debentures. The interest on
rate of interest is paid on on debentures.
even if a company incurs loss in any year, interest must be paid
means
institutions such as LIC, IFCI, SFCs, IDBI etc.
institutions: Financial
3. Loans from financial requirements of business organisations.
provide term loans for meeting working capital
is an internal source of finance. It
back of profi): This
4. Retained earnings:(Ploughing retained for meeting financial
accumulated every year and
represents the
undistributed profit the business itself whenever the
can be reinvested in
retained earnings
requirements. Such source of finance.
It is a cost free
need for working capital arises.
Sources
lemporary or Short Term working
most important
source
of short term (temporary)
1. Commercial banks: This is the are provided by commercial banks. The
capital loans
capital. major
The portion of working are loans, cash credit, overdrafts,
purchasing
commercial bank
different forms of financing by
and discounting of bills. the fixed deposits accepted by a business enterprise
are
2. Public deposits: Public
deposits
directly from the public. country bankers also provide working
lenders and other
Private money
3, Indigenous bankers: high rate of interest
charge a very who
capital loans. They enters ilto a contract
with its customers
on credit, it
sells goods time. If the firm wants
to get immediate
4. Factoring: When a firm specified period of
after a These agents buy the firm's
agree to pay for the goods approach
the tactoring agents.
it c a n
cash againstits sales then
 Financial Management
124

receivables at a discount and then realises the same after that specified period from the firm'
customers. This is called factoring.
Transactionary Sources
is an important
1. Trade creditors: Trade credit arrangements of a concern with its suppliers
source of short term finance. Trade credit consists of creditors
for goods (or sundry creditors)
and bills payable.
2. Depreciation: Amount equal to year is not going out of the
depreciation written off in a
business. It implies that depreciation is a non cash item. Thus depreciation is a source of
working capital.
Usually the entire amount deducted towards depreciation on fixed assets is not invested in the
acquisition offixed assets and is saved and utilised in business as working capital. Thisis also
atemporary source of working capital so long as the acquisition of fixed asset is deferred.
3. Tax liabilities (Provision for taxation): Deferred payment of taxes is also a source of working
capital. Taxes are not paid from day-to-day, but estimated liability for tax is provided in balance
sheet. Besides, business enterprises collect taxes by way of income taxes payable on salaries
of staff deducted at source, old age retirement benefit, sales taxes etc. and retain them for
came neriod in bucinecs to he 1ced aa workina canital.