BBA V SEM FINANCE SPECIALIZATION Prof.

Geeta Joshi
KLS GCC BBA BGM

MODULE 1 WORKING CAPITAL MANAGEMENT

Meaning of Working Capital:

Working capital is the part of total capital. It is used for carrying out regular business operations.
In other words, it is the amount of funds used for financing the day to day operations or
activities.
Working capital indicates revolving a circular flow of cash starting with cash paid for purchase
of material and ending with cash receipt after the sale of finished goods. This is how working
capital is a circular cash flow from cash to inventories and back to cash.

According to Shubin, “working capital is the amount of funds necessary to cover the cost of
operating the enterprise.
C. W. Gerstenberg, “Working capital is the excess of current assets over current liabilities.”

WORKING CAPITAL = CURRENT ASSETS – CURRENT LIABILITIES

Components of Working Capital:

According to net concept working capital has two components viz.,:
i) Current Assets.
ii) Current Liabilities.
i) Current Assets:
Those assets which are converted into cash within a period not exceeding one year normally,
such assets are called Current Assets.
Examples of Current Assets:
Cash in hand, Cash at Bank, Bills receivable, Sundry debtors, Prepaid expenses,
Outstanding incomes.
ii) Current Liabilities:
Those liabilities are to be paid within a period of one year, such liabilities are called current
liabilities. Generally current liabilities are paid out of current assets or the Income from the
business.
Examples of Current Liabilities:
Trade creditors, Outstanding expenses, Short-term borrowings, Taxes and dividend
payable, Bank Overdraft, Outstanding liability currently payable, Advance received from parties
against goods to be sold.

Concepts of Working Capital:

There are two concepts of working capital:
1. Net working. 2. Gross working.
1. Net Working capital is the excess of current assets over the current liabilities.
Net Working Capital = Current Assets – Current Liabilities

2. Gross Working Capital is the capital invested in total current assets of the enterprise.

Working capital is required for the following purposes:

1. For the purchase of raw materials, components and spares.

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BBA V SEM FINANCE SPECIALIZATION Prof. Geeta Joshi
KLS GCC BBA BGM

2. To pay wages and salaries.

3. To incur day-to-day expenses.
4. To provide credit facilities to the customers.
5. To maintain the inventories of raw materials work-in-progress and finished stock.

The types of working capital are as follows:

Net Working Capital:
The net working capital is the difference between current assets and current liabilities. The
concept of net working capital enables a firm to determine how much amount is left for
operational requirements.
Gross Working Capital:
Gross working capital is the amount of funds invested in the various components of current
assets.
Permanent Working Capital:
Permanent working capital is the minimum amount of current assets which is needed to conduct
a business even during the dullest season of the year. This amount varies from year to year,
depending upon the growth of a company and the stage of the business cycle in which it
operates. It is the amount of funds required to produce the goods and services which are
necessary to satisfy demand at a particular point.
It represents the current assets which are required on a continuing basis over the entire year. It is
maintained as the medium to carry on operations at any time.
Temporary or Variable Working Capital:
It represents the additional assets which are required at different times during the operating year-
additional inventory, extra cash etc., Seasonal working capital is the additional amount of current
assets-particularly cash, receivables and inventory which are required during the more active
business seasons of the year.

The following factors determine the amount of working capital:

1.Nature of Industry: The composition of an asset is a function of the size of a business and the
industry to which it belongs. Small companies have smaller proportions of cash, receivables and
inventory than large corporations.
This difference becomes more marked in large corporations. A public utility, for example,
mostly employs fixed assets in its operations, while the merchandising department depends
generally on inventory and receivables. Needs for working capital are thus determined by the
nature of an enterprise.
2. Demand of Industry: Creditors are interested in the security of loans. They want their
obligations to be sufficiently covered. They want the amount of security in assets which are
greater than the liability.
3. Cash Requirements:Cash is one of the current assets which is essential for successful
operations of the production cycle. Cash should be adequate and properly utilised. It would be
wasteful to hold excessive cash.
A minimum level of cash is always required to keep the operations going. Adequate cash is also
required to maintain good credit relations. Richards Osborn has pointed out that cash has
universal liquidity and acceptability. Unlike illiquid assets, its value is clear-cut and definite.

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BBA V SEM FINANCE SPECIALIZATION Prof. Geeta Joshi
KLS GCC BBA BGM

4. Nature of Business: The nature of a business is an important determinant of the level of the
working capital. Working capital requirements depend upon the general nature or type of
business. They are relatively low in public utility concerns, in which inventories and receivables
relatively low in public utility concerns, are rapidly converted into cash. Manufacturing
organisations, however, face problems of slow turnovers of inventories and receivables, and
invest large amounts in working capital.
5. Time:The level of working capital depends upon the time required to manufacture goods. If
the time is longer, the size of working capital is great. Moreover, the amount of working capital
depends upon inventory turnover and the unit cost of the goods that are sold. The greater this
cost, the bigger is the amount of working capital.
6. Volume of Sales:This is the most important factor affecting the size and components of
working capital. A firm maintains current assets because they are needed to support the
operational activities which result in sales.
The volume of sales and size of the working capital are directly related to each other. As the
volume of sales increases, there is an increase in the investment of working capital- in the cost of
operations, in inventories and in receivables.
7.Terms of Purchases and Sales: If the credit terms of purchases are more favorable and those of
sales less liberal, less cash will be invest ed in inventory. With more favorable credit terms,
working capital requirements can be reduced. A firm gets more time for payment to creditors or
suppliers. A firm which enjoys greater credit with banks needs less working capital.
8. Inventory Turnover: If the inventory turnover is high, the working capital requirements will be
low. With a better inventory control, a firm is able to reduce its working capital requirements.
While attempting this, it should determine the minimum level of stock which it will have to
maintain throughout the period of its operations.
9. Receivable Turnover: It is necessary to have an effective control of receivables. A prompt
collection of receivables and good facilities for settling payables result into low working capital
requirements.
10. Business Cycle: Business expands during periods of prosperity and declines during the
period of depression. Consequently, more working capital is required during periods of
prosperity and less during the periods of depression.
11. Value of Current Assets: A decrease in the real value of current assets as compared to their
book value reduces the size of the working capital. If the real value of current assets increases,
there is an increase in the working capital.
12. Variations in Sales: A seasonal business requires the maximum amount of working capital
for a relatively short period of time.
13. Production Cycle: The time taken to convert raw materials into finished products is referred
to as the production cycle or operating cycle. The longer the production cycle, the greater is the
requirement of working capital. Utmost care should be taken to shorten the period of the
production cycle in order to minimize working capital requirements.
14. Credit Control: Credit control includes such factors as the volume of credit sales, the terms of
credit sales, the collection policy etc. With a sound credit control policy, it is possible for a firm
to improve its cash inflow.
15. Liquidity and Profitability:
If a firm desires to take a greater risk for bigger gains or losses, it reduces the size of its working
capital in relation to its sales. If it is interested in improving its liquidity, it increases the level of
its working capital.

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BBA V SEM FINANCE SPECIALIZATION Prof. Geeta Joshi
KLS GCC BBA BGM

However, this policy is likely to result in a reduction of the sale volume, and therefore, of
profitability. A firm, therefore, should choose between liquidity and profitability and decide
about its working capital requirements accordingly.
16. Seasonal Fluctuations: Seasonal fluctuations in sales affect the level of variable working
capital. Often, the demand for products may be of a seasonal nature. Yet inventories have got to
be purchased during certain seasons only. The size of the working capital in one period may,
therefore, be bigger than that in another period.
17.Changes in Technology: Technological developments related to the production process have
a sharp impact on the need for working capital.
18.Firm’s Policies: These affect the levels of permanent and variable working capital. Changes
in credit policy, production policy etc. are bound to affect the size of the working capital.
19. Size of the Firm: A firm’s size, either in terms of its assets or sales, affects its need for
working capital. Bigger firms, with many sources of funds, may need less working capital as
compared to their total assets or sales.

IMPORTANCE OR ADVANTANGES 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 if a business. The main advantages of maintaining adequate amount of working
capital are as follows:
1. Solvency of the business: It helps in maintaining solvency of the business by providing
uninterrupted flow of production.
2. Goodwill: It enables a business concern to make prompt payments and hence helps in creating
and maintains goodwill.
3. Easy loans: A concern having adequate working capital, high solvency and good credit
standing can arrange loans from Banks and others on easy and favorable terms.
4. Cash Discount: It also enables a concern to avail cash discounts on the purchases and hence it
reduces the cost.
5. Regular supply of Raw materials: It ensures regular supply of raw materials and continuous
production.
6. Regular payment of Salaries, Wages and other day to commitments.
7. Exploitation of favorable market conditions: Only concerns with adequate working capital can
exploit favorable market conditions such as purchasing its requirements in bulk when the prises
are lower and by holding its inventories for higher prices.
8. Ability to face crises: It enables a concern to face business crises in emergencies such as
depression because during such periods, generally, there is much pressure on working capital.
9. Quick on regular return on Investments: Sufficiency of working capital enables a concern to
pay quick and regular diviodends to its investors as there may not be much pressure to plough
back profits. This gains the confidence of its investors and creates a favorable market to raise
additional funds in the future.
10. High Morale: It creates an environment of security, confidence, high morale and creates
overall efficiency in the business.

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BBA V SEM FINANCE SPECIALIZATION Prof. Geeta Joshi
KLS GCC BBA BGM

EXCESS OR INADEQUATE WORKING CAPITAL:

Every business concern should have adequate working capital to run its business operations. It
should have neither redundant or excess working capital nor inadequate or shortage of working
capital.
Disadvantages of redundant or excess working capital
1.Excessive Working Capital means idle funds which earn no profits for the business and hence
the business cannot earn a proper rate of return on its investments.
2. When there is a redundant working capital, it may lead to unnecessary purchasing and
accumulation of inventories causing more chance of theft, waste and losses.
3. Excessive working capital implies excessive debtors and defective credit policies which may
cause higher incidence of bad debt.
4. it may result into overall inefficiency in the organization.
5. When there is a excessive working capital, relations with Banks and other financial institutions
may not be maintained.
6. Due to Low rate of Return on investments, the value of shares may also fall.
7. The redundant working capital gives rise to speculative transactions.

Disadvantages or Dangers of Inadequate working capital:

1.A concern which has inadequate working capital cannot pay its short term liabilities in time.
Thus, it will loose its reputation and shall not be able to good credit facilities.
2. It cannot buy its requirements in bulk and cannot avail of discounts etc.
3. It becomes difficult for the firm to exploit favorable market condition and undertake profitable
projects due to lack of working capital.
4. The firm cannot pay day to day expenses of its operation and creates inefficiencies, increases
cost and reduces the profits of the business.
5. It become impossible to utilize efficiently the fixed assets due to non-availability of liquid
funds.
6. The rate of return on investments also falls with the shortage of working capital.

NEED OR OBJECTS OF WORKING CAPITAL:

Working capital is needed for the following purposes:
1.For purchase of Raw materials, components and spares.
2. To pay wages and salaries
3. To incur day- to day expenses and overhead cost such as fuel, power and office expenses etc.
4. to meet the selling cost as packing, advertising etc.
5. To provide credit facilities to the customers.
6. To maintain the inventories of raw materials, work-in progress, stores and spares and finished
stocks.

OPERATING CYCLE:
The time that elapses between the purchases of raw materials and collection of cash for sales is
referred to as Operating cycles, whereas the time length between the payment of raw material
purchases and the collection of cash for sales is referred to as the Cash Cycle.

Operating cycle = Inventory period + Accounts Receivables period

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BBA V SEM FINANCE SPECIALIZATION Prof. Geeta Joshi
KLS GCC BBA BGM

The cash cycle = Operating cycle – Accounts payable period

Operating cycle for a manufacturing firm can be computed by using the following formula:

OC = RMCP + WIPCP + FGCP + ARP

RMCP = Raw Materials Conversion Period or Raw Material Holding Period
WIPCP = Work in Process Conversion Period or WIP Holding Period
FGCP = Finished Goods Conversion Period or Finished Goods Holding Period
ARP = Accounts Receivables Period or Debtors Collection Period

Inventory Conversion Period = RMCP + WIPCP + FGCP

OC = ICP + ARP
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
ICP = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑 ÷365
𝑂𝑝𝑒𝑛𝑖𝑛𝑔 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦+𝐶𝑙𝑜𝑠𝑖𝑛𝑔 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
Average Inventory = 2

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠

ARP = 𝑆𝑎𝑙𝑒𝑠 ÷365

𝑂𝑝𝑒𝑛𝑖𝑛𝑔 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠+𝐶𝑙𝑜𝑠𝑖𝑛𝑔 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠

Average Accounts Receivables = 2
Accounts Receivables = Sundry Debtors and Bills Receivables
Sales refers to Credit Sales.

CASH CYCLE: The time length between the payment of raw material purchases and the
collection of cash for sales is referred to as the Cash Cycle.

Cash cycle = Operating cycle – Accounts payable period or Creditors Payment Period
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒
APP = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑 ÷365
𝑂𝑝𝑒𝑛𝑖𝑛𝑔 𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠+𝐶𝑙𝑜𝑠𝑖𝑛𝑔 𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠
Average Accounts Payable = 2
Accounts Payable includes both Sundry Creditors and Bills Payables