Current Assets Management -Working Capital: Meaning

Working capital is an indicator of the short-term financial position that measures the overall efficiency of an
organization. It is calculated by subtracting current liabilities from current assets and listed directly in its balance
sheet. Current assets mean the money kept in a bank and assets that can be converted into cash in case if any
situation arises. Current liabilities represent debt that an individual will pay within the prescribed year. Finally,
working capital is the money left after subtracting liabilities from an individual's money in the bank.
Current assets consist of cash, accounts receivable, and inventory. Current liabilities include wages, taxes, interest
owed.
working capital is also used to measure the company’s financial health. If there is a larger difference between
what a company owns and what an individual owns for the short-term, the business will be healthier.
If the company owes more than they own, they will have negative working capital, and their business might get
closed. 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. In this article we
will discuss about the various aspects of working capital. Working capital is defined as the excess of current
assets over current liabilities . It forms a part of the aggregate capital of the business. Now, a business needs
working capital to fund its short term obligations. Typically, firms with an optimum level of working capital
indicate efficiency in managing its operations. This further enables the firm to pay for its short-term dues and
day-to-day operational expenses. Therefore, working capital is a measure of business’ liquidity position,
operational efficiency, and short-term financial soundness.

Working Capital = Current Assets – 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.

Types of working capital are mainly divided

● Gross Working Capital

Gross working capital is the total value of the company’s current assets. Current assets include cash,
receivables, short-term investments, and especially market securities.
The Gross working capital does not showcase the current liabilities. Gross working capital can be
 executed by calculating the difference between the existing assets and current liabilities.
The difference remaining is the actual working capital that the company has to meet its obligations.

● Net Working Capital

Networking capital is the difference between the current assets and current liabilities of the company. If
the company’s assets are more than current liabilities, it indicates a positive working capital, and the
company is in a financial position to meet its obligations.
However, if the company’s assets are less than current liabilities, it indicates a negative working capital,
and the company is facing financial distress.
The key difference between gross and net working capital is that gross working capital will always be a
positive value. In contrast, networking capital can either be a negative or positive value.

● Permanent Working Capital

Permanent working capital is the minimum amount of capital required to carry on the operations without
interruption or difficulty.
For example, a company will need minimum cash to keep the operations smooth and running; here, the
minimum amount of money required will act as permanent working capital.

● Regular Working Capital

Regular working capital is the amount of funds businesses require to fund its day to day operations. For
example, cash needed for making payment of wages, raw materials, salaries comes under regular
working capital.

● Reserve Margin Working Capital

Apart from conducting day-to-day activities, a business may need some amount of capital to face
unforeseen circumstances. Reserve margin working capital is nothing, but the money kept aside apart
from the regular working capital. These funds are held separately against unexpected events like floods,
natural calamities, storms, etc.

● Variable Working Capital

Variable working capital can be defined as the capital invested for a temporary period in the business.
Variable working capital is also called fluctuating working capital.
Such capital differs with respect to changes in the business assets or the size of the business.
Furthermore, variable capital is subdivided into two parts:
 1) Seasonable Variable Working Capital
Seasonable variable working capital is the amount of capital kept aside to meet the seasonal demand if
the business is running seasonally.

2) Special Variable Working Capital

Special variable working capital is the temporary rise in the working capital due to any unforeseen or
occurrence of a special event.

Working Capital Policies

1. Conservative Policy

This form of a working capital policy is considered to be the safest one. Here, the focus is on having a reserve of
current assets that allows you to clear current liabilities with ease. A part of this policy also dictates that you
should have enough current assets in hand to take care of emergencies.

While it, theoretically, does leave the proprietor with more than sufficient funds, you must be cognizant of the
fact that you will be left with a significantly lesser amount of monetary resources for reinvestment. Generally,
business people, who are complacent with the scale of their establishment or are trying to survive economically
challenging times, tend to resort to this form of working capital policy.

2. Aggressive Policy

This working capital policy is suited for companies that are in a secure position. With an aggressive working
capital policy, business owners reserve a relatively small amount of current assets and run the activities that they
would need the working capital for on credit.

A business owner who follows the aggressive policy establishes terms that allow them to repay the creditors as
late as possible and collect dues from debtors as early as possible. When they are able to achieve these parameters
successfully, the business owners maintain minimal working capital and proceed with their expansion as planned.
It is generally termed a high-risk policy; so, the proprietor must be sure to weigh the reward against their ability
to absorb or bear risk.

Aggressive working capital financing policy is a risky policy that requires maximum amount of investment in
current assets. Fluctuating as well as permanent current assets under this policy will be financed through short-
term debt. In this policy debt is collected on time and payments to the creditors are made as late as possible.
3. Matching Policy

If you are running a steady, well-established business, you are likely to be comfortable with the prospect of taking
risks. In that case, you can go for a matching working capital policy. Under a matching working capital policy,
the business keeps its current assets almost at par with its current liabilities.

Ideally, a company which is gaining momentum in the market and is on the verge of entering into a new phase of
growth should adopt a matching working capital policy. If you follow the matching policy, you will always have
a greater amount of liquid assets at your disposal, which you can then invest into the expansion of your firm.

4- Hedging Policy

One of the policies by which a firm finances its working capital needs is the hedging policy, also known as
matching policy. This policy works in an arrangement where the current assets of the business are used perfectly
to match the current liabilities.

As per this approach, fixed and permanent current assets are financed through long-term sources and fluctuating
current assets are financed through short-term sources.

This policy is a medium risk proposition and requires a good amount of attention. For example, if a bank loan is
due to be paid after six months, the company will ensure that sufficient amount of cash will be available to repay
the loan on the date of maturity even though it may or may not currently have sufficient cash.

In case of a growth firm, the amount of fixed assets and permanent current asset go on increasing with the passage
of time but the volume of fluctuating current assets change with the change in production level. In Figure 8.1,
Line A and Line B is upward slopped indicating that they go on increasing with the passage of time and as per
hedging principle they are financed through long-term sources like equity and long-term debt.
1. Nature of Business

The first factor which helps in determining the requirement of working capital is the type of business in which
the company is involved. A trading company or a retail shop requires less working capital as the length of the
operating cycle of these types of businesses is small. However, the wholesalers require more working capital, as
they have to maintain a large stock and generally sell goods on credit, increasing the length of the operating cycle.
Besides, a manufacturing company requires a huge amount of working capital as it has to convert its raw material
into finished goods, sell the goods on credit, maintain the inventory of raw materials and finished goods.

2. Scale of Operation

The firms that are operating at a large scale need to maintain more debtors, inventory, etc. Hence, these firms
generally require a large amount of working capital. However, the firms that are operating at a small scale require
less working capital.

3. Business Cycle Fluctuation

A market flourishes during the boom period which results in more demand, more stock, more debtors, more
production, etc., ultimately leading to the requirement for more working capital. However, the depression period
results in less demand, less stock, fewer debtors, less production, etc., which means that less working capital is
required.

4. Seasonal Factors

The companies which sell goods throughout the season require constant working capital. However, the companies
selling seasonal goods require a huge amount of working capital during the season, as at that time there is more
demand and the firm has to maintain more stock and supply the goods at a fast speed, and during the off-season,
it requires less working capital as the demand is low.

5. Technology and Production Cycle

A company using labor-intensive techniques requires more working capital because it has to maintain enough
cash flow for making payments to labour. However, a company using capital-intensive techniques requires less
working capital because the investment made by the company in machinery is a fixed capital requirement, and
also there will be less operating expenses.

6. Credit Allowed

The average period for collection of the sale proceeds is known as the Credit Policy. The credit policy of a
company depends on various factors like the client’s creditworthiness, industry norms, etc. A company following
a liberal credit policy will require more working capital, as it is giving more time to the creditors to pay for the
sale made by the company. However, if a company follows a strict or short-term credit policy then it will require
less working capital.

7. Credit Avail

The time period that a company is getting credit from its suppliers also affects the requirement for working capital.
If a company is getting long-term credit on raw materials from its supplier, then it can manage well with less
working capital. However, if a company is getting a short period of credit from its suppliers, then it will require
more working capital.

8. Operating Efficiency

If a company has a high degree of operating efficiency then it will require less working capital; however, if a
company has a low degree of operating efficiency then it will require more working capital. (Operating cycle of
a firm is the time period from the purchase of raw material to the realisation from debtors). Hence, it can be said
that the length of the operating cycle directly affects the requirements of the working capital of an organisation.

9. Availability of Raw Materials

If the raw material is easily available to the firm and there is a ready supply of inputs and raw material, then the
firm can easily manage with less working capital. Also, as the firm does not need to maintain any stock of raw
materials, they can manage with less stock, and hence less working capital. However, if there is a rough supply
of raw materials, then the firm will have to maintain a large inventory to carry on the operating cycle smoothly.
Therefore, the firm will require more working capital.
10. Level of Competition

If there is competition in the market, then the company will have to follow a liberal credit policy for supplying
goods on time. For this, it will have to maintain higher inventories, resulting in more working capital
requirements. However, if there is less competition in the market or a company is in a monopoly position, then it
will require less working capital, as it can dictate its own terms according to its requirements.

11. Inflation

A rise in the price increases the price of raw materials and the cost of labour, resulting in the increasing
requirement for working capital. However, if a company is able to increase the price of its goods also, then it will
face less problem with working capital. A rise in price has a different effect on the working capital of different
businesses.

12. Growth Prospects

If a firm is planning on expanding its activities, then it will require more working capital, as it needs to increase
the scale of production for expansion, resulting in the requirement of more inputs, raw materials, etc., ultimately
increasing the need for more working capital.

Sources of Working Capital

● Spontaneous Sources: The sources of capital created during normal business activity are called
spontaneous sources of working capital. The amount and credit terms vary from industry to industry and
depend on the business relationship between the buyer and seller. The main characteristic of spontaneous
sources is ‘zero-effort’ and ‘negligible cost’ compared to traditional financing methods. The primary
sources of spontaneous working capital are trade credit and outstanding expenses.
● Short-term Sources: The sources of capital available to a business for less than one year are called short-
term sources of working capital.
● Long-term Sources: The sources of capital available to a business for a longer period, usually more than
one year, are called long-term sources of working capital.

(OR)
1) Spontaneous Sources

Spontaneous working capital financing sources are those generated naturally from normal business activities such
as goods and services availed at credit, trade credit from suppliers & creditors, accrued expenses, etc.

2) Short-term Sources

Short-term sources of working capital are generally short term loans from banks and NBFCs. There are different
options for raising short-term capital, including short-term loans, overdrafts, etc. from commercial banks, invoice
discounting, accrual accounts, etc.

3) Long-term Sources

These sources of working capital finance are available for longer periods and generally include long term loans,
equities, debentures, and the like.

● Trade Credit: The most common way to raise funds for the short term, trade credit is the credit
extended by suppliers, wholesalers, distributors, resellers, etc.
● Sundry Creditors: They offer services and goods to businesses in credit. While they are liabilities, sundry
creditors are also excellent sources of working capital finance.
● Bills Payable: Bills payable are records of deferred payments for the goods and services that a company
buys on credit.
● Notes Payable: These records of payments that a business promises to make within a specific date are
also good sources of working capital.
● Accrued Expenses: Expenditures that have been accrued but whose payments are yet to be made can also
be great sources of working capital.
Short-Term Sources of Working Capital
● Loans from Commercial Banks

Varied business loan schemes are available from major private and public commercial banks across India.

1. Straight Loans- Also known as term loans, these sources of working capital finance involve a straight-
up lump-sum payment to businesses at an interest.
2. Cash Credit- Similar to a line of credit, these short-term sources of working capital can be secured or
unsecured, have maximum repayment tenure of 1 year, and allow businesses to borrow amounts up to a
specific limit.
3. Hypothecation Advances- Businesses put up an asset or stocks as security for a loan in these sources of
working capital. However, the said asset is still under the business’s possession and can be used as
necessary.
4. Pledge Loans- They are secure working capital sources similar to hypothecation advances. However,
the collateral or security pledged can only be used once the debt has been cleared.
5. Overdraft Facility- A bank overdraft allows businesses to overdraw their current account. It is a common
source of working capital finance for companies.
6. Bill Financing- Bill financing helps businesses raise money using outstanding invoices of transactions
already made. This is a great way to unlock the credit stuck in the supply chain.

● Public Deposits

For this particular source of working capital finance, a business can invite the public to make short term deposits
for a high rate of return. According to the Reserve Bank of India, companies can raise to 35% of their paid-up
capital or the money received from selling stocks.

● Trade Deposits

Businesses with good financial standing & reputation can buy raw materials and supplies from vendors on credit.
Deferred payments can be considered sources of working capital finance as vendors allow businesses 3 to 6
months to clear outstanding payments.

● Bill Discounting

For these sources of working capital, outstanding invoices are sold at a discount to financial institutions that
disburse a certain percentage of the invoice amount, helping businesses meet their temporary working capital
needs.
 ● Advances from Customers

One of the most common sources of working capital finance is getting an advance from customers. A business
can ask a buyer to pay a certain amount upfront and use it to meet different working capital requirements.

● Short-Term Loans

A short term or working capital loan comes with high-interest rates but offers substantial repayment flexibility.

● Commercial Paper

Commercial papers are debt instruments issued on the money market by businesses looking to meet their short-
term financial requirements.

● Vendor Financing

Vendor financing, also known as trade credit, is a line of credit extended by a vendor to a business that uses it
to buy the vendor’s supplies. They can then repay the vendor after earning from their sales.

Long-Term Sources of Working Capital

Long-term sources of working capital come with tenures of more than one year and include the following:

● Share Capital

The total amount of capital a company possesses by selling its shares is among the primary external sources of
working capital finance.

● Long-term Loans

Banks and NBFCs offer long-term loans to businesses with repayment tenures of 7 years. However, due to long
tenures, they are not considered ideal sources of working capital financing.

● Debentures

Debentures are unsecured long-term debt instruments issued by companies with a solid financial reputation. The
company is obligated to pay interest to the lender no matter the circumstances.

● Equity Funds

Businesses can also issue equity funds, a type of mutual fund where investors put their money indirectly into the
business’s stocks.

Sources of Working Capital for Small Business

SMEs and start-ups’ lack of credit history limits their working capital sources.
 ● Vendor and Trade Sources

Vendor financing and trade credit are two of the best sources of working capital for small businesses. The credit
period offered, the discount on purchases and the funding provided can help small companies build their working
capital.

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