Working Capital

To run the business smoothly, we need to maintain some inventory (ie. stock level) of raw materials and finished goods.
Due to competition and to improve sales we have to offer some credit period to our custome Depending upon the nature
of production process some amount of goods will be always in work-in-progress stage. All this items keeps on changing
from one stage to other and finally to cash. These are known as our current assets. Cash and other assets which get
converted into cash again, within short duration say within an accounting year are known as current assets.
Supplier of raw materials may allow us some time to pay (ie. creditors), similarly wages and other expenses may not be
paid immediately (expenses payable). These are known as current liabilities which are to be paid within a short period
say within an accounting year. Excess of current assets over current liabilities is known as working capital.
The term working capital can be used in two different ways-
1. Gross working capital: The total of current assets ie. 8,00,000 in above case is gross working capital. This is not
commonly used term.
2. Net working capital: The current assets minus current liability i.e. 6,00,000 in above case is net working capital,
commonly referred as working capital.
3. Other names: Working capital is also known as circulating capital, fluctuating capital and revolving capital.

 WORKING CAPITAL CYCLE

Having seen the meaning of working capital now we will see what is working capital cycle also known as Operating cycle.
To put it simply suppose if every days raw material requirement can be purchased and paid immediately and the raw
material gets converted into finished goods and finished goods are sold and realized in cash immediately then there
would not have been any need for working capital. But in reality raw material is purchased in bulk and stored for some
time before being finally consumed. Similarly finished goods produced remain in stock before finally being sold. The sales
remain in debtor form before finally being realized in cash.
This journey in a business concern starting with cash and again finally reaching to cash through raw material, work-in-
progress, finished goods and debtors stage is known as working capital cycle/ operating cycle. The availability of credit
from supplier will reduce operating cycle.
We can put this operating cycle in a pictorial form as follows-
The length of operating cycle will depend upon the length of each component in it. Longer the operating cycle higher will
be working capital requirement and shorter the operating cycle, lower (less) will be working capital requirement.
Operating Cycle = Raw material holding period + WIP conversion period + Finished goods holding period + Credit period
allowed to debtors
Net operating Cycle = Operating cycle - Credit period enjoyed (received) from creditors
Calculation of conversion period (CP) for Calculation of Net Operating Cycle
a) RMCP= Avg Raw Material Stock + Avg consumption of R.M. per day
Note: When figure of consumption is not given then purchase can be used )
b) WIPCP = Avg WIP + Avg Cost of production per day
Note: When figure of production is not known then cost of goods sold can be used
c) FGCP = Avg Finished Goods stock Avg cost of goods sold per day.

FINANCING OF WORKING CAPITAL

We have seen in the earlier part what is working capital requirement. Now we shall see how this requirement is fulfilled
i.e. how it is financed. Or to put it in other words what are the sources of Working capital finance.
We can divide the sources of financing as follows:
 Long term sources:
Owners Funds: 1. Equity share capital, 2. Preference share capital, 3. Retained earning (ie. Out of profit earned)
Borrowed funds: 1. Debentures 2. Long term loans, Public deposits
 Short term sources: 1. Overdraft/ cash credit limits, Bills discounted etc. from banks. 2. Other short term borrowings.
The working capital will also be financed by any combination from the above sources of Finance.
For deciding the composition of working capital financing we will 1 see whether working capital requirement is same
throughout the year or it keeps on fluctuating. On the basis of time working capital requirement is divided as follows-
 TYPES OF WORKING CAPITAL
1. Permanent Working Capital: That minimum level of current asset which is maintained throughout the year is known
as permanent or fixed working capital. This is the minimum level required always.
2. Temporary Working Capital: When actual working capital increases beyond permanent working capital, the excess is
known as temporary or variable working capital.
The total working capital requirement always keeps on fluctuating because the level of production and sales will not be
same (uniform) throughout the year. This may happen because of seasonal nature of business or due to fluctuating
demand in the market. Hence, highest working capital will be what is required during peak periods.
Approaches of Working Capital Financing
3. Conservative Approach: The very safe or conservative approach will be to finance full permanent working capital
Requirement as well as temporary working capital requirement from long term sources. But it will be Consider. And
whenever working capital need will be lower, the funds will remain idle.
4. Moderate Approach: But in any case some part of total working capital requirement should be always financed from
long term sources and balance only from short term sources. This will give financial stability and will void liquidity
problem. May be permanent part is financed by long term sources and temporary requirement is financed by short
term sources.
5. Aggressive Approach: Only a small part of permanent working capital is financed by long term sources and the
balance of permanent part and all of temporary working capital requirement is financed by short term sources. This
mode may be cheap but it may create liquidity problems if at times of needs short term borrowings cannot be
arranged.
 ESTIMATION OF WORKING CAPITAL/CALCULATION OF WORKING CAPITAL
Now, we will see how the working capital requirement can be forecasted/ ascertained. Working capital keeps on
changing, hence usually it is calculated every year. In case of seasonal business it can be calculated separately for season
and off season period. While forecasting working capital requirements, it should be borne in mind that working Capital
requirements are to be determined on an average basis for the whole year and not at any specific point of time.
A. Working Capital can be Forecasted on any of the following four ways:
1. As a percentage of sales: The working capital will be forecasted as some percentage of sales. This is very simple to
calculate but this may not give very reliable results because with increase in sales it will proportionately increase the
working capital. Actually increase in such cases may be less than proportionate. Say for example sales forecasted 2.5
lakhs p.m. and working capital is estimated at 10% of sales. Annual sales 2.50 x 12 = 30 lakhs.
Hence, working capital requirement = 30 x 10% = 3 lakhs 2.
2. A percentage to project cost/ fixed asset: The working capital will be calculated as some % of project cost/ fixed
asset. This is also simple To use. But increase in sales requires more capital but this increase may not be reflected by
this Method because project cost fixed asset may remain same when sales will increase upto certain Level.
3. On the basis of operating cycle: We have already seen, what is operating cycle. We can estimate working capital by
multiplying operating cycle with the cost of production. Say for example net operating cycle is 4 month and Average
cost of production 1.5 lakh p.m. Then, working capital requirement 4 x 1.56.0 lakhs + desired cash balance.
4. By estimating each element of working capital independently : This is the most proper and scientific way of
estimating working capital requirement and is Commonly adopted.
B. Alternative Approach to Working Capital (Cash cost of working capital): Many experts, calculate the working capital
requirements by working out the cash costs of Work in progress, finished goods and sundry debtors Under this
approach, the debtors are Calculated not as a percentage of sales value but as a percentage of cash costs. Similarly,
work-in- Progress and finished goods are valued according to cash costs (ie. Depreciation and other non Cash
expenditure is excluded). Other items will remain unchanged.
C. Safety Margin (Provision for Contingencies): We have seen that working capital requirement keeps on fluctuating
and is dependent on various factors some internal some external. Hence, the working capital calculated by any of the
methods may change in future period for which we have estimated it, in that case our financial arrangements may
not be sufficient and we may have to face liquidity problems. To avoid such situation management may decide a
certain as safety margin which will be added to the working capital calculated by any method discussed earlier.
D. Effect of profit on working capital: We have seen in earlier part, that the operating cycle start with cash and passes
from 4 stages namely raw material, work-in-progress, finished goods and debtors and ultimately gets converted into
cash when debtors are realised. We know that what we realise from debtors is sale value which is more than the cost
we have put in, this excess realised is profit. For example if we have put in 100 for material, labour and expense to
make the goods, we may realise 120 by selling it. Thus 20 extra cash is the result of profit earned.
So, with each operating cycle getting completed, we will be left with more and more cash, this may ease out our working
capital requirement. But if the sales are progressively increasing then this extra cash generated will be used up for extra
working capital required for each increase in sales. Also this extra cash generated may get used for dividend payment,
withdrawals by partners or for purchase of fixed assets etc.
 Factors which influence working capital.
Some of the important factors on which the amount of working capital required will depend, are As follows: a
a) The nature of product and production process: A product which has simple and show Process of production will have
very negligible or no work-in-progress. Whereas product requiring longer duration to produce will have large amount of
work-in-progress like Tiles, Bricks, Paper, etc.
b) The nature of business whether trading or manufacturing: A Trading concern has to maintain stock of finished goods
only whereas a manufacturer has to keep stock of raw material, packing material, work-in-progress and finished goods
naturally manufacturer needs high working capital.
c) Time lag in replenishing the stock of raw material and its availability: If raw material is easily available within short
time then may be one months stock will be sufficient. But if it requires longer time to replenish 2-3 months stock will
have to be kept. Similarly large inventory will be needed of imported raw material or materials which are available
seasonally.
d) Credit allowed by the suppliers of material and services: Availability of credit reduces our working capital
requirement hence, longer the credit better it will be.
e) Credit allowed to customers: Due to competition etc. we have to allow credit to customers longer the credit period
higher will be the debtors level resulting into higher working capital needs. If proportion of cash sales is more it will
reduce the working capital needs.
f) Finished stock holding policy: If we keep large inventory to avoid stock out situation, then working capital need will
rise drastically.
g) Whether unit is dealing in single product or multi product: If the organisation deals in large number of products it has
to maintain a reasonable amount of stock of all resulting into higher working capital.
h) Whether single or multi model quality product: If for a particular product there are so many models/ quality then
also inventory of each such model will have to be maintained consequently increasing working capital. Example-T.V.,
Fridge, Music System, etc. i) Market competition: Competition compels to allow higher credit to customer, maintain large
and variety of inventory consequently increasing working capital.
 IMPORTANCE & OBJECTIVES OF WORKING CAPITAL MANAGEMENT
Working capital management or short term financial management is a very important and significant part of financial
management. Its importance is because of two reasons:
i) Investment in current assets is a substantial part of total investment in any business Concern.
ii) Investment in current assets and the level of current liabilities has to be continuously adjusted according to sales
level. Hence, working capital decisions are not a one time process but a continuous one.
The importance of working capital management is reflected by the fact that the significant time of finance managers
goes in planning, procuring and managing and controlling the current assets namely inventory, debtors, cash and
marketable securities (short term investments), current liabilities namely creditors and working capital finance ie. Short
term financing from banks or elsewhere at favourable terms and cheap rate..
 Objectives of Working Capital Management
The basic objectives of working capital management are as follows:
 By optimizing the investments in current asset and by reducing the level of current liabilities, the company reduces
the locking up of funds in working capital thereby, it can improve the return on capital employed in the business.
 The second important objectives of working capital management is that the company should always be in a position
to meet its current obligations which should properly be supported by the current assets available with the firm. But
maintaining excess funds in working capital means locking of funds without return.
 The firm should manage its current assets in such a way that the marginal return on investment in these assets is not
less than the cost of capital employed to finance the current assets.