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WORKING CAPITAL MANAGEMENT

INTRODUCTION TO WORKING CAPITAL On the basis of purpose for which finance is required in an organization capital can be classified into Fixed Capital and Working Capital. Working Capital is the capital required for the day to day working of an enterprise. Thus the amount required for purchasing material, pay wages and amount incurred for various overhead expenses are known as working capital. Working capital is also known as revolving capital or circulating capital or short term capital.

CONCEPTS OF WORKING CAPITAL There are mainly two concepts of working capital 1. Gross Working Capital Gross working capital means sum total of current assets. This concept is also known as Quantitative Concept. Current Asset means assets which can be converted into cash within an accounting year. This includes stock of inventories, sundry debtors, bills receivables etc. J S Mill defines working capital as the sum total of current assets 2. Net Working Capital Net working capital means current assets minus current liabilities. It is the excess of current assets over current liabilities. Current liabilities represent claims of outsiders which are expected to mature within one year. This includes sundry creditors, bills payable, bank overdraft etc. This concept is also known as Qualitative Concept. Net working capital can be positive or negative. It is said to be positive when current asset exceeds current liabilities and said to be negative when current liabilities exceeds current assets. C W Gerstenbergh defines working capital as excess of current assets over current liabilities

CLASSIFICATION OF WORKING CAPITAL Working Capital can be classified into two fixed working capital and variable working capital. 1. Fixed or Permanent Working Capital

Fixed Working Capital represents that part of capital which is permanently locked up in the current assets to carry out the business smoothly. This investment is of permanent in nature. For example the investment required to maintain the minimum stock of material, work in progress and finished goods. Permanent working capital again is classified into two; a) Regular Working Capital It is the minimum amount of liquid capital required to keep up the circulation of the capital from cash to inventories, to receivables and again to cash. b) Reserve Margin It is the excess capital over the needs of regular working capital that should be kept in reserve for contingencies that may arise any time. 2. Variable Working Capital Variable working capital means that part of working capital which changes with the changes in the volume of business. It may be divided into; a) Seasonal Working Capital It is the amount required to meet the seasonal liquidity of the business. Production has to be increased during busy season. This needs more working capital. b) Special working Capital It is the amount required to meet special exigencies such as launching of extensive marketing campaigns, for conducting research etc.

IMPORTANCE/ ADVANTAGES OF ADEQUATE WORKING CAPITAL 1. Solvency of business:

Solvency of the business means the ability to meet the payments in time. Payments can be made in time only when there is adequate working capital with the firm 2. Goodwill can be maintained Prompt payment to creditors enhances the goodwill and credit worthiness of the business. 3. Sense of security and confidence Adequacy of working capital creates an environment of security, confidence, high morale and creates overall efficiency in business. 4. Cash Discounts When there is adequate working capital with the firm, they can take advantage of cash discount offered by suppliers. 5. Easy Loan Only a concern with better goodwill, credit worthiness and solvency can command credit from financial institutions at favorable terms. 6. Exploitation of favorable market condition Only concerns with adequate working capital can exploit favorable market conditions such as purchasing its requirements in bulk when the prices are lower and by holding its inventories for higher prices. 7. Meeting unseen contingencies Adequate working capital helps the firm to face contingencies with much confidence. Contingencies like business oscillations, natural calamities, stock piling etc can take place in business 8. Increased production efficiency A continuous supply of raw materials, regular payment of expense, innovations and expansion can be undertaken if there is adequate working capital. 9. Distribution of dividend If a company is short of working capital, they may postpone the payment of dividend. 10. Increase in efficiency of fixed assets Without working capital, fixed assets cannot be properly utilized. The fate of large scale investment in fixed asset is often determined by a relatively small amount of current assets. DANGERS OF EXCESS WORKING CAPITAL 1. Low rate of return on capital

Excess working capital means part of working capital lying as idle. Idle capital does not earn anything. But return will have to be given on the whole capital. This brings down the rate of returns. 2. Decline in capital and overall efficiency To keep up the show of prosperity, the firm may undertake window-dressing. The provisions may not be provided adequately. All these leads to reduction in capital and efficiency. 3. Loss of goodwill and confidence Low rate of return to shareholders result in less market value for company shares. This reduces the confidence of shareholders and they may abandon the company. 4. Misallocation of resources Companies with excessive working capital cannot utilize it effectively. It would have been better to withdraw a part of such scarce resources and invested elsewhere. 5. Evils of over capitalization Excessive working capital leads to overcapitalization with all its attended evils. 6. Inefficient management Excessive working capital denotes the inefficiency of management. The management is not expanding the business otherwise the working capital might have been utilized. 7. Leads to unnecessary purchasing When working capital is more than the requirement, the management undertakes unnecessary and wasteful expenditure. 8. No relation with Bankers When working capital is excess, the firm may not establish good relations with financial institutions, when contingencies arise, they find it difficult to face the situation. 9. Lead to speculative activities When fund is excess of their requirement, the management may spend it on speculative activities or invest in adventurous activities. This will result in loss of capital.

DANGERS OF DEFICIENCY WORKING CAPITAL 1. It may lead to business failure 2. The firm cannot take advantage of new opportunities or adapt to changes.

3. Trade discounts will be lost. 4. Cash discounts will be lost. 5. Financial reputation is lost. Creditors may not co-operate in times of difficulty because of the loss of creditworthiness. 6. Creditors may apply to court for winding up. 7. It affects dividend policy adversely. 8. The company cannot utilize its fixed assets properly. OPERATING CYCLE CONCEPT Operating Cycle in Working Capital refers to the average time elapses between the purchase of raw material and the final cash realization. According to Hunt, William and Donaldson, The working capital is required because of the time gap between the sale and their actual realization in cash. This time gap is technically termed as Operating Cycle of business. 1. Operating Cycle in a Manufacturing Concern

RAW MATERIAL

CASH

WORK IN PROGRESS

ACCOUNTS RECEIVABLE

FINISHED GOODS

2. Operating Cycle in a Trading Concern a) Cash to Inventory b) Inventory to Debtors/ Bills c) Debtors/ Bills to Cash FACTORS DETERMINING WORKING CAPITAL REQUIREMENT

1. Nature of business Public Utility Services generally require small amount of working capital whereas trading concerns require large investment in current assets. Thus the nature of the business determines the amount of working capital. 2. Size of business Greater the size of the business unit, generally larger will be the requirement of working capital. 3. Seasonal Variations The concerns will have busy and slack season. In busy season, the firm needs more working capital since it will have to store large quantity of raw materials and other current assets. 4. Time consumed in manufacture If time consumed in manufacture is larger as in the case of ship building, the working capital required will be more. 5. Turnover of working capital It denotes the speed with which the circulating capital completes its round. If the turnover of working is more, working capital requirement will be comparatively less. 6. Terms of purchase and sales If a concern purchases on cash and sells on credit basis may require more working capital. But a concern which purchases on credit and sells on cash basis may need less amount of working capital. 7. Business cycle fluctuations Business cycles affect the requirements of working capital. In conditions of boom, the firm will need more working capital to stock more materials and need more cash to pay for increased production. 8. Dividend policy If a concern follows a liberal dividend policy, they may need more working capital. If they follow conservative policy, cash will be retained in the business and working capital position will be stronger. 9. Growth and Expansion If the business is in the growth and expansion stage, they may require large amount of working capital. 10. Need to stock pile raw material and finished goods

In certain businesses where stock piling is necessary, large amount of working capital is needed to hold stock. If goods are produced against orders, working capital requirement can be reduced. SOURCES OF WORKING CAPITAL There are a number of sources through which working capital can be raised by a company. Working capital is of two kinds i.e. Permanent Working Capital and Variable Working Capital. The permanent working capital should be financed from long term capital sources and variable working capital should be financed from short term capital sources. Permanent or Long Term Sources of Working Capital 1. Shares It is the most important source of long term working capital. It creates no burden or fixed charge on the earning of the company. The company is not under obligation to return the capital. 2. Debentures Long term working capital can be raised from debentures. Debentures are creditors of the company and a fixed interest has to be paid to them. 3. Retained Profit Profits not distributed to the shareholders are also an important source of long term working capital. It is the cheapest source of capital. Retained profits may be represented by various uncommitted reserves and surpluses or specific reserves created out of profits. 4. Public Deposits Public deposits are the fixed deposits accepted by a business directly from the public. This source of raising short term and medium term working capital was very popular in the absence of banking facilities. 5. Loans from financial institutions Financial Institutions like Life Insurance Corporation of India, Industrial Development Bank of India etc lend term loans to companies for working capital purpose.

Short term Sources of Working Capital 1. Trade Credits

Trade credit refers to credit extended by the suppliers of goods. The creditworthiness of a firm and the confidence of its suppliers are the main basis of securing trade credit. 2. Bank Credit A greater part of the working capital is supplied by commercial banks. They advance credit to customers through cash credit, loans, and overdraft or through discounting of bills of exchange. 3. Indigenous bankers Private money lenders and other country bankers used to lend money for business purpose for short periods. The defect of this source is that they charge a heavy interest. 4. Loans from directors and friends Sometimes directors or friends of the company may advance loans to the company at a very low rate of interest. 5. Advance from customers Some business get advance from customers against orders. This is a cheap source of fund for the business. 6. Installments credit Here, assets are purchased but payments are made in convenient future installments. It is a source of short- term fund. 7. Accrued expense The companies sometimes postpone the payment of expense. These accrued (Due but not paid) expense is a source of working capital. 8. Commercial paper This is unsecured promissory notes issued by companies to finance short term needs.