Working Capital

By
Dr. M S Khan
Working Capital:
Working Capital refers to short-term funds to meet operating
expenses. It refers to the funds, which a company must possess to
finance its day to day operations.

Definition of Working Capital:

Working Capital refers to that part of the firm’s capital, which is
required for financing short-term or current assets such as cash,
marketable securities, debtors and inventories. Funds thus, invested in
current assets keep revolving fast and are constantly converted into
cash and this cash flow out again in exchange for other current assets.
Working capital also known as revolving or circulating capital or
short-term capital.
Concept of Working Capital
There are two concepts of working capital.

1. Gross Working Capital: (Total Current Assets)

The gross working capital, simply called as working capital refers to the
firm’s investment in current assets. Current assets are the assets, which can
be converted into cash within an accounting year or operating cycle. Thus,
Gross Working Capital, is the total of all current assets. It includes
 Inventories (Raw materials and Components, Work-in-Progress, Finished
Goods, Others)
 Trade Debtors
 Loans and Advance
 Cash and Bank Balances
 Bills Receivables.
 Short-term Investment
 Concept of Working Capital
2. Net Working Capital: (Total Current Assets – Total Current
Liabilities)
Net working capital refers to the difference between current assets and
current liabilities. Current liabilities are those claims of outsiders, which are
expected to mature for payment within an accounting year. Net working
capital may be positive or negative. A positive net working capital will
arise when current assets exceed current liabilities and a negative net
working capital will arise when current liabilities exceed current assets i.e.
there is no working capital, but there is a working capital deficit. Current
liabilities includes
 Trade Creditors.
 Bills Payable.
 Accrued or Outstanding Expenses.
 Trade Advances
 Short Term Borrowings (Commercial Banks and Others)
 Provisions
 Bank Overdraft
Needs and Objectives of Working
Capital
 For the purchase of raw materials
 To pay wages and salaries
 To pay day to day overhead costs such as fuel,
power and office expenses etc.
 To meet selling costs such as packaging and
advertising expenses
 To provide credit facilities to the customers
 To maintain the inventories of raw materials,
working in process and finished goods.
Kinds of Working Capital
There are two kinds of working capital:
1. Permanent or Regular Working Capital-The
minimum level of current assets maintained in a firm is
known as permanent or regular working capital.
2. Temporary or Variable Working Capital- Any
additional working capital apart from permanent working
capital required to support the change in production and sales
activities is referred to as temporary or variable working
capital. In other words an amount over and above the
permanent working capital is variable working capital.
Management of Working
Capital
Management of Working Capital is concerned with the problems
that arise in attempting to manage the current assets, the current
liabilities and the inter-relationship that exist between them. In
other words, it refers to the administration of all components of
working capital such as cash, marketable securities, debtors
(receivable), stock (inventories) and creditors (payables). There
are three dimensions in managing Working Capital:
 It is concerned with the formulation of policies with regard to
profitability, risk and liquidity.
 It is concerned with the decision about the composition and level
of current assets.
 It is concerned with the decision about the composition and level
of current liabilities.
Need to maintain balanced Working
Capital
For maximization of profit or minimization of
working capital cost or to maintain balance between
liquidity and profitability there is a need to maintain a
balance in working capital. Excessive working capital
results in unnecessary accumulation of inventories and
indication of defective credit policy, which leads to
managerial inefficiency. Inadequate working capital in
a firm, reduce growth and leads to inefficient
utilization of fixed assets. Shortage of working capital
also hampers the firm’s goodwill in the market.
Requirement of Working Capital
There are no set rules or formula to determine the working capital requirements of the
firms. A large number of factors influence the working capital need of the firms. All
factors are of different importance and also importance change for the firm over time.
Therefore, an analysis of the relevant factors should be made in order to determine the
total investment in working capital. Generally, the following factors influence the
working capital requirements of the firm:
 Nature and size of the business
 Seasonal fluctuations
 Production policy
 Taxation
 Depreciation policy
 Reserve policy
 Dividend policy
 Credit policy:
 Growth and expansion
 Price level changes
 Operating efficiency
 Profit margin and profit appropriation
Estimating Working Capital
Needs
To estimate the Working Capital needs, a number of methods may
be used. The choice of methods of estimating working capital,
factors such as seasonal variation in operations, accuracy of sales
forecasts, investment cost and variability in sales price would
generally be considered.
 Current assets holding period: The estimate of working capital
mainly depends upon the operating cycle of the firm. The operating
cycle is the average period of time required for a firm to make an
initial outlay of cash to produce goods, sell the goods, and receive
cash from customers in exchange for the goods. In order to calculate
the working capital needs, holding period of various types of
inventories, the credit collection period and the credit payment
period are required.
 Ratio of sales: To estimate working capital requirements as a ratio
of sales on the assumption that current assets changes with sales.
 Ratio of fixed investment: To estimate working capital requirement
under this method, working capital is calculated as a percentage of
fixed investment. This ratio is depends upon the nature of business.
Financing of Working
Capital
Financing of working capital can be done in two
ways-
1. Long term sources: It includes shares, debentures,
bonds, loans from banks and financial institutions,
retained earnings and venture capital funds for
innovative projects.
2. Short term sources: It includes bank credit,
transaction credit, advances from customers, bank
advances, loans, overdraft, bills purchase and
discounted, commercial paper and bank deposits
Working Capital
Policy/Approaches
By taking into consideration of what should be the ratio of short term
financing to long term financing of the working capital, approaches are-
 Hedging or Matching Approach: In this approach the finance manager
matches the maturity profile of the assets with maturity profile of the
sources of finance. Fixed assets and permanent current assets should
finance with long term sources and temporary current assets are to be
finances with short term sources.
 Conservative approach: In this approach the firm depends more on
long term sources of finance. The firm finances its permanent working
capital and also a part of its fluctuating working capital with long term
financing. Only a small portion of the temporary working capital
financed through short term sources.
 Aggressive approach: In this approach a firm uses more short term
sources of financing. Here the temporary as well as a part of the
permanent working capital is financed through short term sources.
Thanks