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Working capital is the life blood and nerve centre of a business. Working part of firms capital which is required to finance short term or current assets. According to account terminology-It is the difference between the inflow and outflow of funds. In other words it is net cash flow. Thus working capital is the amount of funds necessary to cover the cost of operating an enterprise.


There are two concepts of working capital: 1. Gross working capital In broad sense, working capital refers to gross working capital. It refers to the firms investment in current assets. Current assets are assets, which can be converted into cash with an accounting year. 2. Net working capital It is the excess of current assets over current liabilities. In other words it is the difference between current assets and current liabilities.Net working capital is the portion of current assets which is financed with long term funds. In a narrow sense working capital is referred as the net working capital.Net working capital may be positive or negative depending upon whether current assets exceed current liabilities or not.


The need for working capital to run the day to day business activities cannot be over emphasized. The need for working capital arises due to time gap between production and realization of cash from sales. Thus working capital is needed for following purposes: a. Purchase of raw materials, components and spares. b. To pay wages and salaries. c. To incur day-to-day expenses and overhead cost like power, office expenses etc. d. To meet various selling costs such as packing, advertising etc.

e. To provide credit facilities to customers. f. To maintain inventories of raw material, work in progress, stores and spares, finished goods. Sufficient working capital is necessary to sustain sales activity; this is referred to operating or cash cycle. The continuing flow from cash to suppliers, to inventory, to accounts receivables and back in to cash is what is called operating cycle. In other words the term cash cycle refers to the length of time necessary to complete the following cycle of events; 1, conversion of cash to inventory 2. Conversion of inventory in to receivables. 3. Conversion of receivables in to cash. The need or objects of working capital in a business can be understood by studying the business under varying circumstances such as a new concern, as a growing concern, and as one, which has attainted maturity. A new concern needs a lot of liquid funds to meet the various initial expenses. The amount of working capital needed goes on increasing with the growth and expansion of the business till it attains maturity. At maturity the amount of working capital needed is called normal working capital.


A firm should maintain adequate working capital. No business can be run successfully with out an adequate amount of working capital. Both excess and inadequate working capital position are dangerous from the firms point of view. The main advantage of maintaining adequate amount of working capital is 1. Adequate working capital protects a business from the adequate situations and also helps in maintaining solvency of business by providing uninterrupted flow of production. 2. The adequate working capital also enables a concern to avail cash discount on the purchase and hence it reduces the cost 3. Regular payment of wage, salaries and supply of raw material could be minimized. 4. Sufficient working capital enables business concern in maintaining goodwill.

5. Business concern with adequate working capital can exploit favorable market conditions like purchasing its

requirements in bulk when the prices are low. And lower by holding its inventories for high prices 6. Only concern with adequate working capital can face business crises in emergencies such as depression because during such periods generally there is much pressure on working capital. 7. Sufficiency of working capital enables a concern to pay quick and regular dividends to its investors as there may not be much pressure to plough back profits. This gains the confidence of its investors and creates favorable market to raise additional fund in the future. 8. It also creates an environment of safety, confidence, and high morale and thus improves over all efficiency of a business.


Excess working capital means idle funds, which earns no profit for the firm. The dangers of excessive working capital are; 1. It results un necessary accumulation of inventories. This increases the chance of inventory mishandling, waste, theft and losses. 2. It is an indication of defective credit policy and slack collation period. 3. It makes management complacement which degenerate in to managerial in efficiency. 4. The company may be tempted to over trade and loss heavily. 5. Due to low rate of return on investment the value of share may also fall. 6. There may be an imbalance between liquidity and profitability. 7. When there is excessive working capital, relation with banks and other financial institutions may not be maintained.


1. It stagnates growth of the firm, as it becomes difficult for the firm to under take profitable projects due to non availability of working capital funds. 2. Fixed assets cannot be efficiently utilized due to the lack of working capital. Thus the firms profitability would deteriorate. 3. Operating efficiencies creep in when it becomes difficult even to meet day to day commitments.

4. a company may loss its reputation when it is not in a position to pay off its short term obligations. As a result the firm faces tight credit terms. 5. It becomes difficult for the firms to exploit favorable conditions. So a company may not be able to take advantage of profitable business opportunities. An enlightened management should there fore maintain the right amount of working capital on continuous basis. Sound financial and statistical techniques, supported by judgment, should be used to predict the quantum of working capital needed at different times.


The following factors are involved in a proper assessment of the quantum of working capital required. 1. nature of business 2. production cycle 3. business cycle 4. production policy 5. credit policy 6. working capital cycle 7. growth and expansion 8. seasonal variations 9. profit level 10.price level changes 11.operating efficiency


Working capital management is concerned with the problems that arise attempting to manage the current assets the current liabilities and the inter relation ship between that exists between them. The term current assets refers to those assets which in the ordinary course of business can be converted in to cash with in one year with out undergoing a diminution in value and with out disrupting the operations of the firm. The major current assets are cash, marketable securities, accounts receivables, inventory. Current liabilities are those liabilities which are intended at their inception to be paid in the ordinary course of business with in one year, out of the current assets or earning of the firm. The basic current liabilities are accounts payable, bills payable, bank overdraft, and outstanding expenses. A goal of working capital management is to manage the firms current assets and liabilities in such a way that a satisfactory level of working capital is maintained. This is so because if the firm cannot maintain a satisfactory level of working capital, it is likely to become insolvent and may even be forced in to bankruptcy. The current assets should be large enough to cover its current liabilities in order to ensure a reasonable margin of safety. Each of the current assets must be managed efficiently in order to maintain liquidity of the firm while not keeping too high a level of one of the firm. Each of the short term sources of financing must be continuously managed to ensure that they are obtained and used in the best possible way. The interaction between current assets and current liabilities is there fore the main theme of the theory of working capital management.


The basic goal of working capital management is to manage the current assets and liabilities of a firm in such a way that a satisfactory level of working capital is maintained.inadquacy of working capital may lead to the firm to insolvency and excessive working capital implies idle funds, which earn no profits for the business. Working capital management policies of a firm have a great effect on its profitability, liquidity, and structural health of the organizations Following are the general principles of working capital management 1. PRINCIPLE OF RISK VARIATION Risk refers to inability of a firm to meet its obligations as and when they become due for payment. Larger investments in current assets with less dependence on short term borrowings increases liquidity, reduces risk and there by decreases the profitability. A conservative management prefers to minimize risk by maintaining a higher level of current assets or working capital while a liberal management assumes greater risk by reducing working capital. 2. PRINCIPLES OF COST OF CAPITAL The various sources of raising working capital finances have different cost of capital and degree of risk involved. Generally higher the risk lower is the cost and vice versa. A sound working capital management should always try to achieve a proper balance between these two.


This principle is concerned with planning the total investments in current assets. According to these principles the amount of working capital invested in each component should be adequately

justified by a firms equity position. The level of current assets may be measured with the help of two ratios 1. Current assets as a percentage of total assets 2. Current assets of total percentage of total assets While deciding about the composition of current assets, the financial manager may consider the relevant industrial averages 3. PRINCIPLE OF MATURITY OF PAYMENT This principle is concerned with planning the sources of finance for working capital. According to this principle a firm should make every effort to relate maturities of payment to its flow of internally generated funds. Maturity pattern of various current obligations is an important factor in risk assumptions and risk assessments. Generally shorter the maturity schedules of current liabilities in relation to expected cash inflows the greater the inability to meet its obligation in time.


Set planning standards for stock days, debtor days and creditor days. Having set the planning standards impress the staff that these targets are just as important as operating budgets and standard costs. To instill and understanding among the staff that working capital management produces profit.

2. Action to stocks
Consider keeping stock in suppliers warehouse, drawing on it as needed and saving warehousing cost. To keep stock levels as low as possible consistent with no running out of stock and not ordering stock in

uneconomically small qualities just in time stock management is fine as long as is just in time and never fails delivery on time.

3. action to debtors or customers

To assess all significant new customer for their ability to pay. Take references and examine the accounts so as to assess them. Re assess all significant customers periodically. Supplying to existing customers who are poor payers which may lead a company to lose sales which in turn affect the quality of the business. Company should consider factoring of sales invoices and the extra cost incurred will be worth in terms of quick payment of sales revenue, less debtor administration and more time to carry out the business. Company also must consider offering discounts for prompt settlement of invoices,

4. action on creditors
Company shall try not to pay invoices too early so as to take advantage of credit offered by suppliers. A firm should try to pay early if the supplier is offering a discount. A company should maintain a register of creditors to ensure that creditors are paid on a correct date not earlier and not later.


The importance of managing working capital is magnified when it refers to firms in developing economies. These firms have many problems, such as being small in size and lack of resources. The list of problems is long and includes low level of product and process technology, small product market, lack of access to capital, lack of physical infrastructure and proper institutional frame work. Because of their small size, firms in developing economies may quickly be exposed to problems of production capacity. To satisfy the demand they may have the product and this makes inventory management more relevant. Both human and financial resources of the firms in developing economies are very limited. The problem of managing working capital investments and short-term debt may be increased by such lack of managerial knowledge. Financially firm in developing countries lack the opportunity of getting benefit of financial markets as the firms are small in size and have less opportunity to go public to benefit from financial markets. Banks will resistant to provide long term loans to such firms. So because of these reasons working capital management is even more important in developing countries than developed countries. It is through the working capital related activities that they are trying to capitalize in order to create value for the firm.

There is a difference between current assets and fixed assets in terms of their liquidity. A firm requires many years to recover the initial investments in fixed assets such as plant and machinery or land and building. On the contrary, investment in current assets is turned over many times in a year. Operating cycle is the time duration required to cover the sales, after the conversion of resources in to inventories, in to cash. The operating cycle of a manufacturing company involves three phases; o Acquisition of resources such as raw material, labour, power and fuel etc. o Manufacture of of the product which includes conversion of raw material in to work in progress in to finished goods. o Sales of the product either for cash or on credit. Credit sales create book debt for collection. The length of the operating cycle is determined by the sum of Inventory conversion period (ICP) Book debt conversion period (BDCP) Inventory conversion period is the total time needed for producing and selling the product. It includes the Raw material conversion period Working progress conversion period Finished goods conversion period. The book debt conversion period includes the time required to collect the outstanding amount from customers. The total of inventory conversion period and book debts and conversion period is some times referred to as gross operating cycle.

It is a powerful tool of financial analysis. A ratio is defined as the indicated quotient of two mathematical expressions and as the relationship between two or more things. In financial analysis a ratio is used as a bench mark for evaluating the financial position and performance of a firm. An accounting figure conveys meaning when it is related to some other relevant information. The relationship between two accounting figures expressed mathematically is known as a financial ratio. Ratio helps to summaries the large quantizes of financial data and to make quantitative judgment about the firms financial performance.

Several ratios calculated from the accounting data can be grouped in to various classes according to the financial activity or the function to be evaluated. Following are the classifications. Liquidity ratios Leverage ratios Activity ratios Profitability ratios

Liquidity ratios measures the firms ability to meet current obligations; leverage ratios shows the proportions of debt and equity in financing the firms asset; activity ratios shows the firms efficiency in utilizing its assets, and profitability ratio measures over all performance and effectiveness of the firm.

Liquidity ratio measures the ability of the firm to meet its current obligations. A firm should ensure that it does not suffer from lack of liquidity, and also that it does not have excess liquidity. The failure of a company to meet its obligations due to lack of sufficient liquidity, will result in a poor credit worthiness, loss of creditors confidence, or even in legal tangles resulting in the closure of the company. A very high degree of liquidity is also bad; idle assets earn nothing. The firms funds will be un necessarily tied up in current assets. There for it is necessary to strike a proper balance between high liquidity and lack of liquidity. Following are the most common liquidity ratios; Current ratio Quick ratio Absolute Quick ratio Interval measures

Current assets are the assets which can be converted in to cash with in a year. Such as marketable securities, debtors, inventories, etc.current liabilities include creditors, bills payable, and short term bank loan. The ratio measures the firms short term solvency. It indicates the availability of the current assets in rupees for every one rupee of current liability. A ratio is greater than one means that the firm has more current assets than current claims against them.

This ratio establishes a relationship between quick or liquid assets and current liabilities. An asset is liquid as it can be converted in to cash immediately or reasonably soon with out a loss of value. Cash is a most liquid asset and inventories are considered to be less liquid. an idle quick ratio is 1:1.


Since cash is most liquid the financial analyst may examine the ratio of cash and its equivalent current liabilities. Trade investment or marketable securities are equivalent of cash. Therefore they may be included in computation of absolute quick ratio.

This ratio indicates that a firms ability to meet its regular cash expenses. Interval measures relate liquid assets to average daily cash outflows.


The difference between the current assets and current liabilities excluding short term borrowings is called net working capital or net current assets. This is some times used to measure the liquidity position of a firm.

The short term creditors, like banks and suppliers of raw material, are more concerned about the firms current debt paying ability. On the other hand the long term creditors like debenture holders; financial institutions etc are more interested in the firms financial strength. In fact the firm should have a strong short as well as long term financial position.

Funds of various owners are invested in various assets to generate sales and profits. The better management of assets, the larger amount of sales. Activity ratios are employed to evaluate the efficiency with which the firm manages and utilizes its assets. These are also called the turn over ratios. Following are the important activity ratios. Inventory turn over ratio Debtors turn over ratio Creditors turn over ratio Current assets turn over ratio Working capital turn over ratio Cash turn over ratio

Inventory turn over ratio; this ratio indicates that the efficiency of firm in selling its product. It shows the conversation of the raw material in to finished goods. Debtors turn over ratio; this shows the number of times debtors turn over in each year. Generally a high value of debtors turn over ratio means the more efficient management of credit. Creditors turn over ratio; it shows efficiency of the firm to pay its debt. And the length of the payment period encourages the suppliers to allow the credit. Current assets turn over ratio; it is the turn over of the current assets. Assets are used to generate sales. This ratio helps to understand the efficiency of the current assets in promoting the sales. Working capital turnover ratio; it shows the efficiency of the working capital management of the firm. Cash turn over ratio; is also shows the involvement of the cash in sales.

A company should earn profits to survive and grow over a long period of time. Profits are essential but it would be wrong to assume that every action initiated by management of the firm should be aimed at maximizing the profit. Profits are the difference between the revenue and expenses. They are the ultimate output of the company. And it will have no future there fore the financial manager should continuously evaluate the efficiency of its company in terms of profits.following are the important profitability ratios. Net profit ratio Gross profit ratio Operating expenses ratio Net profit ratio: it is the profit obtained when operating expenses, interest and taxes are subtracted from the gross profit

Gross profit ratio: this ratio reflects the efficiency with which management produces each unit of product. it indicate the average spread between the cost of goods sold and sales revenue. a high G.P ratio is a sign of good management. Operating expenses ratio: it is an important ratio that changes in the profit margin ratio. a high ratio is unfavorable since it will leave a small amount of operating income to meet interest, dividend etc.

Importance of ratio analysis; o The ability of the firm to meet its current obligations o The extent to which the firm has used its long term solvency by borrowing funds. o The efficiency with which the firm is utilizing its assets in generating sales revenue o The over all operating efficiency and performance of the firm Limitations of ratio analysis;
o It is difficult to decide on the proper basis of comparison. o The comparison is reentered difficult because of difference in situations of two companies of one company over years o The price level changes make the interpretations of ratios invalid o The differences in the definitions of items in the balance sheet and profit and loss statement make the interpretations of ratio difficult. o The ratios calculated at a point of time are less informative and defective as they suffer from short term changes o The ratio are generally calculated from past financial statement and thus are no indicates of future.