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Working Capital 6.1 Concept, Source, Management of working capital

Working Capital:
Working Capital management is concerned with the problems that arise in attempting to manage the current Assets, the current Liabilities and the interrelationship that exists between them. The term current assets refer to those assets which in the ordinary course of business can be , or will be converted into cash within one year without undergoing a diminution in value and without disrupting the operations of the firm. The major current assets are cash, marketable securities, accounts receivable and inventory. Current Liabilities are those liabilities which are intended, at their inception, to be paid in the ordinary course of business, within a year, out of the current assets or earnings of the concern. The basic current liabilities are accounts payable, bills payable, bank overdraft and outstanding expenses. The 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 into bankruptcy. The current assets should be large enough to cover its current liabilities in order to ensure a reasonable margin of safety. The key difference between long-term financial management and working capital management is in terms of the timing of cash. While long term financial decisions like buying capital equipment or issuing debentures involve cash flows over an extended period of time(5 to 15 years or even more), short term financial decisions typically involve cash flows within a year or within the operating cycle of the firm.

Concepts and Definitions of Working Capital: There are two concepts of working capital : gross and Net. The term Gross Working Capital also referred to as working capital , means the total current assets. The term Net Working Capital can be defined in two ways(i) the most common definition of net working capital(NWC) is the difference between current assets and current liabilities , and (ii) alternate definition of NWC is that portion of current assets which is financed with long-term funds.

Working capital management is a significant facet of financial management. Its importance stems from two reasons: 1. Investment in current assets represents a substantial portion of total investment . 2. Investment in current assets and the level of current liabilities have to be geared quickly to changes in sales. To be sure, fixed asset investment and long term financing are also responsive to variation in sales. However this relationship is not as close and direct as it is in the case of working capital components.

Factors Influencing Working Capital Requirements: The working capital needs of a firm are influenced by numerous factors. The important ones are: 1. Nature of Business 2. Seasonality of operations 3. Production Policy 4. Market Conditions

5. Conditions of Supply

1. Nature of Business: The working capital requirements of a firm are closely related to the nature of its business. A service firm, like an electricity undertaking or a transport corporation, which has a short operating cycle and which sells predominantly on cash basis, has modest working capital requirements.

2. Seasonality of operations: Firms which have marked seasonality in their operations usually have highly fluctuating working capital requirements.

3. Production Policy: A firm marked by pronounced seasonal fluctuations in its sales may pursue a production policy which may reduce the sharp variations in working capital requirements.

4. Market Conditions: The degree of competition prevailing in the market place has been an important bearing on working capital needs. When competition is keen, a larger inventory of finished goods is required to

promptly serve customers who may not be inclined to wait because other manufacturers are ready to meet their needs.

5. Conditions of Supply: The inventory of raw materials, spares and stores depends on the conditions of supply. If the supply is prompt and adequate , the firm can manage with small inventory.

Operating Cycle and Cash Cycle: The investment in working capital is influenced by the following events in the operating cycle of the firm: 1. Purchase of raw materials 2. Payment for raw materials 3. Manufacture of goods 4. Sale of finished goods 5. Collection of cash for sales The firm begins with the purchase of raw materials which are paid for after a delay which represents the accounts payable period. The firm converts the raw materials into finished goods and then sell the same . The time lag between the purchase of raw materials and the sale of finished goods is the inventory period. Customers pay

their bills some time after the sales. The period that elapses between the date of sales and the date of collection of receivables is the accounts payable period.

The time that elapses between the purchase of raw materials and the collection of cash for sales is referred to as the Operating Cycle, whereas the time length between the payment for raw material purchases and the collection of cash for sales is referred to as the cash cycle. The operating cycle is the sum of the inventory period and the accounts receivable period, whereas the cash cycle is equal to the operating cycle less the accounts payable period.

Planning of Working Capital: The need for working capital (gross) or current assets cannot be overemphasized . Given the objective of financial decision making to maximize the shareholders wealth, it is necessary to generate sufficient profits. Therefore sufficient working capital is necessary to sustain sales activity. Technically, this is referred to as the operating or cash cycle. The operating cycle can be said to be at the heart of the need for working capital. The continuing flow from cash to suppliers, to inventory to accounts receivable and back into cash is what is called the 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 into inventory; 2. Conversion of inventory into receivables 3. Conversion of receivable into cash. The operating cycle , which is a continuous process, is shown below.

The operating cycle consists of three phases. In phase 1, cash gets converted into inventory. This includes purchase of raw materials, conversion of raw materials into work-in progress, finished goods and finally the transfer of goods to stocl at the end of the manufacturing process. In phase II of the cycle, the inventory is converted into receivables as credit sales are made to customers. The Firms which do not sell on credit obviously not have phase II of the operating cycle.

The last phase III, represents the stage when receivables are collected. This phase completes the operating cycle. Thus, the firm has moved from cash to inventory, to receivables and to cash again.

Permanent and Temporary Working Capital: The operating cycle, thus, creates the need for current assets. However, the need does not come to an end after the cycle is completed. It continues to exist. Business activity does not come to an end after the realization of cash from customers. To carry on business, a certain , a certain minimum level of working capital is necessary on a continuous and uninterrupted basis. For all practical purposes, this requirement has to be met permanently as with other fixed asets. This requirement is referred to as permanent or fixed working capital. Any amount over and above the permanent level of working capital is temporary fluctuating or variable working capital. The position of the required working capital is needed to meet fluctuations in demand consequent upon changes in production and sales as a result of seasonal changes.

Importance of Adequate working capital: The need for adequate investment in working capital can be understood from the following points: 1. Working capital is required to use fixed assets profitably. 2. Funds are required for day-to-day operations and transactions. These are provided by cash and cash equivalents, forming part of current assets. 3. Adequate working capital determines the short-term solvency of the firm. In adequate working capital means that the firm will be unable to meet its immediate payment commitments. This represents under capitalization. 4. Increase in activity levels and sales should be backed up by suitable investment in working capital. 5. The aspects of liquidity and profitability should be analysed by the finance manager. Too much emphasis on profitability may adversely affect liquidity. Hence working capital levels are said to be adequate when: 1. Current assets are greater than Current Liabilities

2. Current ratio= Current Assets/ Current Liabilities is about 2:1. This may differ from industry to industry. 3. Quick ratio= Quick assets/ Quick liabilities is at least 1:1. This may also differ from industry to industry. Approaches of Financing Working capital Requirements: The approaches to financing working capital requirements are: Name of Approach Long term funds used in Matching Approach Fixed assets and Permanent Working capital Conservative Approach Fixed assets , permanent working capital and part of Temporary W.C. Short term funds used in Temporary Working Capital Balance of Temporary Working capital Balance of Permanent working capital and entire Temporary Working capital. Aggressive Approach Fixed Assets and Part of permanent working capital.

Impact in Liquidity Comaparatively well- balanced Impact on Profitability Comparatively well- balanced

High Liquidity

Low Liquidity

Low profitability and return on assets

High return on assets but risky.

Diagrammatic Representation: 1. Matching Concept :

Short term Financing

Assets Fixed Assets Long Term Financing


2. Conservative Approach:

Some sources of financing working capital are : 1. Trade Credit- Credit period availed, use of bills payable etc. 2. Bank Credit- Cash Credit, Overdrafts, Bills Discounting , Working capital demand loan etc. 3. Non bank short term borrowings- Short term unsecured loans. 4. Factoring of Receivables 5. Commercial Paper.

Summary About Working Capital Management : 1. Working capital management is concerned with the problems that arise in managing the current Assets(CA), current Liabilities (CL) and the interrelationships between them. Its operational goal is to manage the CA and CL in such a way that a satisfactory/ acceptable level of net working capital(NWC) is maintained.

2. There are two concepts of working capital (WC): gross and Net. The gross WC means the total CA. The NWC is the difference between the CA and CL. 3. There are three approaches to determine an appropriate financing Mix(i)Hedging /Matching Approach (ii) Conservative Approach (iii) trade off between these two. 4. According to hedging approach, long term funds should be used to finance the permanent core part of the CA and the purely temporary and seasonal requirements should be met out of short-term funds. This approach is a high profit high risk financing mix. 5. According to the conservative approach, the estimated total requirements of the CA should be financed from long term sources. The short-term sources of finance should be used only in emergency situations. The firm has NWC. Equal to the excess of long term financing over the permanent requirement. This approach is a low-profit, low risk combination. 6. Neither the hedging approach nor the conservative approach is suitable for determining an appropriate financing mix. A trade-off between these two extreme approaches would give an acceptable financing strategy. 7. The need form working capital (WC) arises from the cash/operating cycle of a firm. It refers to the length of time required to complete the following

sequence of events: conversion of cash into inventory, inventory into receivables and receivable into cash. The operating cycle creates the need for working capital and its length in terms of time-span required to complete the cycle is the major determinant of the firms working capital needs. 8. The longer is the production cycle , the longer is the WC needed or viceversa. 9. There are two components of WC, namely, CA and CL. Each component is to be separately estimated to determine the correct amount of WC. The relevant factors are the holding periods of the various types of inventories, debtors collection period, creditors payment period, budgeted yearly production/sales, cost of goods produced, cost of sales,average time-lag in payment of wages and other overheads, minimum cash balances and so on. 10.Working capital requirements are to be computed with reference to cash costs and not the sale price as depreciation is a non-cash and hence, does not need WC. The investment required to finance debtors are at cost price. The cash cost approach is appropriate to determine WC, requirement of a firm.