SOURCES AND USES OF WORKING CAPITAL

Any transaction that increases the amount of working capital is a source of working capital. For
example, the sale of merchandise at a price greater than its cost is a source of working capital,
because the increase in cash or receivable from the sale is greater than the decrease in inventory.
Any transaction that decreases working capital is a use of working capital. For example, either
incurring current liability to acquire a noncurrent asset or using cash to pay expenses represents a
decrease in working capital.

Sources of Working Capital:

The following are the sources of working capital:

1. Funds from Business Operations:

If the inflow of funds from sales exceeds the outflow of funds to cover the cost of merchandise
purchases and expenses of doing business, current operations will provide a net source of funds.
If the inflow of funds from sales is less than these outflows, operation will result in a net use of
funds.

As a separate example, assume that the same plant is sold for Rs 90,000; then the non-operating
loss of Rs 10,000 should be added back to net income to arrive at working capital provided by
operations and the working capital provided through sale of plant should be reported at Rs
90,000.

Briefly, the procedure of computing funds provided by operations can be summarized as

follows:

Funds from Operations:

2. Sales of Non-Current Assets:

A business may obtain working capital by selling non- current assets, such as plant and
equipment or long term investments, in exchange for current assets. As long as current assets are
received, the sale is a source of funds regardless of whether the non – current assets are sold at a
gain or loss. For example, assume that a business firm sells for Rs 2,50,000 a plant which cost Rs
3,00,000. Although the plant was sold at a loss, the firm has increased its current assets by Rs
250,000 by selling the plant. Thus, this transaction is a source of working capital.

3. Long-Term Borrowing:

Long-term borrowing, such as issue of debentures and bonds result in an increase in current
assets, thereby increasing working capital. Short-term borrowing, however, does not increase
working capital. When a company borrows cash on short term credit or by signing a short-term
note payable, working capital is unchanged because the increase in current assets is offset by an
increase in current liabilities of the same amount.

4. Issue of Additional Equity Capital:

The issue of additional equity shares results in an inflow of current assets, thereby increasing
working capital. In a similar manner, additional investments of current assets by owners
represent source of funds in single proprietorship and partnership.
Uses of Working Capital:

The following are the uses of working capital:

1. Declaration of Cash dividend:

The declaration of cash dividend results in a current liability (dividend payable) and is therefore
a use of funds. It should be understood that it is the declaration of dividend, rather than the
payment of the dividend, which is the use of funds. Actual payment of the dividend reduces
current assets and current liabilities by the same amount and thus has no effect upon the amount
of working capital. Issue of shares in lieu of dividend does not involve any distribution of assets
and, therefore, are not a use of funds.

2. Purchase of Non-Current Assets:

Purchase of non-current assets, such as plant and equipment, reduce current assets or increase
current liabilities. In either case, working capital is reduced.

3. Repayment of Long-Term Debt:

Working capital is decreased when current assets are used to repay long-term debt. However,
repayment of short-term debts is not a use of funds, since current assets and current liabilities
decrease by the same amount.

Sources and Uses of Funds

We can find out the items that are a source of funds or use of funds from a comparison of

balance sheets of two dates.

You might have noticed that the above given analysis spells out the sources and uses of funds but

it does not help to know their overall impact on net working capital of the firm. For this, we need

to understand what caused a change in NWC and the amount of such a change over a period.
A change in net working capital can be either an increase or a decrease. An increase in net

working capital means its amount at the end of the period is greater than its amount at the

beginning of the period. If the reverse happens, it means a decrease in net working capital.

An increase in net capital balance during account period denotes the deployment of more funds

by the amount of the increase, hence it is considered a use of funds. On the other hand, a

decrease in net working capital balance denotes the availability of funds with the business; hence

it is a source of funds.