A Study On Working Capital

A STUDY ON WORKING CAPITAL Introduction: working capital is of vital significance. It has been observed by Schall and Haley that “managing current assets requires more attention than managing plant and equipment expenditure mismanagement of current assets can be costly. Too large an investment in current assets means typing up capital that can be used productively else where on the other hand too little investment can be also be expensive”.

Meaning of working capital: Capital required for a business can be classified two main categories viz., (i ) Fixed Capital and (ii) Working Capital Every business needs funds for two purposes for its establishment and to carry out its day-to-day operations. Long-term funds are required to create production facilities through purchase of fixed assets such as plant and machinery, land, building, furniture, etc. Investments in theses assets represent that part of firm’s capital which is blocked on a permanent of fixed basis and is called fixed capital. Funds are also needed for short-term purposes for the purchase of raw materials, payment of wages and other day-to-day expenses etc. These funds are known as working capital. working capital refers to 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 being constantly converted in to cash and this cash flows out again in exchange for other current assets. Hence, it is also known as resolving or circulating capital or short-term capital. In the words of Shubin, “working capital is the amount of funds necessary to cover the cost of operating the enterprise”. According to Genesten berg, “circulating capital means current assets of a company that are changed in the ordinary course of business from one from to another, as for example, from cash to inventories, inventories to receivables, receivables in to cash”.

Working capital definitions: The following are the some of the definitions given for working capital by experts in the area of finance J.S.Mill: “The sum of the current assets is the working capital of a business”.

Bonneville and Dewey: “Any acquisition of funds which increases the current assets, increased working capital, for they are one and the same”. C.W.Gerstenberg: “working capital has ordinarily been defined as the excess of current assets over current liabilities”.

Concepts of working capital: There are two concepts of working capital: (A) Balance sheet concept. (B) Operating cycle or circular flow concept. (A) Balance sheet concept. There are two interpretations of working capital under the balance sheet concept: (i) Gross working capital. (ii) Net working capital. The term working capital refers to the gross working capital and represents the amount of funds invested in current assets. Thus, the gross working capital is the capital invested in total current assets of the enterprise. Current assets are those assets are those assets which in the ordinary course of business can be converted into cash with in a short period of normally one accounting year. Examples of current assets are: 1. Cash in hand and bank balance 2. Bills receivables 3. Sundry debtors(less provision for bad debts) 4. Short-term loans and advances 5. Inventories of stocks, as: (a) Raw materials, (b) Work-in-process (c) Stores and spares (d) Finished goods 6. Temporary investments of surplus funds 7. Prepaid expenses 8. Accrued incomes. In a narrow sense, the term working capital refers to the net working capital. Net working capital is the excess of current assets over current liabilities or say: Net working capital = Current Assets _ Current Liabilities. Net working capital may be positive or negative when the current assets exceed the current liabilities the working the working capital is positive and the negative working

capital results when the current liabilities are more than the current assets. Current liabilities are those liabilities which are intended to be paid in the ordinary course of business. Examples of current liabilities are 1. Bills payable 2. Sundry creditors or accounts payable 3. Accrued or outstanding expenses 4. Short-term loans, advances and deposits 5. Dividends payable 6. Bank overdraft 7. Provision for taxation, if it does not amount to appropriation of profits. In the words of Hog land, “working capital is descriptive of that capital which is not fixed. But the more common use of the working capital is to consider it as the difference between the book value of the current assets and capital liabilities”.

Positive or negative working capital: The net working capital of a firm may be positive or negative. When the total current assets exceed the current liabilities, the working capital is positive and the negative working capital results when the current liabilities are more than current assets. The position of negative working capital does not allow a firm to utilize efficiently the fixed assets due to non-availability of liquid funds and it adversely affects its profitability or the rate of return. In fact, no firm can continue business for long-term with a negative working capital. The business of the firm may have to be closed due to technical insolvency.

Types of working capital: Working capital can be divided into two categories on the basis of time. 1. Permanent working capital 2. Temporary or variable working capital

Permanent working capital: This refers to that minimum amount of investment in all current assets which is required at all times to carry out minimum level of business activities. In other words, it represents the currents assets required on a continuing basis over the entire year. Tandon committee has reffered to this type of working capital as “core current assets”.

The following are the characteristics of this type of working capital. 1. Amount of permanent working capital remains in the business in one form of another. This is particularly important from the point of view of financing. The suppliers of such working capital should not except its return during the life-time of the firm. 2. It also grows with the size of the business. In other words, greater the size of the business, greater is the amount of such working capital and vice versa. Permanent working capital is permanently needed for the business and therefore it should be financed out of long-term funds.

Temporary working capital: The amount of such working capital keeps on fluctuating from time to time on the basis of business activities. In other words, it represents additional current assets required at different times during the operating year. For example, extra inventory has to be maintained to support sales during peak sales period. Similarly, receivable also increased and must be financed during period of high sales. On the other hand investment in inventories, receivables, etc., will decrease in periods of depression. Suppliers of temporary working capital can except its return during off season when it is not required by the firm. Hence, temporary working capital is generally financed from short-term sources of finance such as bank credit.

Importance of working capital: Working capital is the life blood and nerve centre of business. Just as circulation of essential in the human body for maintaining life, working capital is very essential to maintain the smooth running of a business. No business can run successfully without an adequate amount of working capital. The main advantages of maintaining adequate amount of working capital are as follows: 1. Solvency of the business: Adequate working capital helps in maintaining solvency of the business by providing uninterrupted flow of production. 2. Goodwill: Sufficient working capital enables a business concern to make prompt payments and hence helps in creating and maintaining goodwill. 3. Easy loans: A concern having adequate working capital, high solvency and good credit standing can arrange loans from banks and others on easy and favourable terms. 4. Cash discounts: Adequate working capital also enables a concern to avail cash discounts on the purchases and hence it reduces costs. 5. Regular supply of raw materials: Sufficient working capital ensures regular supply of raw materials and continuous production. 6. Regular payment of salaries, wages and other day-to-day commitments: A company which has ample working capital can make regular payment of salaries, wages

and other day-to-day commitments which raises the morale of its employees, increases their efficiency, reduces wastages and costs and enhances production and profits. 7. Exploitation of favourable market conditions: Only concerns with adequate working capital can exploit favourable market conditions such as purchasing its requirements in bulk when the prices are lower and by holding its inventories for higher prices. 8. Ability to face crisis: Adequate working capital enables a concern to face business crisis in emergencies such as depression because during such periods, generally, there is much pressure on working capital. 9. Quick and regular return on investments: Every investor wants a quick and regular return on his investments. Sufficiently of working capital enables a concept to pay quick and regular dividends to its investors and creates a favourable market to raise additional funds in the future. 10. High morale: Adequacy of working capital creates an environment of security, confidence, high morale and creates overall efficiency in a business.

Excess or inadequate working capital: Every business concern should have adequate working capital to run its business operations. It should have neither redundant or excess working capital nor inadequate or shortage of working capital. Both excess as well as short working capital positions are bad for any business. However, out of the two, it is the inadequacy of working capital which is more dangerous from the point of view of the firm. Disadvantages of redundant or excessive working capital 1. Excessive working capital means idle funds which earn no profits for the business and hence the business cannot earn a proper rate of return on its investments. 2. When there is a redundant working capital, it may lead to unnecessary purchasing and accumulation of inventories causing more chances of theft, waste and losses. 3. Excessive working capital implies excessive debtors and defective credit policy which may cause higher incidence of bad debts. 4. It may result into overall inefficiency in the organisation. 5. When there is excessive working capital, relations with banks and other financial institutions may not be maintained. 6. Due to low rate of return on investments, the value of shares may also fall. 7. The redundant working capital gives rise to speculative transactions. Disadvantages or dangers of inadequate working capital 1. A concern which has inadequate working capital cannot pay its short-term liabilities in time. Thus, it will lose its reputation and shall not be able to get good credit facilities. 2. It cannot buy its requirements in bulk and cannot avail of discounts, etc. 3. It becomes difficult for the firm to exploit favourable market conditions and undertake profitable projects due to lack of working capital.

4. The firm cannot pay day-to-day expenses of its operations and it creates inefficiencies, increases costs and reduces the profits of the business. 5. It becomes impossible to utilise efficiently the fixed assets due to non-availability of liquid funds. 6. The rate of return on investments also falls with the shortage of working capital.

The need or objects of working capital: The need for working capital cannot be over emphasized. Every business needs some amount of working capital. The need for working capital arises due to the time gap between production and realization of cash from sales. There is an operating cycle involved in the sales and realization of cash. There are time gaps in purchase of raw materials and production; production and sales; and sales and realization of cash. Thus, working capital is needed for the following purposes: 1. For the purchase of raw materials, components and spares. 2. To pay wages and salaries. 3. To incur day-to-day expenses and overload costs such as fuel, power and office expenses, etc. 4. To meet the selling costs as packing, advertising, etc. 5. To provide credit facilities to the customers. 6. To maintain the inventories of raw material, work-in-progress, stores and spares and finished stock. For studying the need of working capital in a business, one has to study the business under varying circumstances such as a new concern, as a growing concern and as one which has attained maturity. A new concern requires a lot of liquid funds funds to meet initial expenses like promotion, formation, etc. These expenses are called preliminary expenses and are capitalised. The amount needed as working capital in a new concern depends primarily upon its size and the ambitions of its promoters. Greater the size of the business unit, generally, larger will be the requirements of working capital. The amount of working capital needed goes on increasing with the growth and expansion of business till it attains maturity. At maturity the amount of working capital needed is called normal working capital.

Operating cycle or circular flow : working capital refers to that part of firm’s capital which is required for financing shortterm or current assets such as cash, marketable securities, debtors and inventories. Funds, thus invested in current assets keep revolving fast and are being constantly converted in to cash and this cash flows out again in exchange of other current assets. It is also known as revolving or circulating capital. The circular flow of concept of working capital is based up on this operating or working capital cycle of a firm. The cycle starts with the purchase of raw material and other resources and ends with the realization cash from the sale of finished goods. It involves purchase of raw material and stores, its conversion into stock of finished goods through work-in-progress with progress with progressive increment of labour and service costs, conversion of finished stock in to sales, debtors and receivables and ultimately realization of cash and this cycle continues again from cash of raw material and so on.

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