INTRODUCTION TO WORKING CAPITAL

Working capital is regarded as life blood of business. Its effect in management ensures
success of business while its inefficient management leads to loss of profits and ultimate
downfall. A study of working capital is of major importance to internal and external analysis
because of its close relationship with the day to day operations in business. Working capital
management is a significant part of business decisions. Maintaining optimal level of working
capital is the crux of the problem with which a finance manager has to deal with because it
involves the tradeoff between risk and return.
A firm is required to carry adequate amounts of working capital so as to deal with
productive and distributive activities smoothly. Holding adequate amounts of raw material
smoothly in stock ensures uninterrupted production activity. Similarly sufficient stock of finished
goods has also to be maintained in anticipation of future demand and for this purpose, also needs
to be maintained in anticipation of future demand and for this purpose the firm needs funds.
Goods sold on credit do not return cash immediately. The firm will have to arrange for funds to
finance their accounts receivable for the period until they are collected. Along with this, a
minimum level of cash is required for ordinary operations of business . However, these assets
have to be maintained at appropriate level as both excess and shortage of working capital will
pose problems for the successful running of business. This calls for setting an optimal level of
working capital.
Working capital management is particularly important for small firms. A small firm may
reduce its fixed assets requirements by renting or leasing plant and equipment but there is no way
before it to avoid an investment in current assets. A finance manager should therefore devote
considerable time to manage current assets. Further, owing to limited access to the capital
markets, the small firm has to rely heavily on trade credit and short term bank loans. Both affect
net working capital by increasing current assets.

NEED FOR WORKING CAPITAL

Given the objective of financial decision making to maximize the shareholders
wealth, it is necessary to generate sufficient profits. The extent to which profits can be earned
will naturally depend, among other things, upon the magnitude of the sales. A successful sales
programme is, in others words, necessary for earning profits by any business enterprise.
However, sales do not convert into cash instantly; there is invariably a time-lag between the sale
of goods and the receipt of cash. There is, therefore, a need for working capital in the form of
current assets to deal with the problem arising out of the lack of immediate realization of cash
against goods sold. Therefore, sufficient working capital is necessary to sustain sales activity.
Technically, this is referred to as the operation or cash cycle. The operating cycle can be said to
be at the heart of 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.

Concept of working capital:

Gross Working Capital = Total of Current Asset
Net Working Capital = Excess of Current Asset over Current Liability
Current Assets

Cash in hand / at bank

Bills Receivable
Sundry Debtors
Short term loans
Investors / stock
Temporary investment
Prepaid expenses
Accrued incomes

Current Liabilities

SIGNIFICANCE OF WORKING CAPITAL

Bills Payable
Sundry Creditors
Outstanding expenses
Accrued expenses
Bank Over Draft

The prime objective of the company is to obtain maximum profit thought the business.
The amount of profit largely depends upon the magnitude of sales. However the sale does not
convert into cash instantaneously. There is always a time gap between sale of goods and receipt
of cash. The time gap between the sales and their actual realization in cash is technically termed
as operating cycle. Additional capital required to have uninterrupted business operations, and the
amount will be locked up in the current assets. Regular availability of adequate working capital
is inevitable for sustained business operation. If the proper fund is not provided for the purpose,
the business operations will be effected. And hence this part of finance to be managed well.

OPERATING CYCLE:

Phase 3

Receivables
Phase 2

Cash
Phase 1

Inventory

The operating cycle consists of three phases:In phase 1, cash gets converted into inventory. This includes of raw materials, conversion
of raw materials into work-in-progress, finished goods and finally the transfer of goods to stock
at the end of the manufacturing process. In the case of trading organizations, this phase is shorter
as there would be no manufacturing activity and cash is directly converted into inventory. The
phase is, of course, totally absent in the case of service organizations.
In phase II of the cycle, the inventory is converted into receivables as credit sales are
made to customers. Firms which do not sell on credit obviously not have phase II of the
operating cycle.
The last phase (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.

CLASSIFICATION OF WORKING CAPITAL

Working capital can be classified on the basis of composition. Thus we have gross
working capital comprising current assets and net working capital, which is the difference
between current assets and current liabilities. Another classification of working capital is the
permanent and variable working capital. The types of working capital are discussed in detail in
the following sections.

Gross working capital

Gross working capital is the amount if funds invented in the various components of
current assets. Current are the assets which can be converted into cash within an accounting year
and include cash, short-term securities, debtors and stock. This concept has the following
advantages.

Financial managers are profoundly concerned with current assets.

Gross working capital provides the correct amount of working capital at the right time.

It enables a firm to realize the greatest return on its investment.

It helps in the fixation of various areas of financial responsibility.

It enables a firm to plan and control funds and to maximize the returns on investment.

For these advantages, gross working capital has become a more acceptable concept in
financial management.

Net working capital

The net working capital is 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 and include creditors (accounts payable), bills payable and outstanding
expenses. The concept of net working capital enables a firm to determine how much amount is
left for operational requirements.

Permanent working capital

Permanent working capital is the minimum amount of current assets which is needed to
conduct a business even during the dullest season of the year. This amount varies from year to
year, depending upon the growth of a company and the stage of the business cycle in which it
operates. It is the amount of funds required to produce the goods and services which are
necessary to satisfy demand at a particular point. It represents the current assets which are
required on a continuing basis over the entire year. It is maintained as the medium to carry on
operations at any time. Permanent working capital has the following characteristics:

(i)

It is classified on the basis of the time factor

(ii)

It constantly changes from one asset to another and continues to remain in the
business process.

(iii)

Its size increases with the growth of business operations.

Temporary or variable working capital

It represents the additional assets which are required at different times during the
operating year, additional inventory, extra cash etc., seasonal working capital is the additional
amount of current assets-particularly cash, receivables and inventory which are required during
the more active business seasons of the year. It is temporarily invested in current assets and
possesses the following characteristics:
(iv)

It is not always gainfully employed, though it may change from one asset to another,
as permanent working capital does and

(v)

It is particularly suited to business of a seasonal or cyclical nature.

Balance sheet working capital

The balance sheet working capital is one which is calculated from the items appearing in
the balance sheet. Gross working capital, which is represented by the excess of current assets,
and net working capital, which is represented by the excess of current assets over current
liabilities are examples of the balance sheet working capital.

Cash working capital

Cash working capital is one which is calculated from the items appearing in the profit and
loss account. It shows the real flow of money or value at a particular time and is considered to
be the most realistic approach in working capital management. It is the basis of the operation
cycle concept which has assumed a great importance in financial management in recent years.
The reason is that the cash working capital indicates the adequacy of the cash flow, which is an
essential pre-requisite of a business.

Negative working capital

Negative working capital emerges when current liabilities exceed current assets. Such a
situation is not absolutely theoretical, and occurs when a firm is nearing a crisis of some
magnitude.

Determinants of Working Capital

There is no specific method to determine working capital requirement for a business.
There are a number of factors affecting the working capital requirement. These factors have
different importance in different businesses and at different times. So a thorough analysis of all
these factors should be made before trying to estimate the amount of working capital needed.
Some of the different factors are mentioned here below:1) Nature of business:- Nature of business is an important factor in determining the working
capital requirements. There are some businesses which require a very nominal amount to be
invested in fixed assets but a large chunk of the total investment is in the form of working
capital. There businesses, for example, are of the trading and financing type. There are
businesses which require large investment in fixed assets and normal investment in the form of
working capital.
2) Size of business:- It is another important factor in determining the working capital
requirements of a business. Size is usually measured in terms of scale of operating cycle. The
amount of working capital needed is directly proportional to the scale of operating cycle i.e. the
larger the scale of operating cycle the large will be the amount working capital and vice versa.
3) Working capital cycle:- In a manufacturing concern, the working capital cycle starts with the
purchase of raw material and ends with the realization of cash from the sale of finished products.
This cycle involves purchase of raw materials and stores, its conversion into stocks of finished
goods through work-in-progress with progressive increment of labour and service costs,
conversion of finished stock into sales, debtors and receivables and ultimately realization of cash
and this cycle continues again from cash to purchase of raw material and so on. The speed with
which the working capital completes one cycle determines the requirements of working capital.
Longer the period of the cycle larger is the requirement of working capital.
4) Business Fluctuations:- Most business experience cyclical and seasonal fluctuations in
demand for their goods and services. These fluctuations affect the business with respect to
working capital because during the time of boom, due to an increase in business activity the
amount of working capital requirement increases and the reverse is true in the case of recession.
Financial arrangement for seasonal working capital requirements are to be made in advance.
5) Production Policy:- As stated above, every business has to cope with different types of
fluctuations. Hence it is but obvious that production policy has to be planned well in advance
with respect to fluctuation. No two companies can have similar production policy in all respects
because it depends upon the circumstances of an individual company.
6) Firms Credit Policy:- The credit policy of a firm affects working capital by influencing the
level of book debts. The credit term is fairly constant in an industry but individuals also have
their role in framing their credit policy. A liberal credit policy will lead to more amount being
committed to working capital requirements whereas a stern credit policy may decrease the
amount of working capital requirement appreciably but the repercussions of the two are not

simple. Hence a firm should always frame a rational credit policy based on the credit worthiness
of the customer.
7) Growth and Expansion activities:- The working capital needs of a firm increases as it grows
in term of sale or fixed assets. There is no precise way to determine the relation between the
amount of sales and working capital requirement but one thing is sure that an increase in sales
never precedes the increase in working capital but it is always the other way round. So in case of
growth or expansion the aspect of working capital needs to be planned in advance.
8) Price Level Changes:- Generally increase in price level makes the commodities dearer.
Hence with increase in price level the working capital requirements also increases. The
companies which are in a position to alter the price of these commodities in accordance with the
price level changes will face fewer problems as compared to others. The changes in price level
may not affect all the firms in same way. The reactions of all firms with regards to price level
changes will be different from one other.
9) Depreciation policy:- It influences the level of working capital by affecting tax liability and
retained earnings of the enterprise. Depreciation is a tax deductible expense. Higher
depreciation results in lower tax liability and greater profits. Similarly, net profits will be less if
higher amount of depreciation is charged. If the dividend policy is linked with net profits, the
firm can pay less dividend by providing more depreciation thus resulting in increased retained
earnings and strong working capital position.

Objectives of Working Capital Management

The basic objective of working capital is to provide adequate support for the smooth
functioning of normal business operations of a company. The term adequate working capital is
subjective depending on managements attitude towards uncertainty/risk.
I. Maintenance of working capital.
II. Availability of ample funds at the time of need.
III. Meet day to day cash flow needs.
IV. Pay wages and salaries when they fall due
V. Pay creditors to ensure continued supplies of goods and services.
VI. Pay government taxation and provider of capital dividends and
VII. Ensure the long term survival of the business entity.

SOURCES OF WORKING CAPITAL

The company can choose to finance its current assets by
Long term sources
Short term sources
A combination of them. Long term sources of permanent working capital include equity and
preference shares, retained earnings, debentures and other long term debts from public deposits
and financial institution. The long term working capital needs should meet through long term
means of financing. Financing through long term means provides stability, reduces risk or
payment. And increases liquidity of the business concern. Various types of long term sources of
working capital are summarized as follow:

Long term sources

Issue of shares It is the primary and most important sources of regular or permanent working
capital. Issuing equity shares as it does not create and burden on the income of the concern. Nor
the concern is obliged to refund capital should preferably raise permanent working capital.
Retained earnings Retained earnings accumulated profits are a permanent sources of regular
working capital. It is regular and cheapest. It creates not charge on future profits of the
enterprises.
Issue of debentures It creates a fixed charge on future earnings of the company. Company is
obliged to pay interest. Management should make wise choice in procuring funds by issue of
debentures.
Long term debt Company can raise fund from accepting public deposits, debts from
financial institutions like banks, corporations etc. the cost is higher than the other financial tools.
Other sources sale of idle fixed assets, securities received from employees and customers are
examples of other sources of finance.

Short term sources of temporary working capital:

Temporary working capital is required to meet the day to day business expenditures. The
variable working capital would finance from short term sources of funds. And only the period
needed. It has the benefits of, low cost and establishes closer relationships with banker.
Some sources of temporary working capital are given below:Commercial bank A commercial bank constitutes a significant sources for short term or
temporary working capital this will be in the form of short term loans, cash credit, and overdraft
and though discounting the bills of exchanges.

Public deposits Most of the companies in recent years depends on this sources to meet their
short term working capital requirements ranging fro six month to three years.
Various credits Trade credit, business credit papers and customer credit are other sources of
short term working capital. Credit from suppliers, advances from customers, bills of exchanges,
promissory notes, etc helps to raise temporary working capital.
Reserves and other funds Various funds of the company like depreciation fund. Provision for
tax and other provisions kept with the company can be used as temporary working capital.
The company should meet its working capital needs through both long term and short term
funds. It will be appropriate to meet at least 2/3 of the permanent working capital equipments
form long term sources, whereas the variables working capital should be financed from short
term sources. The working capital financing mix should be designed in such a way that the
overall cost of working capital is the lowest, and the funds are available on time and for the
period they are really required.

SOURCES OF ADDITIONAL WORKING CAPITAL

Sources of additional working
capital include the following
Existing cash reserves
Profits (when you secure it as
cash)

Payables (credit from suppliers)

New equity
shareholder

or

loans

from

Bank overdrafts line of credit

Long term loans

If you have insufficient working capital and try to increase sales, you can easily over
stretch the financial resources of the business. This is called overtrading. Early warning signs
include Pressure on existing cash Exceptional cash generating activities. Offering high
discounts for clear cash payment Bank overdraft exceeds authorized limit Seeking greater
overdrafts or lines of credit Part paying suppliers or there creditor. Management pre
occupation with surviving rather than managing.

Estimating Working Capital requirements

In order to determine the amount of working capital needed by a firm, a number of
factors viz. production policies, nature of business, length of manufacturing process, rapidity
of turnover, seasonal fluctuations, etc. are to be considered by the finance manager.

Techniques for assessment of working capital requirements:

1) Estimation of components of working capital method:Since working capital is the excess of current assets over current liabilities, an
assessment of the working capital requirements can be made by estimating the amounts of
different constituents of working capital e.g., inventories, accounts receivable, cash, accounts
payable, etc.

2) Percent of sales approach:This is a traditional and simple method of estimating working capital requirements.
According to this method, on the basis of past experience between sales and working capital
requirements, a ratio can be determined for estimating the working capital requirements in
future.
3) Operating cycle approach:According to this approach, the requirements of working capital depend upon the
operating cycle of the business. The operating cycle begins with the acquisition of raw
materials and ends with the collection of receivables.

It may be broadly classified into the following four stages viz.

Raw materials and stores storage stage.
Work-in-progress stage.
Finished goods inventory stage.
Receivables collection stage.
The duration of the operating cycle for the purpose of estimating working capital
requirements is equivalent to the sum of the durations of each of these stages less the credit
period allowed by the suppliers of the firm.

Symbolically the duration of the working capital cycle can be put as follows: O=R+W+F+D-C
Where,
O=Duration of operating cycle;
R=Raw materials and stores storage period;
W=Work-in-progress period;
F=Finished stock storage period;
D=Debtors collection period;
C=Creditors payment period.
After computing the period of one operating cycle, the total number of operating cycles
that can be computed during a year can be computed by dividing 365 days with number of
operating days in a cycle. The total expenditure in the year when year when divided by the
number of operating cycles in a year will give the average amount of the working capital
requirement.

ADEQUACY OF WORKING CAPITAL

Working capital should be adequate for the following reasons:

It protects a business from the adverse effect of shrinkage in the values of current
assets.

It is possible to pay all the current obligations promptly and to take advantage of cash
discounts.

It ensures to a greater extent the maintenance of a companys credit standing and

provides for such emergencies as strikes, floods, fires etc.

It permits the carrying of inventories at a level that would enable a business to serve
satisfactorily the needs of its customers.

It enables a company to extend favorable credit terms to customers.

It enables a company to operate its business more efficiently because there is no delay
in obtaining materials etc. because of credit difficulties.

It enables a business to withstand periods of depression smoothly.

There may be operating losses or decreased retained earnings.

There may be excessive non-operating or extraordinary losses.

The management may fail to obtain funds from other sources for purposes of
expansion.

There may be an unwise dividend policy.

Current funds may be invested in non-current assets.

The management may fail to accumulate funds necessary for meeting debentures on
maturity.

There may be increasing price necessitating bigger investments in inventories and

fixed assets.

When working capital is inadequate, a company faces the following problems:

It is not possible for it to utilize production facilities fully for the want of working
capital
A company may not be able to take advantage of cash discount facilities.
The credit-worthiness of the company is likely to be jeopardized because of the
lack of liquidity.
A company may not be able to take advantages of profitable business
opportunities.
The modernization of equipment and even routine repairs and maintenance
facilities may be difficult to administer.
A company will not be able to pay its dividends because of the non-availability of
funds.
A company cannot afford to increase its cash sales and may have to restrict its
activities to credit sales only.
A company may have to borrow funds at exorbitant rates of interest.
Its low liquidity may lead to low profitability in the same way as low profitability
results in low liquidity.
Low liquidity would positively threaten the solvency of the business. A company
is considered illiquid when it is not able to pay its debt on maturity. It must be
wound up under section 433 of the companies act, 1956, upon its inability to pay
its debt.

DANGERS OF EXCESSIVE WORKING CAPITAL

Too much working capital is as dangerous as too little of it. Excessive w
Working capital raises the following problems:
A company may be tempted to overtrade and lose heavily.
A company may keep very big inventories and tie up its funds unnecessarily.
There may be an imbalance between liquidity and profitability.

 A company may enjoy high liquidity and, at the same time, suffer from low
profitability.
High liquidity may induce a company to undertake greater production which may
not have a matching demand. It may find itself in an embarrassing position unless
its marketing policies are properly adjusted to boost up the market for its goods.
A company may invest heavily in its fixed equipment which may not be justified
by actual sales or production. This may provide a fertile ground for later overcapitalization.

CASH MANAGEMENT
Cash management is one of the key areas of working capital management. Apart from
the fact that it is the most liquid current assets, cash is the common denominator to which all
current assets can be reduced because the other major liquid assets, i.e. receivables and
inventory get converted into cash

Objectives of Cash Management:

The basic objectives of cash management are two:
To meet the cash disbursement needs (payment schedule}
To minimize the funds committed to cash balances.
Meeting the payment schedule:
A basic objective of cash management is to meet the payment schedule, i.e. to have
sufficient cash to meet the cash disbursement needs of a firm. The advantage of adequate
cash is to prevent insolvency.
1. It helps in fostering good relationship with the trade creditors and suppliers of
raw material.
2. A trade discount can be availed business opportunities within the due date.
3. To take advantage of favorable business opportunities
Minimizing funds committed, to cash balances:
The second objective of cash management is to minimize cash balance. A high level
of cash balance will ensure prompt payment together with all the advantages. But it also
implies that large funds will remain idle. A low level of cash balance means failure to meet
the payment schedule. The main of cash management should be to have an optimal amount of
cash balance.

Functions of Cash Management

Cash Management functions are intimately, interrelated and intertwined Linkage among
different Cash Management functions have led to the adoption of the following methods for
efficient Cash Management:
Use of techniques of cash mobilization to reduce operating requirement of cash
Major efforts to increase the precision and reliability of cash forecasting.

Maximum effort to define and quantify the liquidity reserve needs of the firm.
Development of explicit alternative sources of liquidity
Aggressive search for relatively more productive uses for surplus money assets.
The above approaches involve the following actions which a finance manager has to perform.
1. To forecast cash inflows and outflows
2. To plan cash requirements
3. To determine the safety level for cash.
4. To monitor safety level for cash
5. To locate the needed funds
6. To regulate cash inflows
7. To regulate cash outflows
8. To determine criteria for investment of excess cash
9. To avail banking facilities and maintain good relations with bankers

INVENTORY MANAGEMENT
The other major current asset in inventory. The term inventory refers to the stock pile of
the product a firm is offering for sale and the components that make up the product. In other
words, inventory is composed of assets that will be sold in future in the normal course of business
operations. The assets which firms store as inventory in anticipation of need are:
1. Raw materials.
2. Working progress
3. Finished goods.
The raw materials inventory contains items that are purchased by the firm from others
and are converted into finished goods through the manufacturing process. The work in
progress inventory consists of items currently being used in the production process. They are
normally partially or semi-finished goods that are at various stages of production in a multistage production process. Finished goods represent final or completed products which are
available for sales. The inventory of such goods consists of items that have been produced
but are yet to be sold.
Inventory as a current asset, differs from other current assets because only financial
managers are not involved. Rather, all the functional areas, i.e. Finance, Marketing,
production and purchasing are involved.
The job of the Finance manager is to reconcile the conflicting viewpoints of the
various functional areas regarding the appropriate inventory levels in order to fulfill the

overall objectives of maximizing the owners wealth. Thus inventory management like the
management of other current assets should be related to the overall objective of the firms.

RECEIVABLES MANAGEMENT
The basic strategy to reduce the operating cash requirements of a firm is to achieve or
accelerates the collection of receivables so as to reduce the operating cash requirements of a
firm, In order to reduce the average collection period. The receivables represent an important
an important component of the current assets of a firm.
The term receivable is defined as debt owned to the firm by customers arising from
sale of goods or services in the ordinary course of business. When a firm makes an ordinary
sale of goods or service and does not receive payment, the firm grants trade credit and creates
accounts which would be collected in the future. Receivables management is also called trade
credit management. Thus the objective of receivables management is to promote sales and
profits until that point is reached where the return on investment in further finding of
receivables is less than the cost of funds raised to finance the additional credit.
The major categories of costs associated with the extension of credit and accounts
receivable are

Collection cost.
Capital cost.
Delinquency cost.
Default cost.

Benefits: Apart from the costs another factor that has a bearing on accounts receivables
management in the benefit emanating from credit sales. When firms extend trade credit, i.e.
invest in receivables, they intend to increase the sales level. A firm may grant trade credit
either to increase sales to existing customers or attract new customers. The motive for
investment in receivables is growth oriented, and protects its sales retention. The extension
of trade credit has a major investments in receivables will produce higher sales. The Accounts
Receivables Management should aim at a trade-off between profit and risk.