INTRODUCTION

Working capital management is also one of the important parts of the financial management.
It is concerned with short-term finance of the business concern which is a closely related
trade between profitability and liquidity. Efficient working capital management leads to
improve the operating performance of the business concern and it helps to meet the short-
term liquidity. Hence, study of working capital management is not only an important part
of financial management but also is overall management of the business concern.

Working capital is described as the capital which is not fixed but the more common
uses of the working capital is to consider it as the difference between the book value of
current assets and current liabilities.
This chapter deals with the following important aspects of the working capital
management.
• Meaning of Working Capital Management

• Concept of Working Capital Management

• Structure of Working Capital

• Types of Working Capital

• Needs of Working Capital

• Working Capital Position

• Factors determining Working Capital

• Computation of Working Capital

• Working Capital Management Policy

MEANING OF WORKING CAPITAL MANAGEMENT

The capital of a business which is used in its day-by-day trading operations, calculated as the
current assets minus the current liabilities. Working capital is also called operating assets or
net current assets.

Working capital management refers to a company’s managerial accounting strategy

designed to monitor and utilize the two components of working capital, current assets and
current liabilities, to ensure the most financially efficient operation of the company.

Capital of the concern may be divided into two major headings.

Capital

Fixed Capital Working Capital

Fig. 10.1 Capital of the Business

Fixed capital means that capital, which is used for long-term investment of the business concern.
For example, purchase of permanent assets. Normally it consists of non-recurring in nature.
Working Capital is another part of the capital which is needed for meeting day to day
requirement of the business concern. For example, payment to creditors, salary paid to workers,
purchase of raw materials etc., normally it consists of recurring in nature. It can be easily
converted into cash. Hence, it is also known as short-term capital.

Definitions

According to the definition of Mead, Baker and Malott, “Working Capital means Current
Assets”.

According to the definition of J.S.Mill, “The sum of the current asset is the working
capital of a business”.
According to the definition of Weston and Brigham, “Working Capital refers to a
 firm’s investment in short-term assets, cash, short-term securities, accounts receivables
and inventories”.
According to the definition of Bonneville, “Any acquisition of funds which increases
the current assets, increase working capital also for they are one and the same”.
According to the definition of Shubin, “Working Capital is the amount of funds
necessary to cover the cost of operating the enterprises”.
According to the definition of Genestenberg, “Circulating capital means current assets
of a company that are changed in the ordinary course of business from one form to another,
for example, from cash to inventories, inventories to receivables, receivables to cash”.

CONCEPT OF WORKING CAPITAL MANAGEMENT

Working capital can be classified or understood with the help of the following two important
concepts.

Gross Net
Working Working
Capital Capital

Fig. 10.2 Working Capital Concept

Gross Working Capital

Gross Working Capital is the general concept which determines the working capital concept.
Thus, the gross working capital is the capital invested in total current assets of the business
concern.

GWC = CA
Gross Working Capital is simply called as the total current assets of the concern.
Net Working Capital

Net Working Capital is the specific concept, which considers both current assets and
current liability of the concern.

Net Working Capital is the excess of current assets over the current liability of the concern
during a particular period.
If the current assets exceed the current liabilities it is said to be positive working capital; it

NWC = C A – CL
is reverse, it is said to be Negative working capital.

Structure of Working Capital

The different elements or components of current assets and current liabilities
constitute the structure of working capital which can be illustrated in the shape of a
chart as follows:

Structure of Current Assets and Current Liabilities

Current Liabilities Current Assets

Bank Overdraft Cash and Bank Balance
Creditors Inventories: Raw-Materials
Work-in-progress Finished Goods
Outstanding Expenses Spare Parts
Bills Payable Accounts Receivables
Short-term Loans Bills Receivables
Proposed Dividends Accrued Income
Provision for Taxation, etc. Prepaid Expenses
Short-term
Investments

Structure of Working Capital

The study of structure of working capital is another name for the study of working capital
cycle. In other words, it can be said that the study of structure of working capital is the study
of the elements of current assets viz. inventory, receivable, cash and bank balances and other
liquid resources like short-term or temporary investments. Current liabilities usually
comprise bank borrowings, trade credits, assessed tax and unpaid dividends or any other
such things. The following points mention relating to various elements of working capital
deserves:
Inventory- Inventory is major item of current assets. The management of inventories – raw
material, goods-in- process and finished goods is an important factor in the short-run
liquidity positions and long-term profitability of the company.

Raw material inventories- Uncertainties about the future demand for finished goods,
together with the cost of adjusting production to change in demand will cause a financial
manager to desire some level of raw material inventory. In the absence of such inventory,
the company could respond to increased demand for finished goods only by incurring
explicit clerical and other transactions costs of ordinary raw material for processing into
finished goods to meet that demand. If changes in demand are frequent, these order costs
may become relatively large. Moreover, attempts to purchases hastily the needed raw
material may necessitate payment of premium purchases prices to obtain quick delivery and,
thus, raises cost of production. Finally, unavoidable delays in acquiring raw material may
cause the production process to shut down and then re-start again raising cost of production.
Under these conditions the company cannot respond promptly to changes in demand without
sustaining high costs. Hence, some level of raw materials inventory has to be held to reduce
such costs. Determining its proper level requires an assessment of costs of buying and
holding inventories and a comparison with the costs of maintaining insufficient level of
inventories.
Work-in-process inventory- This inventory is built up due to production cycle. Production
cycle is the time- span between introduction of raw material into production and emergence
of finished product at the completion of production cycle. Till the production cycle is
completed, the stock of work-in-process has to be maintained.

Finished goods inventory- Finished goods are required for reasons similar to those causing
the company to hold raw materials inventories. Customer's demand for finished goods is
uncertain and variable. If a company carries no finished goods inventory, unanticipated
increases in customer demand would require sudden increases in the rate of production to
meet the demand. Such rapid increase in the rate of production may be very expensive to
accomplish. Rather than loss of sales, because the additional finished goods are not
immediately available or sustain high costs of rapid additional production, it may be cheaper
to hold a finished goods inventory. The flexibility afforded by such an inventory allows a
company to meet unanticipated customer demands at relatively lower costs than if such an
inventory is not held.
TYPES OF WORKING CAPITAL

Working Capital may be classified into three important types on the basis of time.

Working Capital

Permanent Temporary Semi Variable

Working Capital Working Capital Working Capital

Seasonal Working Special Working

Capital Capital

Fig. 10.3 Types of Working Capital

Permanent Working Capital

It is also known as Fixed Working Capital. It is the capital; the business concern must
maintain certain amount of capital at minimum level at all times. The level of Permanent
Capital depends upon the nature of the business. Permanent or Fixed Working Capital will
not change irrespective of time or volume of sales.

Permanent working capital

Amount of
working
Time
capital

Fig. 10.4 Permanent Working Capital

Temporary Working Capital

It is also known as variable working capital. It is the amount of capital which is required to
meet the Seasonal demands and some special purposes. It can be further classified into
Seasonal Working Capital and Special Working Capital.

The capital required to meet the seasonal needs of the business concern is called as
Seasonal Working Capital. The capital required to meet the special exigencies such as
launching of extensive marketing campaigns for conducting research, etc.

Temporary

Amount of Working

Working Capital

Capital

Time

Fig. 10.5 Temporary Working Capital

Semi Variable Working Capital

Certain amount of Working Capital is in the field level up to a certain stage and after that it
will increase depending upon the change of sales or time.

Semi Variable Working Capital

Amount of Working
Capital

Time

Fig. 10.6 Semi Variable Working Capital

NEEDS OF WORKING CAPITAL
Working Capital is an essential part of the business concern. Every business concern must
maintain certain amount of Working Capital for their day-to-day requirements and meet the
short-term obligations.

Working Capital is needed for the following purposes.

1. Purchase of raw materials and spares: The basic part of manufacturing process is,
raw materials. It should purchase frequently according to the needs of the
business concern. Hence, every business concern maintains certain amount as
Working Capital to purchase raw materials, components, spares, etc.
2. Payment of wages and salary: The next part of Working Capital is payment of
wages and salaries to labour and employees. Periodical payment facilities make
employees perfect in their work. So a business concern maintains adequate the
amount of working capital to make the payment of wages and salaries.
3. Day-to-day expenses: A business concern has to meet various expenditures
regarding the operations at daily basis like fuel, power, office expenses, etc.
4. Provide credit obligations: A business concern responsible to provide credit
facilities to the customer and meet the short-term obligation. So the concern must
provide adequate Working Capital.

Working Capital Position/ Balanced Working Capital Position.

A business concern must maintain a sound Working Capital position to improve the efficiency
of business operation and efficient management of finance. Both excessive and inadequate
Working Capital lead to some problems in the business concern.

A. Causes and effects of excessive working capital.

(i) Excessive Working Capital leads to unnecessary accumulation of raw

materials, components and spares.
(ii) Excessive Working Capital results in locking up of excess Working Capital.

(iii) It creates bad debts, reduces collection periods, etc.

(iv) It leads to reduce the profits.

B. Causes and effects of inadequate working capital

(i) Inadequate working capital cannot buy its requirements in bulk order.

(ii) It becomes difficult to implement operating plans and activate the firm’s
profit target.
(iii) It becomes impossible to utilize efficiently the fixed assets.

(iv) The rate of return on investments also falls with the shortage of Working
Capital.
(v) It reduces the overall operation of the business.
FACTORS DETERMINING WORKING CAPITAL REQUIREMENTS
Working Capital requirements depends upon various factors. There are no set of rules or
formula to determine the Working Capital needs of the business concern. The following
are the major factors which are determining the Working Capital requirements.

Factors

Factors Factors

Working Capital
Determinants

Factors

Fig. 10.7 Factors Determining Working Capital Requirements

1. Nature of business: Working Capital of the business concerns largely depend

upon the nature of the business. If the business concerns follow rigid credit policy
and sell goods only for cash, they can maintain lesser amount of Working Capital.
A transport company maintains lesser amount of Working Capital while a
construction company maintains larger amount of Working Capital.
2. Production cycle: Amount of Working Capital depends upon the length of the
production cycle. If the production cycle length is small, they need to maintain
lesser amount of Working Capital. If it is not, they have to maintain large amount
of Working Capital.
3. Business cycle: Business fluctuations lead to cyclical and seasonal changes in the
business condition and it will affect the requirements of the Working Capital. In
the booming conditions, the Working Capital requirement is larger and in the
depression condition, requirement of Working Capital will reduce. Better business
 results lead to increase the Working Capital requirements.
4. Production policy: It is also one of the factors which affects the Working Capital
requirement of the business concern. If the company maintains the continues
production policy, there is a need of regular Working Capital. If the production
policy of the company depends upon the situation or conditions, Working Capital
requirement will depend upon the conditions laid down by the company.

5. Credit policy: Credit policy of sales and purchase also affect the Working Capital
requirements of the business concern. If the company maintains liberal credit
policy to collect the payments from its customers, they have to maintain more
Working Capital. If the company pays the dues on the last date it will create the
cash maintenance in hand and bank.
6. Growth and expansion: During the growth and expansion of the business
concern, Working Capital requirements are higher, because it needs some additional
Working Capital and incurs some extra expenses at the initial stages.
7. Availability of raw materials: Major part of the Working Capital requirements
are largely depend on the availability of raw materials. Raw materials are the basic
components of the production process. If the raw material is not readily available,
it leads to production stoppage. So, the concern must maintain adequate raw
material; for that purpose, they have to spend some amount of Working Capital.
8. Earning capacity: If the business concern consists of high level of earning
capacity, they can generate more Working Capital, with the help of cash from
operation. Earning capacity is also one of the factors which determines the
Working Capital requirements of the business concern.
 COMPUTATION (OR ESTIMATION) OF WORKING CAPITAL
Working Capital requirement depends upon number of factors, which are already discussed
in the previous parts. Now the discussion is on how to calculate the Working Capital needs
of the business concern. It may also depend upon various factors but some of the common
methods are used to estimate the Working Capital.

A. Estimation of components of working capital method

Working capital consists of various current assets and current liabilities. Hence,
we have to estimate how much current assets as inventories required and how
much cash required to meet the short term obligations.
Finance Manager first estimates the assets and required Working Capital for a
particular period.
B. Percent of sales method

Based on the past experience between Sales and Working Capital requirements, a
ratio can be determined for estimating the Working Capital requirement in future.
It is the simple and tradition method to estimate the Working Capital requirements.
Under this method, first we have to find out the sales to Working Capital ratio and
based on that we have to estimate Working Capital requirements. This method also
expresses the relationship between the Sales and Working Capital.

C. Operating cycle
Working Capital requirements depend upon the operating cycle of the business. The
operating cycle begins with the acquisition of raw material and ends with the collection of
receivables.

Operating cycle consists of the following important stages:

1. Raw Material and Storage Stage, (R)

2. Work in Process Stage, (W)

3. Finished Goods Stage, (F)

4. Debtors Collection Stage, (D)

 5. Creditors Payment Period Stage. (C)

O = R + W + F + D–C

D W

Fig. 10.8 Working Capital Cycle

Each component of the operating cycle can be calculated by the following formula:
Average Stock of Raw Material
R =
Average Raw Material Consumption Per Day

Average Work in Process Inventory

W =
Average Cost of Production Per Day

Average Finished Stock Inventory

F =
Average Cost of Goods Sold Per Day

Average Book Debts

D =
Average Credit Sales Per Day
Average Trade Creditors .
C =
Average Credit Purchase Per Day

WORKING CAPITAL MANAGEMENT POLICY

Working Capital Management formulates policies to manage and handle efficiently; for
that purpose, the management established three policies based on the relationship between
Sales and Working Capital.
1. Conservative Working Capital Policy.

2. Moderate Working Capital Policy.

3. Aggressive Working Capital Policy.

1. Conservative working capital policy: Conservative Working Capital Policy refers to

minimize risk by maintaining a higher level of Working Capital. This type of
Working Capital Policy is suitable to meet the seasonal fluctuation of the
manufacturing operation.

2. Moderate working capital policy: Moderate Working Capital Policy refers to the
moderate level of Working Capital maintenance according to moderate level of sales.
It means one percent of change in Working Capital that is Working Capital is equal
to sales.
3. Aggressive working capital policy: Aggressive Working Capital Policy is one of
the high risky and profitability policies which maintain low level of Aggressive
Working Capital against the high level of sales, in the business concern during a
particular period.

Current Assets
Conservative Policy

Moderate Policy

Aggressive
Policy

Sales

Fig. 10.9 Working Capital Policies