UnitIV: WORKING CAPITAL MANAGEMENT: CONCEPT, IMPORTANCE AND

OBJECTS

INTRODUCTION

It has been often observed that the shortage of working capital leads to the failure of a business. The
proper management of working capital may bring about the success of a business firm. The
management of working capital includes the management of current assets and current
liabilities.Anumberofcompaniesforthepastfewyearshavebeenfindingitdifficulttosolve the increasing
problems of adopting seriously the management of working capital.

A firm may exist without making profits but cannot survive without liquidity. The function of
working capital management in an organization is similar that of the heart in a human body. Also it is
an important function of financial management. The financial manager must determine the
satisfactory level of working capital funds and also the optimum mix of current assets and current
liabilities.
DEFINITION OF WORKING CAPITAL

“Working Capital is the excess of C.A. over current liabilities.”

CONCEPT OF WORKING CAPITAL MANAGEMENT

There are two concepts of working capital viz .quantitative and qualitative. Some people also define
the two concepts as gross concept and net concept.

According to quantitative concept, the amount of working capital refers to ‘total of current assets’.
Current assets are considered to be gross working capital in this concept.

The qualitative concept gives an idea regarding source of financing capital. According to qualitative
concept the amount of working capital refers to “excess of current assets over current liabilities.”

Current assets – “Current assets have a short life span. These type of assets are engaged in current
operation of a business and normally used for short– term operations of the firm during an accounting
period i.e. within twelve months. The two important characteristics of such assets are
(i)short life span, and
(ii)swift transformation in to other form of assets
Cash balance may be held idle for a week or two; account receivable may have a life span of 30 to 60
days, and inventories may be held for 30 to 100 days.

Current liabilities – The firm creates a Current Liability towards creditors (sellers) from whom it has
purchased raw materials on credit. This liability is also known as accounts payable and shown in the
balance sheet till the payment has been made to the creditors. The claims or obligations which are
normally expected to mature for payment within an accounting cycle (1 year) are known as current
liabilities. These can be defined as “those liabilities where liquidation is reasonably expected to
require the use of existing resources properly classifiable as current assets, or the creation of other
current assets, or the creation of other current liabilities.”

TYPESOFWORKINGCAPITAL

According to the needs of business, the working capital may be classified into following two basis:

1) On the basis of periodicity

2) On the basis of concept

On the basis of periodicity:

The requirements of working capital are continuous. More working capital is required in a particular
season or the peck period of business activity. On the basis of periodicity working capital can be
divided under two categories as under:

1. Permanent working capital

2. Variable working capital

(a) Permanent working capital: This type of working capital is known as Fixed Working
Capital. Permanent working capital means the part of working capital which is permanently
locked up in the current assets to carry out the business smoothly. The
minimumamountofcurrentassetswhichisrequiredtoconductthebusinesssmoothly during the
year is called permanent working capital.

1. Regular Working capital:

Minimum amount of working capital required to keep the primary circulation. Some amount
of cash is necessary for the payment of wages, salaries etc.

2. Reserve Margin Working capital:

Additional working capital may also be required for contingencies that may arise any time.
The reserve working capital is the excess of capital over the needs of the regular working
capital is kept aside as reserve for contingencies, such as strike, business depression etc.

(b) Variable or Temporary Working Capital:

The term variable working capital refers that the level of working capital is temporary and
fluctuating. Variable working capital may change from one assets to another and changes
with the increase or decrease in the volume of business.

The variable working capital may also be sub divided in to following two sub-groups.

1. Seasonal Variable Working capital:

Seasonal working capital is the additional amount which is required during the active
business seasons of the year. Raw materials like raw-cotton or jute or sugarcane are
purchased in particular season. The industry has to borrow funds for short period. It is
particularly suited to a business of a seasonal nature. In short, seasonal working capital is
required to meet the seasonal liquidity of the business.

2. Special variable working capital:

Additional working capital may also be needed to provide additional current assets to
meet the unexpected events or special operations such as extensive marketing campaigns
or carrying of special job etc.
2) On the basis of concept:- working capital is divided in to two categories as under:

(A) Gross Working Capital:

Gross working capital refers to total investment in current assets. The current assets employed in
business give the idea about the utilization of working capital and idea about the economic position of
the company. Gross working capital concepts is popular and acceptable concept in the field of
finance.

(B) Net Working Capital:

Net working capital means current assets minus current liabilities. The difference between current
assets and current liabilities is called the net working capital. If the net working capital is positive,
business is able to meet its current liabilities. Net working capital concept provides the measurement
for determining the credit worthiness of company.

FACTORS DETERMINING WORKING CAPITAL

The following factor determine the amount of working capital

1. Nature of Companies:
The composition of an asset is a function of the size of a business and the companies to which
it belongs. Small companies have smaller proportions of cash, receivables and inventory than
large corporation. This difference becomes more marked in large corporations. A public
utility, for example, mostly employs fixed assets in its operations, while a merchandising
department depends generally on inventory and receivable. Needs for working capital are thus
determined by the nature of an enterprise.

2. Demand of Creditors:
Creditors are interested in the security of loans. They want their obligations to be sufficiently
covered. They want the amount of security in assets which are greater than the liability.

3. Cash Requirements:
Cash is one of the current assets which are essential for the successful operations of the
production cycle. A minimum level of cash is always required to keep the operations going.
Adequate cash is also required to maintain good credit relation.

4. Nature and Size of Business:

The working capital requirements of a firm are basically influenced by the nature of its
business. Trading and financial firms have a very less investment in fixed assets, but require a
large sum of money to be invested in working capital.
5. Time:
The level of working capital depends upon the time required to manufacturing goods. If the
time is longer, the size of working capital is great. Moreover, the amount of working capital
depends upon inventory turnover and the unit cost of the goods that are sold. The greater this
cost, the bigger is the amount of working capital.

6. Volume of Sales:
This is the most important factor affecting the size and components of working capital. A firm
maintains current assets because they are needed to support the operational activities which
result in sales. They volume of sales and the size of the working capital are directly related to
each other.
 7. Terms of Purchases and Sales:
Ifthecredittermsofpurchasesaremorefavourableandthoseofsalesliberal,lesscash will be invested
in inventory. With more favorable credit terms, working capital requirements can be reduced.
A firm gets more time for payment to creditors or suppliers. A firm which enjoys greater
credit with banks needs less working capital.

8. Business Cycle:
Business expands during periods of prosperity and declines during the period of depression.
Consequently, more working capital required during periods of prosperity and less during the
periods of depression.

9. Production Cycle:
The time taken to convert raw materials into finished products is referred to as the production
cycle or operating cycle. The longer the production cycle, the greater is the requirements of
the working capital. An utmost care should be taken to shorten the period of the production
cycle in order to minimize working capital requirements.

10. Liquidity and Profitability:

If a firm desires to take a greater risk for bigger gains or losses, it reduces the size of its
working capital in relation to its sales. If it is interested in improving its liquidity, it increase
the level of its working capital. However, this policy is likely to result in a reduction of the
sales volume, and profitability. A firm therefore should choose between liquidity and
profitability and decide about its working capital requirements accordingly.

11. Seasonal Fluctuations:

Seasonal fluctuations in sales affect the level of variable working capital. Often, the demand
for products may be of a seasonal nature. Yet inventories have got to be purchased during
certain seasons only. The size of the working capital in one period may, therefore, be bigger
than that in another.

OPERATINGCYCLE
Operating Cycle of Manufacturing Cycle:

The above operating cycle in figure relates to a manufacturing firm where cash is needs to purchase
raw materials and convert raw materials into work-in-process is converted into finished goods.
Finished goods will be sold for cash or credit and ultimately debtors will be realized.

Operating Cycle of Non-Manufacturing Firm

The non-manufacturing firms, such as whole sellers and retailers, will not have the manufacturing
phase; they will have rather direct conversion of cash into finished stock, into accounts receivables
and then into cash. The operating cycle of a non-manufacturing firm is shown as under.

Operating Cycle of Service and Financial Firms

In addition to this, some service and financial concerns may not have any inventory at all. Such firm
have the shorter operating cycle.

LIQUIDITY VERSUS PROFITABILITY : RISK-RETURNT ANGLE

The firm would make just enough investment in current assets, if it were possible to estimate working
capital needs exactly. Under perfect certainty, the current assets holdings would beat the minimum
level. A ledger investment in current assets under certainty would mean a low rate or return
investment for the firm, as excess investment in current assets will not earn enough return. A smaller
investment in current assets, on the other hand, would mean interrupted production and sales, because
of request stock-outstanding ability to credit or in time to restrictive credit policy.

As it is not possible to estimate working needs accurately, the firm must decide about the levels of
current assets to be carried. The current assets holdings of the firm will depend upon its working
capital policy. It may follow a conservative or an aggressive policy. These polices have different
risk-return implications.

A conservative policy means lower return and risk, while an aggressive policy produces
Higher return and risk.

The two important aims of the working capital management are: profitability and solvency.

Solvency, used in the technical sense, refers to the firm’s continuous ability to meet maturing
obligations. Lenders and creditors expected prompt settlement of their claims as and when due. To
ensure solvency, the firm maintains a relatively large investment in current assets holdings. If the firm
maintains a relatively large investment in current assets, it will have no difficulty in paying the claims
of the creditors when they become due and will be able to fill all sales orders and ensure smooth
production. Thus, a liquid firm has less risk of insolvency; that is, it will hardly experiences a cash
shortage or stock-outs.
The Cost Trade-off:

A different way of looking into the risk-return trade of is in terms of the cost of maintaining a particular
level of current assets. There are two different kinds of costs involved.

First there is the cost of liquidity. If the firm carries too much liquidity, the firm’s rate of return
will be low. Funds tied up in idle cash and excess inventory earn nothing, and receivables levels that
are too large also reduce the firm’s profitability. Thus, the cost of liquidity increases with the level
of current assets.