In an ordinary sense, working capital denotes the amount of funds needed for meeting day-to-day operations of a concern.
This is related to short-term assets and short-term sources of financing. Hence it deals with both, assets and liabilities in the sense of managing working capital it is the excess of current assets over current liabilities. In this article we will discuss about the various aspects of working capital.
The nature of working capital is as discussed below:
- It is used for purchase of raw materials, payment of wages and expenses.
- It changes form constantly to keep the wheels of business moving.
- Working capital enhances liquidity, solvency, creditworthiness and reputation of the enterprise.
- It generates the elements of cost namely: Materials, wages and expenses.
- It enables the enterprise to avail the cash discount facilities offered by its suppliers.
- It helps improve the morale of business executives and their efficiency reaches at the highest climax.
- It facilitates expansion programmes of the enterprise and helps in maintaining operational efficiency of fixed assets.
Concept of Working Capital:
The funds invested in current assets are termed as working capital. It is the fund that is needed to run the day-to-day operations. It circulates in the business like the blood circulates in a living body. Generally, working capital refers to the current assets of a company that are changed from one form to another in the ordinary course of business, i.e. from cash to inventory, inventory to work in progress (WIP), WIP to finished goods, finished goods to receivables and from receivables to cash.
There are two concepts in respect of working capital:
(i) Gross working capital and
(ii) Networking capital.
Gross Working Capital:
The sum total of all current assets of a business concern is termed as gross working capital. So,
Gross working capital = Stock + Debtors + Receivables + Cash.
Net Working Capital:
The difference between current assets and current liabilities of a business concern is termed as the Net working capital.
Net Working Capital = Stock + Debtors + Receivables + Cash – Creditors – Payables.
Need for Working Capital:
Working capital plays a vital role in business. This capital remains blocked in raw materials, work in progress, finished products and with customers.
The needs for working capital are as given below:
- Adequate working capital is needed to maintain a regular supply of raw materials, which in turn facilitates smoother running of production process.
- Working capital ensures the regular and timely payment of wages and salaries, thereby improving the morale and efficiency of employees.
- Working capital is needed for the efficient use of fixed assets.
- In order to enhance goodwill a healthy level of working capital is needed. It is necessary to build a good reputation and to make payments to creditors in time.
- Working capital helps avoid the possibility of under-capitalization.
- It is needed to pick up stock of raw materials even during economic depression.
vii. Working capital is needed in order to pay fair rate of dividend and interest in time, which increases the confidence of the investors in the firm.
Importance of Working Capital:
It is said that working capital is the lifeblood of a business. Every business needs funds in order to run its day-to-day activities.
The importance of working capital can be better understood by the following:
- It helps measure profitability of an enterprise. In its absence, there would be neither production nor profit.
- Without adequate working capital an entity cannot meet its short-term liabilities in time.
- A firm having a healthy working capital position can get loans easily from the market due to its high reputation or goodwill.
- Sufficient working capital helps maintain an uninterrupted flow of production by supplying raw materials and payment of wages.
- Sound working capital helps maintain optimum level of investment in current assets.
- It enhances liquidity, solvency, credit worthiness and reputation of enterprise.
- It provides necessary funds to meet unforeseen contingencies and thus helps the enterprise run successfully during periods of crisis.
Types of working Capital
(a) Gross Working Capital:
Gross working capital refers to the amount of funds invested in various components of current assets. It consists of raw materials, work in progress, debtors, finished goods, etc.
(b) Net Working Capital:
The excess of current assets over current liabilities is known as Net working capital. The principal objective here is to learn the composition and magnitude of current assets required to meet current liabilities.
(c) Positive Working Capital:
This refers to the surplus of current assets over current liabilities.
(d) Negative Working Capital:
Negative working capital refers to the excess of current liabilities over current assets.
(e) Permanent Working Capital:
The minimum amount of working capital which even required during the dullest season of the year is known as Permanent working capital.
(f) Temporary or Variable Working Capital:
It represents the additional current assets required at different times during the operating year to meet additional inventory, extra cash, etc.
It can be said that Permanent working capital represents minimum amount of the current assets required throughout the year for normal production whereas Temporary working capital is the additional capital required at different time of the year to finance the fluctuations in production due to seasonal change. A firm having constant annual production will also have constant Permanent working capital and only Variable working capital changes due to change in production caused by seasonal changes. (See Figure 7.1.)
Similarly, a growth firm is the firm having unutilized capacity, however, production and operation continues to grow naturally. As its volume of production rises with the passage of time so also does the quantum of the Permanent working capital. (See Figure 7.2.)
Determinants of Working Capital
(A) Current Assets:
These assets are generally realized within a short period of time, i.e. within one year.
Current assets include:
(a) Inventories or Stocks
(i) Raw materials
(ii) Work in progress
(iii) Consumable Stores
(iv) Finished goods
(b) Sundry Debtors
(c) Bills Receivable
(e) Short-term Investments
(f) Accrued Income and
(g) Cash and Bank Balances
(B) Current Liabilities:
Current liabilities are those which are generally paid in the ordinary course of business within a short period of time, i.e. one year.
Current liabilities include:
(a) Sundry Creditors
(b) Bills Payable
(c) Accrued Expenses
(d) Bank Overdrafts
(e) Bank Loans (short-term)
(f) Proposed Dividends
(g) Short-term Loans
(h) Tax Payments Due