s Working Capital

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Concept of Working Capital

Working Capital is a capital which is consumed during

a fiscal period in creating current income. It is

investment in current assets and there is cost involved


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Concept of Working Capital

Gross working capital:

Total current assets.

Net working capital:

Current assets - Current liabilities.Net operating working capital (NOWC):

Operating CA Operating CL =

(Cash + Inv. + A/R) (Accruals + A/P)


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Types of Working Capital

1. Net Working Capital

2. Gross Working Capital

3. Permanent Working Capital4. Variable Working Capital

5. Negative Working Capital


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Net Working Capital

The net working capital is the difference

between current assets and current liabilities.


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Gross Working Capital

Gross Working capital is the amount of fundsinvested in the various components of currentassets.

This concept has the following advantages:

(a) It enables a firm to realize the greatest return onits investment

(d) It helps in the fixation of various areas of financialresponsibility

(e) It enables a firm to plan and control funds and to

maximize the return on investment.


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Permanent Working Capital

Permanent working capital is the minimum amount ofcurrent assets which is needed to conduct a business evenduring the dullest season of the year.

This amount varies from year to year, depending upon thegrowth of a company and the stage of the business cyclein which it operates.

Permanent working capital has the followingcharacteristics:

(a) It is classified on the basis of the time factor

(b) Its size increases with the growth of business operations.


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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.

It is not always gainfully employed. It is

particularly suited to business of a seasonal or

cyclical nature


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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.


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S

hort life span Swift transformation into other asset forms

Current Assets Cycle

Accounts

receivable

Finished

goods

Wages, salaries,

factory overheads

Work-in-

process

Raw materials

Cash Suppliers

Characteristics of Working Capital


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The Operating Cycle and the Cash Cycle

TimeAccounts payable period

Cash cycle

Operating cycle

Cash

received

Accounts receivable periodInventory period

Finished goods sold

Firm receives invoice Cash paid for materials

Order

Placed

Stock

Arrives

Raw materialpurchased


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The Operating Cycle and the Cash Cycle

Cash cycle = Operating cycle

Accounts

payable

period


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Nature of Business

Seasonality of Operations

Production Policy

Market Conditions

Conditions ofSupply

FACTORS INFLUENCING WORKING CAPITAL

REQUIREMENTS


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Flexible/Relaxed Restrictive

(Conservative) (Aggressive)

Policy Policy

Liquidity High Low

Inventories Large Small

Debtors High Low

WC Policy


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According to the matching principle, fixed assets and

permanent current assets should be supported by long-term

sources of finance whereas fluctuating current assets must

be supported by short-term sources of finance.

CURRENT ASSETS FINANCING POLICY


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METHODS OF ESTIMATING WORKING CAPITAL

1. Conventional Method: According to theconventional method, cash inflows and

outflows are matched with each other.


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2. Operating Cycle Method

Operating cycle of an enterprise is the length oftime which is required to convert cash into

resources, resources into final product, the final

product into receivables and receivables back into

cash.


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Operating Cycle Method

O =R+W+F+A-P

R= Av Stock of RM/ Per day Consumption

of RMW= Av Stock of WIP/ Per day Production

F = Av Stock of FG / Per day Sales

A= Av book debts / Av. credit sales per day

P = Av trade creditors / credit sales per day


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ADEQUACY OF WORKING CAPITAL

It protects a business from the adverse effects of shrinkage in thevalues of current assets.

It is possible to pay all the current obligations promptly and to takeadvantage ofcash discounts.

It ensures to a greater extent the maintenance of a company'scredit standing and provides for such emergencies as strikes, floodsetc.

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

It enables a company to extend favourable credit terms to

customers. It enables a company to operate its business more efficiently

because there is no delay in obtaining materials.

It enables a business to withstand periods of depression smoothly.


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Contd..

There may be operating losses or decreased retainedearnings.

There may be excessive non-operating or extraordinarylosses.

The management may fail to obtain funds from othersources 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 necessaryfor meeting debentures on maturity.

There may be increasing price necessitating biggerinvestments in inventories and fixed assets.


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When working capital is inadequate, a

company faces the following problems

It is not possible for it to utilise production facilities fully for want ofworking capital.

A company may not be able to take advantage ofcash discountfacilities.

The credit-worthiness of the company is likely to be jeopardisedbecause of lack of liquidity,

A company may not be able take advantage ofprofitable businessopportunities.

The modernisation 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 may have to borrow funds at exorbitant rates of interest.

Its low liquidity may lead to low profitability in the same way as lowprofitability results in low liquidity.


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DANGERS OF EXCESSIVE WORKING

CAPITAL A company may keep very big inventories and tie up its

funds unnecessarily.

There may be an imbalance between liquidity andprofitability . 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 matchingdemand.

A company may invest heavily in its fixed equipmentwhich may not be justified by actual sales orproduction. This may provide a fertile ground for laterover-capitalisation.


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Four test of working capital policy:

There are four test of working capital policy: Level of Working Capital: This should be maintained by a careful study of

the movements of working capital in successive periods. If a managementcan develop a pattern in these movements, this pattern would serve asguide to its changing requirements in relation to certain decisions which aremade from time to time.

Structural Health: The relative health of the various components of theworking capital should be considered from the point of view of liquidity. It isnecessary to draw structural relationships in respect of each componentconstituting the current assets.

Circulation: This is an important feature of the liquid position and involvesthe natural activity cycle of an enterprise. Ratios may be calculated to showthe average period required for the conversion of raw materials into

finished goods, finished goods into sales, and sales into cash. Liquidity: A more comprehensive test to measure liquidity may be adopted

by using following three ratios, each expressed as a percentage of:

(a) Working capital to current assets;

(b) Stocks to current assets;

(c) Liquid resources to current assets

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s Working Capital