WORKING CAPITAL TYPES
There are two kinds of working capital. These are i) permanent working capital, ii) temporary/varying working capital.
1. PERMANENT WORKING CAPITAL
Permanent working capital is defined as the “amount of current assets required to meet a firm’s long-term minimum needs”.
It refers to the minimum amount of all current assets that is required at all times to ensure a minimum level of uninterrupted business operations. Some minimum level of raw materials, working process, bank balance, finished goods, etc.
A business has to carry all the time irrespective of the level of manufacturing/marketing operations.This level of working capital is referred to as core working capital or core current assets.
For a growing business the permanent working capital will be rising, for a declining business it will be decreasing and for a stable business it will be remaining more, or less stay-put.
This part of the working capital being a permanent investment, needs to be financed through long-term funds. Depending upon the changes in the production and sales, the need for working capital, over and above the permanent working capital, will fluctuate.
TYPES-
1. Initial Working Capital:
In the initial period of its operation, a firm must need enough money to pay certain expenses before the business yields cash receipt. In the initial years the banks may not grant loans or overdrafts, sales may have to be made on credit and it may be necessary to pay the creditors immediately. Therefore the owners themselves have to provide necessary funds in the initial period, which may be known as initial working capital.
2. Regular Working Capital:
The firm is always required to keep certain funds with it to continue the regular business operations, which is called as Regular Working Capital. It is required to maintain regular stock of raw materials and work-in-progress and also of the finishes goods, which must be maintained permanently at a definite level. Regular working capital is the excess of current assets over current liabilities. It ensures smooth operation of business.
2. TEMPORARY OR VARYING WORKING CAPITAL:
It varies with the volume of operations. If fluctuates with scale of operations.
This is additional working capital required during up seasons over the above the fixed working capital.
During seasons more production/sales take(s) place resulting in larger working capital needs.
The reverse is true during off-seasons. As seasons alternate, temporary working capital moves up and down like tides. Temporary working capital is defined as the “amount of current assets that varies with seasonal requirements”.
Temporary working capital can be financed through short term funds, ie. current liabilities. When the level of temporary working capital moved up, the business might use short-term funds and when the level of temporary working capital recedes, the business might retire its short term loans.
TYPES-
1.Seasonal Working Capital:
Some business operations require additional working capital during a particular season. For example, the groundnut oil producers may have to purchase groundnut in a particular season and have to employ additional labor for that purpose. These may require additional funds for a temporary period, which may be called as seasonal working capital.
2. Special Working Capital:
In all enterprises, some unforeseen events do occur like sudden increase in demand, downward movement of prices of raw materials, strike or natural calamities, when extra funds are needed to tide over such situation. Such type of extra funds is called as Special working capital.
2. Principle of Risk Variation:
PRINCIPLES OF WORKING CAPITAL:
1. Principle of Optimization:
According to the principle of optimization, the magnitude of working capital
should be such that each rupee invested adds to its net value. In other
words capital should be invested in each component of working capital
as long as the equity position of firm increases.”
The level of working capital must be so kept that the rate of return on investment is optimized.
The working capital should be maintained at an optimum level.
This is the point at which the increase in cost due to decline in
working capital is equal to the increase in the gain associated with it.
2. Principle of Risk Variation:
This principle is based on the assumption that the rate of return on investment is linked with degree of risk
in the business.
Risk here refers to the inability of firm to maintain
sufficient current assets to pay its obligations.
If working capital is
varied relative to sales, the amount of risk that a firm assumes is also
varied and the opportunity for gain or loss is increased.
There is a definite relationship between the degree of risk and
the rate of return.
As a firm assumes more risk, the opportunity for
gain or loss increases. As the level of working capital relative to
sales decreases, the degree of risk increases.
When the degree of risk
increases, the opportunity for gain and loss also increases. Thus, if
the level of working capital goes up, amount of risk goes down, and
vice-versa, the opportunity for gain is like-wise adversely affected.
3. Principle of Cost of Capital:
Each source of working capital has different cost of capital.
The degree of risk also differs from one source to another. The type of
capital used to finance working capital directly affects the amount of
risk that a firm assumes as well as the opportunity for gain or loss and
cost of capital. A firm should raise capital in such a manner that a
balance is maintained between risk and profit.
4.Principle of Maturity of Payment:
This principle states that the working capital should be so raised from
different sources that the firm is able to repay them on maturity out
of its inflows of funds.
Otherwise the firm would fail to repay on
maturity and ultimately, it would find itself into liquidation though it
is earning huge profits. This implies that the firm’s ability to repay
its short-term debts depends not on its earnings but on the flow of cash
into it.
5.Principle of Equity Position:
According to this principle, the amount of working capital invested in
each component should be adequately justified by a firm’s equity
position. Every rupee invested in the working capital should contribute
to the net worth of the firm.
APPROACHES OF WORKING CAPITAL:
1.MATCHING APPROACH:
It is also known as hedging approach .
Under this approach, the funds for
acquiring fixed assets and permanent current should be acquired with
long term funds and for temporary working capital short term funds should be used.
2. CONSERVATIVE APPROACH :
This approach suggests that in addition to fixed assets and permanent current assets, even a part of variable current assets should be financed from long-term sources.
The short-term sources are used only to meet the peak seasonal requirements. During the off season, the surplus fund is kept invested in marketable securities.
Surplus current asset enable the firm to absorb sudden variation in sales, production plans, and procurement time without destructing production plans.
Additionally the higher liquidity level reduces the risk of insolvency. But lower risk translates into lower returns. Large investment in current asset lead to higher interest and carrying cost and encouragement for efficiency.
ADVANTAGES-
1. Conservative policy will enable the firm to absorb day to day risk.
2. It assures continuous flow of operation and illuminates worry about recurring obligation.
3. Under this strategy, long term financing covers more than the total requirement of capital. The excess cash is invested in short-term marketable securities and in need these securities are sold off in the market to meet the urgent requirement of working capital.
3. AGGRESSIVE APPROACH :
This approach depends more on short-term funds. More short-term funds are used particularly for variable current assets and a part of even permanent current assets, the funds are raised from short term sources.
Under this approach current assets are maintained just to meet the current liabilities without keeping cushions for the variation in working capital needs.
The companies working capital is financed by long-term source of capital and seasonal variation are met through short-term borrowing.
ADVANTAGE-
Adoption of this strategy will minimize the investment in net working capital and ultimately it lowers the cost financing working capital needs.
The main drawback of this strategy is that it necessitates frequent financing and also increase, as the firm is variable to sudden shocks.
2. CONSERVATIVE APPROACH :
This approach suggests that in addition to fixed assets and permanent current assets, even a part of variable current assets should be financed from long-term sources.
The short-term sources are used only to meet the peak seasonal requirements. During the off season, the surplus fund is kept invested in marketable securities.
Surplus current asset enable the firm to absorb sudden variation in sales, production plans, and procurement time without destructing production plans.
Additionally the higher liquidity level reduces the risk of insolvency. But lower risk translates into lower returns. Large investment in current asset lead to higher interest and carrying cost and encouragement for efficiency.
ADVANTAGES-
1. Conservative policy will enable the firm to absorb day to day risk.
2. It assures continuous flow of operation and illuminates worry about recurring obligation.
3. Under this strategy, long term financing covers more than the total requirement of capital. The excess cash is invested in short-term marketable securities and in need these securities are sold off in the market to meet the urgent requirement of working capital.
3. AGGRESSIVE APPROACH :
This approach depends more on short-term funds. More short-term funds are used particularly for variable current assets and a part of even permanent current assets, the funds are raised from short term sources.
Under this approach current assets are maintained just to meet the current liabilities without keeping cushions for the variation in working capital needs.
The companies working capital is financed by long-term source of capital and seasonal variation are met through short-term borrowing.
ADVANTAGE-
Adoption of this strategy will minimize the investment in net working capital and ultimately it lowers the cost financing working capital needs.
The main drawback of this strategy is that it necessitates frequent financing and also increase, as the firm is variable to sudden shocks.
