Working Capital : Introduction , Concepts , Needs , Determinants

INTRODUCTION :

Working capital (abbreviated WC) is a financial metric which represents operating liquidity available to a business, organization or other entity, including governmental entity. 

Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. 

Gross working capital equals to current assets. Working capital is calculated as current assets minus current liabilities.If current assets are less than current liabilities, an entity has a working capital deficiency, also called a working capital deficit.

A company can be endowed with assets and profitability but short of liquidity if its assets cannot readily be converted into cash. 

Positive working capital is required to ensure that a firm is able to continue its operations and that it has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses. 

The management of working capital involves managing inventories, accounts receivable and payable, and cash.

CALCULATION :

Working capital is the difference between the current assets and the current liabilities. It is the amount invested by the promoters on the current assets of the organisation.

The basic calculation of the working capital is done on the basis of the gross current assets of the firm.

 

Inputs

Current assets and current liabilities include three accounts which are of special importance. These accounts represent the areas of the business where managers have the most direct impact:

• Accounts receivable (current asset)
• Inventory (current assets), and
• Accounts payable (current liability)

The current portion of debt (payable within 12 months) is critical, because it represents a short-term claim to current assets and is often secured by long-term assets. Common types of short-term debt are bank loans and lines of credit.

An increase in net working capital indicates that the business has either increased current assets (that it has increased its receivables, or other current assets) or has decreased current liabilities—for example has paid off some short-term creditors, or a combination of both.

WORKING CAPITAL MANAGEMENT :

Decisions relating to working capital and short-term financing are referred to as working capital management. These involve managing the relationship between a firm's short-term assets and its short-term liabilities. The goal of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses.

A managerial accounting strategy focusing on maintaining efficient levels of both components of working capital, current assets and current liabilities, in respect to each other. Working capital management ensures a company has sufficient cash flow in order to meet its short-term debt obligations and operating expenses.

Management of working capital

Management will use a combination of policies and techniques for the management of working capital. The policies aim at managing the current assets (generally cash and cash equivalents, inventories and debtors) and the short-term financing, such that cash flows and returns are acceptable.

 
1. Cash management.

Identify the cash balance which allows for the business to meet day to day expenses, but reduces cash holding costs.


2. Inventory management. 

Identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials—and minimizes reordering costs—and hence increases cash flow. Besides this, the lead times in production should be lowered to reduce Work in Process (WIP) and similarly, the Finished Goods should be kept on as low level as possible to avoid over production—see Supply chain management; Just In Time (JIT); Economic order quantity (EOQ); Economic quantity

 
3. Debtors management.

Identify the appropriate credit policy, i.e. credit terms which will attract customers, such that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence Return on Capital (or vice versa); see Discounts and allowances.

 
4. Short-term financing.

Identify the appropriate source of financing, given the cash conversion cycle: the inventory is ideally financed by credit granted by the supplier; however, it may be necessary to utilize a bank loan (or overdraft), or to "convert debtors to cash" through "factoring".

 CONCEPT OF WORKING CAPITAL

There are two concepts of working capital gross concept and net concept.

1.Gross Concept Of Working Capital

 
According to gross concept, working capital refers to all the current assets and represents the amount of funds invested in current assets. Thus, gross working capital is the capital invested in current assets. Current assets are those assets which can be converted into cash within the short-time period.
Gross Working Capital = Total current assets

In this way, gross working capital refers to the firm's investment in current assets. Gross working capital represents total of current assets which includes cash in hand, cash at bank, inventory, prepaid expenses, bills receivable etc.
 

2.Net Concept Of Working Capital

According to the net concept, working capital is the excess of current assets over current liabilities. In other words, the difference between current assets and current liabilities is called net working capital.
Net Working Capital = Current Assets - Current liabilities.

 NEED / IMPORTANCE OF WORKING CAPITAL

1. Strengthen The Solvency

 
Working capital helps to operate the business smoothly without any financial problem for making the payment of short-term liabilities. Purchase of raw materials and payment of salary, wages and overhead can be made without any delay. Adequate working capital helps in maintaining solvency of the business by providing uninterrupted flow of production.

2. Enhance Goodwill

 
Sufficient working capital enables a business concern to make prompt payments and hence helps in creating and maintaining goodwill. Goodwill is enhanced because all current liabilities and operating expenses are paid on time.

3. Easy Obtaining Loan

 
A firm having adequate working capital, high solvency and good credit rating can arrange loans from banks and financial institutions in easy and favorable terms.

4. Regular Supply Of Raw Material

 
Quick payment of credit purchase of raw materials ensures the regular supply of raw materials fro suppliers. Suppliers are satisfied by the payment on time. It ensures regular supply of raw materials and continuous production.

5. Smooth Business Operation

 
Working capital is really a life blood of any business organization which maintains the firm in well condition. Any day to day financial requirement can be met without any shortage of fund. All expenses and current liabilities are paid on time.

6. Ability To Face Crisis

 
Adequate working capital enables a firm to face business crisis in emergencies such as depression.

DETERMINANTS OF WORKING CAPITAL 

(FACTORS AFFECTING WORKING CAPITAL REQUIREMENTS )

1. Size Of Business

 
Working capital requirement of a firm is directly influenced by the size of its business operation. 

Big business organizations require more working capital than the small business organization. 

Therefore, the size of organization is one of the major determinants of working capital.
 

2. Nature Of Business
 

Working capital requirement depends upon the nature of business carried by the firm. 

Manufacturing industries and trading organizations need more working capital than in the service business organizations. 

Service sector does not require any amount of stock of goods.

In service enterprises, there are less credit transactions. But in the manufacturing or trading firm, credit sales and advance related transactions are in large amount. So, they need more working capital.
 

3. Storage Time Or Processing Period
 

Time needed for keeping the stock in store is called storage period. 

The amount of working capital is influenced by the storage period. 

If storage period is high, a firm should keep more quantity of goods in store and hence requires more working capital. Similarly, if the processing time is more, then more stock of goods must be held in store as work-in-progress.
 

4. Credit Period
 

Credit period allowed to customers is also one of the major factors which influence the requirement of working capital. 

Longer credit period requires more investment in debtors and hence more working capital is needed.But, the firm which allows less credit period to customers needs less working capital.
 

5. Seasonal Requirement
 

In certain business, raw material is not available throughout the year. Such business organizations have to buy raw material in bulk during the season to ensure an uninterrupted flow and process them during the entire year.

Thus, a huge amount is blocked in the form of raw material inventories which gives rise to more working capital requirements.
 

6. Potential Growth Or Expansion Of Business
 

If the business is to be extended in future, more working capital is required. More amount of working capital is required to meet the expansion need of business.
 

7. Changes In Price Level
 

Change in price level also affects the working capital requirements. Generally, the rise in price will require the firm to maintain large amount of working capital as more funds will be required to maintain the sale level of current assets.
 

8. Dividend Policy
 

The dividend policy of the firm is an important determinant of working capital. The need for working capital can be met with the retained earning. If a firm retains more profit and distributes lower amount of dividend, it needs less working capital.
 

9. Access To Money Market
 

If a firm has good access to capital market, it can raise loan from bank and financial institutions. It results in minimization of need of working capital.
 

10. Working Capital Cycle
 

When the working capital cycle of a firm is long, it will require larger amount of working capital. But, if working capital cycle is short, it will need less working capital.
 

11. Operating Efficiency
 

The operating efficiency of a firm also affects the firm's need of working capital. The operating efficiency of the firm results in optimum utilization of assets. The optimum utilization of assets in turn results in more fund release for working capital.