What is Working Capital?
The Working Capital management refers to management of the working capital or to be more precise the management of current assets and current liabilities.
Working Capital is also called as “short term capital”. “Liquid Capital”, “Ciculating or revolving capital”,
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Working Capital is the part of the firms capital which is required for financing short term or current assets such as stock, receivables, marketable securities and cash.
Money invested in these current assets keep revolving with relative rapidity and are being constantly converted into cash. This cash flows rotat again in exchange of other such assets.
The goal of working capital management is to manage the firms’ current assets and current liabilities in such a way that a satisfactory level of working capital is maintained.
This is so because, if the firm cannot maintain a satisfactory level of working capital, it is likely to become insolvent and may even be forced into bankruptcy. Each of the short term sources of financing must be continuously managed to ensure that they are obtained and used in the best possible way.
The current assets should be large enough to cover its current liabilities in order to ensure a reasonable margin of safety.
Concept of Working Capital
There is no unanimous decision with the definition of working capital. The word working with reference to capital refers to circulation of capital from one form to another during day-to-day operations of business. The word capital refers to the monetary values of all assets of the business. There is lot of difference of opinions among accountants, enterpreneurs and economists.
There are two concepts of working capital:
Gross Working Capital
It referred to as working capital, means the total current assets.
Net working capital
It can be defined in two ways:
- the most common definition of net working capital is the difference between current assets and current liabilities, and
- alternate definition of Net working capital is that portion of current assets which is financed with long term funds.
Net working capital as a measure of liquidity, is not very useful for comparing the performance of different firms, but it is quite useful for internal control. The goal of working capital management is to manage the current assets and liabilities in such a way that an acceptable level of net working capital is maintained.
Another concept is “operating concept.” The duration or time required to complete the sequence of events right from purchase of raw materials/goods for cash to the realisation of sales in cash is called the operating cycle or working capital cycle.
The net duration of operating cycle is calculated by adding the number of days involved in the different stages of operation. This concept is more appropriate than others. According to this concept, the necessary liquid funds required by a firm for production, administration and selling can be determined for the whole year.
If cash working capital requirements are known in advance, then non-cash current assets may be better managed. Now it is an important tool in projecting working capital requirements of an enterprise.
Types of Working Capital
On the Basis Balance Sheet
- Gross working Capital
- Net working capital
On the Basis of Time
- Permanent working capital
- Variable (Temporary) working capital
- seasonal working capital
- specific working capital
Permanent Working Capital
It means that minimum amount which is parmanently blocked in the business and that cannot be converted into cash in the normal course of business. This amount is definitely required throughout the year on a continuous basis for maintaining the circulation of current assets.
Tondon committee has identified this capital as core current assets. As the business grows the requirement of permanent working capital also increased due to increase in current assets. This portion of working capital is financed through longterm sources.
Variable Working Capital
The amount which is above the permanent level of working capital is called as temporary working capital. Such requirement of this part of working capital financed from short-term funds, whenever needed. It is classified further:
- Seasonal working capital: Some of the industries like refrigertors and coolers may need extra fund to carry on production and to accumulate stock before the sale operations. It is of short term nature, it has to be financed from short term sources like bank loan etc.
- Specific working Capital: Such capital is required to meet unforseen contingencies like slumps and others. It is arranged to meet special exigencies.
Determinants of Working Capital
In order to determine the proper amount of working capital of a firm, the following factors should be considered carefully
- Seasonal nature of the firm
- Firm’s credit policy
- Size of Business
- Nature of business
- Rate of growth of business
- Business cycle
- Duration of operating cycle
- Change in terms of purchase and sales.
The amount of working capital required depends upon a large number of other factors like political stability, means of transport, co-ordination of activities, rate of industrial development, speed of circulation of working capital, profit margin etc.
The above determinants should be considered, because no certain criterian to determine the amount of working capital needs that may be applied to all firms.
Advantages of Working Capital
Inadequate working Capital is harmful for a business organisation. It is a source of energy to a business. The profitability of a business also depends upon planning of adequate working capital.
Following are the advantages to a business enterprise if adequate working capital is available with the firm.
- Adequate working capital enables a firm to pay its suppliers immediately.
- Adequate working capital creates an environment of confidence, high morale, confidence and increases overall efficiency of the business.
- Adequate working capital increases the productivity and efficiency of fixed assets in the business. Adequacy of working capital aftects the use of fixed assets.
- Due to adequate working capital a firm can pay its debt in time and also its collection from debtors is relatively in time. Hence it increases goodwill of the firm because adequate working capital provides better security.
- Despite of sufficient profits, if a firm has unadequate working capital, then it cannot distribute appropriate and enough dividend. Hence, if there is adequate working capital a firm can distribute sufficient profits and it can bring satisfaction among shareholders.
- Due to a better credit worthiness, a firm can easily fetch short-term loans and advances from banks for completing its seasonal and short period needs.
Disadvantages of Working Capital
Excess working capital refers to idle funds which do not earnany profit for the firm. If there is idle funds with a firm following disadvantages are
- If management is not utilising its current resources than it indicate inefficient management.
- Excess working capital means, there is a defective credit policy and collection policy.
- There may be more change of holding excess inventory, if there is excess working capital such situation results upon companies profitability and efficiency in using its resources.
- Excess working capital results, the low rate of return, and it will causing dissatisfaction among shareholders.
- Due to idle funds the efficacy of firm to earn profits is effected, hence due to more interest liability, it reduces the amount of profits.
Hence, if can be concluded that excess working capital reduces return on investment while adequate working capital increase the firms profitability as-well-as goodwill.