WORKING CAPITAL
Working capital is the capital which is necessary for the smooth
working of the organization. This capital is required for the short term uses
and for day to day expenses.
WORKING CAPITAL MANAGEMENT
To manage the working capital from different-different sources is
called working capital management.
CONCEPT OF WORKING CAPITAL
The concept of Working Capital includes Current Assets and Current
Liabilities both. There are two concepts of Working Capital they are Gross
and Net Working Capital.
Working capital management is concerned with the problems that
arise while managing the current assets the current liabilities and the
interrelationship that exits between them. Thus, the working capital
management refers to all aspects of a administration of both current assets
the current liabilities.
GROSS WORKING CAPITAL
Gross Working Capital refers to the firm's investment in Current
Assets. Current Assets are the assets, which can be converted into cash
within an accounting year or operating cycle. It includes cash, short-term
securities, debtors (account receivables or book debts), bills receivables and
stock (inventory).
NET WORKING CAPITAL
Net Working Capital refers to the difference between Current
Assets and Current Liabilities are those claims of outsiders, which are
expected to mature for payment within an accounting year. It includes
creditors or accounts payables, bills payables and outstanding expenses. Net
Working Copulate can be positive or negative. A positive Net Working Capital
will arise when Current Assets exceed Current Liabilities and vice versa.
Thus both concepts, Gross and Net Working Capital, are equally
important for the efficient management of Working Capital. There are no
specific rules to determine a firm's Gross and Net Working Capital but it
depends on the business activity of the firm.
NEGATIVE CAPITAL
Situation in which the current liabilities of a firm exceed its
current assets. It may be that the business is going to collapse since it fails
it meet he commitments to its suppliers ant other creditors inspite of the
fact that its outstanding are collected well and inventories are not very high.
The cause may be overtrading by the business in general or inefficient
financial management.
FIXED WORKING CAPITAL
A business operates within the range of a given activity level and
during a time-period. This activity level does not change. Within this activity
level the volume of operations of the enterprise keep on changing from time
to time due to seasonal factors, cyclical factors and random variations. But
there must be a hard core element in working capital with the broad activity
range within which the business operates. This part of working capital does
not tend to change in response to changes in activity form time to time. Such
hard core element of working capital is called fixed working capital.
VARIABLE WORKING CAPITAL
During a peak a season, working capital requirement could be high and
this may again drop down during the slack-season. This working capital which
varies more or less in proportion to the actual activity indicated by the
production or sales may be called variable working capital.
CHIEF DETERMINANTS OF QUANTUM OF
WORKNG CAPITAL
There are various factors which generally affect the quantum and
composition of working capital required by a business unit. Some of these
factors are mentioned below:
Technology-capital intensity, balancing of productive equipments, etc.
Size or scale-availability of economies of scale.
Marketing conditions-credit conditions, demand pattern including
seasonality, etc.
Broad socio-economic milieu.
Management attitude towards risk taking. This affects the quantum of
inventory to be held.
Optimal relationship between the sequence of production and sales.
External constraints-import restrictions, credit squeeze, money
market, etc.
FACTORS INFLUENCING THE WORKING CAPITAL
REQUIREMENT
All firms do not have the same WC needs .The following are the factors that
affect the working capital needs:
Nature and size of business
The working capital requirement of a firm is closely related
to the nature of the business. We can say that trading and financial
firms have very less investment in fixed assets but require a large
sum of money to be invested in working capital. On the other hand
Retail stores, for example, have to carry large stock of variety of
goods little investment in the fixed assets. Also a firm with a large
scale of operations will obviously require more working capital than
the smaller firm.
The following table shows the relative proportion of investment in current
assets and fixed assets for certain industries:
Current Fixed assets Industries
assets (%)
(%)
10-20 80-90 Hotel and restaurants
20-30 70-80 Electricity generation and Distribution
30-40 60-70 Aluminum, Shipping
40-50 50-60 Iron and Steel, basic industrial chemical
50-60 40-30 Tea plantation
60-70 30-40 Cotton textiles and Sugar
70-80 20-30 Edible oils, Tobacco
80-90 10-20 Trading, Construction
Manufacturing cycle
It starts with the purchase and use of raw materials and
completes with the production of finished goods. Longer the
manufacturing cycle larger will be the working capital requirement;
this is seen mostly in the industrial products.
Business fluctuation
When there is an upward swing in the economy, sales will
increase also the firm’s investment in inventories and book debts will
also increase, thus it will increase the working capital requirement of
the firm and vice-versa.
Production policy
To maintain an efficient level of production the firm’s may
resort to normal production even during the slack season. This will
lead to excess production and hence the funds will be blocked in form
of inventories for a long time, hence provisions should be made
accordingly. Since the cost and risk of maintaining a constant
production is high during the slack season some firm’s may resort to
producing various products to solve their capital problems. If they do
not, then they require high working capital.
Firm’s Credit Policy
If the firm has a liberal credit policy its funds will remain
blocked for a long time in form of debtors and vice-versa. Normally
industrial goods manufacturing will have a liberal credit policy,
whereas dealers of consumer goods will a tight credit policy.
Availability of Credit
If the firm gets credit on liberal terms it will require less
working capital since it can always pay its creditors later and vice-
versa.
Growth and Expansion Activities
It is difficult precisely to determine the relationship
between volume of sales and need for working capital. The need for
WC does not follow the growth but precedes it. Hence, if the firm is
planning to increase its business activities, it needs to plan its
working capital requirements during the growth period.
Conditions of Supply of Raw Material
If the supply of raw material is scarce the firm may need to
stock it in advance and hence need more working capital and vice-
versa.
Profit Margin and Profit Appropriation
A high net profit margin contributes towards the working
capital pool. Also, tax liability is unavoidable and hence provision for
its payment must be made in the working capital plan, otherwise it
may impose a strain on the working capital.
Also if the firm’s policy is to retain the profits it will increase
their working capital, and if they decide to pay their dividends it will weaken
their working capital position, as the cash will flow out. However this can be
avoided by declaring bonus shares out of past profits. This will help the firm
to maintain a good image and also not part with the money immediately, thus
not affecting the working capital position.
WORKING CAPITAL REQUIRMENT FORECASTING
Forecasting operating requirements is important in capital budgeting
and value-based management. One of the fundamental decisions that every
business needs to make is to assess where to invest its funds (capital
budgeting) and to reevaluate, at regular intervals, the quality and risk of its
existing investments (project management). Investment theory specifies
that firms should invest in assets only if they expect them to earn more
than their risk-adjusted hurdle rates. Forecasting operating capital
requirements is a necessary step in estimating the return on projects.
Value-based management is a tool used by management, in which the
value of the firm is estimated according to alternative strategies.
Estimating operating requirements is essential in this process. Useful as a
guide in decision-making, value-based management is also useful for
projecting future financing needs, especially companies whose needs are
changing
The crude methods of forecasting working capital requirement
comprise mainly of establishing some broad percentage relationship between
working capital and various parameters that would influence it. Some such
bases commonly adopted are as follows:
Working capital as percentage of sales
This is simple and most commonly used. It can give some broad
indication only if selling price is fixed and cost structure is stable.
Working capital as percentage of cost of production
This is only ordinarily a good method particularly when the cost
relationship, if not the amount, remains unchanged.
Working capital as percentage of cost of sales
The results may not be reliable because of the inclusion in cost
of sales of selling and distribution costs which, besides including some
policy costs, might vary widely and abruptly.
Working capital as percentage of marginal cost of sales
This is perhaps the best among all these short-cut methods.
Its strength lies in the fact that marginal cost, comprising only the
variable elements in all costs, seldom changes except over a relatively
long period and under extraordinarily situations.
OPERATING CYCLE AND CASH CYCLE
All business firms aim at maximizing the wealth of the shareholder for
which they need to earn sufficient return on their operations. To earn
sufficient profits they need to do enough sales, which further necessitates
investment in current assets like raw materiel etc. There is always an
operating cycle involved in the conversion of sales into cash.
The duration of time required to complete the following sequences of
events in case of a manufacturing firm is called the operating cycle:-
Conversion of cash into raw material
Conversion of raw material into WIP
Conversion of WIP into FG
Conversion of FG into debtors and bills receivable through sales
Conversion of debtors and bills receivable into cash
Each component of working capital namely inventory, receivables
and payables has two dimensions time and money. When it comes to
managing working capital - Time Is Money. Therefore, if cash is
tight, consider other ways of financing capital investment - loans,
equity, leasing etc. Similarly, if you pay dividends or increase
drawings, these are cash outflows remove liquidity from the
business.
Operating Cycle Of Non Manufacturing Firms / Operating
Cycle Of Service And Financial Firms
DEBTORS
CASH
CASH DEBTORS
STOCK OF
FINISHED GOODS
Operating cycle of non-manufacturing firm like the wholesaler and retail
includes conversion of cash into stock of finished goods, stock of finished
goods into debtors and debtors into cash. Also the operating cycle of
financial and service firms involves conversion of cash into debtors and
debtors into cash.
Thus we can say that the time that elapses between the purchase of
raw material and collection of cash for sales is called operating cycle
whereas time length between the payment for raw material purchases
and the collection of cash for sales is referred to as cash cycle. The
operating cycle is the sum of the inventory period and the accounts
receivables period, whereas the cash cycle is equal to the operating cycle
less the accounts payable period.
WORKING CAPITAL FINANCING
Working capital financing is essential to any growing business. It
helps keep your business current and competitive in your market. If you have
commercial real estate or equipment that produces an income for your
business, you can obtain working capital financing that can help pay down
credit lines or accounts payable, freeing up money for growth opportunities.
Before attempting to obtain this type of loan make sure that you have
established good business credit scores. These credit scores will make a big
difference when the lending institution is determining whether to give your
business the money that it needs to succeed.
Working capital financing can range anywhere from $100,000 to
$2,000,000 and more. The loan terms can range anywhere from 15 to 25
years. These loans typically are paid back in installments with no large lump-
sum payments required. This is also known as a fully amortizing loan. Once
acquired working capital financing can be used for acquiring real estate,
expanding a current facility, building a new office, purchasing new
equipment, operating expenses, or to buy out a current owner or
shareholder.
All types of businesses are eligible for working capital financing.
Service businesses, manufacturers, distributors, retail stores, professionals,
restaurants, and gas stations can all benefit from these types of loans.
WORKING CAPITAL FINANCE
Working capital finance is the mechanism of bank credit in India
that has come into existence after the government’s acceptance of
recommendations of the study group to frame guidelines for follow-up of
bank credit which is also called as Tandon Committee. The norms of current
asset both inventory and receivables should be applied to all industrial
borrowers, including he small scale industry with aggregate facilities from
the banking system in excess of Rs. 10 lakhs.
The working capital gap, namely the borrower’s requirements of
finance to carry current assets other than those financed out of his other
current liabilities, could be bridge partly by his own funds and long-term
borrowings and partly by bank borrowings. The maximum permissible level of
bank borrowings could be worked out in three ways.
First method
The borrower will have to contribute a minimum of 25 percent of the
working capital gap from long term funds, mainly owned funds and term
borrowings. This will give a minimum ratio of 1:1.
Second method
The borrower will have to provide a minimum of 25 percent of total
current assets from long-term funds. This will give a current ratio of at
least 1:3:1.
Third method
The borrower’s contribution from long term funds will be to the
extend of the entire ‘core current assets’ and a minimum of 25 percent of
the balance current assets, thus strengthening the current ratio further.
Initially all borrowers had been covered under the first method.
Subsequently Chore Committee recommended that they should move on to
second method. As a result banks have insisting on second method, at least
for relatively large borrowers. Working capital borrowings from the banking
system will be lower under the second method rather than the first method.
IMPORTANT AREAS IN WORKING CAPITAL
MANAGEMENT
Working capital affects the Return on Investment (ROI) in two ways,
the capital employed itself and also the return. Thus any improvement in the
management of working capital will affect ROI very favorably and the
converse is also true.
Management of working capital has two aspects, the requirement
aspect and the finance aspect. The requirement aspect of management has
to be studied from the point of view of the components of working capital.
On the positive side such components are mainly inventory and debtors, and
on the negative side is the component of creditors. Working capital
management in the requirement area thus boils down to the management of
inventory, debtors and creditors. There are three financial ratios which are
important and useful in keeping a constant watch on and controlling these
parameters. These ratios are inventory turnover ratio, debtors turnover
ratio and sundry creditors turnover ratio respectively.
The finance aspect of working capital management essentially means
controlling the cost of finance involved. Cost of finance varies according to
the different sources of finance. Such costs have to be viewed from various
angles namely real cost and opportunity cost, direct cost and associated cost
and implicit cost and explicit cost. Increase in the bank overdraft has some
real or monetary cost which is the incremental interest. A decrease in credit
period allowed by a supplier has an opportunity cost. Again, the direct cost
involved in bank overdraft is the interest, but there are some associated
costs in the form of accounting and administration expenses in connection
with some overdrafts. These associated costs are sometimes more than one
or two percent annually of the overdraft. Interest on loans and overdrafts
paid is the explicit cost. But since such interest is allowed as deduction for
tax purposes, the implicit cost is much lower. Assuming a company is paying a
tax at 60% on an average and it borrows money from the bank 15% interest,
then the explicit cost 15% per annum. But the implicit cost of financing
working capital on this account would be only 40% of 15%, i.e. only 6% since
the balance 9% is actually borne y the government.
Of the problems that might arise in introducing and operating an
effective control system in respect of working capital, mention may be made
of the control of average working capital during a period, of say one year, a
against deployment of working capital as at various points of time within the
same period. Due primarily to operational reasons, sometimes working capital
requirements might show seasonal peaks and troughs with a wide range of
variations. If in such a situation, control is sought to be exercised only on
the basis of average working capital, then this would mostly be ineffective,
if not even impracticable. But if the working capital requirement shows a
steady and uniform pattern, without much of seasonal variations, control
exercised on the basis of average working capital can be meaningful.
We may now come to the concept of effective working capital i.e.
actual working capital. Actual working capital means the working capital
figure arrived at on the basis of the financial accounting records. The
effective working capital employed in the business might be much less
because of the preponderance of old, non-moving or even slow-moving
inventory, old and doubtful debts and also overdue creditors. Adjustments in
these areas would be necessary to arrive at the effective working capital
employed for initiating control actions to bridge the gap between the actual
and effective figures.
The next important concept in working capital management is overtrading
and the reserve situation, undertaking.
Overtrading is a situation which might develop in an enterprise when
its responsibilities, orders and commitments come to be out of proportion to
its available resources, specially the working capital position. Overtrading is
basically a malady, a disease caused partly from ambitious business ventures
and more from defective financial planning.
Undertrading is a situation just opposite to overtrading. The former is
not so deadly a disease as the latter. Undertrading involves real and
opportunity loss of income or profit. Undertrading may be due to internal
factors i.e. ultra-conservative attitude to risk-taking, etc and also external
factors i.e. market constrain, etc.
CONCLUSION
Any change in the working capital will have an effect on a business's
cash flows. A positive change in working capital indicates that the business
has paid out cash, for example in purchasing or converting inventory, paying
creditors etc. Hence, an increase in working capital will have a negative
effect on the business's cash holding. However, a negative change in working
capital indicates lower funds to pay off short term liabilities (current
liabilities), which may have bad repercussions to the future of the company.