Definition of working capital

Gerstenberg

“working capital means current assets of company that are changed in the ordinary course

of business from one form to another, ex: from cash to inventories, inventories to receivables,

receivables into cash”

Shubin

“ Working capital is the amount of funds necessary to the cost of operating the enterprise.

Operating expenses involve investment in current assets, payment towards overhead and expenses.

Investment made in these heads is classified as working capital”.

J. smith

“ The sum of the current assets is the working capital of the business”

’’WORKING CAPITAL = CURRENT ASSETS – CURRENT LIABILITY”

CONCEPT OF WORKING CAPITALThere are two concepts of working capital that are:

1) Balance sheet concept

2) Operating cycle concept.

1) Balance sheet concept:

Working capital as per this defined in terms of current assets and current liabilities. Balance

sheet concept further classifies working capital into a) gross and b) net working capital.

a) Gross working capital: it refers to total investment made in current assets. It is also called

circulating rotating from one head to another. Ex. Cash to raw material, raw material to finished

products, finished products to debtors, and debtors to cash. This concept stresses on quantity

aspect; i.e. to refer to total investment made in different current assets. Bonneville and beway

have defined gross working capital as ’’ any fund received which increases the current assets”.

b) Net Working capital: as per this concept working capital is the difference between current

assets and current liabilities. This concept stresses on quality aspect of working capital. The

difference between current assets highlights on liquidity aspect and quality of current assets. A

firm that has excess of current assets over liabilities is said to possess adequate liquidity. On the

contrary firm that has excess of current liability over current assets means it does not have

adequate liquidity. It means that part of current assets of such firm are financed through fixed

assets.

2) Operating cycle concept:

Operating Cycle or Working Capital Cycle indicates the length of time between affirms

paying for raw materials entering into finished stock and receiving cash on the sales of such

Finished Stock.

This operating cycle differs from firm to firm. Longer the operating cycle greater will be the

amount of Working Capital required and vice versa. Thus it plays an important role in

determining the Working Capital needs of a firm.

OPERATING CYCLE CHART

Cash Raw Materials

Work In Process

Finished goodSales

Debtors

Operating Cycle is the time duration required to convert sales, after the conversion of

resources into inventories, into cash. The operating cycle of a G.C.T.M involves three phases.

1. Acquisition of resources such as raw material, labour, power and

fuel etc.

2. Manufacture of the product which includes conversion of raw

material into work-In- progress into finished goods.

3.Sales of the product either for cash or on credit. Credit sales creates

book Debts for collection.

In the THE GADAG CO-OPERATIVE TEXTILE MILL LTD (manufacturing concern),

the working capital operating cycle starts with the purchase of raw materials and ends with the

realization of cash from the sale of finished products. It is also called as cash conversion cycle,

production cycle etc. It involves the purchase of raw materials and stores, its into stocks of

finished goods through the work-in-Progress with the progressive increment of labor and service

costs, conversion of finished goods (Yarn Products) into sales, Debtors and receivables and

ultimately realization of cash and this cycle continuous again from cash to purchases of raw

material and so on.

CLASSIFICATION OF WORKING CAPITAL

Working capital can be classified on the basis of concept and on the basis of time. Various types

of working capital are as follows

1) On the basis of concept :

Working capital on this basis of concept is classified into

A) Gross working capital: It refers to total investment made in current asset. Current assets

are the asset which can be converted into cash within a short period of an accounting year.

Current assets include cash, debtors, bills receivables and short term securities etc.

Net working capital: It is the difference between current assets and current liabilities. Current

liabilities are those claims of outsiders which are expected to mature for payment within an

accounting year and include creditors, bills payable and outstanding expenses. Net working capital

can be positive or negative.

B) Positive net working capital will arise when current asset exceeds current liabilities. A

negative net working capital occurs when current liabilities are in excess of current assets.

REGULARRESERVE SEASONALSPECIAL

2) On the basis of time :

Classification of working capital in this case is made on the basis

of time for which investment is required. Kinds of working capital in

this category are:

1) Permanent : Some portion of working capital always remain permanent or fixed. This refers to

minimum investment a firm has to make and keep in certain current assets. Firm has to

always maintain minimum cash balance, inventory, debtors etc. as there current assets are

required permanently. They are normally financed through long term capital.

Such permanent working capital is further classified into

a) regular and b) reserve

a) Regular: regular permanent working capital is used in

routine business operations.

b) Reserve: reserve working capital refers to some portion of working capital that is kept as

reserve to meet any contingency.

2) Temporary working capital: required of such capital varies or fluctuates depending on season. Its

requirement is not continous it is normally finance through short term sources, like overdraft,

cash credit and other short term liabilities.

Temporary working capital is further classified into:

A) Seasonal working capital: requirement of working capital is based on particular seasons

ex; winter, summer or festival seasons etc during these seasons there will be additional

demand for the products. To meet out such demand firm has to make additional arrangement

of working capital.

B) Special working capital: requirement of such working capital is necessitated to meet demands

of special occasion’s ex. Occasion of world cup cricket, Olympics, kumba mela, elections.

During these special occasions demand for goods and service will increase. To meet such

special demand firm has to make temporary arrangement of working capital

DETERMINANTS OF WORKING CAPITAL

Requirement of working capital differs from one firm to other. This is because of business

conditions and policies of conducting business differ. Working capital required by each from is

determined by following factors.

1) Nature of business: important factor that determines requirement of working capital is nature of

business a firm is undertaking. Firm that are engaged in production and marketing need more working

capital compared to the firm that are in trading or service oriented business. This is because

manufacturing units need more current assets compared to service oriented units.

2) Size of business: Size of the business obviously determines the requirement of the working capital

bigger the size more is the requirement of the working capital. Larger the scale of operations, larger the

investment required in current assets.

3) Operating cycle: Operating cycle means period from which investment is locked up in

different operations. Longer the period of inventory holding, work in progress, finished goods etc more

is the investment needed in the operations. This necessities more investment in current assets.

4) Stock turn over: stock turnover refers to number of times stock is turned over that is it refers

to sales. Quicker the stock turn over (quick sales) less is the working capital. Slow pace of stock

turnover demands more investment is locked up in operation.

5) Credit policy: Credit policy of the firm will influence requirements of working capital. Firms

that offer liberal credit to the debtor have make more investment in production operations. Such firms

need more working capital to keep their production operation continuous. Requirement of working

capital will be much more if the firm buys on cash and sells on credit. On the contrary firms that buy on

credit and sell on cash basis need less working capital.

6) Production policy: Firms that undertakes all production operations within the organization

need more working capital. Such firms have to make investment to manufacture every component or

part. On the contrary, firms which undertake outsourcing that is buying some of the components or parts

from out side agencies need less working capital.

7) Growth of business: Firms that are experiencing growth need more working capital. Such firms have

to constantly increase their production levels. To meet rising needs of sales targets. They need to

continuously increase investment in current assets.

8) Earning capacity and its appropriation: firms that earn sufficient profits and invest a portion of profit

in business needs less working capital. Ploughing back of profits and accumulated reserves will

minimize dependency on external capital for working capital needs. On the contrary firms that follow

liberal divided policy are firms that do not have adequate surplus need to borrow more to meet regular

working capital needs.

Needs of Working Capital:

The need for working capital to run the day-to-day business activities cannot be

overemphasized. We will hardly find a business firm which does not required any amount of

working capital. Indeed, firms differ in their requirements of the working capital.

The firm’s aim is that maximizing the wealth of shareholders. Earning a steady amount of profit requires successful sales activity. The firm has to invest enough funds in current assets for generating of sales activity. Current assets are needed because sales do not convert into cash instantaneously. There is always an operating cycle involved in the conversion of sales into cash. Therefore Working Capital required for:

1) To meet the cost of inventories including total of raw materials purchased parts, operating

Supplies, work in progress, finished goods.

2) To pay wages, salaries, for indirect labor, clerical staff, managerial and supervision staff.

3) To meet overhead costs, including those of maintenance services activities, fuel, power

charges, taxes and general expense administration.

4) To bear the expansion (with regard to promotion of sales) e.g. expenses on packing,

advertisement, salesmanship, Sales Servicing, After requires, Credit Facilities, Delivery

Services, etc.

IMPORTANCE OF WORKING CAPITAL

Even though the skills for maintaining the working capital are somewhat unique, the goals

are the same-viz. to make an efficient use of funds for minimizing the risk of loss to attain profit

objectives.

Firstly, the adequate of working capital contributes a lot in raising the credit-standing of a

corporation in terms of favorable rates of interest on bank loan, better terms on goods purchased,

reduced cost of production on account of the receipt of cash discounts, etc.

Secondly, a company with sufficient working capital is always in a position to take the advantage

of any favorable opportunity either to purchase raw materials or to execute a special order or to

wait for better market position.

In the third place, the ability to meet all reasonable demands for cash without inordinate delay is

a great psychological factor to improve the all rounds efficiency of the business.

Lastly, during slump the demand for working capital, instead of coming down, shoots up. A

good amount of working capital is locked up in the inventories and book debts. Concerns having

ample resources can tide over that period of depression.

Thus, working capital is regarded as one of the conditioning factors in the long run operations of

the firm, which is often inclined to treat it as an issue of short run analysis and decision making.

Components of Working Capital:

There are two components of Working Capital

A. Current Assets

B. Current Liabilities

A) Current Assets:

Components of Current Assets are as follows:

1. Cash & Bank Balance

2. Stock of Raw Material at cost- work in process and Finished

Goods.

3. Advanced Recoverable in Cash or kind or kind or for value to

be received.

4. Deposits under the company scheme.

5. Advanced payment of income takes credit certificates..

6. Outstanding debts for a period exceeding six months.

7. Balance with central excise authorities.

B) Current Liabilities:

Components of Current Liabilities are as follows:

1. Sundry Creditors for the goods and expenses.

2. Income tax deducted at sources from contractors.

3. Expenses Payable.

4. Unclaimed Dividend.

5. Security Deposits.

6. Liabilities for bills discounted.

7. Bank Overdraft Acceptance.

Working Capital Management concerned with the following aspects:

1. Cash Management:

Cash is the important current asset for the operation of the business. cash is the basic

input needed to keep the business running on a continuous basis; it is also the ultimate output

expected to be realized by selling the service or product manufactured by the firm. The firm

should keep sufficient cash, neither more nor less.

Cash is the liquid form of an asset. It is the ready money available in the firm or with

the business, essential for its operations. A firm needs the cash for the following three purposes:

(a) The Transaction Motive:

(b) The Precautionary Motive:

(c) The Speculative Motive:

2. Receivables Management:

Receivable represents amounts owed to the firm as a result of sale of goods or

services on the ordinary course of business. These are claims of the firm against its

customers and form part of its current assets. These receivables are carried for the

customers. The period of credit and extent of receivables depends upon the credit policy

followed by the firm. The main purpose of maintaining or investing in receivables is to

meet competitors, to increase sales, and to maintain a cordial relationship with the clients.

3. Inventory management:

Every enterprise needs inventory for smooth running of its activities. It serves as a

link between production and distribution process. There is, generally a time lag between the

recognition of a need and its fulfillment. The greater the time lag, the higher the requirements

for inventory. The unforeseen fluctuations in demand and supply of goods necessitate the

need for inventory. Moreover, it provides a cushion for future price fluctuations.