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WORKING CAPITAL
Capital required for a business can be classified under two main categories via,
1) Fixed Capital
2) Working Capital
Long terms funds are required to create production facilities through purchase of
fixed assets such as P&M, land, building, furniture, etc. Investments in these assets
represent that part of firm’s capital which is blocked on permanent or fixed basis and
is called Fixed Capital.
Funds are also needed for short-term purposes for the purchase of raw material,
payment of wages and other day–to-day expenses etc. These funds are known as
Working Capital.
In simple words, working capital refers to that part of the firm’s capital which is
required for financing short- term or current assets such as cash, marketable
securities, debtors & inventories. Funds, thus, invested in current assts keep revolving
fast and are being constantly converted in to cash and this cash flows out again in
exchange for other current assets. Hence, it is also known as revolving or circulating
capital or short term capital.
The gross working capital is the capital invested in the total current assets of the
enterprise. Current assets are those Assets which can convert in to cash within a short
period normally one accounting year.
CONSTITUENTS OF CURRENT ASSETS
2) Bills receivables
3) Sundry debtors
a. Raw material
b. Work in process
d. Finished goods
7. Prepaid expenses
8. Accrued incomes.
9. Marketable securities.
In a narrow sense, the term working capital refers to the net working. Net working
capital is the excess of current assets over current liability, or, say:
Net working capital can be positive or negative. When the current assets
exceeds the current liabilities are more than the current assets. Current liabilities are
those liabilities, which are intended to be paid in the ordinary course of business
within a short period of normally one accounting year out of the current assts or the
income business.
CONSTITUENTS OF CURRENT LIABILITIES
3. Dividends payable.
4. Bank overdraft.
6. Bills payable.
7. Sundry creditors.
The gross working capital concept is financial or going concern concept whereas net
working capital is an accounting concept of working capital. Both the concepts have
their own merits.
The gross concept is sometimes preferred to the concept of working capital for the
following reasons:
2. Every management is more interested in total current assets with which it has to
operate then the source from where it is made available.
3. It take into consideration of the fact every increase in the funds of the enterprise
would increase its working capital.
It’s a qualitative concept, which indicates the firm’s ability to meet to its
operating expenses and short-term liabilities.
IT indicates the margin of protection available to the short term creditors.
It is an indicator of the financial soundness of enterprises.
It suggests the need of financing a part of working capital requirement out of
the permanent sources of funds.
CLASSIFICATION OF WORKING CAPITAL
On the basis of concept working capital can be classified as gross working capital and
net working capital. On the basis of time, working capital may be classified as:
Temporary working capital differs from permanent working capital in the sense that is
required for short periods and cannot be permanently employed gainfully in the
business.
IMPORTANCE OR ADVANTAGE OF ADEQUATE WORKING CAPITAL
Easy loans: Adequate working capital leads to high solvency and credit standing
can arrange loans from banks and other on easy and favorable terms.
Cash Discounts: Adequate working capital also enables a concern to avail cash
discounts on the purchases and hence reduces cost.
Ability to Face Crises: A concern can face the situation during the depression.
Every business concern should have adequate amount of working capital to run its
business operations. It should have neither redundant or excess working capital nor
inadequate nor shortages of working capital. Both excess as well as short working
capital positions are bad for any business. However, it is the inadequate working
capital which is more dangerous from the point of view of the firm.
1. Excessive working capital means ideal funds which earn no profit for the firm
and business cannot earn the required rate of return on its investments.
3. Excessive working capital implies excessive debtors and defective credit policy
which causes higher incidence of bad debts.
5. If a firm is having excessive working capital then the relations with banks and
other financial institution may not be maintained.
6. Due to lower rate of return n investments, the values of shares may also fall.
Every business needs some amounts of working capital. The need for working
capital arises due to the time gap between production and realization of cash from
sales. There is an operating cycle involved in sales and realization of cash. There are
time gaps in purchase of raw material and production; production and sales; and
realization of cash.
The requirement of the working capital goes on increasing with the growth and
expensing of the business till it gains maturity. At maturity the amount of working
capital required is called normal working capital.
There are others factors also influence the need of working capital in a business.
2. SIZE OF THE BUSINESS: Greater the size of the business, greater is the
requirement of working capital.
4. LENTH OF PRDUCTION CYCLE: The longer the manufacturing time the raw
material and other supplies have to be carried for a longer in the process with
progressive increment of labor and service costs before the final product is obtained.
So working capital is directly proportional to the length of the manufacturing process.
6. WORKING CAPITAL CYCLE: The speed with which the working cycle
completes one cycle determines the requirements of working capital. Longer the cycle
larger is the requirement of working capital.
DEBTORS
8. CREDIT POLICY: A concern that purchases its requirements on credit and sales
its product / services on cash requires lesser amt. of working capital and vice-versa.
11. EARNING CAPACITY AND DIVIDEND POLICY: Some firms have more
earning capacity than other due to quality of their products, monopoly conditions, etc.
Such firms may generate cash profits from operations and contribute to their working
capital. The dividend policy also affects the requirement of working capital. A firm
maintaining a steady high rate of cash dividend irrespective of its profits, needs
working capital than the firm that retains larger part of its profits and does not pay so
high rate of cash dividend.
12. PRICE LEVEL CHANGES: Changes in the price level also affect the working
capital requirements. Generally rise in prices leads to increase in working capital.
Others FACTORS: These are:
• Operating efficiency
• Management ability
• Irregularities of supply
• Import policy
• Asset structure
• Importance of labor
• Banking facilities, etc
2. It is concerned with the decision about the composition and level of current
assets.
3. It is concerned with the decision about the composition and level of current
liabilities.
As we know working capital is the life blood and the centre of a business.
Adequate amount of working capital is very much essential for the smooth running of
the business. And the most important part is the efficient management of working
capital in right time. The liquidity position of the firm is totally effected by the
management of working capital. So, a study of changes in the uses and sources of
working capital is necessary to evaluate the efficiency with which the working capital
is employed in a business. This involves the need of working capital analysis.
The analysis of working capital can be conducted through a number of devices, such
as:
1. Ratio analysis.
2. Fund flow analysis.
3. Budgeting.
1. RATIO ANALYSIS
1. Current ratio.
2. Quick ratio
4. Inventory turnover.
5. Receivables turnover.
Fund flow analysis is a technical device designated to the study the source from which
additional funds were derived and the use to which these sources were put. The fund
flow analysis consists of:
The short –term creditors of a company such as suppliers of goods of credit and
commercial banks short-term loans are primarily interested to know the ability of a
firm to meet its obligations in time. The short term obligations of a firm can be met in
time only when it is having sufficient liquid assets. So to with the confidence of
investors, creditors, the smooth functioning of the firm and the efficient use of fixed
assets the liquid position of the firm must be strong. But, a very high degree of
liquidity of the firm being tied – up in current assets. Therefore, it is important proper
balance in regard to the liquidity of the firm. Two types of ratios can be calculated for
measuring short-term financial position or short-term solvency position of the firm.
1. Liquidity ratios.
2. Current assets movements ‘ratios.
A) LIQUIDITY RATIOS
Liquidity refers to the ability of a firm to meet its current obligations as and when
these become due. The short-term obligations are met by realizing amounts from
current, floating or circulating assts. The current assets should either be liquid or near
about liquidity. These should be convertible in cash for paying obligations of short-
term nature. The sufficiency or insufficiency of current assets should be assessed by
comparing them with short-term liabilities. If current assets can pay off the current
liabilities then the liquidity position is satisfactory. On the other hand, if the current
liabilities cannot be met out of the current assets then the liquidity position is bad. To
measure the liquidity of a firm, the following ratios can be calculated:
1. CURRENT RATIO
2. QUICK RATIO
3. ABSOLUTE LIQUID RATIO
1. CURRENT RATIO
Current Ratio, also known as working capital ratio is a measure of general liquidity
and its most widely used to make the analysis of short-term financial position or
liquidity of a firm. It is defined as the relation between current assets and current
liabilities. Thus,
1) CURRENT ASSETS
2) CURRENT LIABILITES
Current assets include cash, marketable securities, bill receivables, sundry debtors,
inventories and work-in-progresses. Current liabilities include outstanding expenses,
bill payable, dividend payable etc.
A relatively high current ratio is an indication that the firm is liquid and has the ability
to pay its current obligations in time. On the hand a low current ratio represents that
the liquidity position of the firm is not good and the firm shall not be able to pay its
current liabilities in time. A ratio equal or near to the rule of thumb of 2:1 i.e. current
assets double the current liabilities is considered to be satisfactory.
e.g.
As we know that ideal current ratio for any firm is 2:1. If we see the current ratio of
the company for last three years it has increased from 2003 to 2005. The current ratio
of company is more than the ideal ratio. This depicts that company’s liquidity position
is sound. Its current assets are more than its current liabilities.
2. QUICK RATIO
Quick ratio is a more rigorous test of liquidity than current ratio. Quick ratio may be
defined as the relationship between quick/liquid assets and current or liquid liabilities.
An asset is said to be liquid if it can be converted into cash with a short period without
loss of value. It measures the firms’ capacity to pay off current obligations
immediately.
1) Marketable Securities
2) Cash in hand and Cash at bank.
3) Debtors.
A high ratio is an indication that the firm is liquid and has the ability to meet its
current liabilities in time and on the other hand a low quick ratio represents that the
firms’ liquidity position is not good.
A quick ratio is an indication that the firm is liquid and has the ability to meet its
current liabilities in time. The ideal quick ratio is 1:1. Company’s quick ratio is more
than ideal ratio. This shows company has no liquidity problem.
Although receivables, debtors and bills receivable are generally more liquid than
inventories, yet there may be doubts regarding their realization into cash immediately
or in time. So absolute liquid ratio should be calculated together with current ratio and
acid test ratio so as to exclude even receivables from the current assets and find out
the absolute liquid assets. Absolute Liquid Assets includes :
Interpretation :
These ratio shows that company carries a small amount of cash. But there is
nothing to be worried about the lack of cash because company has reserve, borrowing
power & long term investment. In India, firms have credit limits sanctioned from
banks and can easily draw cash.
Funds are invested in various assets in business to make sales and earn profits. The
efficiency with which assets are managed directly affects the volume of sales. The
better the management of assets, large is the amount of sales and profits. Current
assets movement ratios measure the efficiency with which a firm manages its
resources. These ratios are called turnover ratios because they indicate the speed with
which assets are converted or turned over into sales.
Depending upon the purpose, a number of turnover ratios can be calculated.
They are :
The current ratio and quick ratio give misleading results if current assets include high
amount of debtors due to slow credit collections and moreover if the assets include
high amount of slow moving inventories. As both the ratios ignore the movement of
current assets, it is important to calculate the turnover ratio.
Inventory turnover ratio measures the speed with which the stock is converted into
sales. Usually a high inventory ratio indicates an efficient management of inventory
because more frequently the stocks are sold; the lesser amount of money is required to
finance the inventory. Whereas, the low inventory turnover ratio indicates that the
inefficient management of inventory. A low inventory turnover implies over
investment in inventories, dull business, poor quality of goods, stock accumulations
and slow moving goods and low profits as compared to total investment.
(Rupees in Crore)
This ratio shows how rapidly the inventory is turning into receivable through
sales. In 2004 the company has high inventory turnover ratio but in 2005 it has
reduced to 1.75 times. This shows that the company’s inventory management
technique is less efficient as compare to last year.
e.g.
Interpretation :
Inventory conversion period shows that how many days inventories takes to
convert from raw material to finished goods. In the company inventory conversion
period is decreasing. This shows the efficiency of management to convert the
inventory into cash.
A concern may sell its goods on cash as well as on credit to increase its sales and a
liberal credit policy may result in tying up substantial funds of a firm in the form of
trade debtors. Trade debtors are expected to be converted into cash within a short
period and are included in current assets. So liquidity position of a concern also
depends upon the quality of trade debtors. Two types of ratio can be calculated to
evaluate the quality of debtors.
e.g.
Interpretation :
This ratio indicates the speed with which debtors are being converted or turnover
into sales. The higher the values or turnover into sales. The higher the values of
debtors turnover, the more efficient is the management of credit. But in the company
the debtor turnover ratio is decreasing year to year. This shows that company is not
utilizing its debtor’s efficiency. Now their credit policy becomes liberal as compare to
previous year.
The average collection period ratio represents the average number of days for which a
firm has to wait before its receivables are converted into cash. It measures the quality
of debtors. Generally, shorter the average collection period the better is the quality of
debtors as a short collection period implies quick payment by debtors and vice-versa.
The average collection period measures the quality of debtors and it helps in
analyzing the efficiency of collection efforts. It also helps to analysis the credit policy
adopted by company. In the firm average collection period increasing year to year. It
shows that the firm has Liberal Credit policy. These changes in policy are due to
competitor’s credit policy.
Working capital turnover ratio indicates the velocity of utilization of net working
capital. This ratio indicates the number of times the working capital is turned over in
the course of the year. This ratio measures the efficiency with which the working
capital is used by the firm. A higher ratio indicates efficient utilization of working
capital and a low ratio indicates otherwise. But a very high working capital turnover is
not a good situation for any firm.
e.g.
Interpretation :
This ratio indicates low much net working capital requires for sales. In 2005,
the reciprocal of this ratio (1/1.64 = .609) shows that for sales of Rs. 1 the company
requires 60 paisa as working capital. Thus this ratio is helpful to forecast the working
capital requirement on the basis of sale.
INVENTORIES
(Rs. in Crores)
Inventories are a major part of current assets. If any company wants to manage its
working capital efficiency, it has to manage its inventories efficiently. The graph
shows that inventory in 2002-2003 is 45%, in 2003-2004 is 43% and in 2004-2005 is
54% of their current assets. The company should try to reduce the inventory up to
10% or 20% of current assets.
(Rs. in Cores)
Cash is basic input or component of working capital. Cash is needed to keep the
business running on a continuous basis. So the organization should have sufficient
cash to meet various requirements. The above graph is indicate that in 2003 the cash is
4.69 crores but in 2004 it has decrease to 1.79. The result of that it disturb the firms
manufacturing operations. In 2005, it is increased upto approx. 5.1% cash balance. So
in 2005, the company has no problem for meeting its requirement as compare to 2004.
DEBTORS:
(Rs. in Crores)
CURRENT ASSETS:
(Rs. in Crores)
This graph shows that there is 64% increase in current assets in 2005. This
increase is arising because there is approx. 50% increase in inventories. Increase in
current assets shows the liquidity soundness of company.
CURRENT LIABILITY:
(Rs. in Crores)
Current liabilities shows company short term debts pay to outsiders. In 2005 the
current liabilities of the company increased. But still increase in current assets are
more than its current liabilities.
(Rs. in Crores)
RESEARCH METHODOLOGY
The methodology, I have adopted for my study is the various tools, which basically
analyze critically financial position of to the organization:
I sincerely hope, through the evaluation of various percentage, ratios and comparative
analysis, the organization would be able to conquer it’s in efficiencies and makes the
desired changes.
FINANCIAL STATEMENTS:
2. To provide other needed information about charges in such economic resources and
obligation.
3. To provide reliable information about change in net resources (recourses less
obligations) missing out of business activities.
Though financial statements are relevant and useful for a concern, still they do not
present a final picture a final picture of a concern. The utility of these statements is
dependent upon a number of factors. The analysis and interpretation of these
statements must be done carefully otherwise misleading conclusion may be drawn.
1. Financial statements do not given a final picture of the concern. The data given in
these statements is only approximate. The actual value can only be determined when
the business is sold or liquidated.
2. Financial statements have been prepared for different accounting periods, generally
one year, during the life of a concern. The costs and incomes are apportioned to
different periods with a view to determine profits etc. The allocation of expenses and
income depends upon the personal judgment of the accountant. The existence of
contingent assets and liabilities also make the statements imprecise. So the financial
statements are at the most interim reports rather than the final picture of the firm.
3. The financial statements are expressed in monetary value, so they appear to give
final and accurate position. The value of fixed assets in the balance sheet neither
represent the value for which fixed assets can be sold nor the amount which will be
required to replace these assets. The balance sheet is prepared on the presumption of a
going concern. The concern is expected to continue in future. So, the fixed assets are
shown at cost less accumulated depreciation. Moreover, there are certain assets in the
balance sheet which will realize nothing at the time of liquidation but they are shown
in the balance sheets.
4. The financial statements are prepared on the basis of historical costs or original
costs. The value of assets decreases with the passage of time current price changes are
not taken into account. The statement are not prepared with the keeping in view the
economic conditions. The balance sheet loses the significance of being an index of
current economic realities. Similarly, the profitability shown by the income statements
may be representing the earning capacity of the concern.
5. There are certain factors which have a bearing on the financial position and
operating result of the business but they do not become a part of these statements
because they cannot be measured in monetary terms. The basic limitation of the
traditional financial statements comprising the balance sheet, profit & loss A/c is that
they do not give all the information regarding the financial operation of the firm.
Nevertheless, they provide some extremely useful information to the extent the
balance sheet mirrors the financial position on a particular data in lines of the structure
of assets, liabilities etc. and the profit & loss A/c shows the result of operation during
a certain period in terms revenue obtained and cost incurred during the year.
It is the process of identifying the financial strength and weakness of a firm from the
available accounting data and financial statements. The analysis is done
CALCULATIONS OF RATIOS
Ratios are relationship expressed in mathematical terms between figures, which are
connected with each other in some manner.
CLASSIFICATION OF RATIOS
The traditional classification has been on the basis of the financial statement to which
the determination of ratios belongs.
These are:-
Composite ratios