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Meaning
• The term working capital (WC) refers to the difference
between current assets and current liabilities.
• Current assets are assets which can be converted into cash
or cash equivalent during the normal operating cycle or
within a period of one year and includes cash, marketable
securities, debtors, inventories, prepaid expenses, bill
receivables.
• Current liabilities are those short term liabilities which
have to be paid in the normal operating cycle or within a
period of one year. It includes creditors, bank overdraft,
short term loans, trade payables, outstanding expenses.
Concepts of Working Capital
On the ●
Gross working capital means total current
assets.
basis of ●
Net working capital means the difference
between current assets and current
liabilities.
Value
On the ●
Permanent Working Capital-the continuous and uninterrupted
requirement of a certain minimum level of working capital to carry on the
business
basis of ●
Temporary Working Capital - refers to that part of total working capital,
which is required by an entity in addition to the permanent working
capital. It is also called variable working capital which is used to finance
the short term working capital requirements which arises due to
fluctuation in sales volume.
Time
Determinants of Working Capital
1. General nature of business – for instance, service industry
do not maintain big inventories – needs least amount of
working capital.
Manufacturing concerns or construction firms- large
inventories, book debts – high levels of working capital.
Business where most of transactions are cash in nature
(Restaurants)– less WC.
Railway companies with huge fixed investment usually
have the lowest needs for current assets, partly because
of cash nature of their business and partly due to their
rendering a service.
2. Production Cycle – refers to the time involved in the
manufacture of goods. It covers the time span
between the procurement of raw materials and the
completion of the manufacturing process resulting
into the finished goods.
• Longer the time span, higher will be the requirement
of working capital. For instance, firms in the shipping
industry, it takes almost two to three years to build a
ship.
• Shorter the production cycle, lower will be the
requirement of working capital. For instance, firms in
the services industry.
3. Sales Growth - It affects working capital
because the level of working capital of every
firm depends on its sales. Firms that have
growth opportunities are seen as firms that
have proper investment opportunities and
hence will need more working capital to take
advantage of their opportunities.
4. Credit policy: It influences the requirement of
working capital through credit terms granted
by the firm to its customers.
The stringent credit policy (to the customers)
would require lesser amount of WC and the
liberal credit policy would entail a huge
requirement of WC due to more money tied
up in book debts.
5. Business Cycle-The variations in business conditions may be in
two directions – boom and recession.
For instance, firm’s liquidity is expected to increase during
booming times and the vice versa during down times.
During the economic boom, firms spend more on fixed assets
so as to increase their productivity and also spend more on
inventories and debtors as sales will increase automatically .
On the other hand, during economic decline, sales fall and so
will the levels of inventories and debtors. This further make
firms to reduce their short-term borrowing thus reducing the
need for working capital. This means that during better
economic times, working capital is expected to be high while
the expectations are for a low working capital during down
times.
6. Vagaries in the availability of raw material
due to certain reasons may compel the firms
to purchase and stock the raw materials in
excess quantity then genuine requirements.
An excessive inventory would lead to higher
WC requirements.
Fluctuations in the availability of raw material
may be due to lean supplies, seasonal
availability or bans on flights from certain
countries from where the raw materials have
to be imported.
7. Profit Levels – the net profit is a source of WC
to the extent that it has been earned in cash.
The availability of such funds would depend
on the dividend policy of the firm. High WC
requirement may entail a company to follow
low dividend payout policy.
8. Price level changes: Rising prices necessitates
the use of more funds for maintaining an
existing level of activity. The effect of rising
prices is that a higher amount of WC is
needed.
Those companies which can raise their selling
prices proportionately, there is no serious
problem regarding the WC.
9. Operating Efficiency – The management can
contribute to a sound WC position through
operating efficiency. Although the
management cannot control the rise in prices,
it can ensure the efficient utilization of
resources by eliminating waste, improving
coordination and so on. Efficiency of
operations accelerates the pace of cash cycle,
improves the profitability and results into
internal generation of funds thus resulting into
lesser working capital requirements.
Approaches of working capital investment
Approaches of WC investment