Working Capital

Introduction

• A firm invests a part of its permanent capital in fixed assets and keeps a part of it for working capital e., for meeting the day to day requirements.
• We will hardly find a firm which does not require any amount of working capital for its normal operations. The requirement of working capital varies from firm to firm depending upon the nature of business, production policy, market conditions, seasonality of operations, conditions of supply
• Working capital to a company is like the blood to human body. It is the most vital ingredient of a
• Working capital management if carried out effectively, efficiently and consistently, will assure the health of an

Meaning of Working Capital :

Working capital is defined as the excess of current assets over current liabilities.

Current assets are those assets which will be converted into cash within the current accounting period or within the next year as a result of the ordinary operations of the business. They are cash or near cash resources. These include:

• Cash and Bank Balances
• Receivables
• Inventory
  • Raw materials, stores and spares
  • Work – in - progress
  • Finished goods
• Prepaid expenses
• Short-term advances
• Temporary investments

The value represented by these assets circulates among several items. Cash is used to buy raw – materials, to pay wages and to meet other manufacturing expenses. Finished goods are produced. These are held as inventories. When these are sold, accounts receivables are created. The collection of accounts receivable brings cash into the firm. The cycle starts again. Current liabilities are the debts of the firms that have to be paid during the current accounting period or within a year.

These include:

• Creditors for goods
• Outstanding expenses e., expenses due but not paid.
• Short – term
• Advances received against
• Taxes and dividends payable
• Other liabilities maturing within a

Working capital is also known as circulating capital, fluctuating capital and revolving capital. The magnitude and composition keep on changing continuously in the course of business.

Gross and Net Working Capital

Generally the Working capital has its significance in two perspectives – ‘Gross working capital’ and ‘Net Working capital’.

Gross Working capital: The gross working capital refers to investment in all the current assets. The total of investments in all current assets is known as gross working capital.

Net Working Capital:

• It is the excess of current assets over current This is, as a matter of fact, the most commonly accepted definition. Some people define it as only the difference between current assets and current liabilities.
• It is that portion of a firm’s current assets which is financed by long – term

Need for Working Capital

The basic objective of financial management is to maximize shareholders’ wealth. This is possible only when the company earns sufficient profit. The amount of such profit largely depends upon the magnitude of sales. However, sales do not convert into cash instantaneously. There is always a time gap between the sale of goods and receipt of cash. Working capital is required for this period in order to sustain the sales activity. In case adequate working capital is not available for this period, the company will not be in a position to sustain the sales since it may not be in a position to purchase raw materials, pay wages and other expenses required for manufacturing the goods to be sold.

Permanent and Temporary Working Capital:

Working capital can be divided into two categories on the basis of time:

1. Permanent Working Capital
2. Temporary or Variable Working

Permanent working capital represents the assets required on continuing basis over the entire year, whereas temporary working capital represents additional assets required at different items during the operation of the year.

Permanent working capital: This refers to that minimum amount of investment in all current assets, which is required at all times to carry out minimum level business activities. In other words, it represents the current assets required on a continuing basis over the entire year. Tandon Committee has referred to this type of working capital as “Hard Core current basis”.

The following are the characteristics of this type of working capital:

1. Amount of permanent working capital remains in the business in one form or This is particularly important from the point of view of financing. The suppliers of such working capital should not expect its return during the life-term of the firm.
2. It also grows with the size of the In other words, greater the size of the business, greater is the amount of such working capital and vice versa.

Permanent working capital is permanently needed for the business and therefore, it should preferably be financed out of long – term funds.

Temporary working capital: It refers to that part of total working capital which is required by a business over and above permanent working capital. It is also called variable working capital. Since the volume of temporary working capital keeps on fluctuating from time to time. In other words, it represents additional currents assets required at different times during the operating year. For example, extra inventory has to be maintained to support sales during peak sales period. Similarly, receivable also increase and must be financed during period of high sales. On the other hand investment in inventories, receivables, etc., will decrease in periods of depression. Temporary working capital is generally financed from short – term sources of finance such as bank credit.

Permanent working capital is fixed over a period of time, while temporary working capital is fluctuating. The permanent working capital is increasing over a period of time with increase in the level of business activity. This happens in case of a growing company. Hence, the permanent working capital line is not horizontal with the base line.