Working Capital | Financial Management |



 Management of working capital is considered to be one of the most important areas of day to day management of a firm. It is concerned with adequacy of current assets. No business can run without adequate investment in working capital. Working capital refers to the amount of fund required to finance current assets, i.e. investment in stocks, debtors, cash and other current assets, Current assets are essential to use fixed assets profitably. For example, a machine can not nun without availability of raw material. The investment on the purchase of raw material is identified as working capital.

The working capital can be defined in two ways:

 Gross working capital

 The gross working capital refers to the investment in all the current assets taken together.

Net working capital 

This is the excess of total current assets over total current liabilities. However if only working capital is addressed, consider it to be net working capital.
 The other classification of investment can be permanent working capital and temporary working capital.

 Permanent working capital:

 It refers to the hard core working capital which is that minimum level of investment carried by the business at all times to carry out minimum level of its activities.

 Temporary working capital:

 It refers to that part of total working capital which is required over and above permanent working capital. It is also referred as variable working capital.

 Optimum/Adequate working capital:

 Adequacy of working capital will determine the efficiency with which the daily business may be carried on. Inadequate working capital definitely dampens the operating efficiency of the firm as production can not be carried efficiently if adequate raw materials are not there in firm's godown.

Further if large sum is used to invest in working capital, a lot of our funds may be lying unused in the form of dead stock, unrealisable debtors and idle cash. So the finance manager has to ensure that the amount of working capital available with his concern is neither too large nor too small for its requirements.
 But what is adequate investment i.e. optimum working capital has to be found out. We can not support unnecessary extra investment in our current assets and thereby blocking our funds without adequate return on that So we have to find out, exactly how much fund do we need in order to finance our current assets. Again it is clear that some portion of current assets is financed by creditors and other current liabilities. So in this chapter, we are required to find out the requirement of working capital.

Working capital cycle:

 Working capital cycle refers to the length of time between the firm's paying cash for materials for entering into production process and the inflow of cash from debtors (sales), for example, cash is converted into materials materials into Work in progress (WIP) , WIP into finished goods, finished goods into debtors, debtors into cash and again cash to raw materials This cycle goes on and this is called an operating cycle or cash cycle.
Duration of operating cycle is the number of days in which the money invested in raw material is reconverted into money from debtors It is computed by adding velocities for various items of CA and CL.
 Operating cycle=R+W+F+D-C with regard to time only.
 The various components of operating cycle may be calculated as shown below:

 Raw material storage period=  ASRM x 365 
                                            TRMC during the year

 WIP holding period=   AWIP inventory x 365
                                           TCP for the year

 Finished goods storage period= ASFG x 365 
                                               TCGS for the year

 Debtor's collection period= ABD x 365
                                            TCS for the year 

Credit period availed=  ATC x 365 
                                   TCP for the year

ASRM- Average stock of raw material.
TRMC- Total raw material consumed.
ASFG- Average stock of finished goods.
AWIP- Average work in progress.
TCP- Total cost of production.
TCGS-Total cost of goods sold
ABD- Average book debts
TCS- total credit sale
ATC-Average trade creditors

Here other time lag is not considered like outstanding expenses and prepaid expenses and other items It can be seen that larger is the operating cycle, larger is the requirement of working capital and lower is the overall profit. Whereas smaller is the operating cycle, smaller is the requirement of funds and higher is the profits. So it should be the aim of a finance manager to reduce the operating cycle by reducing the velocities of each item of current assets and increasing the velocities of creditors without damaging our goodwill.

Q- Distinguish between financing of fixed assets and financing of current asset ?

Fixed Assets
Current Assets
Fixed Assets are long-term resources of a business.
Current Assets are sort-term resources of a business.
Fixed Assets are the hold for the purpose of running business to earn profit.
Current Assets are hold for the purpose of running business for day to day operation and sales.
Fixed Assets are valued at cost less depreciation.
Current Assets are valued at cost or market price, whichever is less.
Source of funds
Fixed Assets are acquired out of long-term funds.
Current Assets are acquired at short-term funds.
Subject to change
Fixed Assets are not usually subject to change.
Current Assets are usually subject to change.
Type of Profit
Fixed Assets if sold, result in capital profit.
Current Assets if sold, result in trading or revenuer profit.

Q- When will the working capital be negative? What does it signifies in terms of financial health of an enterprise ?

When a company's current liabilities more than its current assets. This means that the liabilities that need to be paid within one year exceed the current assets that are monetizable over the same period. Working capital is calculated as the difference between a company's current assets and current liabilities. Working capital will be negative when the liabilities not paid within time period.

Affect of negative working capital in terms of financial health of an enterprise:
  1.  Cannot pay short term obligations in time.
  2.  Loose of goodwill.
  3. Cannot avail discounts and other benefits (Economies of scale).
  4. Difficult for the firm to exploit favorable market condition.
  5. Rate of return on investment fall with the shortage of working capital.
  6. Difficult to pay day to day expenses of operations

Q- Write a short note on Adequacy of current assets is a myth?

Adequacy of current assets is a myth

 Current Assets are an integral part of a business. They are part of working capital and are required for proper functioning and earning adequate amount of profits. The profits earning capacity of a firm is decided by its investments in fixed Assets but this profit cannot be earned without employing current assets. 
The investment in raw materials, stock in .process, finished goods and other current assets varies during the year. Current assets are financed by a combination of long term and short term sources of finance. Long term sources of finance usually support" the fixed assets and sometimes also provide the margin money for working capital. Short term sources support the current assets. Further, if a firm is not bale to meet out its liabilities, the goodwill-of the firm would be affected. 
Thus, Adequacy of current assets is required by any firm for long term sustainable growth and performance of a firm, Therefore, Adequacy of current assets is not a myth but a necessity.

Adequacy of current assets is a myth

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