A write up on Working Capital

Last updated: 07 January 2008

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1. Explain the concept of Working Capital. Ans: The term working capital refers to the amount of capital which is readily available to an organization. Working capital finances the Cash Conversion Cycle of a business-the time required to convert raw materials into finished goods, finished goods into sales, and accounts receivable. The term working capital may be used in two different ways: A. Gross Working Capital- It refers to the firm’s investment in all the current assets. It is based on following premises: I. With every increase in funds, the gross working capital will increase. II. The management is more concerned with total current assets as they constitute the total funds available for operating purpose than with the sources from which the funds came Example: The ABC Limited has a cash balance of Rs.10,000 , Debtors of Rs.50,000 , Inventory of Raw material Rs.1,00,000 and Inventory of Finished goods Rs.2,00,000 then gross working capital of ABC Limited will be Rs.3,60,000. B. Net Working Capital- It refers the amount of current assets that exceeds current liabilities. It is the amount of current assets financed by long-term liabilities. It is based on following premises: I. In the long run what matters is the surplus of currents assets over current liabilities. II. The creditors and investor use this concept to judge the financial soundness of the enterprise. III. To meet the contingencies one has to rely upon the excess of current assets over current liabilities. IV. It helps to find out the correct financial position of companies. · The net working capital measures firm’s liquidity. · The net working capital may be negative or positive. Formula Net working capital= Current Assets- Current liabilities 2. Explain the concept of negative Working Capital. Ans: A negative working capital is a sign of managerial efficiency in a business with low inventory and accounts receivable (which means they operate on an almost strictly cash basis). In any other situation, it is a sign a company may be facing bankruptcy or serious financial trouble. Excess of current liabilities over current assets is called as negative working capital. To remedy a negative working capital position, a firm has these alternatives: (1) It can convert a long-term asset into a current asset-for example, by selling a piece of equipment or a building, by liquidating a long-term investment, or by renegotiating a long-term loan receivable; (2) It can convert short-term liabilities into long-term liabilities-for example, by negotiating the substitution of a current account payable with a long-term note payable; (3) It can borrow long term; (4) It can obtain additional equity through a stock issue or other sources of paid-in capital; (5) It can retain or "plow back" profits