Working Capital Management
When we hear about “Working Capital” the first question that comes into our mind is what is “Working Capital” and How to manage it?
So friends lets understand all the concepts related to Working Capital and its Management.
First Question: What is Working Capital?
Ans: According to Park & Gladson-
“The excess of current assets of a business (i.e. cash, accounts receivables, inventories) over current items owned to employees and others (such as salaries & wages payable, accounts payable, taxes owned to government)”.
The concept of working capital was, first evolved by Karl Marx. Marx used the term ‘variable capital’ means outlays for payrolls advanced to workers before the completion of work. He compared this with ‘constant capital’ which according to him is nothing but ‘dead labour’. This ‘variable capital’ is nothing wage fund which remains blocked in terms of financial management, in working- process along with other operating expenses until it is released through sale of finished goods. Although Marx did not mentioned that workers also gave credit to the firm by accepting periodical payment of wages which funded aportioned of W.I.P, the concept of working capital, as we understand today was embedded in his ‘variable capital’.
Broadly speaking there are two types of Working Capital:
1. Gross Working Capital: Its is simply firm’s investment in Current Asset.
2. Net Working Capital: Which is defined as Current Asset minus Current Liabilities. There is also another category of Working Capital which is known as
3. Net Operating Working Capital (NOWC): It is defined as Current Operating Asset minus Current Operating liabilities.
It is equal to Cash+ Accounts Receivables+ Inventories-Accounts Payables-Accruals.
But since we have heard about only two categories of working capital mentioned above, hence we will continue our discussion for those two categories.
Second Question: How to Manage it?
Ans: For giving the question of this answer we will analyze three questions listed below:
1. What is the appropriate amount of working capital
2. How to finance the working capital.
3. How to manage the Components of Working capital i.e. Current Asset and Current Liabilities
Now, let’s go into some depth:
1. Generally in a manufacturing unit current asset exceeds one half of total asset.
2. And Current liabilities are the main source of finance for small and medium firms.
3. Therefore working capital management affect company’s risk, return and price.
Now look at the below diagram:
Impact on Liquidity:
Impact on Expected Profitability:
Impact on Risk:
Summary of the Optimal Amount of Current Assets:
Now we have come to know about the importance of Working capital but our basic question which are listed initially are still pending. Now let’s solve them one by one.
For finding out the answer of the question what the appropriate level of WC is, let’s discuss some points which should be kept in mind while determining the appropriate level of WC:
1. Cost incurred on Material, Wages and overheads.
2. Time period taken for which raw material kept in stores
3. Time period taken for converting WIP into Finished Goods.
4. Time period taken for which Finished goods are stored in warehouse before sales.
5. Credit period allowed to customers
6. Average credit period for which advances payments is made.
7. Credit period allowed by suppliers to the firm for making payments.
8. Time taken in making payments to labors for their wages and other expenses.
9. Margin of safety required: It is generally calculated as a fixed % of Working Capital.
Hopefully now you can understand how to determine the optimum level of WC.
I will try to given answer of our other two questions in the next articles.
Note: (The author is the member of ICAI. His area of interest is Finance. For any queries and suggestions he can be approached at Email: firstname.lastname@example.org)