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Concept of Working Capital Management

Sarvesh Mani Tiwari,CFA(ICFAI) 
Updated on 01 May 2021


What is working Capital

Every business needs funds for two purposes- for its establishment and to carry out its day to day operations. Long term funds are required to create production facilities through purchase of fixed assets such as plant and machinery, land, building, furniture etc. Investments in these assets represent that part of firms capital which is blocked on a permanent or fixed basis and is called fixed capital.
Funds are also needed for short term purposes for the purchase of raw materials, payment of wages and other day to day expenses, etc. These funds are known as Working Capital. Working Capital may be regarded as lifeblood of a business, while its inefficient management can lead not only to loss of profits but also lead to the ultimate down fall of a concern. Hence, working capital management if carried out effectively, efficiently and consistently, will assure the health of an organization.
Concept of Working Capital
For the proper understanding of Working Capital, it is necessary to understand the various concepts of Working Capital. The main concepts of Working Capital are as follows:
1.Quantitative or Gross Working Capital Concept;
2.Qualitative or Net Working Capital Concept.
1- Quantitative or Gross Working Capital Concept;
According to this concept Working capital is the total of the entire current asset. This view places more emphasis on the quantitative aspect of working capital rather than its Qualitative aspect. This concept is important due to the following reasons:
a)It enables the enterprise to provide correct amount of Working Capital at the right time;
b)Every management is more interested in the total current assets with which it has to operate than the sources from where it is made available;
c) The gross concept takes into consideration the fact that every increase in the funds of the enterprise would increase its Working Capital;
d)The gross concept of Working Capital is more useful in determination the rate of return on investments in Working Capital.
2- Qualitative or Net Working Capital Concept:
This concept gives more emphasis on the qualitative aspect rather than the quantitative aspect rather than the quantitative aspect of working capital. According to this concept the excess of the current assets over current liabilities is known as working capital. If the current assets and current liabilities are equal; it indicates absents of working capital in the business.
The net working capital concept is important due to the following reasons:
a)It is a qualitative concept which indicates the firms ability to meet its operating expenses and short term liabilities;
b)It indicates the margin of protection available to the short- term creditors, i.e., the excess of current assets over current liabilities;
c) It is an indicator of the financial soundness of an enterprise;
d)It suggests the need for financing a part of the Working Capital requirements out of permanent sources of funds.
Objective of the Working Capital Management:
The basic objectives of the working capital management are as follows:
1. To optimize the investment in current asset and to reduce the level of current liabilities, so that the company can reduce the locking up of funds in working capital and, can improve the return on capital employed in the business;
2. Working capital management is that the company should always be in a position to meet its current obligations which should be properly be supported by the current asset available with the firm. But maintaining excess funds in working capital means locking of funds without return;
3. To manage the firms current assets in such a way that the marginal return on investment in these assets is not less than the cost of capital employed to finance the current assets.
The need of Working Capital:
The need for working capital cannot be emphasized. Every business needs some amount of working capital. The need for working capital arises due to time gap between production and realization of cash from sales. Thus the working capital is needed for the following purposes:
1- For the purchase of raw materials, components and spares;
2- To pay wages and salaries;
3- To incur day to day expenses and overhead costs such as fuel, power and office expenses, etc;
4- To meet the selling costs facilities to the customers;
5- To provide credit facilities to the customers;
6- To maintain the inventories of raw material, work-in progress, stores and spares and finished stock.
Kinds or Types of Working Capital
Working Capital can be classified on the following basis:
Kinds or Types of Working Capital
On the basis of Concepts On the basis of necessities
Gross Working Capital; Fixed working Capital;
Net Working Capital; Variable Working Capital;
On the basis of concept:
Working capital can be divided into following categories on the basis of Concepts:
Gross Working Capital:
Gross Working Capital is the amount of funds invested in the various components of current assets.
Net working Capital:
The net working capital is the difference between the current assets and current liabilities.
On the basis of Necessities:
Working capital can be divided into following categories on the basis of necessities:
Fixed (Permanent or Core) 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 of business activities. In other words, it represents the current assets required on a continuing basis over the entire year.
Variable (Temporary or seasonal) Working Capital:
The amount of such working capital keeps on fluctuating from time to time on the basis of business activities.
Component of Working Capital
There are two of the major following components of the Working Capital:
1- Current Assets:
Current assets are those assets which can be converted into cash in the normal course of business within a short period- say a maximum of one year. They are also called floating or circulating assets because they cannot be put to constant use. They are meant for resale or produced for the purpose of sale i.e., converting them into cash. In brief , the list of current assets comprises of :
I. Cash in hand and bank balances;
II. Bills receivables;
III. Sundry debtors (less provision for bad debts);
IV. Short-term loans and advances;
V. Inventories of stocks as:
Raw- material,
Stores and spares,
Finished goods.
VI. Temporary Investments of surplus funds;
VII. Prepaid Expense;
VIII. Accrued Incomes.
2- Current Liabilities:
Current liabilities are those liabilities which are intended to be paid in the ordinary course of business within a short period of normally one accounting year out of the current assets or the income of the business. Such as:
I. Bills Payable;
II. Sundry creditors or accounts payable;
III. Accrued or outstanding Expenses;
IV. Short-term loan, advances and deposits;
V. Dividends Payable;
VI. Bank overdrafts;
VII. Provision for taxation.
Sources of working Capital
A firm can arrange working capital from the following two sources:
1)Long-term sources
2)Short-term Sources.
1)Long-term sources:
The sources of long term financing can be broadly classified into the following two categories:
Owned sources:
I. Issue of share:
Arrangement of working capital through issue of shares dose not create a fixed obligation on incomes of the business. Thus it is preferable to arrange the permanent working capital through issue of shares.
II. Retained Earnings:
A firm can meet its working capital requirement by reinvesting the profits earned by it. Reinvestment the profits earned profit is a regular and cost less sources of funds.
III. Reserves:
Like retained earnings, the use of reserves for financing the working capital requirement is also a costless sources of finance.
Borrowed Sources:
It mainly includes the issue of debentures or long-term loans.
2). Short-term Sources:
Internal Sources:
It mainly includes depreciation provision, outstanding liabilities and provision for taxation.
External sources:
Short-term external sources of financing working capital include the following:
I. Trade credit:
Usually the manufacturing concerns, wholesalers and retailers avail this type f credit. Such credit is extended by suppliers of goods or raw-materials. This facility is given for a short period which may extend for a few weeks or a few months, based on prevailing market usage. No interest is charged by the suppliers if payment is made by the customer before the expiry of the credit period.
II. Bank credit:
Normally companies obtain short-term working capital from banks in the form of short-term loans, cash credit, and overdraft and through discounting the bill of exchange.
III. short-term loans from financial institutions:
The requirement of working capital can also be stratified by arranging short-term loans from financial institution.
IV. Public Deposits:
Business firms sometimes succeed in mobilizing enough funds by way of short-term deposits from publics. By and large attraction of higher rate of interest prompts the public to put their savings as short-term deposits with business firms.
V. Advance from customers:
Advance form customers are also considered as a principle source of short-term working capital finance.

Operating Cycle of the Working Capital

Raw material components
& Manufacturing
Selling & Distribution
General Administration
Financial Costs
Finished Goods
Inter dependence among the components of Working Capital
A company starting with cash purchase raw-materials, components etc., on cash credit basis. These materials will be converted into finished goods after undergoing the stage of work-in-progress. For this purpose in the company has to make payments towards wages, salaries and other manufacturing costs. Payments to suppliers have to be made on purchase in the case of credit purchase. Further, the company has to meet other operating costs such as selling and distribution costs (interest on borrowed capital). In case the company sells its finished goods on a credit basis, it will pass through one more stage, viz, accounts receivable and gets back cash along with profit on the expiry of credit period. Once again the cash will be used for the purchase of materials and or payment to suppliers and the whole cycle termed as working capital operating cycle itself. This process indicates the dependence of each stage or component of working capital on its previous stage or component.

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Sarvesh Mani Tiwari,CFA(ICFAI) 

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