5. WORKING CAPITAL
WORKING CAPITAL
Meaning of Working Capital: Capital required for the business can be of two types:
1. Fixed Capital 2. Working Capital
Fixed capital is required to create the production facilities through purchase of fixed assets like Land, Machinery, and Building etc. Investment in these assets represents that part of firm’s capital, which is blocked on permanent or fixed basis and is called fixed capital. Funds are also needed for short-term purpose for the purchase of Raw material, Payment of Wages etc. these funds are known as Working Capital. In simple words, working capital refers to that part of firm’s capital, which is required for financing short-term assets.
Definitions of Working Capital: According to Shubin: “Working Capital is the amount of funds necessary to cover the cost of operating the enterprises.” According to Genestenberg: “ Working Capital means current assets of a comp-any that are changed in the ordinary course of business from one form to another as for e.g. Cash to inventories, inventories to receivables and receivables to cash”.
KINDS OF WORKING CAPITAL
(A) On the basis of concept
(i) Gross working capital concept: According to this concept, working capital means total of all current assets of business.. Gross working capital = Total current assets.
Gross Working Capital is simply called as the total current assets of the concern.
GWC = CA
(ii) Net working capital concept: According to this concept, working capital means excess of current assets over current liabilities.
Net Working capital = Current Assets – current Liabilities
NWC = C A – CL
NWC = C A – CL
Component of Working Capital
Working capital constitutes various current assets and current liabilities. This can be illustrated by the following chart.
Current Assets
Cash in Hand
Cash at Bank
Bills Receivable
Sundry Debtors
Short-term Loans Advances
Inventories
Prepaid Expenses
Accrued Income
Current Liability
Bills Payable
Sundry Creditors
Outstanding Expenses
Short-term Loans and Advances
Dividend Payable
Bank Overdraft
Provision for Taxation
TYPES OF WORKING CAPITAL
Working Capital may be classified into three important types on the basis of time.
1 Permanent Working Capital
2 Temporary Working Capital
a. Seasonal Working Capital
b.Special Working Capital
3 Semi Variable Working Capital
Permanent Working Capital
It is also known as Fixed Working Capital. It is the capital; the business concern must maintain certain amount of capital at minimum level at all times. The level of Permanent Capital depends upon the nature of the business. Permanent or Fixed Working Capital will not change irrespective of time or volume of sales.
Temporary Working Capital
It is also known as variable working capital. It is the amount of capital which is required to meet the Seasonal demands and some special purposes. It can be further classified into Seasonal Working Capital and Special Working Capital. The capital required to meet the seasonal needs of the business concern is called as Seasonal Working Capital. The capital required to meet the special exigencies such as launching of extensive marketing campaigns for conducting research, etc.
Semi Variable Working Capital
Certain amount of Working Capital is in the field level up to a certain stage and after that it will increase depending upon the change of sales or time.
NEEDS OF WORKING CAPITAL
Working Capital is an essential part of the business concern. Every business concern must maintain certain amount of Working Capital for their day-to-day requirements and meet the short-term obligations. Working Capital is needed for the following purposes.
1. Purchase of raw materials and spares: The basic part of manufacturing process is, raw materials. It should purchase frequently according to the needs of the business concern. Hence, every business concern maintains certain amount as Working Capital to purchase raw materials, components, spares, etc.
2. Payment of wages and salary: The next part of Working Capital is payment of wages and salaries to labour and employees. Periodical payment facilities make employees perfect in their work. So a business concern maintains adequate the amount of working capital to make the payment of wages and salaries.
3. Day-to-day expenses: A business concern has to meet various expenditures regarding the operations at daily basis like fuel, power, office expenses, etc.
4. Provide credit obligations: A business concern responsible to provide credit facilities to the customer and meet the short-term obligation. So the concern must provide adequate Working Capital
Working capital constitutes various current assets and current liabilities. This can be illustrated by the following chart.
Current Assets
Cash in Hand
Cash at Bank
Bills Receivable
Sundry Debtors
Short-term Loans Advances
Inventories
Prepaid Expenses
Accrued Income
Current Liability
Bills Payable
Sundry Creditors
Outstanding Expenses
Short-term Loans and Advances
Dividend Payable
Bank Overdraft
Provision for Taxation
TYPES OF WORKING CAPITAL
Working Capital may be classified into three important types on the basis of time.
1 Permanent Working Capital
2 Temporary Working Capital
a. Seasonal Working Capital
b.Special Working Capital
3 Semi Variable Working Capital
Permanent Working Capital
It is also known as Fixed Working Capital. It is the capital; the business concern must maintain certain amount of capital at minimum level at all times. The level of Permanent Capital depends upon the nature of the business. Permanent or Fixed Working Capital will not change irrespective of time or volume of sales.
Temporary Working Capital
It is also known as variable working capital. It is the amount of capital which is required to meet the Seasonal demands and some special purposes. It can be further classified into Seasonal Working Capital and Special Working Capital. The capital required to meet the seasonal needs of the business concern is called as Seasonal Working Capital. The capital required to meet the special exigencies such as launching of extensive marketing campaigns for conducting research, etc.
Semi Variable Working Capital
Certain amount of Working Capital is in the field level up to a certain stage and after that it will increase depending upon the change of sales or time.
NEEDS OF WORKING CAPITAL
Working Capital is an essential part of the business concern. Every business concern must maintain certain amount of Working Capital for their day-to-day requirements and meet the short-term obligations. Working Capital is needed for the following purposes.
1. Purchase of raw materials and spares: The basic part of manufacturing process is, raw materials. It should purchase frequently according to the needs of the business concern. Hence, every business concern maintains certain amount as Working Capital to purchase raw materials, components, spares, etc.
2. Payment of wages and salary: The next part of Working Capital is payment of wages and salaries to labour and employees. Periodical payment facilities make employees perfect in their work. So a business concern maintains adequate the amount of working capital to make the payment of wages and salaries.
3. Day-to-day expenses: A business concern has to meet various expenditures regarding the operations at daily basis like fuel, power, office expenses, etc.
4. Provide credit obligations: A business concern responsible to provide credit facilities to the customer and meet the short-term obligation. So the concern must provide adequate Working Capital
Working Capital Position/ Balanced Working Capital Position.
A business concern must maintain a sound Working Capital position to improve the efficiency of business operation and efficient management of finance. Both excessive and inadequate Working Capital lead to some problems in the business concern.
A. Causes and effects of excessive working capital.
(i) Excessive Working Capital leads to unnecessary accumulation of raw materials, components and spares.
(ii) Excessive Working Capital results in locking up of excess Working Capital.
(iii) It creates bad debts, reduces collection periods, etc.
(iv) It leads to reduce the profits.
B. Causes and effects of inadequate working capital
(i) Inadequate working capital cannot buy its requirements in bulk order.
(ii) It becomes difficult to implement operating plans and activate the firm’s profit target.
(iii) It becomes impossible to utilize efficiently the fixed assets.
(iv) The rate of return on investments also falls with the shortage of Working Capital.
(v) It reduces the overall operation of the business.
FACTORS DETERMINING WORKING CAPITAL REQUIREMENTS
Working Capital requirements depends upon various factors. There are no set of rules or formula to determine the Working Capital needs of the business concern. The following are the major factors which are determining the Working Capital requirements.
1. Nature of business: Working Capital of the business concerns largely depend upon the nature of the business. If the business concerns follow rigid credit policy and sell goods only for cash, they can maintain lesser amount of Working Capital. A transport company maintains lesser amount of Working Capital while a construction company maintains larger amount of Working Capital.
2. Production cycle: Amount of Working Capital depends upon the length of the production cycle. If the production cycle length is small, they need to maintain lesser amount of Working Capital. If it is not, they have to maintain large amount of Working Capital.
3. Business cycle: Business fluctuations lead to cyclical and seasonal changes in the business condition and it will affect the requirements of the Working Capital. In the booming conditions, the Working Capital requirement is larger and in the depression condition, requirement of Working Capital will reduce. Better business results lead to increase the Working Capital requirements.
4. Production policy: It is also one of the factors which affects the Working Capital requirement of the business concern. If the company maintains the continues production policy, there is a need of regular Working Capital. If the production policy of the company depends upon the situation or conditions, Working Capital requirement will depend upon the conditions laid down by the company.
5. Credit policy: Credit policy of sales and purchase also affect the Working Capital requirements of the business concern. If the company maintains liberal credit policy to collect the payments from its customers, they have to maintain more Working Capital. If the company pays the dues on the last date it will create the cash maintenance in hand and bank.
6. Growth and expansion: During the growth and expansion of the business concern, Working Capital requirements are higher, because it needs some additional Working Capital and incurs some extra expenses at the initial stages.
7. Availability of raw materials: Major part of the Working Capital requirements are largely depend on the availability of raw materials. Raw materials are the basic components of the production process. If the raw material is not readily available, it leads to production stoppage. So, the concern must maintain adequate raw material; for that purpose, they have to spend some amount of Working Capital.
8. Earning capacity: If the business concern consists of high level of earning capacity, they can generate more Working Capital, with the help of cash from operation. Earning capacity is also one of the factors which determines the Working Capital requirements of the business concern.
WORKING CAPITAL MANAGEMENT POLICY
Working Capital Management formulates policies to manage and handle efficiently; for that purpose, the management established three policies based on the relationship between Sales and Working Capital.
1. Conservative Working Capital Policy.
2. Moderate Working Capital Policy.
3. Aggressive Working Capital Policy.
1. Conservative working capital policy: Conservative Working Capital Policy refers to minimize risk by maintaining a higher level of Working Capital. This type of Working Capital Policy is suitable to meet the seasonal fluctuation of the manufacturing operation.
2. Moderate working capital policy: Moderate Working Capital Policy refers to the moderate level of Working Capital maintainance according to moderate level of sales. It means one percent of change in Working Capital, that is Working Capital is equal to sales.
3. Aggressive working capital policy: Aggressive Working Capital Policy is one of the high risky and profitability policies which maintains low level of Aggressive Working Capital against the high level of sales, in the business concern during a particular period.
SOURCES OF WORKING CAPITAL
Working Capital requirement can be normalized from short-term and long-term sources. Each source will have both merits and limitations up to certain extract. Uses of Working Capital may be differing from stage to stage.
Long-term
Shares
Debenture
Public Deposit
Loans from Financial Institutions
Retained Earning
Short-term
Bank Loan and Credit
Arrangements
Advances
Installment Credit
Short-term Instruments
The above sources are also classified into internal sources and external sources of working capital. Internal sources such as:
• Retained Earnings
• Reserve and Surplus
• Depreciation Funds etc.
External sources such as:
• Debentures and Public Deposits
• Loans from Banks and Financial Institutions
• Advances and Credit
• Financial arrangements like Factoring, etc.
Determining the Finance Mix
Determining the finance mix is an important part of working capital management. Under this decision, the relationship among risk, return and liquidity are measured and also which type of financing is suitable to meet the Working Capital requirements of the business concern.
There are three basic approaches for determining an appropriate Working Capital finance mix.
1. Hedging or matching approach
2. Conservative approach
3. Aggressive approach.
Hedging Approach Hedging approach is also known as matching approach. Under this approach, the business concern can adopt a financial plan which matches the expected life of assets with the expected life of the sources of funds raised to finance assets. When the business follows matching approach, long-term finance shall be used to fixed assets and permanent current assets and short-term financing to finance temporary or variable assets.
Conservative Approach Under this approach, the entire estimated finance in current assets should be financed from long-term sources and the short-term sources should be used only for emergency requirements. This approach is called as “Low Profit – Low Risk” concept.
Aggressive Approach Under this approach, the entire estimated requirement of current assets should be financed from short-term sources and even a part of fixed assets financing be financed from short- term sources. This approach makes the finance mix more risky, less costly and more profitable.
WORKING CAPITAL AND BANKING COMMITTEE
Banking finance to working capital requirements is a very important part of the business concern. Banks provide finance to business concerns to meet the requirements. To regulate and control bank finance, RBI constitute committees. These committees submit reports with findings and recommendations to formulate the finance policy of the banks. The major committee and the recommendations are as follows:
(Committee- Year - Major Recommendations)
DEHEJIA 1969 Appraisal of credit applications received by banks for granting loan.
TANDON 1975 Banks must carry out the realize appraisal for granting loan Fixation of norms for bank lending to industry.
CHORE 1980 No bifurcation of cash credit accounts separate limits for peak level and non peak level requirements.
MARATHE 1984 Second method of lending to industry, introduction of fast track concept.
KANNAN 1997 Regular conduct with the borrowers, periodical monitoring the credit disposition.
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