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OBJECTIVES
The term Working Capital refers to the capital required for day-to-day operations of a business
enterprise. It is represented by excess of Current assets over Current Liabilities. It is necessary
for any organization to run successfully its affairs, to provide for adequate working capital. Too
large investment in Current Assets means blocking the capital that can be used productively
elsewhere. On the other hand too little investment can be expensive. For example, insufficient
inventory may cause loss of sales to Customers.
All this indicates that proper estimation of the Working Capital requirements is a must for
running the business efficiently and profitably.
Current
WORKING
CAPITAL =
Assets
||
- Current liabilities
The importance of having working capital is best understood as 'costs expended before payment
received for goods/service provided to the customer'. Therefore, no capital means no production
and no customers, which means no capital...
There are basically two concepts of working capital Gross Working Capital:
It is the amount of capital invested in the total Current assets of the enterprise.
Current assets are those assets, which in ordinary course of business can be
converted into cash within a short period of normally one accounting year.
Cash in hand
Bank balances
Bills Receivables
Raw material
Work in progress
Finished Goods
Prepaid expenses
Accrued Incomes.
Current Liabilities:
Current Liabilities are debts payable within an accounting period. Current assets are converted
into cash to pay current liabilities.
Current Liabilities include:
Bills Payable
Dividends Payable
Bank Overdraft
It is a conventional rule to maintain the level of current assets twice the level of current
liabilities. A weak liquidity position poses a threat to the solvency of the company and makes it
unsafe and unsound. A negative working capital means a negative liquidity and at times it may
prove to be harmful for the companys reputation. Excessive liquidity is also bad. It may be due
to mismanagement of current assets. Therefore prompt and timely action should be taken by the
management to improve and correct the imbalances in the liquidity position of the firm.
Gross Working Capital is a Going Concern/Financial Concept where as the Net Working
Capital is an Accounting Concept of working capital.
OBJECTIVE:
The objective of working capital management is to maintain the optimum balance of each of the
working capital components. This includes making sure that funds are held as cash in bank
deposits for as long as and in the largest amounts possible, thereby maximizing the interest
earned. However, such cash may more appropriately be "invested" in other assets or in reducing
other liabilities. Other objectives of working capital management are as follows: To identify cash flow cycles of the firm.
To maintain the level of current assets twice the level of current liabilities.
To help the company to maintain good business relations.
To determine the future capital, liquidity position and other requirements of
the company.
Ratio analysis can be used to monitor overall trends in working capital and to
identify areas requiring closer management.
On basis of Concept
Gross
Net
Fixed
Capital
On basis of Time
Permanent/
Temporary/
Working
Working
Variable
Capital
Working
Working
Capital
Capital
Regular Reserve
WC
WC
Seasonal Special
WC
WC
There is always a minimum level of Current Assets, which are continuously required by the
enterprise to carry out its normal business operations. Example: Every firm has to maintain a
minimum amount of raw materials, Work-in-Progress, Finished goods and cash balance.
Minimum level of Current Assets is called permanent or fixed working capital as this part of
Working Capital is permanently blocked in Current Assets. As the business grows, requirements
of permanent Working capital also increase due to increase in current assets.
i. Regular Working Capital: It is required to ensure circulation of Current Assets from cash
to inventories, from
Credit policy-A company which allows liberal credits to its customers, may have
higher sales but will need more working capital as compared to a company which has
an efficient debt collection machinery and observing strict terms. The working capital
requirements can also be affected by the credit facilities enjoyed by the company.
Business cycle-Different phases of business cycle i.e, boom, recession, recovery etc.
also affect the working capital reuirement. In case of boom condition business
activities expand .As a result, the need for cash, inventories etc. increases resulting in
more and more funds blocked in these current assets. In case of recession period,
there is usually dullness in business activities and there will be an opposite effect on
the level of working capital requirement. There will be a fall in inventories and cash
requirements etc.
The period of time which elapses between the point at which cash begins to be expended on the
production of a product and the collection of cash from a customer.
The faster a business expands, the more cash it requires for working capital and investment. The
cheapest and best sources of cash exist as working capital right within business. Good
management of working capital will generate cash, which will help improve profits and reduce
risks. Bear in mind that the cost of providing credit to customers and holding stocks can
represent a substantial proportion of firms total profits.
There are two elements in the business cycle that absorbs cash:
The main sources of cash are Payables (your creditors) and Equity and Loans.
When it comes to managing working capital- TIME IS MONEY. If you can get money to move
faster around the cycle (e.g. collect monies due from debtors more quickly) or reduce the amount
of money tied up (e.g. reduce inventory levels relative to sales), the business will generate more
cash or it will need to borrow less money to fund working capital.
As a consequence, you could reduce the cost of bank interest or youll have additional free
money available to support additional sales growth or investment. Similarly, if you can negotiate
improved terms with suppliers e.g. get longer credit or an increased credit limit; you effectively
create free finance to help fund future sales.
ii)
Depending on the above mentioned requirements following are the sources of financing working
capital-
SOURCES
Long Term Sources
Shares
Commercial Banks
Debentures
Commercial paper
Public Deposits
Loans from Financial institutions
Trade Creditors
Installment credit
Accounts payables
Accrued Expenses
Most businesses cannot finance the Operating Cycle (accounts receivable days +
inventory days) with accounts payable financing alone. Consequently, working
capital financing is needed. This shortfall is typically covered by the net profits
generated internally or by externally borrowed funds or by a combination of the two.
Most businesses need short-term working capital at some point in their operations.
For instance, retailers must find working capital to fund seasonal inventory buildup
between September and November for Christmas sales. But even a business that is
not seasonal occasionally experiences peak months when orders are unusually high.
This creates a need for Working Capital to fund the resulting Inventory and Accounts
Receivable buildup.
Some small businesses have enough cash reserves to fund seasonal Working
Capital needs. However, this is very rare for a new business. If your new venture
experiences a need for short-term Working Capital during its first few years of
operation, you will have several potential sources of funding. The important thing is
to plan ahead. If you get caught off guard, you might miss out on the one big order
that could have put your business over the hump.
Here are the five most common sources of short-term working capital financing:
Equity
Trade Creditors
Factoring
Line Of credit
Short-term Loans
Equity: If your business is in its first year of operation and has not yet become
profitable, then you might have to rely on equity funds for short-term working
capital needs. These funds might be injected from your own personal resources or
from a family member, friend or third-party investor.
Trade Creditors: If you have a particularly good relationship established with your
trade creditors, you might be able to solicit their help in providing short-term
working capital. If you have paid on time in the past, a trade creditor may be willing
to extend terms to enable you to meet a big order. For instance, if you receive a big
order that you can fulfill, ship out and collect in 60 days, you could obtain 60-day
terms from your supplier if 30-day terms are normally given. The trade creditor will
want proof of the order and may want to file a lien on it as security.
Line Of Credit: Banks to new businesses do not often give Lines of credit.
However, if your new business is well capitalized by equity and you have good
collateral, your business might qualify for one. A line of credit allows you to borrow
funds for short-term needs when they arise. The funds are repaid once you collect
the accounts receivable that resulted from the short-term sales peak. Lines of credit
typically are made for one year at a time and are expected to be paid off for 30 to
60 consecutive days sometime during the year to ensure that the funds are used for
short-term needs only.
Short-term loan: While your new business may not qualify for a line of credit from
a bank, you might have success in obtaining a one-time short-term loan (less than a
year) to finance your temporary working capital needs. If you have established a
good banking relationship with a banker, he or she might be willing to provide a
short-term note for one order or for a seasonal inventory and/or accounts receivable
buildup.
In addition to analyzing the average number of days it takes to make a product
(inventory days) and collect on an account (account receivable days) vs. the
number of days financed by accounts payable, the operating cycle analysis provides
one other important analysis.
From the operating cycle, a computation can be made of the dollars required to
support one day of accounts receivable and inventory and the dollars provided by a
day of accounts payable.
Working capital has a direct impact on CASH FLOW in a business. Since cash flow
is the name of the game for all business owners, a good understanding of working
capital is imperative to make any venture successful.
Over-capitalization
(and
therefore
waste
through
under
utilization
of