Working Capital

The term working capital is commonly used for the capital required for day-
to-day operations of a business. Generally, two concepts of working capital
are the gross working capital and the net working capital. Gross refers to the
firm's total investment in the current assets. Net supports the view that
working capital is the difference of current assets and current liabilities. Net
working capital may be positive or negative although gross working capital is
always positive. According to the other school of thought (Net concept), the
working capital refers to the difference between current assets and current
liabilities. It is the excess of current assets over current liabilities. Current
liabilities refer to the claims of outsiders which are expected to mature for
payment within an accounting year and include creditors for goods, bills
payable, bank overdraft, accrued expenses, etc. A positive net working
capital arises when current assets exceed current liabilities and a negative
net working capital arises when current liabilities exceed current assets.
Both aspects have equal importance for management – the first focuses the
attention on the optimum investment in and financing of the current assets
whereas the second indicates the liquidity position of the firm and suggests
the extent to which working capital needs may be financed by permanent
sources of funds.
A company starting with purchases of raw materials, components on a cash
or credit basis. These materials will be converted into finished goods after
undergoing the stage of work in process. For this purpose, the company has
to make payments towards wages, salaries and other manufacturing costs.
Payments to suppliers have to be makde on purchase in the case of cash
purchases and on the expiry of credit period in the case of credit purchases.
Further, the company has to meet other operating costs such as selling and
distribution costs, general, administrative costs and non-operating costs as
well as financial costs. In case the company sells its finished goods on a cash
basis, it will receive cash along with profit with least delay. When it sells
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 the 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
or operating cycle repeats itself. This process also indicates the dependence
of each stage or component of working capital on its previous stage or
component.
The dependence of one component of working capital on its previous
stage/component is described above highlighting the inter-dependence
among the components of working capital. However, there can be other
kinds of inter-dependence which are not dictated by the usual sequence of
manufacturing and selling operations. For example, in case the
manufacturing process may require a raw material which is in short supply.
Then the company may have to make advance payment in anticipation of
the receipt of that raw material. This will cause an immediate drain on cash
resources unlike a situation where credit purchase of raw materials can be
made. Similarly, if there is an excessive accumulation of finished goods
inventory, the company may have to provide more liberal credit period
and/or relax its existing credit standards which will increase sundry debtors.
In situations of greater need for cash even providing cash discount as part of
the credit terms for sale which is likely to boost the cash resources, may
have to be resorted to. In such cases, the relative benefits and costs may
have to be taken into consideration before taking decisions.
TYPES OF WORKING CAPITAL
Working capital can be classified on the basis of its concept or on the basis
of periodicity of its requirements.
(A) On the basis of Concept
On the basis of its concept, the working capital may be divided into gross
working capital and net working capital. Gross working capital is represented
by the total current assets and Net working capital is the excess of current
assets over current liabilities. Net working capital can be positive or
negative. If current assets are in excess of current liabilities, it is positive net
working capital and if current liabilities are in excess of current assets, it is
negative net working capital.
(B) On the basis of Periodicity of Requirements
Working capital can also be classified into Fixed or Permanent Working
Capital and Temporary or Variable Working capital.
Permanent or Fixed Working Capital
It represents that part of working capital which is permanently locked up in
the current assets to carry out the business smoothly and efficiently. This
investment in current assets is of a permanent nature and will increase as
the size of the business expands. Examples are the investments required to
maintain the minimum stock of raw materials, work in progress, finished
products, loose tools and equipments. It also requires minimum cash
balance to be kept in reserve for the payment of wages, salaries and all
other current expenditure throughout the year. The permanent fixed working
capital can again be subdivided into Regular working capital and Reserve
Margin or Cushion Working Capital.
Regular working capital is the minimum amount of liquid capital needed to
keep up the circulation of the capital from cash to inventories, to receivable
and again to cash. This would include sufficient minimum bank balance to
discount all bills, maintain adequate supply of raw materials, etc. Reserve
Margin or Cushion working capital is the excess over the needs or regular
working capital that should be kept in reserve for contingencies that may
arise at any time. These contingencies include rising prices, business
depression, strikes, experiments with new products, etc.
Temporary or Variable Working Capital
Variable working capital changes with the increase or decrease in the volume
of business. It can also be sub-divided into Seasonal and Special. The
working capital required to meet the seasonal liquidity of the business is
seasonal working capital. On the other hand, special working capital is that
part of the variable working capital which is required for financing the special
operations such as extensive marketing campaigns, experiments with
products or methods of production, special jobs, etc.
FACTORS AFFECTING WORKING CAPITAL
The need of working capital is not always the same. It varies from year to
year or even month to month depending upon a number of factors. There
are no set rules or formulae to determine working capital needs of the firm.
Each factor has its own importance and the importance of factor changes for
a firm over time. In order to determine the proper amount of working capital
of a concern, the following factors should be considered carefully:-
Nature of business: The amount of working capital is basically related to the
nature and volume of the business. In concerns where the cost of raw
materials to be used in the manufacture of a product is very large in
proportion to its total cost of manufacture, the requirements of working
capital will be large. On the contrary, concerns having large investments in
fixed assets require lesser amount of working capital.
Size of the business unit: Size of the business unit is also a determining
factor in estimating the total amount of working capital. The general
principle in this regard is that the bigger the size, the larger will be the
amount of working capital required since the larger business units are
required to maintain larger inventories for the flow of the business.
Seasonal Variations: Strong seasonal movements create special problems of
working capital in controlling the financial swings. A great many companies
have to carry out seasonal business such as sugar mills, oil mills or woollen
mills, etc. and therefore they require larger amount of working capital in the
season to purchase the raw materials in large quantities and utilize them
throughout the year.
Time Consumed in Manufacture: The average time taken in the process of
manufacture is also an important factor in determining the amount of
working capital. The longer the period of manufacture, the larger the
inventory required. Though capital goods industries manage to minimise
their investment in inventories or working capital by asking advances from
the customers as work proceeds on their orders.
Turnover of Circulating Capital: Turnover means the ratio of gross annual
sales to average working assets. In simple words, it means the speed with
which circulating capital completes its rounds or the number of times the
amount invested in working assets have been converted into cash by sale of
the finished goods and re-invested in working assets during a year. The
faster the sales, the larger the turnover. Conversely, the greater the
turnover, the larger the volume of business to be done with given working
capital.
Labour v/s Capital Intensive Industries: In labour intensive industries, larger
working capital is required because of regular payment of heavy wage bills
and more time taken in completing the manufacturing process. The capital
intensive industries require lesser amount of working capital because of the
heavy investment in fixed assets and shorter period in manufacturing
process.
Need to Stockpile Raw Material and Finished Goods: In industries, where it is
necessary to stockpile the raw materials and finished goods, it increases the
amount of working capital tied up in stocks and stores. In certain lines of
business where the materials are bulky and best purchased in large
quantities such as cement, stockpiling is usual. Such concerns require larger
working capital.
Terms of Purchase and Sale: Terms (cash or credit) of purchase and sales
also affect the amount of working capital. If a company purchases all goods
in cash and sells its finished product on credit also naturally, it will require
larger amount of working capital. On the contrary, a concern having credit
facilities and allowing no credit to its customers, will require lesser amount
of working capital. Terms and conditions of purchase and sale are generally
governed by prevailing trade practices and by changing economic conditions.
Conversion of Current Assets into Cash: The need of having cash in hand to
meet the day-to-day requirements, e.g. payment of wages and salaries,
rents, rates, etc. has an important bearing in deciding the adequate amount
of working capital. The greater the cash requirements, the higher will be the
need of working capital.
Growth and Expansion: Growing concerns require more working capital than
those which are static. It is logical to expect larger amount of working
capital in a growing concern to meet its growing needs of funds for its
expansion and/or diversification programmes though it varies with economic
conditions and corporate practices.
Business Cycle Fluctuations: Business cycles affect the requirement of
working capital. At times, when the prices are going up and boom conditions
prevail, the tendency is to pile up a large stock of materials and to maintain
a large stock of finished goods with an expectation to earn more profits. The
other type of business cycle, i.e. depression involves in locking up of a big
amount in working capital as the inventories remain unsold and book debts
uncollected.
Profit Appropriation: Some firms enjoy dominant position in the market due
to quality product or good marketing. On the other hand, a firm facing
extremely tough competition may earn low margins of profits. A high net
profit margin contributes towards working capital provided it is earned in
cash. The working capital requirement will be estimated on how the cash
available is used rightfully. The contribution towards working capital is
affected by the way in which profits are appropriated and therefore it is
affected by taxation, depreciation, reserve policy, etc.
Price Level Changes: The financial manager should also anticipate the effect
of price level changes on working capital requirements of the firm.
Generally, rising price levels will require higher amount of working capital
since to maintain the same level of current assets, higher investment will be
required. The effects of rising price levels will be different for different firms
depending upon their price policies, nature of the product, ability to pass on
the increase to the customer, etc.
Dividend Policy: There is a well established relationship between dividend
and working capital in companies where conservative dividend policy is
followed. The changes in working capital position bring about an adjustment
in the dividend policy. A shortage of cash may induce the management for
reducing cash dividend. On the other hand, strong cash position may justify
higher cash dividend.
Other Factors: In addition to the above, there are a number of other factors
which affect the requirement of working capital. Some of them are the
production and distribution policies, absence of specialisation in the
distribution of products, means of transportation and communication
infrastructure, hazards and contingencies inherent in a particular business,
etc.

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