UNIT – 5 WORKING CAPITAL MANAGEMENT

Concept Of Working Capital Management

 Management term if we describe in general manner means planning,

organizing, directing, controlling of activities.

 Generally company management can be divided into two categories which

are short term and long term. So short term which means day to day
management is known as working capital management. Now let get
detail idea of it.

What Is Working Capital Management?

 Working capital management is a business strategy designed to ensure that a

company operates efficiently by monitoring and using its current assets and
liabilities to the best effect.

 The primary purpose of working capital management is to enable the

company to maintain sufficient cash flow to meet its short-term operating
costs and short-term debt obligations.

Working Capital = Current Asset – Current liabilities

Current assets include anything that can be easily converted into cash within 12
months. These are the company's highly liquid assets. Some current assets include
cash, accounts receivable, inventory, and short-term investments.

Current liabilities are any obligations due within the following 12 months. These
include operating expenses and long-term debt payments.
Meaning of working capital management

 Working capital is the amount of funds needed to operate the routine

operations of business. These are recurring cash purchase of inputs,
payment for input brought on credit, maintenance of various facilities,
Non –recurring payments etc.

 Inputs are materials, labour and other services. Working capital

enables a firm to put fixed assets to operation.

Classification of working capital :

Bank overdraft
Temporary
(short term period)
working capital
Commercial paper
Types of capital

Permenant working
share capital,
(for long term debentures
period) capital

Definitions:

According to the definition of J.S.Mill, “The sum of the current asset

is the working capital of a business”.

According to the definition of Weston and Brigham, “Working

Capital refers to a firm’s investment in short-term assets, cash, short-
term securities, accounts receivables and inventories”.
According to Shubin”Working capital the number of funds necessary to cover the
cost of operating the enterprise”.

Key Points

 Working Capital Management requires monitoring a company's assets

and liabilities to maintain sufficient cash flow.

 The strategy involves tracking three ratios: the working capital ratio,
the collection ratio, and the inventory ratio.

 Keeping those three ratios at optimal levels ensures efficient working

capital management.

1) Working Capital Ratio: The working capital ratio or current ratio is

calculated as current assets divided by current liabilities. It is a key
indicator of a company's financial health as it demonstrates its
ability to meet its short-term financial obligations.

Working capital ratios of 1.2 to 2.0 are considered desirable, but a

ratio higher than 2.0 may suggest that the company is not effectively
using its assets to increase revenues.
Working capital ratio= Current Asset
Current Liability

2) Collection Ratio: The collection ratio is a measure of how efficiently

a company manages its accounts receivables. as if company cannot
receives its due then company may suffer loss. so bad debts amount
should be less.

3) Inventory Ratio: The final element of working capital management is

inventory management. To operate with maximum efficiency and
maintain a comfortably high level of working capital, a company must
 keep sufficient inventory on hand to meet customers' needs while
avoiding unnecessary inventory that ties up working capital.

Features of Working Capital Management

 Short-Term Needs: Working capital is being utilized in acquiring

current assets which will be converted to cash for a short period only.
so it can be said that working capital need is only to meet short term
needs for smooth running of business transactions.

 Circular Movement: Working capital is being converted to cash

constantly which will just be turned as a working capital all over
again. Here due to the short term time period it can be easily
converted into cash and again reconvert in inventory. so can be said
that it is having circular movement.
 The element of Permanency: Although it is just a kind of short
term capital, working capital is needed by a business forever and
always. For growth and Development Company require to pay
equal attention on short term needs also.

 An element of Fluctuation (changes): Working still fluctuates

every now and then even it is something permanent. as market is
highly uncertain. So company must prepare preplan proper for
effective working of business.

 Liquidity: It is very liquid for it can be converted as cash any time

without losing anything.

 Less Risky: Investments in current assets such as working capital

come with less risk for it is just for the short term.

 Special Accounting System No Needed: Since working capital is

a short term asset that will last for a year only, there will be no
need for the adoption of a special accounting system. so it makes
 easy working of accounting system and create less burden for
managers.

NEED OF WORKING CAPITAL MANAGEMENT

Purchase Payment
of Raw of wages
materials & salary

Provide
Day to day credit
expenses obligation
s

1) To run business operations effectively without wastage and hurdles: it is

necessary for any business to operate functions wisely without occurring
wastage. so ultimately it saves the cost of production. Hence quality of
products increases.

2) To maintain liquidity: business situations are always uncertain. so it is very

necessary for company to maintain adequate level of liquidity. so in the
emergency situation firm can easily cope up.
3) To attain expected level of revenues and profit: After proper maintaining
working capital company can easily meet their targets. It is highly chances
that company can meet their expected level of revenue and earn adequate
amount of profit.

4) Purchase of Raw materials: In a manufacturing unit company require huge

amount of raw material to meet day to day requirements. For that company
must have adequate amount of cash to meet this requirement.

5) Payment of wages & salary: Employees are giving their dedications,

utilizing their skills and talents for companies so in return company requires
paying salaries and wages to their employee and workers. it require to pay
on a monthly basis and daily basis. For that company must possess adequate
amount of liquidity.

6) Day to day expenses: Generally companies require maintaining its day to

day obligations. Like stationary, other miscellaneous requirement. so
planning must be done properly to meet this obligations.

7) Provide credit obligations: Here company often does sells in a credit. so

company require to maintain proper balance between credit sales and
purchase. Creditworthiness of customers should be check properly.
credit purchase (30000) - cash – credit sales ( 50000)
Factors Affecting Working Capital Management
 Nature of industry and business

Production cycle time

Shortage of supply of Raw material

Seasonality of Industry

Credit and dividend policy

Taxes

Competition

Price level

Growth and expansion

Structure of current asset and libilities

Expectations

1) NATURE OF BUSINESS AND INDUSTRY

The management of working capital is completely different from industry to

industry. A simple comparison of the service industry and manufacturing industry
can clarify the point. In the service industry, there is no inventory and therefore,
one big component of working capital is already avoided. So, the nature of the
industry is a factor in determining the working capital requirement.
 2) SEASONALITY OF INDUSTRY AND PRODUCTION POLICY

Businesses based on seasons like manufacturing of ACs whose demand peaks in

summer and dips in winter. The requirement of working capital will be more in
summer compared to winter if they are produced in the fashion of their demand.
The policy of producing throughout the year can smoothen the fluctuation of the
working capital requirement.

3) COMPETITION

If the industry is competitive, quick response to customer needs is compulsory and

therefore a higher level of inventory is maintained. Liberal credit terms are also
mandatory with good service to survive in the market. So, higher the competition,
higher would be the requirement of working capital.

4) PRODUCTION CYCLE TIME

The production cycle time refers to the time required for converting the raw
materials into finished goods. Higher, this time, higher would be the time of
blocking funds in the working capital.

5) GROWTH AND EXPANSION

Some industries are static (fixed) and others are growing. Obviously, growing
industry grows the requirement of working capital also as compared to static
industry.

6) SHORTAGE OF SUPPLY OF RAW MATERIAL

If the raw material supply is not smooth for any reason, companies tend to store
more of raw materials than needed and that increased requirement of working
capital.
 7) TAXES
Taxes are often paid in advance. This also blocks a part of working capital.
Depending on the tax environment of the industry, working capital needs are also
affected.

8) DIVIDEND POLICY

Dividend policy determines the level of retained profits with the business and
retained profits are also used for working capital. This is how; dividend policy
affects the need for working capital.

9) PRICE LEVELS

The price levels of inventory and other expenses such as labor rates etc increase
the working capital requirement. If the company also is able to increase the price of
their finished goods, it reduces this impact.

10) STRUCTURE OF CURRENT ASSET AND LIABILITIES

Working capital need is affected by structure of current asset – percentage of

each item to total current asset and also structure of current liabilities. Their
liquidity is also major factor influencing quality of assets. lower the liquidity
equivalent higher the need of working capital.

Asset A 1month Asset B 2 month

From the above it can be that said that asset A 1 is more liquitable than the
asset B as it take only one month for conversation asset in to cash

11)EXPECTATIONS

Working capital need is determined by future expectations. Example, if

management expects raw material prices to increase in future, they may buy
huge quantity today at low prices to meet future contingency. For this, they
will require special working capital. Similarly, if management expects future
 demand for finished goods to go up, it may decide to build up finished goods
inventories. For this special working capital will be needed.

TYPES OF WORKING CAPITAL MANAGEMENT

Types of
working
capital

On the On the
basis of basis of
concept time

gross net permanent temporary

working working or fixed or variable
working working
capital capital capital
capital

regular reserve seasonal special

working working working working
capital capital capital capital

I) On the basis of concept

1) Gross working capital (GWC)

GWC refers to the firm’s total investment in current assets.

 Current assets are the assets which can be converted into cash within an
accounting year (or operating cycle) and include cash, short-term securities,
debtors, (accounts receivable or book debts) bills receivable and stock (inventory).

2) Net working capital (NWC).

NWC refers to the difference between current assets and current liabilities.

Current liabilities (CL) are those claims of outsiders which are expected to
mature for payment within an accounting year and include creditors
(accounts payable), bills payable, and outstanding expenses.

NWC can be positive or negative.

 Positive NWC = CA > CL

 Negative NWC = CA < CL

II) ON THE BASIS OF TIME :-

1) Permanent or fixed working capital :-

 It is also called fixed working capital. It means to carry on the day to day
expenses the firm is required to maintain the minimum amount of working capital.
For example the firm is required to maintain the minimum level of raw material,
finished goods or cash balance etc.

• a) Regular working capital- it means the minimum amount which the firm
has to keep with itself to carry on the day to day operation.

• b) Reserve working capital- it means the excess amount over the regular
working capital for uncertain circumstances like strike, lock out, depression
etc.

2) Temporary working capital:  It is also called variable working capital,

which is required to meet the seasonal demands as well as for special
purposes.

• a) Seasonal working capital- it is required to meet the seasonal needs of the

enterprise.
 • b) Special working capital- it is required for some special purposes of the
enterprise. For example advertising the product of the firm requires special
working capital.

• Temporary working capital is for short period and fluctuates while

permanent working capital is stable and fixed.

OPERATING CYCLE
• Working capital is also called a circulating capital or revolving capital. That
is the money/capital which circulates in various forms of current assets in a
continued manner. For example, at a point of time, funds may be tied up in
raw materials, and then later converted into semi-finished products, then into
finished/ final products and when these finished products are sold, it is
converted either into account receivables or cash.

• This cash is reinvested in current assets. Thus, the amount always keeps on
circulating or revolving from cash to current assets and back again to cash.
That is why some people prefer to use the term liquidity management
instead of working capital management. Although this circulation takes
place at short intervals, the money is required again and again.

• According to I. M. Pandey,

“Operating cycle is the time duration involved in the acquisition of

resources, conversion of raw materials into work- in-process into finished
goods, conversion of finished goods into sales and collection of sales.”

Thus, operating cycle of a manufacturing enterprise involves three phases:

1. Acquisition of resources such as raw material, labour, power and fuel etc.

2. Manufacture of the product which includes conversion of raw material

into work-in-progress into finished goods.

3. Sale of the product either for cash or on credit. Credit sales create account
receivable for collection.

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Cash sales

 Operating Cycle = RMCP+ WIPCP+FGCP+RCP

 RMCP = Raw materials conversion period.
 WIPCP= Work in progress conversion period.
 FGCP = Finished goods conversion period.
 RCP = Receivables conversion period.

 RMCP = 
(Average Stock of Raw Materials/ Raw Material Consumption per Day)
 WIPCP =
(Average Stock of work in progress / Total cost of production per day)
 FGCP =
(Average stock of finished goods / Total cost of Sales per day)
 RCP =
(Average Accounts Receivables / Net credit sales per day)

 Therefore, the circular flow concept of working capital is based upon the
above operating or working capital cycle of a firm.

 Hence, it is inferred that more amount of working capital is required if there

is any long period of operating cycle and vice versa

 Capital/finance is regarded as life-blood of any enterprise. Therefore, the

significance of working capital in an enterprise lies in the fact that its
circulation has to be properly regulated in the business. Because, any over-
circulation or under-circulation may create problems just as improper blood
circulation called high or low blood pressure, in the human body may create
problems.

COMPONANTS OF WORKING CAPITAL MANAGEMENT

 Current Assets Current Liability

Cash in Bills
Hand Payable
Cash at Sundry
Bank Creditors
Bills Outstanding
Receivable Expenses

Sundry Debtors Short-term Loans and

Advances
Short-term
Dividend
Loans Advances
Payable

Inventories Bank
Overdraft
Prepaid
Expenses Provision for
Taxation
Accrued
Income

SOURCES OF WORKING CAPITAL MANAGEMENT

 1) Spontaneous source

The word ‘spontaneous’ itself explains that this source of working capital is
readily or easily available to the business in the normal course of business
affairs. The quantum and terms of this credit depend on the industry norms
and the relationship between buyer and seller. These sources include trade
credit.

The biggest benefit of spontaneous sources as working capital is its

‘effortless raising’ and ‘insignificant cost’ compared to traditional ways of
financing.

Maximum credit limit, the period of credit, and discount on cash payment.
Each supplier will have a maximum credit limit defined for the buyer
depending on the business capacity and creditworthiness of the buyer.
Similarly, the credit period is defined say 30 days, 45 days etc. Discount on
cash payment is allowed to the buyer if the payment immediately on buying
the materials. This percentage of discount is an opportunity cost for the
buyer.
E.G.- Trade creditors, Bills payable

2) Short term sources of working capital

Tax and dividend provisions are current liabilities and cannot be delayed. The fund
that would have been used in paying these provisions act as working capital till the
point these are not paid.

Short-term working capital finance availed from banks and financial institutions
are costly compared to spontaneous and long-term sources in terms of rate of
interest but have great time flexibility.

Due to time flexibility, the finance manager can use the funds and pay interest on
the money which his business utilizes and can pay them anytime when cash is
available.
Overall, in comparison to long-term sources where you have to hold funds even
when not required, these facilities prove cheaper.

E.G. – Bank overdraft,

Cash credits, Commercial paper

3) Long term sources of working capital

Long-term sources can also be divided into internal and external sources. Long-
term internal sources of finance are retained profits and provision for depreciation
whereas external sources are Share Capital, long-term loan, and debentures.

Long-term Internal Sources.

RETAINED PROFIT
PROVISION FOR DEPRECIATION

Long-term External Sources

SHARE CAPITAL
LONG-TERM LOAN
DEBENTURES

Retained profits and accumulated depreciation are as good as funds available to the
business without any explicit cost. These are the funds completely earned and
owned by the business itself. They are utilized for expansion as well as working
capital finance.

Long-term external sources of finance like share capital is a cheaper source of

finance but is not commonly used for working capital finance.

Working capital can be classified as temporary working capital and permanent

working capital. It is advisable to use long-term sources for permanent and short-
term sources for temporary working capital requirements. This will optimize the
working capital cost and enforce good working capital management practices.