Inspira- Journal of Modern Management & Entrepreneurship 83

ISSN : 2231–167X, Volume 01, No. 02, October, 2011, pp.83-91

Working Capital Management and Corporate Performance

Ravi Kant Modi

Working Capital Management is controlling & managing the current

assets of a firm. Working capital management is management for the short
term. This is of critical importance to a firm. As pointed out in the survey,
managers spend about 70% in respect of managing for the short-term
management. Every day companies takes in money, write receipts, check
balances, maintain receivables records, manage inventory and the like. Also,
short term management should not be discounted. As the old saying goes, “If
you can make it in the short term long enough, you do not need to worry
about the long-term”.
An organization should properly plan to its working capital. In the
absence of proper planning of working capital, an organization may face at
one time inadequate working capital and at the other time excess working
capital. Need for working capital to continue the daily operational activities of
business cannot be overemphasized. The need for maintaining an adequate
working capital can hardly be questioned. Just as the circulation of blood is
very necessary in the human body to maintain life, similarly the flow of funds
is very necessary to maintain business. If it becomes weak, the business will
hardly progress, prosper and survive. Sooner or later it will topple down. By
maintaining an adequate amount of working capital, the concern is able to
maintain sound credit and avoid insolvency, take advantage of cash discount
facility offered by suppliers and bargain profitably in any transaction, carry
out expansion programmes, undertake research and innovations. In fact,
every activity of a business, howsoever microscopic it may be, affects the
working capital position directly or indirectly.
Adequate working capital ensures regular payment of dividends to
the share-holders. In the absence of adequate working capital, profits may be
used to cover up the inadequacy of the working capital and consequently the
shareholders will be deprived of the dividends. The concern may lose its
prospective and potential investors for its future issue.


Faculty Member, Department of Commerce, LBS PG College, Tilak Nagar, Jaipur
84 Inspira- Journal of Modern Management & Entrepreneurship: October, 2011

Concept of Working Capital

Working Capital has two concepts: the first is the “Gross Concept”
and the second is the “Net Concept”. Both the concepts of working capital are
also known as “Quantitative concept and qualitative concept.” The net
concept of working capital has been called as the “qualitative” concept and
the gross concept as the “quantitative” concept of working capital.
The first concept of working capital, i.e. gross concept is related to the
investment in current assets of an organisation. Current assets are those which
are converted or changed into cash within an accounting period. Gross
concept of working capital refers to the total of current assets. It is also known
as circulating/current capital or the sum of total current assets of a business
and quantitative concept. Actually, gross working capital concept indicates
towards the current assets management in two ways:-
1. The level of current assets; and
2. The financing of current assets.
The level of current assets should be adequate as per needs of the
business surplus and inadequate investment in .current assets should be
avoided since both are detrimental to the business. The finance manager
should be aware of taking necessary timely action regarding this matter well
in time. Financing of current assets points towards the management of needed
funds. Funds should not remain idle. The finance manager should have an
appropriate knowledge of investment avenues where funds should be
invested according to risk in profitability.
The net concept of working capital or qualitative approach
differentiates between assets and current liabilities. Current liabilities are
those claims of outsiders which are expected to mature for payment within an
accounting year and include creditors, bills payable, bank overdraft and
outstanding expenses.
In character the net concept is useful to all the creditors like sundry creditors,
suppliers or short term loan and advance. So, the qualitative concept indicates
two things:
1. The liquidity position and financial soundness of a business.
2. Suggests the level of working capital to what extent needs may be financed
by the permanent sources of funds.

Thus, we find that both the net and gross concepts of working capital
have their own uses and merits. The gross concept is a going concern concept
in which management is particularly interested because for the productive
utilization of fixed assets, all the current assets are necessary. The net concept
is useful to gauge the financial soundness of a concern and is of special
interest to sundry creditors and suppliers of short term loans and advances. It
Working Capital Management and Corporate Performance …. 85

creates complete confidence among the creditors about the security of their
amounts.
Every activity of a business directly or indirectly affects the current
position of an enterprise. So, its needs should be properly estimated and
calculated. A proper estimate of working capital requirements is very
necessary for any organisation to run its affairs successfully, efficiently and
profitably. However, there are no set rules or formula to determine the
working capital requirements. A large number of factors influence the
working capital needs of a firm. The factors are of different nature and
importance. Working capital requirements of a business concern are
determined by a wide variety of factors-Internal and External.
Requirements of working capital of a business concern depend upon a
large number of factors as nature and size of business, manufacturing cycle,
business fluctuations, production policy, the rate of stock turnover and the
state of economic situation. It is not possible to rank them because all such
factors are of different importance and the influence of individual factors
changes for a firm over time. It is rightly observed that “there is no precise
way to determine the exact amount of gross or net working capital for every
enterprise. The data and problem of each company should be analysed to
determine the amount of working capital”. These factors are:
(1) Nature of Business
(2) The Size of Business Operations
(3) Production Cycle
(4) Business Fluctuation Cycles
(5) Credit Policy
(6) Availability of Credit
(7) Production Policy
(8) Seasonal Variations
(9) Rate of Stock Turnover
(10) Future Interest Rates
(11) Changes in Price Level
(12) Other Factors
There are also many other factors which affect the working capital
requirements such as management’s ability, import policy, importance of
labour, banking facilities, operating efficiency etc.
Techniques of Estimating Working Capital
To estimate the requirement of working capital becomes a difficult
and complicated problem in any concern at a particular level of production.
To solve this problem there are various techniques, which are successfully
applied in practice.
86 Inspira- Journal of Modern Management & Entrepreneurship: October, 2011

The following techniques are generally used in estimating working capital

for the future period-
 Percentage of Sales Method .
 Operating Cycle Method
 Projected Balance-Sheet Method
 Adjusted Profit and Loss Method
 Regression Analysis Method
Main techniques are discussed as follows—
(1) Percentage of Sales Method
This method is based on a certain percentage of estimated sales to
project the working capital requirements.
It determines the relationship between working capital and sales on
the basis of past experience. It is an easy method to calculate and estimate the
working capital requirements. But because of assumption of linear
relationship, it cannot be used universally.
(2) Operating Cycle Method
The operating cycle of a business concern is the concern of one
particular current asset to the other current assets. It begins with the purchases
of raw materials and ends with the collection of accounts receivables.
It may be classified into four stages as under—
(i) Raw material storage stage
(ii) Work in progress stage
(iii) Finished goods storage stage
(iv) Receivables collection stage
Each stage has its operating cycle and sum of all operating cycle stages,
is the total durations of operating cycle.
Symbolically it can be presented thus :
OC = M+W+F+D-C
Here OC = Operating Cycle Period
M = Materials Storage Period
W = Work in Progress
F = Finished Goods Storage Period
D = Debtors Collection Period
C = Creditors Payment Period
The computation of the above components of operating cycle may be
described as under—
Average stock of Raw Materials
Materials Storage Period (M) = --------------------------------------------------------
Average Consumption of Raw materials Per Day
Average stock of Work in Progress
Work-in-Progress (W) = ----------------------------------------------
Average Work Cost Per Day
Working Capital Management and Corporate Performance …. 87

Average Stock of Finished Goods

Finished Goods Storage Period (F) = ------------------------------------------------
Daily Average Cost of Goods Sold

Average Debtors+Bills Receivables

Debtors Collection Period (D) = --------------------------------------------------
Credit Sales Per Day

Average Creditors+Bills Paybles

Creditors Payment Period( C ) = ----------------------------------------------
Credit Purchases Per Day

365/Days of Year
No. of Operating Cycles = -----------------------------
Operation Cycle Period

Total Operating Expenses

Working Capital = C+OC×CS or -----------------------------------------
N No. of Operating Cycles

Here C = Cash Balance Required

OC = Operating Cycle Period
CS = Estimated Cost of Goods Sold.
N = No. of Days in a Year.
(3) Projected Balance Sheet Method
Under this method, estimates of different assets and liabilities are
made taking into consideration the transaction in the ensuing period.
Thereafter a balance sheet is prepared based on these forecast assets and
liabilities that are known as projected balance sheet.
The difference between current assets and current liabilities is treated
as working capital. This method is applicable to most of the financial business
concerns.
(4) Adjusted Profit and Loss Method
According to this method, estimated profit is calculated based on the
transactions of the ensuing period. Thereafter increase or decrease in working
capital is computed, adjusted the estimated profit by cash inflow and cash
outflow.
(5) Regression Analysis Method
In the sphere of working capital management regression analysis
method helps in making estimation after establishing the average relationship
in the past years between sales, and working capital and it's various
88 Inspira- Journal of Modern Management & Entrepreneurship: October, 2011

components. The analysis can be carried out through the graphic portrayals or
mathematical equations. The relationship between working capital and sales
may be simple linear, curvilinear and multiple regressions. It can be applied in
a simple or complex situation.
Adequacy of Working Capital
Financial management always wants to maintain adequate working
capital for smooth running of any business and maximizing returns on
investment. The need for maintaining adequate working capital can hardly be
questioned.
Just as the circulation of blood is very necessary in the human body to
maintain life, similarly to maintain the health of a concern smooth flow of
funds is very necessary. Inadequate amount of working capital can warn to
the solvency of business concern if it fails to meet its current obligations. Many
a time business failure takes place due to lack of working capital. It is
generally observed that inadequate working capital is a business ailment.
Working capital should be just adequate not more, not less to the needs of the
business concern since the working capital is considered the life blood and
controlling nerve centre of a business.
An organisation has to maintain adequate working capital for the
following reasons—
1. It is possible to pay to all current liabilities soon and to take benefits of
cash discount.
2. It ensures to a great extent, the maintenance of a company’s credit
standing and provides for such emergencies as strikes, floods, and fire
etc.
3. It protects a business from adverse effects of shrinkage in the value of
current assets.
4. It enables a company to extend favorable credit terms to its customers.
5. It enables a company to operate its business more efficiently because
there is no delay in obtaining materials, inventory etc.
6. It permits carrying of inventories at a level that would enable a business
to serve satisfactorily the needs of its customers.
7. Because of inadequate working capital, there may be operating losses or
decreasing retained earnings.
8. Due to shortage of working capital, there may be excessive non
operating or extraordinary wages.
9. It enables a business to withstand period of depression smoothly.
10. Current funds may be invested in noncurrent assets.
11. The management may fail to obtain funds from other sources for the
purposes of expansion.
12. There may be an unwise dividend policy.
Working Capital Management and Corporate Performance …. 89

13. Management may fail to accumulate funds required for redemption of

debentures on maturity.
14. Increasing price may necessitate large investment in inventories and
fixed assets.
Adequacy of working capital is much important from the business point
of view. The amount of working capital should be adequate and sufficient to
operate the business in an efficient manner. More investment in working
capital must be avoided because it impairs an organization's profitability as
idle investment does not earn anything.
Policy For Working Capital
The Principle test of working capital policy in an enterprise is as
follows:
Level of Working Capital

Liquidity Structural Health

Circulation

Test of Working Capital Policy

1. Level of Working Capital
This should be maintained by a careful study of the movements of
working capital in successive periods. If a management can develop a pattern
in these movements, this pattern will serve as a guide to its changing
requirements in relation to certain decisions which are made from time to
time.
2. Structural Health
The relative health of the various components of working capital, viz,
inventory, accounts receivables, cash and bank balances, etc.,) should be
considered from the point of view of liquidity. It is necessary to draw
structural relationship in respect of each component constituting the current
assets.
3. Circulation
This is an important feature of the liquid position and fnvolves the
natural activity cycle of an enterprise. Ratios may be calculated to show the
average period required for the conversion of raw material into finished
goods, finished goods into sales and sales into cash.
90 Inspira- Journal of Modern Management & Entrepreneurship: October, 2011

4. Liquidity
Liquidity is the ability of the firm to meet its current obligations as
they fall due Similarly, Liquidity is the case with which assets may be
converted into cash without loss. Further, The ratios are called ‘Liquidity
ratios’ because they give an indication of the degree of liquidity or Moneyness
of the current assets of the company. A more comprehensive test to measure
liquidity may be adopted by using the following three ratios, each expressed
as a percentage of:
(a) Working capital to current assets;
(b) Inventories to current assets; and
(c) Liquid resources to current assets.
Thus, the aim of working capital management is to manage a concern’s
current assets and current liabilities in such a way that a satisfactory level of
working capital is maintained. This is so because if the concern cannot
maintain a satisfactory level of working capital, it is likely to become insolvent
and even be forced into bankruptcy. Each of the current assets must be
managed efficiently in order to maintain the liquidity of a concern while not
keeping too high a level of any one of them. Each of short term sources of
financing must be continuously managed to ensure that they are obtained and
used in the best possible way.
Proper management of working capital is very important for the success
of a concern. It aims at protecting the purchasing power of assets and
maximizing the return on investments.” “The manner of management of
current assets to a very large extent determines the success of operations of a
concern. Constant management is required to maintain appropriate levels in
the various working capital accounts. Cash and financial budget aid in
establishing proper proportions, sales expansion, dividend declaration, plant
expansion, new product lines increased salaries and wages, rising price level
etc. add strain on working capital maintenance.
The management of working capital is becoming increasingly important
as organisations realise that approximately half of their investment are in
working capital. Current assets should be large enough to cover current
liabilities in order to ensure a reasonable margin of safety. For daily expenses,
adequacy of working capital is necessary because if working capital is
inadequate then a firm can not run its business well. Mismanagement of
working capital also leads the business towards loss.
Working capital management has emerged as a major factor in the
profitability of business. This has been caused in part by the high cost of funds
and the complexities of the business.
Thus, sufficient working capital management is very necessary for
smooth operations of a concern. Management accountants must pay adequate
Working Capital Management and Corporate Performance …. 91

attention to the assets of working capital and its components both on the
assets as well as liability side.

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