Working capital: Meaning, Concepts, Needs

Working capital Working capital typically means the firms holding of current or short-term assets such as cash, receivables, inventory and marketable securities. These items are also referred to as circulating capital Corporate executives devote a considerable amount of attention to the management of working capital.

Definition of working capital Working Capital refers to that part of the firms capital, which is required for financing short-term or current assets such a cash marketable securities, debtors and inventories. Funds thus, invested in current assets keep revolving fast and are constantly converted into cash and this cash flow out again in exchange for other current assets. Working Capital is also known as revolving or circulating capital or short-term capital. Capital required for a business can be classified under two main categories via, 1) Fixed Capital 2) Working Capital Every business needs funds for two purposes for its establishment and to carry out its day- to-day operations. Long terms funds are required to create production facilities through purchase of fixed assets such as plant & machinery, land, building, furniture, etc. Investments in these assets represent that part of firms capital which is blocked on permanent or fixed basis and is called fixed capital. Funds are also needed for short-term purposes for the purchase of raw material, payment of wages and other day to-day expenses etc. These funds are known as working capital. In simple words, working capital refers to that part of the firms capital which is required for financing short- term or current assets such as cash, marketable securities, debtors & inventories. Funds, thus, invested in current assts keep revolving fast and are being constantly converted in to cash and this cash flows out again in exchange for other current assets. Hence, it is also known as revolving or circulating capital or short term capital. CONCEPT OF WORKING CAPITAL There are two concepts of working capital: 1. Gross working capital 2. Net working capital

The gross working capital is the capital invested in the total current assets of the enterprises current assets are those Assets which can convert in to cash within a short period normally one accounting year. There are two definitions of working capital (1) Gross working capital (2) Net working capital Gross working capital refers to working capital as the total of current assets, whereas the net working capital refers to working capital as excess of current assets over current liabilities. In other words net working capital refers to current assets financed by long term funds. Accordingly, Gross working capital = Total current assets Net working capital = Current assets Current liabilities The net working capital position of the firm is an important consideration, as this will determine the firms profitability and risk. Here the profitability refers to profits after expenses and risk refers to the probability that a firm will become technically insolvent where it will be unable to meet obligations when they become due for payment. A finance manager has to make an appropriate financing mix, which will limit the risk and increase the profitability. Financing mix refers to the proportion of current assets financed by current liabilities and long term funds. There are two approaches which determine the financing mix (1) Aggressive approach (2) Conservative approach. According to aggressive approach the long term funds are used to finance only the core or fixed portion of current assets (e.g., minimum level of finished goods inventory, raw material etc) and the other portion i.e. temporary and seasonal requirements are financed by short term funds. This is of high risk and high profit financing mix. According to conservative approach the total current assets are financed from long term sources and short term sources are used only in emergency situation i.e. when there is an unexpected cash outflow. This is of low-risk and low-profit financing mix. As we observed two methods of financing mix, one method is of high risk high profit and other is of risk low profit. A finance manager has to trade off between these two extremes. Operating Cycle: The objective of financial management is to maximize the shareholders wealth. So it is needed to generate sufficient profits. The profits generated depend mainly on sales volume. When the goods are being sold on credit as is the normal practice of business firms today to cope with increased competition the sale of goods cannot be converted into cash instantly because of time lag between sales and realization of cash.

As there is a time lag between sales and realization of receivables there is a need for sufficient working capital to deal with the problem which arises due to lack of immediate realization of cash against goods sold. The operating cycle is the length of time required for conversion of non-cash assets into cash. This operating cycle refers to the time taken for the conversion of cash into raw material, raw materials into work-in-progress, work-in-progress into finished goods, finished into receivables into cash and this cycle repeats. The operating cycle length differs from firm to firm. If a firm has lengthy production process or a firm has liberal credit policy the length of operating cycle will be more. On the other hand, if a firm does not extent credit or the firm is not a manufacturing concern i.e. where cash will be converted into inventory directly then the length of operating cycle will be reduced to a greater extent.

The length of operating cycle can be calculated by calculating periods of raw material storage, work in process, finished gods storage and debtors collection period. 1. 2. 3. 4. 5. Raw materials storage period=Average stock of raw materials and stores/ Average daily consumption of raw material and stores Work in process period=Average work in process inventory /Average cost of production per day Finished goods storage period=Average finished goods inventory / Average cost of goods sold per day Debtors collection period= Average book debts / Average credit sales per day Length of operating cycle = 1+2+ 3+4

Need of Working Capital The need for working capital (gross) or current assets cannot be over emphasized. Given the objective of financial decision making to maximize the shareholders wealth, it is necessary to generate sufficient profits. The extent to which profits can be earned will naturally depend, among other things, upon the magnitude of the sales. A successful sales programmer is, in other words, necessary for earning profits by any business enterprise. However; sales dont convert into cash instantly: there is invariably a time lag between the sale of goods and the receipt of the cash. There is therefore, a need for working capital in the form of the current assets to deal with the problem arising out of the lack of immediate realization of cash against goods sold. Therefore sufficient working capital is necessary to sustain sales activity. Technically, this is referred to as the operating or cash cycle. The operating cycle can be said to be at the heart of the need of working capital. The continuing flow from the cash to suppliers, to inventories to accounts receivable and bank into cash is what is called the operating cycle.