WORKING CAPITAL

Meanings
 Outcome of the lecture
1. To understand the meaning of working capital
2. To understand the significance of working
capital
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 UNIT 5
Working Capital
Meanings of working capital Also Called
/Circulating Capital/Revolving Capital:

1.Working capital is the short term capital

required by a business for its operations.

2.The short term period means time equal to or

less than one year.
Working Capital- Example

1.The situation when we make a new hotel is CAPITAL

BUDGETING /LONG TERM INVESTMENT
DECISION………this decision is for many years.
2.The situation when we RUN a new hotel is called
WORKING CAPITAL DECISION…..and normally
accounting standards of the world say that we have to
make ONE YEAR OPERATIONS RESULT for every
business. Like: Balance sheet and Trading and Profit
and Loss Account.(It is for one year).
WORKING CAPITAL
 Concept of Working Capital(Kinds)

Working capital of a business can be studied in

following FOUR kinds:
1.GROSS CONCEPT: It is sum/addition of all current
assets in the balance sheet of a business like:
Inventory;
Sundry debtors;
Bills receivables;
Cash in hand and at Bank;
Prepaid Expenses etc.
Concept of Working Capital(Kinds)
2.NET WORKING CAPITAL:
Net working Capital is the difference between
Current Assets and Current Liabilities.
NWC=CA-CL
(NWC=Net Working Capital
CA=Current Assets
CL=Current liabilities)
……………………………………….cont.next
Concept of Working Capital(Kinds)
Current Assets are already discussed in previous
slide.
Current Liabilities can be:
1.Sundry Creditors
2.Wages and Expenses Payables
3.Short term borrowings
4.Overdraft facility/cash credit facilities etc.
Concept of Working Capital(Kinds)
ON THE BASIS OF TIME:
PREMANENT/FIXED WORKING CAPITAL:
1.It is the part of working capital which is
permanent and fixed for a given business.
2.It can be regular working capital or reserve
working capital
Concept of Working Capital
ON THE BASIS OF TIME:
VARIABLE WORKING CAPITAL:
This type of working capital is not fixed and
hence varying as per the need of the business. It
may be SEASONAL or SPECIAL .
Difference between Permanent and
Temporary working capital
 Assessment Task???

From the balance sheet given on previous slide:

Find:
1.Current Assets
2.Current liabilities
3.Net Working Capital
4.Current Ratio(Hint Current Ratio=C/A-C/L)
 Working Capital -Determinants

Working Capital determinants meaning:

Determining working capital means to literally
find what is the amount of working capital
needed by a business at a particular point of
time.
 Determinants of working capital
For determining the amount of working capital we have
to consider various underlying factors, like:
1.Nature of business:
It means the nature of business definitely affects the size
of working capital. For example:
1.Seasonal factory like a sugar mill need more working
capital when crushing or sugar cane starts in October of
every year till March next.
2.Ship construction companies need more money in
initial years when a ship making is under progress.
 Working Capital Determinants
2.AGE OF BUSINESS:
Already established businesses has got more
bases and relationships management in
comparison to new businesses.
It is therefore possible that the Current Assets
and Current Liabilities composition of Old
businesses is different in comparison to new
businesses.
 Working Capital Determinants
3.COMPETITION LEVEL:
The more competitive a business is ;more the
working capital is needed.

4.STAGE OF BUSINESS:
The growing business need more working capital
in relation of stable and declining businesses.
 Working Capital Determinants
5.PHILOSPHY OF MANAGEMENT:
Some management boards are more conservative
in approach in relation to aggressive approached
ones. Hence there is more working capital
needed in conservative approached businesses
than the ones who are aggressively approached.
 Working Capital Determinants

6. SIZE OF BUSINESS:
The largest the size of a business the greater the
amount of working capital needed and vice versa
of medium and smaller businesses.
 Working Capital Determinants
7. STRENGTH OF FINANCIAL STATEMENT:
The more powerful balance sheet of business
means that the business has got more profits and
reserves to provide for working capital.
Similarly, losses stricken businesses has got
different composition and pattern of assets and
liabilities(in comparison to powerful businesses
as discussed).
 Working Capital Determinants
Operating Cycle and Cash Cycle:
The operating cycle and cash cycle of a business
definitely affects Working Capital. Companies
with long operating and Net cycle need more
working capital than companies with
average/moderate or smaller operating/net cycle
respectively.
 Operating Cycle
Operating Cycle Meanings:
Operating Cycle is the time required from
beginning of the production or manufacturing
process till completion of the production or
manufacturing process.
The longer the operating cycle; the more the
working capital needed and vice versa
for smaller the operating cycle; the lesser the
working capital needed.
 Operating Cycle
Thus operating cycle is the time required to convert the raw
material into finished goods through a process of manufacturing
or production.
Similarly;Cash cycle is the time between cash spending and cash
receipt.
 Operating Cycle
• The operating cycle of a company consists of time
period between the procurement of inventory and the
collection of cash from receivables.
• The operating cycle is the length of time between the
company’s outlay on raw materials, wages and other
expenses and inflow of cash from sale of goods.
• Operating cycle is an important concept in
management of cash and management of working
capital because the LENGTH of operating cycle is
ONE of the working capital determinants.
Duration of Operating Cycle
Operating Cycle in DAYS
 Operating Cycle-Types
Operating Cycle is of TWO types:
1.Gross Operating Cycle: It is the time required
from raw material purchase to raw material
storage to raw material in process(Work in
progress) to finished goods to finished goods in
stock to finished goods sold on credit(Debtors)
to time required to collect money from debtors.
 Operating Cycle-Types
Net Operating Cycle(NOC):
It is Gross Operating Cycle(GOC) less creditors
Payment period(CPP).
NOC=GOC-CPP
(Actually Operating Cycle tells us what is the amount required to carry the process.
Gross Operating Cycle(GOC) tells us the maximum amount needed to carry the
process(Gross).
Net Operating Cycle is the adjustment made with reference to credit amount by suppliers.
The reason being the amount of credit given by raw material suppliers reduce the gross
amount needed as per GOC.
Therefore NOC=GOC-CPP)……SEE PREVIOUS SLIDE OF…OPERATING CYCLE IN
DAYS/
 Profitability and Liquidity Trade Off

Liquidity meanings:
It is the amount of easily cash convertible(liquid)
resources needed to carry the business operations
like cash; bank balance etc.
Profitability Meanings:
Profitability is the amount of earnings resulting
in profits of a business.
 Liquidity and profitability Tradeoff

The tradeoff between liquidity and profitability is as follows:

1.The more liquidity a business has the less profitability is it
having and risk is also very low.
2.The less liquidity a business has the more profitability is it
having but risk is very high.
3.The average liquidity a business has the average profitability
is it having along with average risk.
(Idle resources(more cash in hand etc.) are very bad and therefore the profitability is very low and
risk is also very low etc. THEREFORE THERE IS NEED TO HAVE RIGHT SIZE OF
LIQUIDITY FOR PROFITABILITY face to face RISK. Excess as well as Lesser Liquidity both
are not good; there is need to balance the liquidity for optimum profitability with reference to
capacity of business to bear risk).
 Liquidity vs profitability
• Measurement of Liquidity:
• The liquidity is normally measured with the help of the following
financial ratios:
• (a) Current Ratio;
• (b) Liquid Ratio;
• (c) Absolute Liquidity Ratio;
• (a) Current Ratio:
• It is the relation between the amount of current assets and the amount
of current liabilities. It is essentially a tool for measuring short-term
liquidity and solvency position of firms. In other words, it may be stated
that this ratio is taken to measure the margin of safety of current assets
over current liabilities that the management of a firm maintains in
obtaining business finance from short-term sources.
 Liquidity vs profitability
• Generally, a 2 : 1 ratio is considered as normal
(i.e., for every two rupees of current assets
there is only one rupee of current liability) and
it expresses the satisfactory liquidity position
But current ratio alone cannot be accepted as
an indicator of firm’s liquidity without
qualification.
 Liquidity vs profitability
• (b) Liquid Ratio:
• It is the ratio between total liquid assets to total
liquid liabilities. The normal for such ratio is taken to
be 1:1. As a tool for assessment of liquidity position
of firms, it is considered to be much better than that
of the current ratio as it eliminates the snags in the
same, since it indicates the relationship between
strictly liquid assets whose realizable value is almost
certain on the one hand, and strictly liquid liabilities
on the other.
 Liquidity vs profitability
• (c) Absolute Liquidity Ratio:
• Liquid ratio measures the relationship between
cash and near cash items on the one hand and
immediately maturing obligation on the other. But
as the composition of cash and near cash items in
the calculation of liquid ratio, comprises accounts
receivable also, doubts have been expressed about
the efficacy even of this ratio as a flawless tool for
measuring liquidity position of a firm.
 Liquidity vs profitability
• Meaning of Profitability:
• Profitability of a firm is represented by the
rate of return on its capital employed.
• This is measured as:
 MCQ
• In finance, "working capital" means the same
thing as
A total assets.
B fixed assets.
C current assets.
D current assets minus current liabilities.
 MCQ
• A
 MCQ
Which of the following would be consistent with a
more aggressive approach to financing working
capital?
A Financing short-term needs with short-term funds.
B Financing permanent inventory buildup with long-
term debt.
C Financing seasonal needs with short-term funds.
D Financing some long-term needs with short-term
funds.
 MCQ
• D
 MCQ
Which asset-liability combination would most likely result in the
firm's having the greatest risk of technical insolvency?
A Increasing current assets while lowering current liabilities.

B Increasing current assets while incurring more current liabilities.

C Reducing current assets, increasing current liabilities, and

reducing long-term debt.

D Replacing short-term debt with equity.

 MCQ
• C
 MCQ
Which of the following illustrates the use of a hedging (or
matching) approach to financing?
A Short-term assets financed with long-term liabilities.

B Permanent working capital financed with long-term liabilities.

C Short-term assets financed with equity.

D All assets financed with a 50 percent equity, 50 percent long-

term debt mixture.
 MCQ
• B
 MCQ
In deciding the appropriate level of current assets for the
firm, management is confronted with
A a trade-off between profitability and risk.

B a trade-off between liquidity and marketability.

C a trade-off between equity and debt.

D a trade-off between short-term versus long-term

borrowing.
 MCQ
• A
 MCQ
………. varies inversely with profitability.
A Liquidity.

B Risk.

C Blue.

D False.
 MCQ
• A
 MCQ
Spontaneous financing includes
A accounts receivable.

B accounts payable.

C short-term loans.

D a line of credit.
 MCQ
• B
 MCQ
Permanent working capital
A varies with seasonal needs.

B includes fixed assets.

C is the amount of current assets required to meet a

firm's long-term minimum needs.

D includes accounts payable.

 MCQ
• C
 MCQ
Financing a long-lived asset with short-term financing would be
A an example of "moderate risk -- moderate (potential)
profitability" asset financing.

B an example of "low risk -- low (potential) profitability" asset

financing.

C an example of "high risk -- high (potential) profitability" asset

financing.

D an example of the "hedging approach" to financing.

 MCQ
• C
 MCQ
Net working capital refers to
A total assets minus fixed assets.

B current assets minus current liabilities.

C current assets minus inventories.

D current assets.
 MCQ
• B