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Working Capital Management

Module-III

Prepared by: T.DILLESWAR RAO, Sr. Lecturer, GIMS, GUNUPUR


Introduction of Working Capital Management
Working capital management is the device of finance. It is related to management of current
assets and current liabilities. After learning working capital management, finance people can
use this tool for fund flow analysis. Working capital is very significant for paying day to day
expenses and long term liabilities.
Working capital (abbreviated WC) is a financial metric which represents operating liquidity
available to a business, organization, or other entity, including governmental entity. Along
with fixed assets such as plant and equipment, working capital is considered a part of
operating capital. Net working capital is calculated as current assets minus current liabilities.
It is a derivation of working capital, that is commonly used in valuation techniques such as
DCFs (Discounted cash flows). If current assets are less than current liabilities, an entity has
a working capital deficiency, also called a working capital deficit.
Working Capital = Current Assets
Net Working Capital = Current Assets Current Liabilities
Net Operating Working Capital = Current Assets Non Interest-bearing Current Liabilities
Equity Working Capital = Current Assets Current Liabilities Long-term Debt
A company can be endowed with assets and profitability but short of liquidity if its assets
cannot readily be converted into cash. Positive working capital is required to ensure that a
firm is able to continue its operations and that it has sufficient funds to satisfy both maturing
short-term debt and upcoming operational expenses. The management of working capital
involves managing inventories, accounts receivable and payable, and cash.
Calculation: Current assets and current liabilities include three accounts which are of special
importance. These accounts represent the areas of the business where managers have the most
direct impact:
Accounts receivable (current asset)
Inventory (current assets), and
Accounts payable (current liability)
The current portion of debt (payable within 12 months) is critical, because it represents a
short-term claim to current assets and is often secured by long term assets. Common types of
short-term debt are bank loans and lines of credit.
An increase in working capital indicates that the business has either increased current assets
(that is has increased its receivables, or other current assets) or has decreased current
liabilities, for example has paid off some short-term creditors.
Working capital management:
Decisions relating to working capital and short term financing are referred to as working
capital management. These involve managing the relationship between a firm's short-term
assets and its short-term liabilities. The goal of working capital management is to ensure that
the firm is able to continue its operations and that it has sufficient cash flow to satisfy both
maturing short-term debt and upcoming operational expenses
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By definition, working capital management entails short term decisions - generally, relating
to the next one year period - which is "reversible". These decisions are therefore not taken on
the same basis as Capital Investment Decisions (NPV or related, as above) rather they will be
based on cash flows and / or profitability.
One measure of cash flow is provided by the cash conversion cycle - the net number of days
from the outlay of cash for raw material to receiving payment from the customer. As a
management tool, this metric makes explicit the inter-relatedness of decisions relating to
inventories, accounts receivable and payable, and cash. Because this number effectively
corresponds to the time that the firm's cash is tied up in operations and unavailable for other
activities, management generally aims at a low net count.
In this context, the most useful measure of profitability is Return on capital (ROC). The result
is shown as a percentage, determined by dividing relevant income for the 12 months by
capital employed; Return on equity (ROE) shows this result for the firm's shareholders. Firm
value is enhanced when, and if, the return on capital, which results from working capital
management, exceeds the cost of capital, which results from capital investment decisions as
above. ROC measures are therefore useful as a management tool, in that they link short-term
policy with long-term decision making.
Credit policy of the firm: Another factor affecting working capital management is credit
policy of the firm. It includes buying of raw material and selling of finished goods either in
cash or on credit. This affects the cash conversion cycle.
Management of working capital:
Guided by the above criteria, management will use a combination of policies and techniques
for the management of working capital. These policies aim at managing the current assets
(generally cash and cash equivalents, inventories and debtors) and the short term financing,
such that cash flows and returns are acceptable.
Cash management: Identify the cash balance which allows for the business to meet day to day
expenses, but reduces cash holding costs.
Inventory management: Identify the level of inventory which allows for uninterrupted
production but reduces the investment in raw materials - and minimizes reordering costs - and
hence increases cash flow. Besides this, the lead times in production should be lowered to
reduce Work in Progress (WIP) and similarly, the Finished Goods should be kept on as low
level as possible to avoid over production - see Supply chain management; Just In Time
(JIT); Economic order quantity (EOQ); Economic quantity
Debtors management: Identify the appropriate credit policy, i.e. credit terms which will
attract customers, such that any impact on cash flows and the cash conversion cycle will be
offset by increased revenue and hence Return on Capital (or vice versa); see Discounts and
allowances.
Short term financing: Identify the appropriate source of financing, given the cash conversion
cycle: the inventory is ideally financed by credit granted by the supplier; however, it may be
necessary to utilize a bank loan (or overdraft), or to "convert debtors to cash" through
"factoring".
Meaning and Concept of Working Capital and its management
Working capital is that part of companys capital which is used for purchasing raw material
and involve in sundry debtors. We all know that current assets are very important for proper
working of fixed assets. Suppose, if you have invested your money to purchase machines of
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company and if you have not any more money to buy raw material, then your machinery will
no use for any production without raw material. From this example, you can understand that
working capital is very useful for operating any business organization. We can also take one
more liquid item of current assets that is cash. If you have not cash in hand, then you can not
pay for different expenses of company, and at that time, your many business works may delay
for not paying certain expenses. If we define working capital in very simple form, then we
can say that working capital is the excess of current assets over current liabilities.
Types of Working Capital
1. Gross working capital
Total or gross working capital is that working capital which is used for all the current assets.
Total value of current assets will equal to gross working capital.
2. Net Working Capital
Net working capital is the excess of current assets over current liabilities.
Net Working Capital = Total Current Assets Total Current Liabilities
This amount shows that if we deduct total current liabilities from total current assets, then
balance amount can be used for repayment of long term debts at any time.
3. Permanent Working Capital
Permanent working capital is that amount of capital which must be in cash or current assets
for continuing the activities of business.
4. Temporary Working Capital
Sometime, it may possible that we have to pay fixed liabilities, at that time we need working
capital which is more than permanent working capital, then this excess amount will be
temporary working capital. In normal working of business, we dont need such capital.
In working capital management, we analyze following three points
Ist Point
What is the need for working capital?
After study the nature of production, we can estimate the need for working capital. If
company produces products at large scale and continues producing goods, then company
needs high amount of working capital.
2nd Point
What is optimum level of Working capital in business?
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Have you achieved the optimum level of working capital which has invested in current
assets? Because high amount of working capital will decrease the return on investment and
low amount of working capital will increase the risk of business. So, it is very important
decision to get optimum level of working capital where both profitability and risk will be
balanced. For achieving optimum level of working capital, finance manager should also study
the factors which affects the requirement of working capital and different elements of current
assets. If he will manage cash, debtor and inventory, then working capital will automatically
optimize.
3rd Point
What are main Working capital policies of businesses?
Policies are the guidelines which are helpful to direct business. Finance manager can also
make working capital policies.
1st Working capital policy
Liquidity policy
Under this policy, finance manager will increase the amount of liquidity for reducing the risk
of business. If business has high volume of cash and bank balance, then business can easily
pays his dues at maturity. But finance manger should not forget that the excess cash will not
produce and earning and return on investment will decrease. So liquidity policy should be
optimized.
2nd Working Capital Policy
Profitability policy
Under this policy, finance manger will keep low amount of cash in business and try to invest
maximum amount of cash and bank balance. It will sure that profit of business will increase
due to increasing of investment in proper way but risk of business will also increase because
liquidity of business will decrease and it can create bankruptcy position of business. So,
profitability policy should make after seeing liquidity policy and after this both policies will
helpful for proper management of working capital.
There are a number of factors which determine the amount of working capital requirements in
business. Therefore, it is not possible to give general principles applicable to all enterprises
equally. It is desirable to analyze the factors in the context of each particular unit. We may
point out some basic factors influencing working capital requirements.
(1) Nature and Volume of Business: The nature and volume of business is an important factor
in deciding the amount of working capital. For example, the amount of working capital is
generally more in trading concerns and in service units as compared to the manufacturing
units. The retail trading units have also to invest large funds in working capital. In some
manufacturing units also, the working capital holds a significant place. On the other hand,
public utilities require less working capital. Other manufacturing units need more working
capital as compared to public utilities.
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The relation between the volume of business and the requirement of working capital is more
direct and clear. The bigger the size of the units, the more will be the requirement of working
capital.
(2) Length of Manufacturing Cycle: The time that elapses from the purchase and use of raw
materials to the production of finished goods is called manufacturing cycle. The longer the
period a manufacturing cycle takes, the larger is the amount of working capital required,
because the funds get locked up in production process for a longer period of time.
It is in view of this that, when alternative methods of production are available, the method
with the shortest manufacturing cycle should be chosen (assuming other factors to be equal).
Once a choice is made, care is taken to see that the manufacturing cycle is completed within a
specified period. Any delay in production is bound to increase the requirement of working
capital.
(3) Business Fluctuations: Business fluctuations are of two types: seasonal fluctuations which
arise out of seasonal changes in demand for the product and cyclical fluctuations which occur
due to ups and downs of economic activities in the country as a whole.
If demand for the product is seasonal, production will have to be increased during the season,
and it will have to be reduced during the off-season. Correspondingly, there will be
fluctuations in the requirement of working capital. The business unit will have to face some
other problems in addition to this one. It has to bear extra expenses to increase production
when product demand increases. It has to bear, costs even to maintain work force and
physical facilities during slack season. For this reason, many units prefer to continue
production even during slack season and increase the level of their inventories.
The cyclical fluctuations are made up of periods of prosperity and depression. The sales and
prices increase during prosperity necessitating more working capital in the form of
inventories and book-debts. If new investment is made in fixed capital to meet additional
demand for the product, then also there will be an increase in working capital requirement.
Generally, business units adopt the policy to borrow funds on a large scale to increase
investment in working capital. As against this, the requirement of working capital gets
reduced during depression and therefore they adopt the policy of reducing their short term
debts.
(4) Production Policy: The production policy of business is also an important determinant of
working capital requirement. If the policy of Constant Production is adopted, there are two
possible effects. If demand for the product is regular and constant, this policy helps in
reducing working capital requirement to the lowest possible level. But if demand for the
product is seasonal, this policy raises the level of inventory during off season and thereby
increases the working capital requirement. If the cost of maintaining inventory is
considerably high, the policy of varying production according to demand is preferred. If the
unit produces varied products, it can reduce the requirement of working capital by adjusting
the structure of production to the changes in demand.
(5) Credit Policy: In the present-day circumstances, almost all units have to sell goods on
credit. The nature of credit policy is an important consideration in deciding the amount of
working capital requirement. The larger the volume of credit sales, the greater will be the
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requirement of working capital. Also, the longer the period the collection of payment takes,
the greater will be the requirement of working capital.
Generally, the credit policy of an individual firm depends on the norms of the industry to
which the firm belongs. Yet it is possible to pursue different credit policies for different
customers in accordance with their creditworthiness. To ignore creditworthiness of the
individual customers can be dangerous to the firm. In addition, it is necessary that the firm
should be prompt in collection of payments. Any slackness in this respect will increase the
requirement of working capital and will increase the chance of bad debts
(1) Availability of Credit: The amount of credit that a firm can obtain, as also the length of the
credit period significantly affects the working capital requirement. The greater the prospects
of getting credit, the smaller will be its requirement of working capital because it can easily
purchase raw materials and other requirements on credit.
Creditworthiness can also the interpreted to mean that the firm can function smoothly even
with a smaller amount of working capital if it is assured that it can obtain loans from the bank
immediately and easily. The firm does not need then to keep a wide margin of safety.
(2) Growth and Expansion: The working capital requirements increase with growth and
expansion of business. Hence planning of the working capital requirements and its
procurement must go hand in hand with the planning of the growth and expansion of the firm.
The implementation of the production plan that aims at the growth or expansion of the unit
necessitates more of fixed capital and working capital both.
Even the expansion of the volume of sales increases the requirements of working capital. Of
course, it is difficult to establish a quantitative relationship between them. An important point
to be noted is that the requirements of working capital emerge before the growth or expansion
actually takes place.
(3) Profit and its Distribution: The net profit of a firm is a good index of the resources
available to it to meet its capital requirements. But, from the viewpoint of working capital
requirement, it is the profit in the form of cash which is important, and not the net profit. The
profit available in the form of cash is called cash profit and it can be assessed by adding or
deducting non-cash items from the net profit of the firm. The larger the amount of cash profit,
the greater will be the possibility of acquiring working capital.
But, in fact the entire amount of cash profit may not be available to meet working capital
needs. The portion of cash profit which is available for this purpose depends on the profit
distribution policy. The policies with regard to distribution of dividends, ploughing back of
profit and tax payments will determine the portion of cash profit which the firm can use to
meet its working capital needs. Even depreciation policy can influence the amount of cash
available, as depreciation of capital assets is deductible item of expenditure and it reduces tax
liability.
(4) Price Level Fluctuations: A general statement may be made that with price rise, a firm
will require more funds to purchase its current assets. In other words, the requirements of
working capital will increase with the rise in prices. But all firms may not be affected equally.
The prices of all current assets never go up to the same extent. Price of some current assets
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rise less rapidly than those of the others. Hence for the firms which use such current assets,
the working capital need will increase by a smaller amount. Besides, if it is possible to pass
on the burden of high prices of raw materials to the customers by raising the prices of final
product, then also there will be no increase in working capital requirements.
(5) Operating Efficiency: If a firm is efficient, it can use its resources economically, and
thereby it can reduce cost and earn more profit. Thus, the working capital requirement can be
reduced by more efficient use of the current assets.

Working Capital Calculation


Before discuss about how working capital is calculated, it is essential to define a couple of
terms who have quite a bit to do with the calculation of working capital.
Current Assets
Another little something we hear a lot but don't know the meaning of. The definition of
current assets is indeed quite ambiguous and contextual. Current assets are generally those
assets which can be liquidated quickly or whenever you need them liquidated. While this
seems fairly straightforward, the ambiguity revolves around the word 'quickly'. How quickly
is quickly? Different answers are given by different companies in different industries. But the
general assumption is that when you look to the assets side of the balance sheet, certain items
like cash-in-hand, cash at bank, marketable securities and working inventory and debtors
(again, debatable) make the grade as current assets.
Current Liabilities
The definition of current liabilities, in contrast, is fairly simple. Current liabilities are those
liabilities that might have to be paid any time soon. The payment date for current liabilities is
not fixed and the debt might mature anytime. But then again, a long term loan is not and
never will be a current liability, even if it has to be paid off tomorrow. Current liabilities are
simply those liabilities which you might have to pay up for anytime. So typically current
liabilities is the sum of the amount owed to creditors and, sometimes, bills payable.
Working Capital
Simply, working capital is calculated as:
Working Capital = Current Assets Current Liabilities
In the formula means that the working capital ought to be positive i.e. the total of the current
assets should be more, often twice as much for the sake of unforeseen risk factors, the total of
the current liabilities.

Determinants of Working Capital:-There are a number of determinants of working capital. There is no particular set or formula
to determine the working capital requirements of firms. Diversified factors having different
importance, influences working capital needs of firms. Again the importance of factors also
changes for a firm over time. So it is important to analyse the relevant factors to determine
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the total investment in working capital. The following are the some important factors
influencing the requirements of working capital of a firm:-1. Nature of business
2. Seasonality of operations
3. Production cycle
4. Production policy
5. Credit Policy
6. Market conditions
7. Conditions of supply
Nature of Business: The working capital requirement of a firm depends on the nature of the
business. For example, a firm involved in sale of services rather than manufacturing or a firm
is allowing only cash sales. In the first instance, no investment is required in either raw
materials or WIP or finished goods, while in the second instance there exists no receivables as
there is immediate realization of cash
Hence the requirement of working capital will be lower.
Seasonality of Operations:
If the product of the firm has a seasonal demand like refrigerators, the firms need high
working capital in the periods of summer, as the demand for the refrigerators is more and the
firm needs low working capital in the periods of winter, as the demand for the product is low.
Production Cycle:
The term production cycle refers to the time involved in the manufacture of goods. It covers
the time span between the procurement of the raw materials and the completion of the
manufacturing process leading to the production of goods. As funds are necessarily tied up
during the production cycle, the production cycle has a bearing on the quantum of working
capital. The longer the time span of production cycle, the larger will be the funds tied up and
therefore the larger the working capital needed and vice versa.
Production Policy:
The quantum of working capital is also determined by production policy. In case of the firms
having seasonal demand of the products like refrigerators, air coolers etc., The production
policy of the firm determines the amount of working capital requirement. If the firm has
production policy to carry production at a steady level to meet the peak demand, this will
result in a large accumulation of finished goods (inventories) during the off-seasons and the
abrupt sale during the peak season. The progressive accumulation of finished goods will
naturally require an increasing amount of working capital. If the firm has production policy to
produce only when there is a demand then the firm needs low working capital during the
slack season and high working capital during season.
Credit Policy:
The level of the working capital is also determined by the credit policy, as the firms credit
policy determines the amount of receivables. If the firm has a liberal credit policy, then the
firm needs high working capital and the firm needs low working capital if the companys
credit policy does not allow it to extend credit to the buyers.
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Market Conditions:
The working capital requirements are also determined by the market conditions. In case of
the high degree of competition prevailing in the market the firm has to maintain larger
inventories as customers are not inclined to wait for the product. This needs higher working
capital requirements. If there is good demand for the product and the competition is weak, a
firm can manage with smaller inventory of finished goods, as customers can wait for the
product if it is not available in the market. Thus, a firm can manage with low inventory and
will need low working capital requirements.
Conditions of Supply:
The availability of raw materials and spares also determine the level of working capital. If
there is ready availability of raw materials and spares, a firm can maintain minimum
inventory and need less working capital. If the supply of raw materials is unpredictable, then
the firm has to acquire stocks as and when they are available for ensuring continuous
production. Thus, the firm needs to maintain larger inventory average and needs larger
requirement of working capital.
Current Assets Financing Policy
After establishing the level of current assets, the firm must determine how these should be
financed. What mix of term capital and short term debt should the firm employ to support its
current assets?
For the sake of simplicity assets are divided into two classes, viz. fixed assets and current
assets. Fixed assets are assumed to grow at a constant rate which reflects the secular rate of
growth in sales. Current assets, too, are expected to display the same long term rate of
growth; however, they exhibit substantial variation around the trend line, thanks to seasonal
(or even cyclical) patterns in sales and/or purchases.
The investment in current assets may be broken into two parts: permanent current assets and
temporary current assets. The former represents what the firm requires even at the bottom of
its sales cycle.
The latter reflects a variable component that moves in line with seasonal fluctuations.
Several strategies are available to a firm for financing its capital requirements. Three
strategies are illustrated by lines A,B, and C below.
Strategy A: Long term financing is used to meet fixed asset requirement as well as peak
working capital requirement. When the working capital requirement is less than its peak
level, the surplus is invested in liquid assets (cash and marketable securities).
Strategy B: Long term financing is used to meet fixed assets requirement, permanent working
capital requirement, and a portion of fluctuating working capital requirement. During
seasonal swings, short-term financing is used during seasonal down swing surplus is invested
in liquid assets.
Strategy C: Long term financing is used to meet fixed asset requirement and permanent
working capital requirement. Short term financing is used to meet fluctuating working capital
requirement.
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The Matching Principle:


According to this principle, the maturity of the sources of financing should match the
maturity of the assets being financed. This means that fixed assets and permanent current
assets should be supported by long term sources of finance whereas fluctuating current assets
must be supported by short term sources of finance.
The rationale for the matching principle is fairly straightforward. If a firm finances a long
term asset (say, machinery) with a short term debt (say, commercial paper), it will have to
periodically refinance the asset. Whenever the short term debt falls due, the firm has to refinance the assets. This is risky as well as inconvenient. Hence, it makes sense to ensure that
the maturity of the assets and the sources of financing are properly matched.
Operating cycle and cash cycle:
The investment in working capital is influenced by four key events in the production and
sales cycle of the firm:
1. Purchase of raw materials
2. Payment of raw materials
3. Sale of finished goods
4. Collection of cash for sales
The firm begins with the purchase of raw materials which are paid for after a delay which
represents the cost payable period. The firm converts the raw material to finished goods and
then sells the same. The time lag between the purchase of raw materials and the sale of
finished goods is the inventory period. Customers pay their bills sometimes after the sales.
The period that elapses between the date of sales and the date of collection of receivables is
the accounts payable period (debtors period).
The time that elapses between the purchase of raw materials and the collection of cash for
sales is referred to as the operating cycle, whereas the time between the payment for raw
materials purchases and the collection of cash for sales is referred to as the cash cycle. The
operating cycle is the sum of the inventory period and the accounts receivable period,
whereas the cash cycle is equal to the operating cycle less, the accounts payable period.
From the financial statements of the firm, we can estimate the inventory period, the accounts
receivable period, and the accounts payable period.

Estimation of working capital requirement


Working capital plays a very important role in day-to-day working of the business. If mistake
is committed in estimating the working capital, it can create considerable difficulty for the
management. In spite of having enough long-term capital, there are instances when
companies have gone into liquidation due to non-availability of working capital. The finance
manager has to be extra careful while estimating requirement of working capital for various
time periods.
Thus the question of estimation of working capital requirement assumes great importance.
The level of activity and the time period of production cycle are important. The credit
allowed to debtors and credit available from creditors, have also to be taken into account.
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In estimating working capital, current assets have to be carefully estimated and at the same
time current liabilities have also to be estimated. The difference between the two gives the net
amount of working capital.
Thus, Current Assets in the form of investment in (i) stock of raw material (ii) stock of workin-progress (iii.) stock of finished goods (iv) debtors (v) expenses paid in advance (vi)
minimum cash required etc. are estimated. Out of this, current liabilities like (i) creditors for
purchase of goods (ii) creditors for expenses (iii) advance received from customers etc. are
deducted to obtain the Net Working Capital.
(1) Stock of Raw Materials: The total quantity of production and the time period for
which raw materials are to be kept in stock are two important factors determining the
investment in stock of raw materials e.g. if the raw materials remain in stock for two
months before it is issued to production and if the monthly consumption of materials
is Rs. 40,000, then the value of stock of raw materials considered for working capital
requirements is Rs. 80,000.
(2) Wages and Overheads: The amounts unpaid for wages and overheads are treated as
current liabilities. It depends upon the lag in the payment of wages and overheads. If
monthly wages are Rs. 1, 20,000 and lag in payment of wages is 1/2 month, it means that
unpaid wages would be Rs. 60,000.
(3) Stock of Work in Progress: In a manufacturing business, there is bound to be some
work in the process of manufacture at any moment of time. This is work in progress. It is
to value on the basis of raw materials used, wages paid and overheads paid for the period
for which it remains in stock.
(4) Stock of Finished Goods: After the goods are finished in the factory, it is shifted to the
warehouse, where it will lie, till it is dispatched to the customers. The time period for
which the finished goods remain in go down and its cost of production decide the amount
locked up the stock of finished goods.
(5) Debtors: When goods are sold on credit the value of sales made is blocked till the
amount is collected. This amount is the investment in debtors. While estimating the
amount, the period of credit granted to debtors is taken into account.
There are two methods of showing debtors in current assets for the purpose of computing
working capital (i) Investment in debtors is taken at sales value which includes profit also
and (ii) It is taken at cost of sales value, which does not include profit. The second
alternative is more logical.
6) Advance Payments: Sometimes, expenses are paid in advance or some advance is paid
against purchases. Income-tax is also paid in advance. These advance payments are
treated as part of current assets for the purpose of computation of working capital.
(7) Minimum Cash Balance: The Company requires minimum cash balance (including
bank balance) to be maintained for meeting day-today expenses. This is treated as part of
current assets.
(8) Credit Allowed by Creditors: The credit allowed by the suppliers when materials are
purchased, reduces the requirement of working capital. Suppose the average monthly
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purchase is Rs. 50,000 and creditors allow one month credit, then the creditors included
in current liabilities are Rs. 50,000.
(9) Time lag in Payment of Expenses: Wages and other expenses are generally not paid
immediately. It is paid after a gap of some time, say one month. So one month is called
time lag in payment. On the basis of the monthly expenses, the amount outstanding for
expenses is calculated and is treated as a current liability.
(10) Advance from Customers: Sometimes, advance is received from customers, which
reduces the amount of working capital required. Hence it becomes a part of current
liabilities.
The total of current liabilities is deducted from total current assets. The difference is the
requirement of working capital.

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