UNIT IV

WORKING CAPITAL MANAGEMENT

Working capital management is the fund available for meeting day-to-day requirements of an
enterprise. It is a fact that a part of the fixed or permanent capital is invested in assets, which are kept in
the business permanently or for a longer period, for the purpose of earning profit. Similarly, yet another
part of permanent capital available for supporting the day-to-day normal operations, in known as working
capital. The working capital produces various costs namely materials, wages and expenses. These costs
usually lead to production and sales in case of manufacturing concerns and sales alone in others. In
accounting, working capital is the difference between the inflow and outflow of funds or it denotes
excess amount of current assets over the value of current liabilities.
DIFFERENT CONCEPTS OF WORKING CAPITAL:
GROSS CONCEPT:
Gross (concept) working capital is the amount of funds invested in the various components of
current assets. Current assets includes cash in hand, cash at bank, short term investments, debtors, bills
receivable, stock of raw materials, work in progress, stock of finished goods, prepaid expenses and
advance payment of expenses and other assets which are converted into cash with in one year. This
concept has the following advantages:
Gross working capital provides the correct amount of working capital at the right time.
It enables a firm to realize the greatest return on its investment.
It enables a firm to plan and control funds and to maximise the return on investment.
For these advantages, gross working capital has become a more acceptable concept in financial
management.
NET CONCEPT:
Net working capital refers to the excess of current assets over its current liabilities. Current
liabilities are those liabilities, which are expected to mature for payment within an accounting year.
Current liabilities includes creditors, bills payable, outstanding expenses and income received in
advance.Net working capital cash be positive or negative. A positive net working capital will arise when
current assets exceed current liabilities. A negative net working capital will arise current liabilities exceed
current assets.
SIGNIFICANCE OF GROSS AND NET CONCEPTS:
The two concepts have equal significance from management point of view. The gross concepts
focus attention on a) optimum investment in current assets and b) Financing of current assets. It should be
realized that the working capital needs of the firm may be fluctuating with the changing business activity.
This may cause excess or shortage of working capital frequently. The management should take action and
correct imbalances.
Another aspect of gross working capital points to the need of arranging funds to finance current
assets. Whenever a need for working capital funds arises, arrangement should be made quickly. Similarly,
if some surfaces funds arise, they should be invested in short term securities.
Net working capital concept covers the judicious mix of long term and short term funds for
financing current assets. For every firm, a minimum amount of net working capital is permanent.
Therefore it should be financed with the permanent sources of funds such as equity capital, preference
capital, debentures and retained earnings. Management must therefore decided the extent to which current
assets should be financed with long term funds.
Importance of Gross concept:
Gross concept provides correct amount of working capital at right time.

 Every management is more interested in the total current assets it has to operate.
Every increase in funds of the company would increase in its working capital.
This concept would be useful to determine the rate of return on investment for company organisation
where there is a divorce between ownership management and control.
Importance of Net concept:
It is qualitative concept the indicated the firms ability to meet its operating expenses and short-term
liabilities.
It indicate the margin of protection available to short term creditors.
It is an indicator of financial soundness of company.
It is suitable for sole trading concern and partnership firm.
TYPES OF WORKING CAPITAL
Working capital can be divided into two categories on the basis of time:
1. Permanent working capital.
2. Temporary working capital.
3. Gross working capital.
4. Net working capital.
PERMANENT WORKING CAPITAL:
This refers to that minimum amount of investment in all current assets which is required at all
times to carry out minimum level of business activities. In other words, it represents the current assets
required on a containing basis over the entire year. Tandon committee has referred to this type of working
capital as core current assets.
Amount of permanent working capital remains in the business in one form or another. This is
particularly important from the point of view of financing. The suppliers of such working capital
should not expect its return during the life-time of the firm.
It also grows with the size of the business. In other words, greater size of the business, greater is the
amount of such working capital and vice-versa.
Permanent working capital is permanently needed for the business and therefore, it should be
financed out of long term funds.
The diagrams given below illustrate the difference between permanent and temporary working
capital. In figure I permanent working capital is fixed over a period of time, while temporary working
capital is fluctuating. In figure 2, the permanent working capital increasing over a period of time with
increase in the level of business activity. This happens in case of a growing company. Hence the
permanent working capital line is not horizontal with the base line in fig. 1.

Amount of Working capital (Rs)

Temporary
or Fluctuating
Permanent

Operating cycle
A sales do not convert into cash instantly; there is invariably a time lag between the sale of
goods and the receipt of cash. There is, therefore, a need for working capital in the form of current assets
to deal with the problem arising out of 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 Cycle. The operating cycle can be said to be the heart of the need for working capital.
The continuing flow from cash to suppliers, to inventory, to accounts receivables and back into cash is
what is called the operating cycle
FACTORS DETERMINING WORKING CAPITAL:
Determinants of Working Capital:
General nature of business
Production cycle
Business cycle
Production policy
Credit policy
Growth and expansion
Vagaries in the availability of Raw material
Profit level
Level of taxes
Dividend policies
Depreciation policy
Price level changes
Operating efficiency
Nature of Business:
The nature of business is an important determinant of the level of the working capital. Working
capital requirements depend upon the general nature or type of business. They are relatively low in public
utility concerns, in which the inventories and receivables are rapidly converted into cash. Manufacturing
organizations, however, face problems of slow turnovers of inventories and receivable and invest large
amounts in working capital.
Time:
The level of working capital depends upon the time required to manufacture goods. If the time is
longer, the size of working capital is great. Moreover, the amount of working capital depends upon
inventory turnover and the unit cost of the goods that are sold. The greater this cost, the bigger is the
amount of working capital.
Volume of Sales:
This is the most important factor affecting the size and components of working capital. A firm
maintains current assets because they are needed to support the operational activities which result in sales.
The volume of sales and size of the working capital are directly related to each other. As the volume of
sales increases, there is an increase in the investment of working capital in the cost of operations, in
inventories and receivable.

Terms of Purchases and Sales:

If the credit terms of purchases are more favorable and those of sales less liberal, less cash will be
invested in inventory. With more favourable credit terms, working capital requirements can be reduced. A
firm gets more time for payment to creditors or suppliers. A firm gets more time for payment to creditors
or suppliers. A firm which enjoys greater credit with banks needs less working capital.
Inventory Turnover:
If the inventory turnover is high, the working capital requirements will be low. With a better
inventory control, a firm is able to reduce its working capital requirements. While attempting this, it
should determine the minimum level of stock which it will have to maintain throughout the period of its
operations.
Receivable Turnover:
It is necessary to have an effective control of receivable. A prompt collection of receivable and
good facilities for settling payable result into low working capital requirements.
Business Cycle:
Business expands during periods of prosperity and declines during the period of depression.
Consequently, more working capital is required during periods of prosperity and less during the periods of
depression. During marked upswings of activity, there is usually a need for larger amounts of capital to
cover the lag between collection and increased sales and to finance purchases of additional materials to
support growing business activity. Moreover, during the recovery and prosperity phase of the business
cycle, prices of raw materials and wages tend to rise require additional funds to carry even the same
physical volume of business. Later, as the depression run its course, the concern may find that it has a
larger amount of working capital on hand than current business volume may justify.
Variation in Sales:
A seasonal business requires the maximum amount of working capital for a relatively short period
of time.
Production cycle:
The time taken to convert raw materials into finished products is referred to as the production
cycle or operating cycle. The longer the production cycle, the greater is the requirement of working
capital. An utmost care should be taken to shorten the period of the production cycle in order to minimize
working capital requirements.
Liquidity and Profitability:
If a firm desires to take a greater risk for bigger gains or losses, it reduces the size of its working
capital in relation to its sales. If it is interested in improving its liquidity, it increases the level of its
working capital. However, this policy is likely to result in a reduction of the sales volume, and therefore,
of profitability and decide about its working capital requirements accordingly.

Inflation
As a result of inflation, size of the working capital is increased in order to make it easier for a firm
to achieve a better cash inflow. To some extent, this factor may be compensated by the rise in selling price
during inflation.
Seasonal Fluctuations:
Seasonal fluctuations in sales affect the level of variable working capital. Often the demand for
products may be of a seasonal nature. Yet inventories have got to be purchased during certain seasons
only. The size of the working capital in one period may, therefore, be bigger than that in another.
Repayment Ability:
A firms repayment ability determines the level of its working capital. The usual practice of a firm
is to prepare cash flow projections according to its plans of repayment to fix working capital levels
accordingly.
Change in Technology:
Technological developments related to the production process have a sharp impact on the need for
working capital.
Size of the Firm:
A firms size, either in terms of its assets or sales, affects its need for working capital. Bigger
firms, with many sources of funds, may need less working capital as compared to their total assets or
sales.
Attitude of Risk:
The greater the amount of working capital, the lower is the risk of liquidity.
ADEQUACY OF WORKING CAPITAL:
The working capital should be adequate for the following reasons:
It protects the business from the adverse effects of shrinkage in the value of assets.
It is possible to pay all the obligations promptly and to take advantage of cash discount.
It ensures to a greater extent the maintenance of a companys credit standing and provides for such
emergencies as strikes, floods, fibres etc.
It permits the carrying of inventories at a level that would enable a business to serve satisfactorily the
needs of its customers.
It enables a company to extend favourable credit terms to customers
It enables a company to operate its business more efficiently because there is no delay in obtaining
materials, etc., because of there is no delay in obtaining materials, etc., because of credit difficulties.
It enables a business to withstand periods of depression smoothly.
There may be operating losses or decreased retained earnings.
There may be excessive non-operating or extraordinary losses.
The management may fail to obtain funds from other sources for purposes of expansion.
There may be an unwise dividend policy.
Current funds may be invested in non-current assets.
The management may fail to accumulate funds necessary for meeting debentures on maturity.

 There may be increasing price necessitating bigger investments in inventories and fixed assets.
When working capital is inadequate a company faces the following problems:

It is not possible for it to utilize production facility fully for want of working capital.
A company may not be able to take advantage of cash discount facilities.
The credit-worthiness of the company is likely to be jeopardized because of lack of liquidity.
A company may not be able take advantage of profitable business opportunities.
The modernization of equipment and even routine repairs ad maintenance facilities may be difficult to
administer.
A company will not able to pay its dividends because of the non availability of funds.
A company can not afford to increase its cash sales and may have restrict its activities to credit sales
only.
A company may have to borrow funds at exorbitant rates of interest.
Its low liquidity may lead to low profitability in the same way as low profitability results in low
liquidity.
Low liquidity would positively threaten the solvency of the business.

Dangers of Excessive Working Capital:

Too much working capital is as dangerous as too little of it. Excessive working capital raises the following
problems:
A Company may be tempted to over trade and lose heavily.
A Company may keep very big inventories and tie up its funds unnecessarily.
There may be an imbalance between liquidity and profitability.
A Company may enjoy high liquidity and, at the same time, suffer from low profitability.
High liquidity may induce a company to undertake greater production, which may not have a
matching demand. It may find itself in an embarrassing position unless its marketing policies are
property a fertile ground for later over-capitalisation.
A Company may invest heavily in its fixed equipment, which may not be justified by actual sales or
production. This may provide a fertile ground for later over-capitalisation.
Excessive working capital may be as unfavourable inadequacy of working capital because of the large
volume of funds not being used productively.
The availability of excess working capital may lead to carelessness about costs and therefore, to
inefficiency of operations.
SOURCESS OF SHORT TERM WORKING CAPITAL:
Short term working capital involves financing of day to day business operations not exceed a year.
This source may be classified in (i) as internal and (ii) external sources.
INTERNAL SOURCES:
1.Depreciation funds:
This fund is created out of profits which provide a good source of working capital.
2.Provision for taxation:
There is time lag between making the provision for and payment of taxation to Government. This
may be utilized during the intermittent period temporarily.

3.Accrued expenses:
The Company some times postpone certain expenditure which it has received services already.
These accrued expenses are a limited sources of short term finance.
4.Deferred Income:
Deferred income or income received in advance represents funds received for goods and services
which the company has agreed to supply in future. It constitutes an important source of finance.
EXTERNAL SOURCES:
1. Trade Credit:
It refers to the credit that a company gets from suppliers of goods in the normal course of business.
It is a major source of finance and normally every concern uses this as a normal trade practices. There are
three types of trade credit namely a) open account b) notes payable and c) Trade acceptance. In open
account supplier supply goods on credit and agrees to pay the due as per the sales invoice. This credit is
based on credit worthiness of the buyer and he need not sign any debt instrument for the amount due to
the seller. Some times the trade credit may be in the form of bills payable. A bill is a formal
acknowledgement of an obligation to repay the outstanding amount. In trade acceptance seller draws a bill
on buyer ordering him to pay the bill on future date.
2. Bank Credit:
After trade credit, bank credit is the most important source of financing working capital
requirements in India. A bank consists firms sales and production plans and the current assets in
determining its financial requirements. A firm can borrow funds in the following forms. A)old b) cash
credit c)bills and d) loan etc.
3. Customers Credit:
Advance may also be obtained from customers against contract entered into by the firm. Such
advance amount can be used for working capital.
4. Public Deposits:
Large and small firm have received public deposits in recent years in finance their working capital
requirements. A firm can accept this deposit only up to 25% of its share capital and reserves. Accompany
is offered no security against this deposit.
5. Inter corporate deposits:
A deposit made by one company with another for a period up to six month is known as inter
corporate deposits.
6. Factoring:
A factor is a financial institution which offers services to management and financing of debts
arising from credit sales.
7. Commercial Paper:
Commercial paper represents short-term unsecured promissory notes issued by firms, which enjoy a
fairly high credit rating. Generally large firms with considerable financial strength are able to issue
commercial paper. The important features of commercial papers are as follows:
The maturity period of commercial paper ranges from 60 to 180 days.
Commercial paper is sold at discount from its face value and redeemed at its face value.
Commercial paper is either directly placed with investors or sold through dealers.
Investors who intend holding it till its maturity usually buy commercial paper. Hence there is no
well-developed secondary market for commercial paper.
8. Loan from Managing Director of Directors:
Some times directors or managing director of the company provide loans to the company at a very
negligible or no rate of interest.
9.Government Assistance:

Government provides short-term finances to firms by allowing them tax concessions, loans, to
assist their production.

SOURCES OF WORKING CAPITAL

INTERNAL SOURCES
Depreciation
Provision for tax
Accrued Expenses
Deferred Income

EXTERNAL SOURCES
Trade Credit
Bank Credit
Customers Credit
Public Deposits
Factoring
Commercial Paper