INTRODUCTION TO WORKING CAPITAL

Working Capital is the Life-Blood and Controlling Nerve Center of a

business
The working capital precisely refers to management of current assets. A
firms working capital consists of its investment in current assets, which
include short-term assets such as:
Cash and bank balance,
Inventories,
Receivables (including debtors and bills),
Marketable securities.
Working capital is commonly defined as the difference between current assets
and current liabilities.

WORKING CAPITAL = CURRENT ASSETS-CURRENT LIABILITIES

There are two major concepts of working capital:

Gross working capital
Net working capital

Gross working capital:

It refers to firm's investment in current assets. Current assets are the assets,
which can be converted into cash with in a financial year. The gross working
capital points to the need of arranging funds to finance current assets.

Net working capital:

It refers to the difference between current assets and current liabilities. Net
working capital can be positive or negative. A positive net working capital
will arise when current assets exceed current liabilities. And vice-versa for
negative net working capital. Net working capital is a qualitative concept. It
indicates the liquidity position of the firm and suggests the extent to which
working capital needs may be financed by permanent sources of funds. Net
working capital also covers the question of judicious mix of long-term and
short-term funds for financing current assets.

Significance Of Working Capital

The management of working capital is important for several reasons:

For one thing, the current assets of a typical cellular firm account for half of
its total assets. For a distribution company, they account for even more.
Working capital requires continuous day to day supervision. Working
capital has the effect on company's risk, return and share prices,
There is an inevitable relationship between sales growth and the level of
current assets. The target sales level can be achieved only if supported by
adequate working capital Inefficient working capital may lead to
insolvency of the firm if it is not in a position to meet its liabilities and
commitments.

LIQUIDITY VS PROFITABILITY: RISK - RETURN TRADE OFF

Another important aspect of a working capital policy is to maintain and provide

sufficient liquidity to the firm. Like the most corporate financial decisions, the
decision on how much working capital be maintained involves a trade off- having
a large net working capital may reduce the liquidity risk faced by a firm, but it
can have a negative effect on the cash flows. Therefore, the net effect on the value
of the firm should be used to determine the optimal amount of working capital.
Sound working capital involves two fundamental decisions for the firm. They are
the determination of:
The optimal level of investments in current assets.
The appropriate mix of short-term and long-term financing used to support
this investment in current assets, a firm should decide whether or not it should
use short-term financing. If short-term financing has to be used, the firm must
determine its portion in total financing. Short-term financing may be preferred
over long-term financing for two reasons:
The cost advantage
Flexibility
But short-term financing is more risky than long-term financing. Following table
will summarize our discussion of short-term versus long-term financing.

Maintaining a policy of short term financing for short term or temporary assets
needs (Box 1) and long- term financing for long term or permanent assets needs
(Box 3) would comprise a set of moderate risk profitability strategies. But what
one gains by following alternative strategies (like by box 2 or box 4) needs to
weighed against what you give up.