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Working capital is a measurement of an entitys current assets, after subtracting its liabilities.

Sometimes referred to as operating capital, it is a valuation of the amount of liquidity a business or organization has for the running and building of the business. Generally speaking, companies with higher amounts of working capital are better positioned for success. They have the liquid assets needed to expand their business operations as desired. Sometimes, a company will have a large amount of assets, but have very little with which to build the business and improve processes. Even a profitable company may have this problem. This can occur when a company has assets that are not easy to convert into cash. Working capital can be expressed as a positive or negative number. When a company has more debts than current assets, it has negative working capital. When current assets outweigh debts, a company has positive working capital. Changes in working capital will impact a business cash flow. When working capital increases, the effect on cash flow is negative. This is often caused by the liquidation of inventory or the drawing of money from accounts that are due to be paid by the business. On the other hand, a decrease in working capital translates into less money to settle short-term debts

Concept of working Capital by V S RAMA RAO on FEBRUARY 7, 2009 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. Raw materials storage period = Average stock of raw materials and stores/ Average daily consumption of raw material and stores 2. Work in process period = Average work in process inventory /Average cost of production per day 3. Finished goods storage period = Average finished goods inventory / Average cost of goods sold per day 4. Debtors collection period

Factors determining working capital requirements

Nature of business Size of business Production policy Manufacturing process Seasonal variations Working capital cycle Rate of stock turn over Credit policy Business cycles

Rate of growth of business Price level changes Earning capacity & dividend policy Other factors.

Factors Affecting working Capital needs

by V S RAMA RAO on FEBRUARY 7, 2009

A firm should have neither low nor high working capital. Low working capital involves more risk and more returns, high working capital involves less risk and less returns. Risk here refers to technical insolvency while returns refer to increased profits/earnings. The amount of working capital is determined by a wide variety of factors. 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. 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.