Concept and Types of Working Capital for Financial Management and Policy Mcom Sem 2 Delhi University

Concept and Types of Working Capital for Financial Management and Policy Mcom Sem 2 Delhi University

Concept and Types of Working Capital for Financial Management and Policy MCOM Sem 2 Delhi University : In financial management, two important decisions are very vital and crucial. They are decision regarding fixed assets/fixed capital and decision regarding working capital/current assets. Both are important and a firm always analyzes their effect to final impact upon profitability and risk. Fixed capital refers to the funds invested in such fixed or permanent assets as land, building, and machinery etc. Whereas working capital refers to the funds locked up in materials, work in progress, finished goods, receivables, and cash etc. Thus, in very simple words, working capital may be defined as “capital invested in current assets.” Here current assets are those assets, which can be converted into cash within a short period of time and the cash received is again invested into these assets. Thus, it is constantly receiving or circulating. Hence, working capital is also known as circulating capital or floating capital.

Concept and Types of Working Capital for Financial Management and Policy Mcom Sem 2 Delhi University

CONCEPT OF WORKING CAPITAL

There are two concepts of working capital. These are:

1. Gross working capital: (Total Current Assets)

The gross working capital, simply called as working capital refers to the firm’s investment in current assets. Current assets are the assets, which can be converted into cash within an accounting year or operating cycle. Thus, Gross working capital, is the total of all current assets.

It includes

a. Inventories (Raw materials and Components, Work-in-Progress, Finished Goods, Others)

b. Trade Debtors

c. Loans and Advance

d. Cash and Bank Balances

e. Bills Receivables.

f. Short-term Investment

Concept and Types of Working Capital for Financial Management and Policy Mcom Sem 2 Delhi University

2. Net Working Capital: (Total Current Assets – Total Current Liabilities)

Net working capital refers to the difference between current assets and current liabilities. Current liabilities are those claims of outsiders, which are expected to mature for payment within an accounting year. Net working capital may be positive or negative. A positive net working capital will arise when current assets exceed current liabilities and a negative net working capital will arise when current liabilities exceed current assets i.e. there is no working capital, but there is a working capital deficit.

It includes

a. Trade Creditors.

b. Bills Payable.

c. Accrued or Outstanding Expenses.

d. Trade Advances

e. Short Term Borrowings (Commercial Banks and Others)

f. Provisions

g. Bank Overdraft

Concept and Types of Working Capital for Financial Management and Policy Mcom Sem 2 Delhi University

Types of working capital:

Working capital can be divided into two categories on the basis of time:

1. Permanent, fixed or regular working capital,

2. Temporary, variable, fluctuating, seasonal or specified working capital.

Concept and Types of Working Capital for Financial Management and Policy Mcom Sem 2 Delhi University

Permanent working capital:

This refers to minimum amount of investment required in all current assets at all times to carryout minimum level of activity. In other words, it represents the current assets required over the entire life of the business. Tandon committee has referred to this type of working capital as ‘Core current assets’ or ‘Hard-core working capital’. The need for investment in current assets may increase or decrease over a period of time according to the level of production. Some 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. Tandon Committee has pointed out that this type of core current assets should be financed through long-term sources like capital, reserves and surplus, preference share capital, term loans, debentures, etc. Leader in two-wheelers Hero Honda Ltd. and in four-wheelers Maruthi Udyog Ltd. keeping their model in each type in their showrooms are typical examples of permanent working capital.

Depending upon the production and sales, the need for working capital over and above permanent working capital will change. The changing working capital may also vary on account of seasonal changes or price level changes or unanticipated conditions. For example, raising the prices of materials, labour rate and other expenses may lead to an increase in the amount of funds invested in the stock of raw materials, work-in-progress as well as in finished goods. Sometimes additional working capital may be required to face the cut-throat competition in the market.

Concept and Types of Working Capital for Financial Management and Policy Mcom Sem 2 Delhi University

Sometimes when the company is planning for special advertisement campaigns organised for promotional activities or increasing the sales, additional working capital may have to be financed. All these extra capital needed to support the changing business activities are called temporary, fluctuating or variable working capital. Determination of working capital requirements: There are no uniform rules or formulae to determine the working capital requirements in a firm. A firm should not plan its working capital neither too much nor too low. If it is too high it will affect profits. On the other hand if it is too low, it will have liquidity problems. The total working capital requirements is determined by a wide variety of factors.

They also vary from time to time. Among the various factors, the following are necessary. 1. Nature of business: The working capital requirements of an organization are basically influenced by the nature of its business. The trading and financial institutions require more working capital rather than fixed assets because these firms usually keep more varieties of stock to satisfy the varied demands of their customers. The public utility service organisations require more fixed assets rather than working capital because they have cash sales only and they supply only services and not products.

Thus, the amounts tied up with stock and debtors are almost nil. Generally, manufacturing business needs, more fixed assets rather than working capital. Further, the working capital requirements also depend on the seasonal products.

Concept and Types of Working Capital for Financial Management and Policy Mcom Sem 2 Delhi University

Size of the business:

Another important factor is the size of the business. Size of the business means scale of operation. If the operation is on a large scale, it will need more working capital than a firm that has a small-scale operation.

Concept and Types of Working Capital for Financial Management and Policy Mcom Sem 2 Delhi University

Operating cycle:

The term “production cycle” or “manufacturing cycle” refers to the time involvement from cash to purchase of raw materials and completion of finished goods and receipt of cash from sales. If the operating cycle requires a longer time span between cash to cash, the requirement of working capital will be more because of larger tie up of funds in all the processes. If there is any delay in a particular process of sales or collection there will be further increase in the working capital requirements. A distillery is to make a relatively heavy investment in working capital. A bakery will have a low working capital.

Concept and Types of Working Capital for Financial Management and Policy Mcom Sem 2 Delhi University

Production policy:

The requirements of working capital are also determined by production policy. When the demand for the product is seasonal, inventory must be accumulated during the off-season period and this leads to more cost and risks. These firms, which manufacture variety of goods, will have advantages of keeping low working capital by adjusting the production according to season.

Turnover of Working capital:

The speed of working capital is also influenced by the requirements of working capital. If the turnover is high, the requirement of working capital is low and vice versa. Working Capital Turnover = Cost of goods sold Working capital

Credit Terms: The level of working capital is also determined by credit terms, which is granted to customers as well as available from its creditors. More credit period allowed to debtors will result in high book debts, which leads to high working capital and more bad debts. On the other hand liberal credit terms available from creditors will lead to less working capital.

Growth and Expansion: As a company grows and expands logically, it requires a larger amount of working capital. Other things remaining same, growing industries need more working capital than those that are static

Concept and Types of Working Capital for Financial Management and Policy Mcom Sem 2 Delhi University

Price level changes:

Rising prices would necessitate the organization to have more funds for maintaining the same level of activities. Raising the prices in material, labour and expenses without proportionate changes in selling price will require more working capital. When a company raises its selling prices proportionally there will be no serious problem in the working capital.

Operating efficiency: Though the company cannot control the rising price in material, labour and expenses, it can make use of the assets at a maximum utilisation with reduced wastage and better coordination so that the requirement of working capital is minimised.

Other factors: Level of taxes: In this respect the management has no option. If the government increases the tax liability very often, taxes have to be paid in advance on the basis of the profit on the current year and this will need more working capital.

Concept and Types of Working Capital for Financial Management and Policy Mcom Sem 2 Delhi University

Dividend policy: Availability of working capital will decrease if it has a high dividend payout ratio. Conversely, if the firm retains all the profits without dividend, the availability of working capital will increase. In practice, although many firms earn profit, they do not declare dividend to augment the working capital.

Concept and Types of Working Capital for Financial Management and Policy Mcom Sem 2 Delhi University

Significance of working capital:

The basic objective of financial management is to maximize the shareholders’ wealth. This is possible only when the company increases the profit. Higher profits are possible only by way of increasing sales. However sales does not convert into cash instantaneously. So some amount of funds are required to meet the time gap arrangement in order to sustain the sales activity, which is known as working capital. In case adequate working capital is not available for this period, the company will not be in a position to sustain stocks as it is not in a position to purchase raw materials, pay wages and other expenses required for manufacturing goods to be sold. Working capital, thus, is a life-blood of a business.

As a matter of fact, any organization, whether profit oriented or otherwise, will not be able to carry on day-to-day activities without adequate working capital. Problems of inadequate working capital: Proper management of working capital is very important for the success of an enterprise. It should be neither large nor small, but at the optimum level.

Concept and Types of Working Capital for Financial Management and Policy Mcom Sem 2 Delhi University

In case of inadequate working capital, a business may suffer the following problems.

1. Purchase of raw materials: Availing the cash discount from the suppliers (creditors) or on favourable credit terms may not be available from creditors due to shortage of funds. For eg. This situation arises when the suppliers supply the goods on two months credit allowing 5% cash discount, if it is payable within the 30 days. In the above situation, if a person buys material for Rs. 10,000 by availing the cash discount, he has to pay only Rs 9500 [10,000 – 500]. This is possible only with the help of adequate working capital.

2. Credit rating: When the financial crisis continues due to shortage of funds [working capital], the credit worthiness of the company may be lost, resulting in poor credit rating. E.g. a company is having the liquid assets of Rs 20,000, current assets of Rs 30,000 and current liabilities of Rs 40,000. From the above data we can determine the short-term solvency with the help of the following ratios 1. Liquid ratio 0.50 and 2. Current ratio 0.75. The standard ratios are 1:1 and 2:1 for liquidity ratio and current ratio respectively. But seeing the above ratios, it shows that the short-term solvency is very poor. This clearly shows that the company is not in a position to repay the short-term debt. This is due to inadequate working capital.

3. Seizing business opportunity: Due to lack of adequate working capital, the company is not in a position to avail business opportunity during boom period by increasing the production. This will result in loss of opportunity profit. E.g. During boom or seasonal period, generally the company will be getting more contribution per unit by accepting special orders or by increasing the production, matching with high demand. This opportunity can be availed only if it is having sufficient amount of working capital.

4. Duration of operating Cycle: The duration of operating cycle is to be extended due to inadequate working capital. E.g. If the company’s duration of operating cycle is 45 days when a company is having sufficient amount of working capital, due to delay in getting the material from the suppliers and delay in the production process, it will have to extend the duration of operating cycle. Consequently, this results in low turnover and low profit.

5. Maintenance of plant and machinery: Due to lack of adequate working capital, plant and machinery and fixed assets cannot be repaired, renovated, maintained or modernized in an appropriate time. This results in non-utilisation of fixed assets. Moreover, inadequate cash and bank balances will curtail production facilities. Consequently, it leads to low fixed assets turnover ratio. E.g. Cost of goods sold is Rs 2,40,000 fixed assets is Rs 60,000 and average industrial fixed assets turnover ratio is 10 times. Fixed assets turnover ratio= Cost of sales = 2,40,000 = 4 times Fixed assets 60,000 When industrial average ratio is 10 times and the actual turnover ratio is 4 times, it is understood that the fixed assets are not utilized to the maximum.

6. Higher interest: In order to account for the emergency working capital fund, the company has to pay higher rate of interest for arranging either shortterm or long-term loans.

7. Low Return on Investment (ROI): Inadequate working capital will reduce the working capital turnover, which results in low return on investment.

8. Liquidity verses profitability: Inadequate working capital may result in stock out of cost, reduced sales, loss of future sales, loss of customers, loss of goodwill, down time cost, idle labour, idle production and finally results in lower profitability.

9. Dividend policy: A study of dividend policy cannot be possible unless and otherwise the organization has sufficient available funds. In the absence of proper planning and control, the company’s inadequate working capital will cause the above said problems.

Concept and Types of Working Capital for Financial Management and Policy Mcom Sem 2 Delhi University

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