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Determinants of Working Capital for Financial Management and Policy Mcom sem 2 Delhi University

Determinants of Working Capital for Financial Management and Policy Mcom sem 2 Delhi University

Determinants of Working Capital for Financial Management and Policy Mcom sem 2 Delhi University

Determinants of Working Capital for Financial Management and Policy MCOM sem 2 Delhi University : Capital required for a business can be classified under two main categories (1) Fixed Capital (2) Working Capital Every business needs funds for two purposes for its establishment and to carry out its day-to-day operations. Long-term funds are required to create production faculties through purchase of fixed assets such as plant and machinery, land, building, furniture etc. Investments in these assets represent that part of firm’s capital which is blocked on a permanent or fixed basis and is called fixed capital. Funds are also needed for short-term purposes for the purchase of raw materials, payment of wages and other day-to-day expenses, etc. These funds are known as working capital.

Determinants of Working Capital for Financial Management and Policy Mcom sem 2 Delhi University

CONCEPTS OF WORKING CAPITAL

There are two concepts of working capital:

(A)Balance Sheet Concept

(B) Operating Cycle or Circular Flow Concept

Determinants of Working Capital for Financial Management and Policy Mcom sem 2 Delhi University

(A)Balance Sheet Concept:

There are two interpretations of working capital under the balance sheet concept:

(i) Gross Working Capital

(ii) Net Working capital In the broad sense, the term working capital refers to the gross working capital and represents the amount of funds invested in current assets. Thus, the gross working capital is the capital invested in total current assets of the enterprise; current assets are those assets which in the ordinary course of business can be converted into cash within a short period of normally one accounting year.

In a narrow sense, the term working capital refers to the new working capital. Net working capital is the excess of current assets over current liabilities or say: Net Working Capital = Current Assets – Current Liabilities. Net Working Capital may be positive or negative. When the current assets exceed the current liabilities the working capital is positive and the negative working capital results when the current liabilities are more than the current assets. Current liabilities are those liabilities which are intended to be paid in the ordinary course of business within a short period of normally one accounting year out of the current assets or the income of the business.

The gross working capital concept is financial or going concern concept whereas net working capital is an accounting concept of working capital. These two concepts of working capital are not exclusive; rather both have their own merits.

Determinants of Working Capital for Financial Management and Policy Mcom sem 2 Delhi University

(B)Operating Cycle or Circular Flow Concept

As discussed earlier, working capital refers to that part of firm’s capital which is required for financing short-term or current assets such as cash, marketable securities, debtors and inventories. Funds, thus, invested in current assets such as cash, marketable securities, debtors and inventories. Funds, thus, invested again in exchange for other current assets.

Determinants of Working Capital for Financial Management and Policy Mcom sem 2 Delhi University

CHARACTERISTICS OF WORKING CAPITAL

1. Short –term Requirements: Working capital is utilized to purchase current assets which can be easily converted into cash in short period of time. The length of production process decides the duration of working capital; it is the time period between sale and cash receipts.

2. Circular Movement: Working capital is continuously transformed into cash but it again turns into working capital. This process is on continuous basis. When cash is utilized to purchase current assets and with the help of current assets goods are produced and sold then therefore working capital is also termed as circulating capital.

3. Permanence: Working capital is a short-term capital but in order to continue the production process it is always required by the firm. Hence working capital is also termed as permanence or regular working capital.

4. Instability: Though working capital is required permanently in a firm but the amount of working capital required frequently changes with the changes in production level, changes in purchase, sale policy, price level and demand level. The amount of working capital that changes due to changes in other factors is called variable working capital.

5. Liquidity: Working capital can be easily converted into cash, hence it is more liquid. Firms which maintain adequate amount or working capital finds easy to convert it into cash in time when cash is required.

6. Less Risky: Working capital is the investment in current assets which is for a short period of time. Hence it involves less risk. Working capital does not involve any risk related to technological changes. It involves a very less amount of physical risk only.

7. Special Accounting System not Required: As working capital is for short-term usually for one year. Hence, there is no need to adopt special accounting system for it.

Determinants of Working Capital for Financial Management and Policy Mcom sem 2 Delhi University

FACTORS DETERMINING THE WORKING CAPITAL REQUIREMENTS

The Working capital requirements of a concern depend upon a large number of factors such as nature and size of business, the character of their operations, the length of production cycles, the rate of stock turnover and the state of economic situation. It is not possible to rank them because all such factors are of different importance and the influence of individual factors changes for a firm over time. However the following are important factors generally influencing the working capital requirements.

1. Nature or Character of Business:

The Working capital requirements of a firm basically depend upon the nature of its business. Public utility undertakings like Electricity. Water supply and Railways need very limited working capital because they offer cash sales only and supply services, not products, and as such no funds are tied up in inventories and receivables. On the other hand trading and financial firms require less investment in fixed assets but have to invest large amount in current assets like inventories, receivables and cash; as such they need large amount of working capital.

The manufacturing undertakings also require sizable working capital along with fixed investments. Generally speaking it may be said that public utility undertaking require small amount of working capital, trading and financial firms require relatively very large amount, whereas manufacturing undertakings require sizable working capital between these two extremes.

2. Size Business/Scale of Operations:

The working capital requirements of a concern are directly influenced by the size of its business which may be measured in terms of scale of operations. Greater the size of business unit, generally larger will be the requirements of working capital. However, in some cases even a smaller concern may need more working capital due to high overhead charges, inefficient use of available resources and other economic disadvantages of small size.

3. Production Policy:

In certain industries the demand is subject to wide fluctuations due to seasonal variations. The requirements of working capital in such cases depend upon the production policy. The production could be kept either steady by accumulating inventories during slack periods with a view to meet high demand during the peak season or the production could be curtailed during the slack season and increased during the peak season. If the policy is to keep production steady by accumulating inventories it will require higher working capital.

4. Manufacturing Process/Length of Production Cycle:

In manufacturing business, the requirements of working capital increase in direct proportion to length of manufacturing process. Longer the process period of manufacture, larger is the amount of working capital required. The longer the manufacturing time, the raw material and other supplies have to be carried for a longer period in the process with progressive increment of labor and service costs before the finished product is finally obtained. Therefore, if there are alternative processes of production, the process with the shortest production period should be chosen.

5. Seasonal Variations:

In certain industries raw material is not available throughout the year. They have to buy raw materials in bulk during the season to ensure an uninterrupted flow and process them during which gives rise to more working capital requirements. Generally, during the busy season, a firm requires larger working capital than in the slack season.

6. Working Capital Cycle:

In a manufacturing concern, the working capital cycle starts with the purchase of raw material and ends with the realization of cash from the sale of finished products. This cycle involves purchase of raw materials and stores, its conversion into stocks of finished goods through work-in-progress with progressive increment of labor and service costs, conversion of finished stock into sales, debtors and receivables and ultimately realization of cash and this cycle continues again from cash to purchase of raw material and so on.

7. Rate of Stock Turnover:

There is a high degree of inverse co-relationship between the quantum of working capital and the velocity or speed with which the sales are affected. A firm having a high rate of stock turnover will need lower amount of working capital as compared to a firm having a low rate of turnover.

8. Credit Policy:

The credit policy of a concern in its dealing with debtors and creditors influence considerably the requirements of working capital. A concern that purchases its requirements on credit and sells its products/services on cash requires lesser amount of working capital. On the other hand a concern buying its requirements for cash and allowing credit to its customers, shall need larger amount of working capital as very huge amount of funds are bound to be tied up in debtors or bills receivables.

9. Business Cycles:

Business cycle refers to alternate expansion and contraction in general business activity. In a period of boom i.e., when the business is prosperous, there is a need for larger amount of working capital due to increase in sales, rise in prices, optimistic expansion of business, etc.

10. Rate of Growth of Business:

The working capital requirements of a concern increase with the growth and expansion of its business activities. Although, it is difficult to determine the relationship between the growth in the volume of business and the growth in the working capital of a business, yet it may be concluded that for normal rate of expansion in the volume of business, we may have retained profits to provide for more working capital but in fast growing concerns, we shall require larger amount of working capital.

11. Earning Capacity and Dividend Policy:

Some firms have more earning capacity than others due to quality of their products, monopoly conditions, etc. Such firms with high earning capacity may generate cash profits from operations and contribute to their working capital. The dividend policy of a concern also influences the requirements of its working capital. A firm that maintains a steady high rate of cash dividend irrespective of its generation of profits needs more working capital than the firm that retains larger part of its profits and does not pay so high rate of cash dividend.

12. Price Level Changes:

Changes in the price level also affect the working capital requirements. Generally, the rising prices will require the firm to maintain larger amount of working capital as more funds will be required to maintain the same current assets. The affect of rising prices may be different for different firms. Some firms may be affected much while some others may not be affected at all by the rise in prices.

13. Other Factors:

Certain other factors such as operating efficiency, management ability, irregularities of supply, import policy, asset structure, importance of labor, banking facilities, etc., also influence the requirements of working capital.

Determinants of Working Capital for Financial Management and Policy Mcom sem 2 Delhi University

Working Capital Management

This is a managerial accounting strategy which focuses on maintaining efficient levels of both components OF working capital – current assets and current liabilities (Adeoran, Josaiah, Boson Fakunled and Imuzeze, 2012). Decisions relating to working capital and short-term financing are referred to as working capital management (Nimalathason, 2010). It is the regulation, adjustment and control of the balance of current assets and current liabilities of a firm such that maturing obligations are met, and the fixed assets are properly serviced. It is the determination of optimum level of working capital to keep monitoring and controlling the level of individual components to ensure that the optimum level is not exceeded, and provision of funds to finance current assets.

“Working capital is the life-blood and controlling nerve centre of a business”. No business can be successfully run without an adequate amount of working capital. To avoid the shortage of working capital at once, an estimate of working capital requirements should be made in advance so that arrangements can be made to procure adequate working capital. Methods of Estimating Working Capital Requirements

Determinants of Working Capital for Financial Management and Policy Mcom sem 2 Delhi University

The following method are usually followed in forecasting working capital requirements of a firm

1. Percentage of Sales Method

2. Regression Analysis Method

3. Cash Forecasting Method

4. Operating Cycle Method

5. Projected Balance Sheet Method

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