Concept of Working Capital Working capital refers to short-term funds, need to meet operating expenses. It refers to the funds; to finance its day-to-day operations. It is concerned with current assets and current liabilities. If a firm can’t maintain a satisfactory level of working capital, it may become insolvent or bankrupt. Broadly there are 2 concepts of working capital, such as: 1. Gross Working Capital (Quantitative Concept) 2. Net working Capital (Qualitative Concept) Both these concepts of working capital have operational significance.
The two concepts are not mutually exclusive. The ‘gross concept’ emphasizing the ‘use’ and the ‘net concept’ emphasizes the ‘source’. 1. Gross Working Capital The total current assets are termed as the gross working capital. It is also known as quantitative or circulating capital. It refers to firm’s investment in short term assets such as cash, marketable securities, accounts receivables, prepaid expenses, inventories etc. Significance a. Optimum investment in current assets. -: Inadequate working capital leads to insolvency and excessive will lead to less profitability.
Financing of current assets. -: If funds arise it should be invested in short term securities, don’t keep it idle. 2. Net Working Capital The excess of current assets over current liabilities represents net working capital. It may be positive or negative. Net working capital indicates the liquidity of the business. Significance a. Maintaining Liquidity Position-: Current assets help in meeting financial obligations. Generally for every one rupee of current asset there should be one rupee of current liability. b. Extent of long term capital n financing current assets-: If there are Rs 100000 current assets and Rs 75000 current liabilities then NWC is Rs 25000, and it supposed to be financed from long term funds.
Efficient management of working capital involves control over the current assets and current liabilities, which are the main components of working capital. 1. Components of current assets: Currents assets are those, can be converted into cash within a year. It consists of cash, marketable securities, inventories, debtors, prepaid expenses. 2.
Components of current Liabilities: Current liabilities are those to be paid in a year. It consists of creditors, short-term borrowings, taxes and proposed dividends. To ensure optimum investment in current assets. • To ensure adequate flow of funds for current operations. • To speed up the flow of funds. • Maintain liquidity and profitability. Maximize shareholders’ wealth possible only when there is sufficient return. • Discharge day-to-day liabilities. • Protect the business from adverse effects in emergencies. • Determines the relevant levels of current assets and their efficient use. To sustain sales activity. Sales don’t convert into cash immediately. It needs time to collection of cash.
For maximization profits or minimize working capital cost and maintain balance between liquidity and profitability, we need to maintain a balance in working capital. It should not be excessive or inadequate. Firm should manage adequate working capital to run its business • Excessive working capital means idle funds which earns no profit. • Inadequate working capital disturbs production and weakens the firm’s profitability.
Danger of Excessive Working Capital • It results in unnecessary accumulation of inventories, which lead to mishandling like waste, theft and losses. • It is indication of defective credit policy and slack collection period. This leads to higher bad debts that reduce profits. • It makes managerial inefficiency. • Accumulation inventories tend to make speculative profits grow. This type of speculation makes the firm to follow liberal dividend policy and difficult to cope up with in future when the firm is unable to make speculative profits. Danger of Inadequate Working Capital: It declines growth because it’s difficult to undertake profitable projects for non-availability of working capital. • Difficult to implement operating plans and achieve firm’s target. • Difficult to meet day-to-day commitments. • Inefficient utilization of fixed assets. • The firm unable to avail attractive credit opportunities. • Firm loses its reputation.
The continuing flow from cash: to suppliers: to inventory: to accounts receivables and back into cash is operating cycle. 1. Operating cycle for manufacturing firm: ` Stock of raw material is held in order to ensure smooth production. Similarly stock of finished goods has to be carried out to meet the demand. 2. Operating Cycle of a Non-manufacturing Firm Non-manufacturing firms are wholesalers, retailers, service firms. They will have the direct conversion of cash into finished goods and into cash.