What is Working Capital? Definition, Types, Cycle, Sources

  • Post last modified:29 March 2021
  • Reading time:12 mins read

What is Working Capital?

Working Capital is another part of the capital which is needed for meeting day to day requirement of the business concern. For example, payment to creditors, salary paid to workers, purchase of raw materials, etc. normally it consists of recurring in nature. It can be easily converted into cash. Hence, it is also known as short-term capital.

Working Capital Definition

The sum of the current asset is the working capital of a business J.S.Millr
Working Capital refers to a firm’s investment in short-term assets, cash, short-term securities, accounts receivables, and inventories Weston and Brigham

Components of Working Capital

The Net working capital represents current assets minus current liabilities. Current assets refer to those assets which are used for day-to-day activities of the firm

  1. Current Assets
  2. Current Liabilities

Current Assets

These assets constitute the following :

  1. Inventories: Inventories represent raw materials and components work in progress and finished goods.
  2. Trade debtors: Trade debtors comprise credit sale is to customers.
  3. Prepaid expenses: These are those expense which has been paid for goods and service whose benefits have yet to be received.
  4. Loans and advances: They represent loans and advances given by a firm to other firms for a short period of time.
  5. Investment: These assets comprise short-term surplus funds invested in government securities, shares, and short-term bonds.
  6. Cash and bank balances: These assets represent cash in hand and at the bank which is used for meeting operational requirements. This kind of current assets is purely liquid but nonproductive

Current Liabilities

Current liabilities represent that part of obligations that the firm has to clear to the outside parties in a short period, generally within a year. These liabilities comprise the following:

  1. Sundry Creditors: These liabilities stem out of the purchase of raw materials on credit terms usually for a period of one to two months.
  2. Bank Overdrafts: These include withdrawals in excess of credit balance, standing in the firm’s current account with banks.
  3. Short-Term Loans: Short-term borrowings by the firm from banks and others form part of current liabilities as short-term loans.
  4. Provisions : These include provisions for taxation, proposed dividends and contingencies

Types of Working Capital

  1. Permanent working capital
  2. Temporary working capital
  3. Gross working capital
  4. Net working capital
  5. Negative working capital

Permanent working capital

It means the minimum amount of investment in all current assets which is regarded at all times to carry on the minimum level of business activities. The operating cycle is a continuous process and therefore, the need for current assets. But the magnitude of current assets increases and decreases over time. There are an always a minimum level of current assets required at all time by the firm to carry on its business operations. This minimum level of current assets required known as permanent working capital’ or ‘fixed working capital’.

Temporary working capital

This is also called the ‘fluctuating or variable working capital. The amount of temporary working capital keeps on changing depending upon the change in production and sales. For example, extra inventory of finished goods will have to be maintained to support the peak periods of sale and the investment in receivables may also increase during such period. On the other hand investment in raw material, work-in-progress and finished goods will decrease if the market is slack.

Gross working capital

It is the amount of funds invested in the variouscomponents of current assets. The gross working capital is considerablyuseful in making current estimate of working capital needs of the firm.

Net working capital

It is the difference between current assets and current liabilities. The concept of networking capital enables a firm to determine the exact amount available at its disposal for operational requirements.

Negative working capital

When current liabilities exceed current assets negative working capital emerges. Such a situation occurs when a firm is nearing a crisis of some magnitude

Working Capital Cycle

The duration of time required to complete the following cycle of events in case of a manufacturing firm is called the operating cycle (Working CapitalCycle):

  1. Conversion of cash into raw materials.
  2. Conversion of raw materials into work in process.
  3. Conversion of work in a process into finished goods.
  4. Conversion of finished goods into debtors and bills receivables through sales.
  5. Conversion of debtors and bills receivables into cash.

The operating cycle of a trading firm has the following cycle of events:

  1. Cash into inventories.
  2. Inventories into accounts receivable.
  3. Account receivables into cash

Working Capital Management

Working capital management is a significant part of business decisions and is of major concern to a finance manager in as much as accomplishment of value maximization goal depends essentially on prudent working capital with which finance manager is seriously concerned because the problem of the trade-off between risk and return is involved. A firm is required to carry an adequate amount of working capital so as to carry on the productive and distributive activities smoothly. The level of working capital of a firm is fluctuating, depending upon changes in level of fixed assets, seasonal factors, fiscal and monetary policies of the country and the management policies

Working Capital management involves two main processes :

  1. Determination of the size of the amount of working capital.
  2. Arranging the sources of working capital. Working capital management is practiced by taking into account the following aspects:
  • Management of cash
  • Accounts receivables management
  • Inventory management

Determination of Working Capital

  1. Nature of an enterprise
  2. Size of the business
  3. Production policy of the firm
  4. Terms of buying and selling
  5. Volume of sales
  6. Manufacturing process (Cycle)
  7. Business cycle
  8. Supply of raw materials
  9. Profit margin
  10. Profit appropriation
  11. Growth and Expansion
  12. Operating Efficiency
  13. Capital structure of the company
  14. Price level changes
  15. Credit policy of R.B.I

Nature of an enterprise

For a firm engaged in manufacturing activity, sufficiently large amount of funds will required to carry inventories. Small companies have smaller proportions of cash, receivables and inventory than large corporations. This difference becomes more marked in large corporations. A public utility concern,for example, mostly employs fixed assets in its operations, while a merchandising department depends generally on inventory and receivables. Generally public utility concerns which are setup the render public services required large amount of finished assets, their inventory requirement is usually less.

Size of the business

The size of a business have also an important impact on its capital needs. Size may be measured in terms of operation. A firm with a larger scale of operation will need more working capital than a small firm. The composition of current assets is a function of the size of business and the industry to which it belongs

Production policy of the firm

The production policies pursued by the management have a significant effect on the requirements of the working capital of the business. For example, if the management of an enterprise decides to hold inventory worth 3 months production requirement to maintain fairly steady production throughout the year, it will require a large amount of cash to finance the inventory requirements than the one following a hand-to-mouth policy of carrying inventories.

Terms of buying and selling

Terms on which goods are bought and sold decide, to a large extent, the amount of cash reserve that a firm will have to hold. If a business firm can manage to buy materials on credit terms but sells its production cash, it can run its affairs with a little cash balance. The reserve tendency will be found where the firm makes purchases on a cash basis but it has to sell its products to customers on credit terms. In short, the working capital requirement are also affected by the credit facilities enjoyed by the firm.

Volume of sales

Needs for working capital are mostly determined by the volume of sales. This is the factor, which affects the size of working capital. A firm maintains current assets because they are needed to support the operational activities which result in sales. The volume of sales and the size of working capital are directly related to each other. As the volume of sales and the size of the working capital are directly related to each other. As the volume of sales increases, there is an increase in the investment of working capital.

Manufacturing process (Cycle)

The magnitude of investment in work-in-process essentially dependent upon the time lag between feeding raw materials in the production process and completing the finished product. The longer the time required for inventories to travel through the various product process, the greater would be fund requirements to carry work-in-process inventory and vice-versa. It is usually observed that the length of the production period is greater where the production process is complex and complicated.

Business cycle

Business expands during the period of prosperity and declines during the period of depression. Consequently, more working capital is required during the period of prosperity and less during the period of depression. Raw materials inventory requirements vary depending on fluctuation in the level of economic activity. Where the management expects expansionary tendency to set in the ensuing months and prices of materials are very likely to shoot up, it would be in the fitness of things to buy the materials in bulk to exploit the forthcoming opportunities. But in the event of depressions, the firm would be hesitant to stockpile.

Supply of raw materials

The need to pile substantially large stock of materials increases the level of investment in raw materials inventory. In the case of specific manufacturing, certain companies have to obtain and maintain a large reserve of raw materials due to their irregular sales and intermittent supply. This is particularly true in case of companies requiring special kinds of raw materials has to be kept instore to avoid any possibility of the production process coming to a dead halt. Thus, the working capital requirements in the case of such industries would be large.

Profit margin

The net profit is an important source of working capital to the extent it has been earned in cash. Every business house has a different capacity to generate profit from trading operations. Some firms enjoy a dominant position(i.e. known as cash cow position) due to quality product or good marketing management or monopoly power in the market and earn a high-profit margin. Some other firms may have to operate in an environment of intense competition and may earn a low margin of profit is a high net profit margin contributes towards the working capital pool.

Profit appropriation

Corporate taxes affect the rate of a dividend of the concerns, ultimately its effect on working capital also. Even in net profits are earned in cash at the end of the period, the whole of it is not available for working capital purposes. The contribution towards working capital would be affected by the way in which profits are appropriated. The availability of cash generated from operations thus depends upon taxation dividend and retention policy and depreciation policy.

Growth and Expansion

Another factor that influences the need of working capital is the policy of growth and expansion of the business. If a business concern has ambitious plans for growth and expansion, it requires a large amount of working capital, to fulfill such requirements. On the other hand, in case the company has already expanded considerably, it does not require funds for further expansions.

Operating Efficiency

By accelerating the efficiency of production engineers and planners, the length of the production period can be shortened. Consequently, fund requirements to carry investment in work-in-process will decline. A firm, which is engaged in a few processes of production of goods, if contracts with others for other processes, its inventory requirements will be less than what it would have been had the firm engaged in complete production.

Capital structure of the company

Capital structure of a company refers to the composition of its capitalization and it includes all long-term capital sources viz. loans, reserves, shares, and bonds. If shareholders have provided some funds towards the working capital needs also (at least to satisfy the permanent working capital needs) the management will find it relatively easy to manage working capital. If the company has to-depend entirely upon outside sources for both permanent and temporary working capital needs, it faces an uphill task under dear money conditions.

Price level changes

Generally, rising price levels will require a firm to maintain higher amount of working capital. The same levels of current assets will need increased investment when prices are increasing. However, the companies which can immediately revise their product prices with rising price levels will not face a severe working capital problem. Further, the effects of increasing general price level will be felt differently by the firms as individual prices may move differently. It is possible that some companies may not be affected by the rising prices while others may be badly hit by it.

Credit policy of R.B.I

Credit policy of R.B.I. is another important factor that influences the requirement of working capital. If the Reserve Bank of India follows selective and restrictive credit policies, the working capital position becomes difficult. Suppliers insist on advance payments, while it will be difficult to sell unless competitive credit terms are offered to the customers. Therefore, before a precise estimate of working capital needs of the enterprise, finance manager must be well versed with the variables that influence the magnitude of cash, receivables and inventories

Sources of Working Capital

  1. Long-Term Financing
  2. Short Term Financing
  3. Spontaneous Financing

Long-Term Financing

In long-term financing following are the sources which can be tapped by the financial manager:

  1. Loans from financial institutions.
  2. Floating of debentures: In this context, the mode of raising funds by issuing convertible debentures or bonds is also gaining ground.
  3. Accepting public deposits.
  4. Issue of additional equity shares.
  5. Raising funds by internal financing (i..e profitability through cost control, cost reduction, rationalizing inventory stocks, etc.

Short Term Financing

These sources include short-term bank loans, commercial papers, and factoring receivables, cash credit, overdraft bill discount, etc.

Spontaneous Financing

The major sources of such financing are trade credit and outstanding expenses. (In fact, spontaneous sources of financing are cost-free, therefore a business house would like to finance its current assets from spontaneous sources as much as possible)

Go On, Share & Help your Friend

Did we miss something in Human Resource Management Tutorial or You want something More? Come on! Tell us what you think about our post on Working Capital in the comments section and Share this post with your friends.

best udemy courses

Leave a Reply