Working Capital (operating capital), sometimes called gross working capital, simply refers to the firm's

total current assets.

Short-Term Financial Management includes management of current assets and current liabilities, including
accounts payable (trade credit), notes payable (bank loans), and accrued liabilities.

Typical Current Assets include cash and cash equivalents, accounts receivable, inventory.

Net Working Capital = current assets - current liabilities.

Current Assets are closely related to sales. Moreover, influenced by the size of the firm, the nature of the
firm firm's market position etc.

Net Operating Working Capital Is Defined as current assets minus noninterest- bearing current liabilities
(accounts payable and accruals).

Cash Conversion Cycle (CCC) is the length of time funds are tied up in working capital, or the length of time
between paying for working capital and collecting cash from the sale of the working capital.

The excess of current assets over current liabilities is termed as “Net Working Capital”. It represents the
amount of current assets which would remain if all current liabilities were paid. Both the concept of
working capital has their own points of importance. If the objective is to measure the size and extent to
which current assets are being used. ‘Gross concept' is useful; whereas in evaluating the liquidity position
of an undertaking ‘Net concept' becomes pertinent and preferable.

The two important characteristics of such assets are:

i. Short life span,

ii. Swift transformation into other form of assets.

Like-wise facility of credit sale is also very essential for sales promotions. It is rightly observed that "many
a times business failure takes place due to lack of working capital". Adequate working capital provides a
cushion for bad days, as a concern can pass its period of depression without much difficulty.

O’Donnel correctly explained the significance of adequate working capital and mentioned that “to avoid
interruption in the production schedule and maintain sales, a concern requires funds to finance inventories
and receivables.“

The adequacy of cash and current assets together with their efficient handling virtually determines the
survival or demise of a concern. An enterprise should maintain adequate working capital for its smooth
functioning. Both, excessive working capital and inadequate working capital will impair the profitability and
general health of a concern.

Therefore, working capital is needed till a firm gets cash on sale of finished products. It depends on two
factors:

i. Manufacturing cycle i.e., the time required for converting the raw material into finished product;
and
ii. Credit policy i.e., credit period given to customers and credit period allowed by creditors.
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The factors influencing the working capital decisions of a firm may be classified as two groups.

1. The Internal Factors Include: Nature of business size of business, firm's product policy, credit
policy, dividend policy, and access to money and capital markets, growth and expansion of
business etc.
2. The External Factors Include: Business fluctuations, changes in the technology, infrastructural
facilities, import policy and the taxation policy etc.

Structure of Working Capital

The different elements or components of current assets and current liabilities constitute the structure of
working capital which can be illustrated in the shape of a chart as follows-

Structure of Current Assets and Current Liabilities

Current Liabilities Current Assets
Bank Overdraft Cash and Bank Balance
Creditors Inventories: Raw materials
Work-in-progress
Finished Goods
Outstanding Expenses Spare Parts
Bills Payable Accounts Receivables
Short-term Loans Bills Receivables
Proposed Dividends Accrued Income
Provision for Taxation Prepaid Expenses
Short-term Investment

Working Capital may be classified in three ways-

1) Concept based working capital,

2) Time based working capital,

3) Classification on the basis of financial reports.

1) Concept Based Working Capital

a) Gross Working Capital: It refers to the firm’s investment in total current or circulating assets.

b) Net Working Capital: The term “Net Working Capital” has been defined in two different ways:

(i) It is the excess of current assets over current liabilities. This is, as a matter of fact, the
most commonly accepted definition. Some people define it as only the difference
between current assets and current liabilities. The former seems to be a better
definition as compared to the latter.
(ii) It is that portion of a firm’s current assets which is financed by long-term funds.

c) Negative Working Capital: This situation occurs when the current liabilities exceed the current
assets. It is an indication of crisis to the firm.

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2) Time Based Working Capital

a) Permanent or Fixed Working Capital

(i) Regular Working Capital

(ii) Reserve Working Capital

b) Temporary or Variable Working Capital

(i) Seasonal Working Capital

(ii) Special Working Capital

a) Permanent Working Capital: This refers to that minimum amount of investment in all current assets
which is required at all times to carry out minimum level of business activities. In other words, it
represents the current assets required on a continuing basis over the entire year. Tandon Committee
has referred to this type of working capital as “Core current assets”.

The following are the characteristics of this type of working capital:

• 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. The suppliers of such working capital
should not expect it’s return during the life-time of the firm.

• It also grows with the size of the business. In other words, greater the size of the business,
greater is the amount of such working capital and vice versa. Permanent working capital is
permanently needed for the business and therefore, it should be financed out of long-term
funds.

b) Temporary Working Capital: The amount of such working capital keeps on fluctuating from time to
time on the basis of business activities. In other words, it represents additional current assets required
at different times during the operating year. For example, extra inventory has to be maintained to
support sales during peak sales period. Similarly, receivable also increase and must be financed
during period of high sales. On the other hand, investment in inventories, receivables, etc. will
decrease in periods of depression.

Suppliers of temporary working capital can expect it’s return during off season when it is not required by
the firm. Hence, temporary working capital is generally financed from short-term sources of finance such
as bank credit.

Classification on the Basis of Financial Reports

The information of working capital can be collected from Balance Sheet or Profit and Loss Account; as
such the working capital may be classified as follows:

1) Cash Working Capital: This is calculated from the information contained in profit and loss account.
This concept of working capital has assumed a great significance in recent years as it shows the
adequacy of cash flow in business. It is based on ‘Operating Cycle Concept’.

2) Balance Sheet Working Capital: The data for Balance Sheet Working Capital is collected from the
balance sheet. On this basis the Working Capital can also be divided in three more types:

a. Gross Working Capital,

b. Net Working Capital and
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 c. Working Capital Deficit.

The length of time between the firm's payment for its raw materials and the collection of payment from the
customer is known as the firm's Cash Conversion Cycle (CCC).

Cash Conversion Cycle (CCC) = (Inventory period + Receivables period) – Accounts Payable Period

Here-

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The longer the production process, the more cash the firm must keep tied up in inventories. Similarly, the
longer it takes customers to pay their bills, the higher the value of accounts receivable.

On the other hand, if a firm can delay paying for its own materials, it may reduce the amount of cash it
needs. In other words, accounts payable reduce net working capital.

Working Capital Trade-off

The cash conversion cycle is not cast in stone. To a large extent it is within management's control. Working
capital can be managed.

For example, the cost of holding inventory includes not only the opportunity cost of capital but also storage
and insurance costs and the risk of spoilage or obsolescence. All of these carrying costs encourage firms
to hold current assets to a minimum.

While carrying costs discourage large investments in current assets, too low a level of current assets
makes it more likely that the firm will face shortage costs.

An important job of the financial manager is to strike a balance between the costs and benefits of current
assets, that is, to find the level of current assets that minimizes the sum of carrying costs and shortage
costs.

Businesses require capital-that is, money invested in plant, machinery, inventories, accounts receivable,
and all the other assets it takes to run a company efficiently. Typically, these assets are not purchased all
at once but are obtained gradually over time as the firm grows. The total cost of these assets is called the
firm's Total Capital Requirement.

The total capital requirement can be met through either long or short-term financing.

• When long-term financing does not cover the total capital requirement, the firm must raise
short-term capital to make up the difference.
• When long-term financing more than covers the total capital requirement, the firm has surplus
cash available for short-term investment.

Thus, the amount of long-term financing raised, given the total capital requirement, determines whether
the firm is a short-term borrower or lender.

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Link Between Long-term and Short-Term Financing
The “Relaxed Strategy” in Panel A always implies a short-term cash surplus. This surplus will be invested
in marketable securities. The “Restrictive Policy” illustrated in Panel C implies a permanent need for short-
term borrowing. Finally, Panel B illustrates an “intermediate strategy” implies that the firm has spare cash
which it can lend out during the part of the year when total capital requirements are relatively low, but it is
a borrower during the rest of the year when capital requirements are relatively high.

There are some observations about the best level of long-term financing relative to the total capital
requirement-

• Matching maturities
• Permanent working-capital requirements
• The comforts of surplus cash

Working Capital and Financing Decisions

On the basis of above strategies and observations, the financing on working capital can be discussed under
three approaches:

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 1. The Matching Principle: Finance short-
term needs with short-term sources and
long-term needs with long-term sources.
The underlying logic is that, in the long-
run, the firm will be exposed to less risk
and lower financing costs if the matching
principle is followed. It is also called
Hedging or self- liquidation Approach.
2. Conservative Approach or Principle:
A policy where all of the fixed and current
assets of a firm are financed with long-
term capital, and very small or
insignificant current assets are financed
with short-term funds.

3. Aggressive Approach or Principle: A

policy where all of the fixed assets of a
firm are financed with long-term capital,
but some of the firm's permanent current
assets are financed with short-term non
spontaneous sources of funds.

Trade-off between Profitability and Risk

In evaluating a firm's net working capital position, an important consideration is the trade-off between
profitability and risk. In other words, the level of net working capital has a bearing on profitability and risk.

The risk of becoming technically insolvent is measured using net working capital (NWC). It is assumed that
the greater the amount of NWC, the less risk prone the firm is, or the greater the NWC, the more liquid the
firm is. Therefore, the less likely it is to become technically insolvent. Contrary, lower levels of NWC and
liquidity are associated with increasing levels of risk. The relationship between liquidity, NWC and risk is
such that if either NWC or liquidity increases, the firm's risk decreases and vice-versa.

Problems and Solutions

Cannon Company is attempting to develop a current asset policy. Its Fixed Assets are $60,00,000 and the
firm plans to maintain a 50% debt-to asset ratio. The interest rate is 10% on all debts. The three alternative
current assets policies under considerations are to carry current assets that total 40%, 50% and 60% of
projected sales. The company expects to earn 15% before tax and interest on sales of $3 million. The firm's
marginal tax rate is 35%. Calculate the expected return on equity under each of the alternatives.

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Factors Determining Working Capital Requirements
There are no fixed set of rules or formula to determine the Working Capital needs of the business concern.
The following are the major factors which are determining the Working Capital requirements-

• Nature of business
• Production cycle
• Business cycle
• Production policy
• Credit policy
• Growth and expansion
• Availability of raw materials
• Earning capacity

Computation (or Estimation) of Working Capital

Some of the common methods are used to estimate the Working Capital:

(i) Estimation of components of working capital method

(ii) Percentage of sales method

Operating cycle: The operating cycle begins with the acquisition of raw material and ends with the
collection of receivables.

Operating cycle consists of the following important stages:

1) Raw Material and Storage Stage (R)

2) Work in Process Stage (W)
3) Finished Goods Stage (F)
4) Debtors Collection Stage (D)
5) Creditors Payment Period Stage (C)

Each component of the operating cycle can be calculated by the following formula-

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Sources of Working Capital
Working Capital requirement can be normalized from short-term and long-term sources. Uses of Working
Capital may be differing from stage to stage.