Working capital management

Introduction: The term working capital is commonly used for the capital required for day-
to-day working in a business concern, such as for purchasing raw material, for meeting day-
to-day expenditure on salaries, wages, rents rates, advertising etc. But there are much
disagreement among various financial authorities (Financiers, accountants, businessmen and
economists) as to the exact meaning of the term working capital.
Definition:
Working capital refers to the circulating capital required to meet the day to day operations of
a business firm. Working capital may be defined by various authors as follows:
1. According to Weston & Brigham -Working capital refers to a firm‘s investment in short
term assets, such as cash amounts receivables, inventories etc.
2. Working capital means current assets. —Mead, Baker and Malott
3. ―The sum of the current assets is the working capital of the business” —[Link] Working
capital is defined as ―the excess of current assets over current liabilities and provisions”.
The term ―working capital “is often referred to ―circulating capital” which is frequently
used to denote those assets which are changed with relative speed from one form to another
i.e., starting from cash, changing to raw materials, converting into work-in-progress and
finished products, sale of finished products and ending with realization of cash from debtors.
Working capital has been described as the ―life blood of any business which is apt because
it constitutes a cyclically flowing stream through the business”
Types of Working Capital:
Depending upon the Periodicity & concept working capital can be classified as below:
1. Permanent Working Capital
It is that portion of the working capital that remains permanently tied up in current assets to
undertake business activity uninterruptedly. In other words, permanent working capital is the
least amount of current assets needed to carry out business effortlessly. Thus, it is also
known as fixed working capital.
The amount of fixed working capital required by a business depends upon the size and the
growth of the business. For instance, minimum cash or stock required by a firm to undertake
the operational activities of the business. Now, permanent working capital can be further
subdivided into two categories:
2. Regular Working Capital
This is defined as the least amount of capital required by a business to fund its day-to-
day operations of a business. Examples include payment of salaries and wages and
overhead expenses for the processing of raw materials.
3. Reserve Margin Working Capital
Apart from day-to-day activities, a business may need some amount of capital for unforeseen
circumstances. Reserve Margin Working Capital is nothing but the amount of capital
kept aside apart from the regular working capital. These pool of funds are kept separately
for unforeseen circumstances such as strikes, natural calamities, etc
4. Variable Working Capital
This can be defined as the working capital invested for a temporary period of time in the
business. For this reason, it is also called as fluctuating working capital. Such a capital varies
with respect to the change in the size of the business or changes in the assets of the business.
Further, variable working capital is subdivided into two categories
5. Seasonal Variable Working Capital
This refers to the increased amount of working capital a business needs during the peak
season of the year. A business may even have to borrow funds to meet its working capital
needs. Such a working capital specifically meets the demands of business having a seasonal
nature.
6. Special Variable Working Capital
Supplementary working capital may also be required by a business to undertake
exceptional operations or unforeseen circumstances. The capital required for such
circumstances is termed as special variable working capital. Funds needed to finance
marketing campaigns, unforeseen events like accidental fires, floods, etc
7. Gross Working Capital
This refers to the aggregate amount of funds invested in the current assets of the
business. In other words, Gross Working Capital is the total of the current assets of the
business. These include:
 Cash
 Accounts Receivable
 Inventory
 Marketable Securities and
 Short-Term Investments
Gross Working Capital used alone neither shows the complete picture of the short-term
financial soundness. Nor does it showcase the operational efficiency of the business. Current
assets should be compared with the current liabilities to get a better understanding of a
business’s operational efficiency. That is, how efficiently a business utilizes its short term
assets to meet its day-to-day cash requirements.
8. Net Working Capital
Net Working Capital is the amount by which current assets exceed the current liabilities
of a business. Thus, the working capital equation is defined as the difference between current
assets and current liabilities. Where current assets refer to the sum of cash, accounts
receivable, raw material and finished goods inventory. Whereas, current liabilities include
accounts payable.
The amount of working capital in a business is the indicator of liquidity, operational
efficiency and short-term financial soundness of the business. Businesses having adequate
working capital typically have the ability to invest and grow.
On the other hand, businesses having insufficient working capital have higher odds of going
bankrupt. This is because of their inability to pay for their short-term obligations, thus
making it difficult for them to grow.
Characteristics of Working Capital:
1. 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 its return during the life-time of the firm.
2. 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.
3. 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
its 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.
4. Negative Working Capital: This situation occurs when the current liabilities exceed
the current assets. It is an indication of crisis to the firm.
Need for Working Capital:
Working capital is needed till a firm gets cash on sale of finished products. It depends on two
factors:
i. Manufacturing cycle i.e. 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. Thus, the sum total of these times is called an ―Operating cycle‖ and it
consists of the following six steps:
 Conversion of cash into raw materials.
 Conversion of raw materials into work-in-process.
 Conversion of work-in-process into finished products.
 Time for sale of finished goods—cash sales and credit sales.
  Time for realisation from debtors and Bills receivables into cash.
 Credit period allowed by creditors for credit purchase of raw materials, inventory and
creditors for wages and overheads.
Adequate working capital:
Adequate working capital means an amount of working capital sufficient to meet day to day
operation activities of the business concern under normal situations. No business can run
successfully without an adequate amount of working capital. If an enterprise has an adequate
working capital, it is able to carry on its affairs without any financial stringency and
economically. It will also be ready to face losses and unforeseen emergencies without
inviting any disaster.
Importance or advantages of adequate or optimum working capital:
The following are the advantages of adequate working capital.
1. Solvency of the Business: Adequate working capital ensures uninterrupted flow of
production. The finished goods can be sold thereby increase in sales turnover and results in
the sufficient cash in hand. In this way, solvency of the business is maintained.
2. Cash Discount: If proper cash balance is maintained, the business can avail of the cash
discount facilities offered to it by the suppliers.
3. Goodwill: Whenever the solvency of the business is maintained, the business concern can
make the payments within the stipulated time very easily. If so, the good will of the business
concern is created and maintained in the days to come.
4. Liquidity: An able businessman can determine the extent of working capital requirements
i.e. adequate working capital. In this context, the liquidity of the business concern is
maintained with the help of adequate working capital.
5. Easy Loan: If a business concern maintains high solvency of business and goodwill banks
and financial institutions are ready to extent credit facility i.e. loan on favorable terms. In this
way, the business concern gets the loan very easily.
6. Meeting unseen Contingencies: It provides funds for unseen emergencies so that a
business can successfully meet the contingencies. The impact of contingencies on the
business operation can be reduced at the maximum.
7. Regular Supply of Raw Materials: Adequate working capital ensures regular supply of
raw material for continuous flow of production.
8. High Morale: The executives cannot use the available funds according to their wishes. If
so, misuse of funds is highlighted through the business operation. The uses of funds increase
efficiency of employees and results in the higher income. In this way, high morale is
maintained among the employees.
9. Regular Payment of Commitments: The wages and salaries and other day to day
operating expenses should be paid within the stipulated time. It is possible only because of
maintaining adequate working capital. The regular payment of commitments increase the
efficiency of employees and reduces wastage, costs and enhances production and profits.
10. Good Relations with Banks and Financial Institutions: A business concern can repay
its loan with interest within the due date by having adequate working capital. This type of
practice ensures good relations with banks and financial institutions.
11. Exploitation of favorable Market Conditions: Market condition is in such a way that
trade discount and low price are available for bulk purchase. These type of favorable market
conditions can be availed only if adequate working capital is maintained.
12. Increased Fixed Assets Productivity: Generally, fixed assets are acquired for increasing
earning capacity of the business concern. Therefore, the fixed assets should be used properly.
The fixed assets can be used properly for increasing productivity with the help of adequate
working capital.
13. Ability to Face Crisis: Adequate working capital enables a business concern to face the
crisis during emergency period such as depression. Most of the business concern have no
adequate working capital during depression period. If one business concern has adequate
working capital, the specified business concern can reap more benefits.
14. Research and Innovation Programme: No research programme, innovation and
technical developments are possible to be undertaken without sufficient amount of working
capital.
15. Quick and Regular Return on Investments: Investor would always look for a way to
earn quick bucks. They also expect a regular returns on their investments. A company can
pay the dividends to its shareholders i.e. investors very quickly and regularly by maintaining
sufficient amount of working capital. This type of practice helps in obtaining confidence
among the shareholders.
16. Expansion Facilitated: The expansion of any type of business programme requires
additional funds. Adequate working capital facilitates the business concern for the successful
implementation of the expansion programme.
17. Increased Profitability: There should be a right proportion of fixed assets and current
assets. The maintenance of adequate working capital ensures the right proportion of fixed
assets and current assets. If so, there is a chance of being increased profitability of the
business concern.
Determinants of working capital:
The factors influencing the working capital decisions of a firm may be classified as two
groups, such as internal factors and external factors. The internal factors includes, 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. The external factors
include business fluctuations, changes in the technology, infrastructural facilities, import
policy and the taxation policy etc. These factors are discussed in brief in the following lines.
I. Internal Factors:
1. Nature and size of the business: The working capital requirements of a firm are basically
influenced by the nature and size of the business. Size may be measured in terms of the scale
of operations. A firm with larger scale of operations will need more working capital than a
small firm. Similarly, the nature of the business - influence the working capital decisions.
Trading and financial firms have less investment in fixed assets. But require a large sum of
money to be invested in working capital. Retail stores, business units require larger amount of
working capital, whereas, public utilities need less working capital and more funds to invest
in fixed assets.
2. Firm‘s production policy: The firm‘s production policy (manufacturing cycle) is an
important factor to decide the working capital requirement of a firm. The production cycle
starts with the purchase and use of raw material and completes with the production of
finished goods. On the other hand production policy is uniform production policy or seasonal
production policy etc., also influences the working capital decisions. Larger the
manufacturing cycle and uniform production policy –larger will be the requirement of
working capital. The working capital requirement will be higher with varying production
schedules in accordance with the changing demand.
3. Firm‘s credit policy: The credit policy of a firm influences credit policy of working
capital. A firm following liberal credit policy to all customers require funds. On the other
hand, the firm adopting strict credit policy and grant credit facilities to few potential
customers will require less amount of working capital.
4. Availability of credit: The working capital requirements of a firm are also affected by
credit terms granted by its suppliers – i.e. creditors. A firm will need less working capital if
liberal credit terms are available to it. Similarly, the availability of credit from banks also
influences the working capital needs of the firm. A firm, which can get bank credit easily on
favourable conditions, will be operated with less working capital than a firm without such a
facility
5. Growth and expansion of business: Working capital requirement of a business firm tend
to increase in correspondence with growth in sales volume and fixed assets. A growing firm
may need funds to invest in fixed assets in order to sustain its growing production and sales.
This will, in turn, increase investment in current assets to support increased scale of
operations. Thus, a growing firm needs additional funds continuously.
6. Profit margin and dividend policy: The magnitude of working capital in a firm is
dependent upon its profit margin and dividend policy. A high net profit margin contributes
towards the working capital pool. To the extent the net profit has been earned in cash, it
becomes a source of working capital. This depends upon the dividend policy of the firm.
Distribution of high proportion of profits in the form of cash dividends results in a drain on
cash resources and thus reduces company‘s working capital to that extent. The working
capital position of the firm is strengthened if the management follows conservative dividend
policy and vice versa
7. Operating efficiency of the firm: Operating efficiency means the optimum utilisation of a
firm‘s resources at minimum cost. If a firm successfully controls operating cost, it will be
able to improve net profit margin which, will, in turn, release greater funds for working
capital purposes.
8. Co-ordinating activities in firm: The working capital requirements of a firm is depend
upon the co-ordination between production and distribution activities. The greater and
effective the co-ordinations, the pressure on the working capital will be minimized. In the
absence of co-ordination, demand for working capital is reduced.
II. External Factors:
1. Business fluctuations: Most firms experience fluctuations in demand for their
products and services. These business variations affect the working capital requirements.
When there is an upward swing in the economy, sales will increase, correspondingly, the
firm‘s investment in inventories and book debts will also increase. Under boom, additional
investment in fixed assets may be made by some firms to increase their productive capacity.
This act of the firm will require additional funds. On the other hand when, there is a decline
in economy, sales will come down and consequently the conditions, the firm try to reduce
their short-term borrowings. Similarly the seasonal fluctuations may also affect the
requirement of working capital of a firm.
2. Changes in the technology: The technological changes and developments in the area
of production can have immediate effects on the need for working capital. If the firm wish
to install a new machine in the place of old system, the new system can utilise less
expensive raw materials, the inventory needs may be reduced there by working capital
needs.
3. Import policy: Import policy of the Government may also effect the levels of working
capital of a firm since they have to arrange funds for importing goods at specified times.
4. Infrastructural facilities: The firms may require additional funds to maintain the
levels of inventory and other current assets, when there is good infrastructural facilities in
the company like, transportation and communications.
5. Taxation policy: The tax policies of the Government will influence the working
capital decisions. If the Government follow regressive taxation policy, i.e. imposing heavy
tax burdens on business firms, they are left with very little profits for distribution and
retention purpose. Consequently the firm has to borrow additional funds to meet their
increased working capital needs. When there is a liberalised tax policy, the pressure on
working capital requirement is minimised. Thus the working capital requirements of a firm
is influenced by the internal and external factors.
6. Import policy: Import policy of the Government may also effect the levels of
working capital of a firm since they have to arrange funds for importing goods at specified
times.
7. Infrastructural facilities: The firms may require additional funds to maintain the levels
of inventory and other current assets, when there is good infrastructural facilities in the
company like, transportation and communications.
8. Taxation policy: The tax policies of the Government will influence the working
capital decisions. If the Government follow regressive taxation policy, i.e. imposing heavy
tax burdens on business firms, they are left with very little profits for distribution and
retention purpose. Consequently the firm has to borrow additional funds to meet their
increased working capital needs. When there is a liberalised tax policy, the pressure on
working capital requirement is minimised. Thus the working capital requirements of a firm
is influenced by the internal and external factors.
Excess or Inadequate working capital:
Every business concern should have adequate working capital to run its business operations.
It should have either redundant or excess working capital nor inadequate or shortage of
working capital. Both excess as well as short working capital positions are bad for any
business. However, out of the two, it is the inadequacy of working capital which is more
dangerous from the point of view of the firm.
Disadvantages of Excess working capital:
1. Excessive Working Capital means ideal funds which earn no profits for the business and
hence the business cannot earn a proper rate of return on its investments.
2. When there is a redundant working capital, it may lead to unnecessary purchasing and
accumulation of inventories causing more chances of theft, waste and losses
3. Excessive working capital implies excessive debtors and defective credit policy which may
cause higher incidence of bad debts.
4. It may result into overall inefficiency in the organization.
5. When there is excessive working capital, relations with banks and other financial
institutions may not be maintained.
6. Due to low rate of return on investments, the value of shares may also fall.
7. The redundant working capital gives rise to speculative transactions
Disadvantages of Inadequate working capital:
1. A concern which has inadequate working capital cannot pay its short-term liabilities in
time. Thus, it will lose its reputation and shall not be able to get good credit facilities.
2. It cannot buy its requirements in bulk and cannot avail of discounts, etc.
3. It becomes difficult for the firm to exploit favourable market conditions and undertake
profitable projects due to lack of working capital.
4. The firm cannot pay day-to-day expenses of its operations and it creates inefficiencies,
increases costs and reduces the profits of the business.
5. It becomes impossible to utilize efficiently the fixed assets due to non-availability of liquid
funds.
6. The rate of return on investments also falls with the shortage of working capital.
Sources of working capital:
1. Issue of Shares: A share is a financial instrument that represents a portion of the
ownership of the business for a financial investment in the business. Issue of shares is the
most important source of raising long term funds. Most companies collect fixed capital by
issuing shares. Generally, there are two types of shares, these includes equity and preference
shares.
2. Issue of Debentures: A Debenture represents the borrowed capital of the company. Fixed
capital is also collected from issue of debentures, a debenture is defined as a certificate of
acceptance of loans which is given under the company’s stamp and carries an undertaking
that the debenture holder will get a fixed return (fixed on the basis of interest rates) and the
principal amount whenever the debenture matures.
3. Loan from Financial Institutions: A loan paid back over an agreed period (term) where
principal and interest are paid off in monthly repayments. This interest may be fixed or
variable. Banks and other commercial lenders are popular sources of loans. Commercial
finance companies may be considered when the business is unable to secure financing from
other commercial sources.
4. Retained Earnings: Retained earnings are a part of undistributed profits earned by the
company. Since, the company does not distribute all of its profits to the shareholders. This
saved profit is called retained earnings. It is very economical because no interest payment is
to be made. Retained earnings are the cheapest source of fixed capital.
5. Sale of Capital Assets: Another way of raising funds is the sale of a firm’s assets that are
no longer needed, selling land, buildings, or machinery can cater to long term and bigger
finance needs. A major drawback in this type of financing is the benefits of useful assets
which are sold can no more accrue to the business.
6. Invoice Discounting: Invoice or bill discounting is a process in which goods and services
sold to customer on the basis of credit is cashed through a bank before the maturity date of
the bill at a value less than the par value of the bill. While discounting a bill, the Bank buys
the bill before it is due and credits the value of the bill after a discount charge to the business
concern’s account.
The bank then collects full value on the draft or bill of exchange when payment comes due.
The amount of the discount in the form of interest depends on the amount of time left before
the bill matures, and on the perceived risk attached to the bill.
7. Installment Credit: Installment credit is a form of finance to pay for goods or services
over a period through the payment of principal and interest in regular payments. The loan is
made on the basis of the borrower’s integrity and ability to pay.
8. Factoring: It is an arrangement in which a business sells of accounts receivable on a
contract basis to an agency known as a factor in order to obtain cash payment before the
accounts come due. The factor also undertakes exclusive responsibility for credit analysis of
new accounts, payments collection, and credit losses. A factoring agreement normally states
the exact conditions and procedures for the purchase of an account.
The factor, like a lender against a pledge of accounts receivable, chooses accounts for
purchase, selecting only those that appear to be acceptable credit risks. Where factoring is to
be on a continuing basis, the factor will actually make the firm’s credit decisions because this
will guarantee the acceptability of accounts. Factoring is normally done on a notification
basis, and the factor receives payment of the account directly from the customer.
9. Bank Loans: In order to meet temporary working capital requirement another channel is
borrowing Short-term loans from banks. These loans are to be repaid within a shorter
duration from the time they are borrowed. Usually bank loan involves high rate of interest.
10. Trade Finance: Trade credit is an important external source of working capital for a
company, in trade finance or credit an arrangement between two firms in made in which one
firm grants credit to another firm for the purchase of goods or services without making
immediate full payment.
It is credit obtained through open-account purchases represented by an accounts payable by
the buyer and an accounts receivable by the seller. For example, a credit of 2/10 net 30
indicates 2% cash discount if paid within 10 days, otherwise due in 30 days, this translates
into a 37% annual interest rate if the cash discount is foregone.
11. Commercial Papers: Commercial paper is a short-term financial instruments issued in
the form of an unsecured promissory by large corporations with high credibility to get funds
on order to meet short term debt obligations. Commercial Paper was introduced in India in
1990 with an objective to enable highly reputed and creditworthy corporate borrowers to
raise short term funds. Commercial paper generally matures in a short period of time and
usually does not exist for more than 270 days.
10. Trade Finance: Trade credit is an important external source of working capital for a
company, in trade finance or credit an arrangement between two firms in made in which one
firm grants credit to another firm for the purchase of goods or services without making
immediate full payment.
It is credit obtained through open-account purchases represented by an accounts payable by
the buyer and an accounts receivable by the seller. For example, a credit of 2/10 net 30
indicates 2% cash discount if paid within 10 days, otherwise due in 30 days, this translates
into a 37% annual interest rate if the cash discount is foregone.
11. Commercial Papers: Commercial paper is a short-term financial instruments issued in
the form of an unsecured promissory by large corporations with high credibility to get funds
on order to meet short term debt obligations. Commercial Paper was introduced in India in
1990 with an objective to enable highly reputed and creditworthy corporate borrowers to
raise short term funds. Commercial paper generally matures in a short period of time and
usually does not exist for more than 270 days.