Financial Management Chapter 5

WORKING CAPITAL MANAGEMENT

Introduction- Meaning and Definition, types of working capital, Operating cycle, Determinants of
working capital needs – Estimation of working capital requirements -problems. Sources of working
capital, Cash Management, Receivable Management, and Inventory Management (Concepts only).

Meaning
The term working capital in the broad sense refers to investments made in current assets
which comprises of cash, debtors, bills receivable, inventories, etc.
OR
In other words, it is the aggregate of all the currents assets held by a firm as on the given date
it is that part of the capital i.e., retained in liquid form.

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

TYPES OF WORKING CAPITAL

Types Of Working Capital

On the Basis of Value On the Basis of Time

Gross Working Net Working Permanent Working Temporary Working

Capital Capital Capital Capital

Negative Working Capital Positive Working Capital

1. Gross Working Capital: This is also known as circulating capital, operating capital or current
capital. It refers to the total of investments on current assets such as cash in hand, cash at bank,
accounts receivable, stock of finished goods, work-in-progress, stock of raw materials, prepaid
expenses, etc. The gross working capital is a financial or going concern concept.
Gross working capital = Total of current asset

2. Net Working Capital: Net working capital means the difference between current assets and current
liabilities. The net working capital is an accounting concept. Based on nature of difference
between current assets and current liabilities, the net working capital is named as:
(a) positive net working capital and (b) negative net working capital.
(a) Positive Working Capital: Positive working capital refers to the situation where current
assets are more than the current liabilities. If current assets > current liabilities positive working
capital. It indicates that, the company is financially sound in terms of working capital.
(b) Negative Working Capital: Negative working capital refers to a situation where the current
assets lesser than the current liabilities. It is also known as working capital deficit which means

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Financial Management Chapter 5
the excess of current liabilities over current assets. It indication of financial crisis of a business
in terms of its working capital status.
Negative working capital = current liabilities > current assets.
3. Permanent Working Capital: It is also known as fixed working capital which refers to the
minimum amount of investments in current assets required throughout the year for carrying
out the business operations. It is the irreducible amount of working capital.
This is the working capital, which is required for financing the stock of raw materials, finished
goods, paying wages, salaries and other payments of regular nature. s and other payments of
regular nature.
4. Temporary / Variable Working Capital: It refers to the amount of working capital, which goes
on fluctuating from time to time with changes in the volume of business activities. It is similar
to variable cost. During the peak season, more amount of working capital is required and slack
season, small amount of working capital is required.
OPERATING CYCLE
Collection Cash

Account
Purchase
Receivables

Raw
Customer
Material/
Services
Inventory

Finished
Production
Goods

DETERMINANTS OF WORKING CAPITAL NEEDS

The following are the factors which has its own effect on the working capital requirements of a
concern:
1. Nature of the Business: The nature business is one of the important factors affecting the working
capital. Service rendering and public utilities concerns business like railways, electricity supply
companies have large fixed assets but they require small amount or working capital. However,
manufacturing and trading enterprises like steel industry, cement industry need more working
capital as they have to invest substantially on inventories and accounts.
2. Scale of Operation / Size of Business: Size of operations is also affecting the working capital
requirements. Large-size business organizations require large amount of working capital but
small size business organizations require small amount of working capital.
3. Growth and Expansion of The Business: The growing and expanding business organizations
plans require more amount working capital compared to which are not growing and
expanding.
4. Length of Manufacturing Process: Longer the manufacturing process, the higher will be the
amount of working capital requirements. In trading concern, no manufacturing process is
involved so small amount Working capital requirements.
5. Production Policies: It has its great impact on the working capital needs. A capital-intensive
industry requires more fixed capital than working capital but labour-intensive industry
requires less fixed capital but more working capital.

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Financial Management Chapter 5
6. Rapidity of Turnover: This has the great impact on the working capital requirements because a
firm. If company's goods sold quickly or fast it requires less working capital. On the other hand,
if company's goods sold or turnover is very low or slow it requires more working capital.
7. Seasonal Fluctuations in Demand: his factor effects working capital requirements because
seasonal factors create production and shortage problems. For ex: seasonal agricultural
production must be purchased in the month of production for smooth running of business for
the full year. Similarly, demand of woollen clothes is in the winter only but has to be
manufactured throughout the year resulting in more working capital.
8. Dividend Policy: Dividends are paid out of profits earned, and its payments requires in cash. A
concern that maintains a steady high rate of cash dividend irrespective of its generation of
profits needs more working capital than the concern that retains larger part of its profits and
does not pay so high rate of cash dividend.
9. Level of Taxes: Higher taxes are a strain on the working capital of the firm.
10. Depreciation Policy: This has an indirect effect on the working capital of the firm because when
a company charges higher depreciation it reduces the profit available for dividend and results
in the less outflow of cash in the form of dividend.
11. Profit Level: A company which can earn high profits can contribute to the generation of internal
funds which results in contribute to the generation of internal funds which results in
contribution to more working capital.
12. Credit Policy of the Concern: It dealings with debtors and creditors influence considerably the
requirements of working capital. A concern that purchases it requirements on credit and sells
its product/services on cash requires lesser amount 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.
13. Price Level Changes: In the periods of raising prices a concern who has to pay more for the
purchases it makes but cannot increase the prices of its products considerably requires more
working capital.
14. Repayment Ability: A firm's repayment ability determines the level of its working capital. The
usual practice of firm is to prepare cash flow projection according to its plans of repayment and
fix working capital levels accordingly.
15. Cash Reserves: It would be necessary for a firm maintain some cash reserves to enable it to meet
contingent disbursements. This would provide a buffer against abrupt shortage in cash flows.
16. Changes in Technology: Technological developments related to the production process have a
sharp impact on the need for working capital.
17. Operational And Financial Efficiency: Working capital turnover is improved with a better
operational and financial efficiency of a firm. With a greater working capital turnover, it may
be able to reduce its working capital requirements.
18. Activities of the Firm: A firm's stocking on heavy inventory or selling on easy credit terms calls
for a higher level of working capital than for selling services or making cash sales.

Estimation of working capital requirements

The estimation of working capital requirements can be done using three main approaches:
1. Operating Cycle Method
2. Percentage of Sales Approach
3. Regression Analysis Approach
To estimate working capital accurately, it's essential to project future needs based on reliable
data. Since banks and financial institutions rely on these projections for financing, they must be as
precise as possible.

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Financial Management Chapter 5
SOURCES OF WORKING CAPITAL:
A business concern may procure funds from various sources to meet its working capital
requirements.

Sources of working capital

Long-term sources Short-term sources Other

sources

1. Issue of debentures
1). Trade credit
2. Sale of fixed assets
2). Bank credit 1). Accrued expenses
3. Public deposits
Bank over draft 2). Deferred incomes
4. Redeemable
preference shares Cash credit 3). Commercial
Loans paper
5. Ploughing back of
profits Bills purchased / discounted 4). Retained profits
6. Term finance from Working capital term loans 5). Depreciation and
industrial finance Amortization
Letter of credit provisions
corporations
3). Advance from customers
4). Short-term Public deposit
5). Indigenous bankers
6). Installment credit
7). Factoring

I The important sources of Long-Terms Working Capital are:

1. Issue of debentures: By the issue of redeemable debentures the company can raise long term
finance. They enjoy a lot of benefits through the issue of debentures like low interest rates fixed
interest, interest chargeable to profits for the purpose of income-tax and so on.
2. Sale of fixed assets: Any idle fixed assets can be sold and this fund can be utilized for financing
the working capital requirements.
3. Public deposits: Long term public deposit not exceeding 3 years also has become one
of the important sources of long-term working capital requirements.
4. Redeemable preference shares: The main merit of this type of source is that the dividend on
preference shares is fixed and it does not create any charge on the assets of the company.
Further, the redemption of preference shares is a remedy to the over capitalization problems.
5. Ploughing back of profits: It means the re-investment by a concern of its surplus earnings in
its business. A part of the earned profits may be ploughed back by the concern in meeting their
long-term working capital requirements. It is internal sources of finance and it is the cheapest
source of working capital.
6. Term finance from industrial finance corporations: There institutions give loans for a period
varying from 3 to 7 years and the financial institutions which provide such loans are LIC, SFC,
UTI and ICICI.

II The important sources of Short-Term or Temporary or Variable Working Capital:

1. Trade credit: It refers of the credit extended by the supplier of goods and services to the trade
customers/buying firms in the normal course of business. Means buying firm do not pay cash
immediately for the purchase made, but after an agreed period of time. The duration of the
credit is usually 15 days to 90 days. The three types of trade credit are:

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(a) Open accounts or accounts payable: Under which goods are sold to customers without
accepting any document or instrument evidencing the debts due.
(b) Notes payable: Under goods are sold on credit to the customers by executing the
promissory notes as a proof of debt.
(c) Trade acceptances: Under which goods are sold on credit to the customers by accepting
the drafts or bills of exchange drawn by the suppliers.
2. Bank credit: It represents the most important short-term sources of working capital finance.
Working capital finance is provided by banks in six ways:
(a) Bank over draft: It refers to an arrangement whereby the bank allows the firms to
withdraw in excess of the balance standing in its bank deposit account within a specified
limit. Only for current deposit account holders.
(b) Cash credit: The cash credit facility is to those of overdraft facility except the fact that the
firm need not have a formal current account, but cash credit is granted against the pledge
or hypothecation of stock or pledge of marketable instruments etc., are personal security.
(c) Loans: Under this arrangement, the entire amount of borrowing is disbursed at one time
only, either in cash or by transfer to the company's current account. It is a single advance.
The loan may be repaid in Installments with interest.
(d) Bills purchase/discounted: Discounting bills of exchange refers to an act of selling a bill
to obtain payment for it before its maturity.
(e) Working capital term loans: Under this arrangement, banks may grant working capital
term loans to the firms for period of 3 to 7 years, repayable in yearly or half yearly
Installments.
(f) Letter of credit: It refers a letter written by buyer bank to the seller stating that the bank
guarantees payment of an invoiced amount that in case of default or failure of the payment
made by the buyer.
3. Advances from customers: Some business get advances from their customers and agents
against orders and this source is a short-term source of finance for them. It is a cheap source
of finance and in order to minimize their investment in working capital.
4. Short-term public deposits: It is one of important source of working capital finance for well-
established big companies with huge capital base. The period of public deposits is restricted to
a maximum 3 years.
5. Indigenous bankers: Private money-lenders and other country bankers used to be the only
source of finance prior to the establishment of commercial banks. They charge very high rate
of interest and exploited the customers to the largest extent possible. Now-a-days they lost
their monopoly for the establishment of commercial banks.
6. Installment credit: Which the assets are purchased and possession of goods is taken
immediately but the payment is made in installment over a pre-determined period of time with
interest on the unpaid price.
7. Factoring: Factoring refers the outright sale of receivable/trade by a firm (client) at a discount
to a factor (financial intermediary) to obtain funds. Hence forth, the factor becomes
responsible for all credit control, sales accounting and debt collection from the buyers.
Different types of factoring are:
1. Invoice discounting
2. Advance factoring
3. Full factoring
4. Outright purchase of accounts receivables
5. With resource factoring
6. Without resource factoring
7. Maturity factoring

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Financial Management Chapter 5
8. Undisclosed factoring
III The Other Sources
1. Accrued expenses: Accrued expenses are the expenses which have been incurred but not yet
due and hence not yet paid also. These simply represent a liability that a firm to pay the
service already received by it. The most important items of accruals are wages and salaries,
interest and taxes.
2. Deferred incomes: Deferred incomes are incomes received in advance before supplying goods
and services. They represent funds received by a firm for which it has to supply goods or
services in future. These funds increase the liquidity of a firm and important source of short-
term finance.
3. Commercial papers: It represents unsecured promissory notes issued by firm to raise short-
term funds. It is an important money market instrument in advanced countries. In India, the
Reserve Bank of India introduced commercial paper in the Indian money market. The
maturity period of commercial paper, in India mostly ranges from 91 to 180 days. It is sold
at a discount from its face value and redeemed at face value on its maturity.
Cash Management
Cash Management refers to planning, controlling, and optimizing the usage of cash and cash
equivalents of a business. It ensures that the firm has sufficient liquidity to meet short-term
obligations while avoiding idle cash.

Objective
Maintain a balance — not too much (which reduces profitability) and not too little (which risks
insolvency).

Receivables Management (Accounts Receivable Management)

Receivables Management involves planning and controlling the amounts due from customers
(credit sales). It ensures timely collection of debts while maintaining good customer relationships.

Objective
Minimize the risk of bad debts and improve the speed of cash inflows without losing sales due to
strict credit policies.

Inventory Management
Inventory Management is the process of planning and controlling the levels of raw materials,
work-in-progress, and finished goods to ensure smooth production and sales. It balances between
carrying too much inventory (which increases storage and holding costs) and too little inventory
(which risks production delays and stockouts).

Objective
Maintain optimal inventory levels for uninterrupted operations at the lowest possible cost.

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Financial Management Chapter 5
Pro-Forma for Estimation Of Working Capital Requirement
1. For a trading concern: Pro-Forma
Statement of Working Capital Requirement
Particulars Amount
Current Assets:
1. Cash Xxx
2. Debtors or Receivables (For………..Month’s Sales) Xxx
3. Stock (For………..Month’s Sales) Xxx
4. Advance payments ……if any Xxx
5. Others Xxx
Less: Current Liabilities:
1. Creditors (for……month’s purchases) Xxx
2. Lag in payment of expenses (outstanding expenses, if Xxx
any) Xxx
Working capital (CA-CL) Xxx
Add: Provision / Margin Capital Requirement xxx
Net Working Capital Requirement
Notes:
1. Profit should be ignored while calculating working capital requirement as funds Provided by
profits may or may not be used as working capital.
2. Stock and debtors should be taken at cost unless otherwise required in a given question.

2. For a Manufacturing Concern

Statement of Working Capital Requirement
Particulars Amount
Current Assets:
1. Stock of Raw Materials (For………..Month’s Sales) Xxx
2. Work-in-progress (For….. Months)
a. Raw Materials xxx Xxx
b. Direct Labour xxx Xxx
c. Overheads xxx Xxx
3. Stock of finished goods (For………..Month’s Sales)
a. Raw Materials xxx Xxx
b. Direct Labour xxx Xxx
c. Overheads xxx Xxx
4. Sundry Debtor or Receivables (For…..Month’s sales)
a. Raw Materials xxx Xxx
b. Direct Labour xxx Xxx
c. Overheads xxx Xxx
5. Payment in advance (if any) Xxx
6. Balance of cash (Required to meet day to day expenses) Xxx
7. Any other (if any) Xxx
Less: Current Liabilities:
Xxx
1. Creditors (for……month’s purchases of Raw Materials)
Xxx
2. Lag in payment of expenses (outstanding expenses..
months)
Xxx
Working capital (CA-CL) Xxx
Add: Provision / Margin for Contingencies xxx
Net Working Capital Requirement

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Financial Management Chapter 5
Notes:
1. Profit should be ignored while calculating working capital requirement for the following
reasons:
a. Profit may or may not be uses as working capital.
b. Even if profits are to be uses for working capital it has to be reduced by the amount of
income-tax, drawings, dividend paid etc.
2. Calculation of work-in-progress depends upon its degree of completion as regards materials,
labour and overheads. However, if nothing is given in a question as regards the degree of
completion, it is suggesting the students to take 100% cost of material, labour as well as
overheads, because, in such a case the average period of work-in-process must have been
calculated as equivalent period of completed periods.
The same approach has been followed by various famous authors on this subject, but some
authors have assumed in the above case 100% consumption of raw materials and 50% in case of
labour and overheads).
Illustration 1
Prepare an estimate of working capital requirement from the following information of a trading
concern.
a) Projected annual sales 1,00,000 units.
b) Selling price ₹8 per unit.
c) Percentage net profit on sales 25.
d) Average credit period allowed to customers - 8 weeks.
e) Average credit period allowed to suppliers - 4 weeks.
f) Average stock holding in terms of sales requirement -12 weeks.
g) Allow 10 per cent for contingences.

Illustration 2
Prepare an estimate of working capital requirement from the following information of a trading
concern.
a) Project annual sales 1,20,000 units.
b) Selling price ₹10 per unit.
c) Percentage net profit as sales 30%.
d) Average credit period allowed 10 customers — 10 weeks.
e) Average credit period allowed to suppliers — 5 weeks.
f) Average stock holding in terms of sales requirement — 5 Weeks.
g) Allow 15 per cent for contingencies.

Illustration 3
Prepare an estimate of working capital requirement from the following data of a trading concern.
a) Project annual sales 80,000 units.
b) Selling price ₹ 8 per unit.
c) Percentage net profit as sales 20.
d) Average credit period allowed to customers — 10 weeks.
e) Average credit period allowed to suppliers — 8 weeks
f) Average stock holding in terms of sales requirement — 10 weeks.
g) Allow 20 per cent for contingencies.

Illustration-4
From the following information compute the working capital requirement for a company.
(a) Annual sales units
(b) Selling price ₹8 per unit
(c) Percentage net profit on sales 25%

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Financial Management Chapter 5
(d) Average credit period allowed to customer - 8 weeks
(e) Average credit period allowed by suppliers - 4 weeks
(f) Average stock holding in terms of sales requirement - 12 weeks
(g) Allow 10% for contingencies.

Illustration 5
X Co., is desirous to purchase a business and has consulted you and one point on which you are
asked to advise them is the average amount of working capital which will be required in the first
year's working.
You are given the following estimates and are instructed to add 10 per cent to your computed
figure to allow for contingencies:
Details Figures for the years
1. Amount blocked up in stocks:
Stock of Finished goods 12,000
Stock of stores, materials 20,000
2. Average credit sales:
Inland sales — 8 weeks credit 6, 00,000
Export sales — 2 weeks credit 1,60, 000
3. Lag in payment of wages and other outgoings:
Wages – 2 Weeks 5, 00, 000
Stock of materials — 2 months 1,00, 000
Rent, Royalties — 6 months 20,000
Clerical staff— 1 month 10,000
Miscellaneous Exps — 2 months 1,00,000
4. Payment in Advances:
Sundry expenses (paid quarterly) 20,000

Illustration 6
A Cost Sheet of a company provides the following particulars:
Elements of cost Amount Per Unit
Materials 80
Direct labour 30
Overheads 60
Total Cost 170
Profit 30
Selling Profit 200
The following further particulars are available:
(a) Raw materials are in stock for one month(average).
(b) Raw materials are in process on an average for half a month.
(c) Finished goods are in stock on an average for one month.
(d) Credit allowed to supplier is one months.
(e) Lag in payment of overheads is one month.
(f) Lag in payment of wages is 11/2 weeks.
(g) 1/4th output is sold against cash.
(h) Cash in hand and at bank is expected to be ₹ 1,25,000.
(i) Credit allowed to customer 2 months.
You are required to prepare a statement showing the working capital needed to finance level of
activity of 2,08,000 units of production.

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Financial Management Chapter 5

Question Bank
Section A (2 Marks)
1. What are the sources of Working Capital? (2013,2016,2019)
2. List any two repercussions when a firm has excess Working Capital. (2013)
3. What are the factors which determine the Working Capital needs of a company? (2013)
4. What do you mean Permanent Working Capital? (2014)
5. Mention any four components of Working Capital. (2014, 2015,2018)
6. What is gross Working Capital (2021)
7. State the concepts of Working Capital (2022)
8. Mention four factors influencing Working Capital (2024)
9. What are the advantages of Adequate Working Capital? (2024)

Section B (4 Marks)

1. Briefly explain the sources of working capital. (2014, 2015,2018,2021,2024)

2. What factors determine working capital needs? (2016)
3. Briefly explain the motives of holding cash. (2025)

Section C (12 Marks)

1. What is working capital? Discuss the importance of adequate working capital.

(2016,2022,2024)
2. Give a brief note on sources of funding working capital (2016)
3. Briefly explain the factors influencing the amount of working capital (2018,2023)
4. What is working capital? Explain the factors determining the working capital. (2019,2021,
2025)

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