introduction of working capital management

7/25/2019 Introduction of Working Capital Management

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Introduction of Working capital management

Working capital refers to that part of the rms capital which isrequired for nancing short- term or current assets such as cash,marketable securities, debtors & inventories.

Funds, thus, invested in current assts keep revolving fast and arebeing constantl converted in to cash and this cash !ows outagain in e"change for other current assets. #ence, it is alsoknown as revolving or circulating capital or short term capital.

Working capital management is concerned with the problemsarise in attempting to manage the current assets, the currentliabilities and the inter relationship that e"ist between them.

$he term current assets refers to those assets which in ordinarcourse of business can be, or, will be, turned in to cash within oneear without undergoing a diminution in value and withoutdisrupting the operation of the rm.

$he ma%or current assets are cash, marketable securities, account

receivable and inventor.

urrent liabilities ware those liabilities which intended at thereinception to be paid in ordinar course of business, within a ear,out of the current assets or earnings of the concern.

$he basic current liabilities are account paable, bill paable,bank over-draft, and outstanding e"penses.

$he goal of working capital management is to manage the rmscurrent assets and current liabilities in such wa that thesatisfactor level of working capital is mentioned.


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Meaning of Working Capital

apital required for a business can be classied under two main

categories via,

'( Fi"ed apital

)( Working apital

*ver business needs funds for two purposes for its establishment

and to carr out its da- to-da operations.

+ong terms funds are required to create production facilities

through purchase of "ed assets such as p&m, land, building,

furniture, etc.

nvestments in these assets represent that part of rms capital

which is blocked on permanent or "ed basis and is called "ed

capital.

Funds are also needed for short-term purposes for the purchase of

raw material, pament of wages and other da to- da e"penses

etc.

$hese funds are known as working capital. n simple words,

working capital refers to that part of the rms capital which is

required for nancing short- term or current assets such as cash,

marketable securities, debtors & inventories.

Funds, thus, invested in current assts keep revolving fast and are

being constantl converted in to cash and this cash !ows out

again in e"change for other current assets. #ence, it is also

known as revolving or circulating capital or short term capital.


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Concept of working capital

$here are two concepts of working capital

'. /ross working capital

). 0et working capital

$he gross working capital is the capital invested in the total

current assets of the enterprises current assets are those

1ssets which can convert in to cash within a short period

normall one accounting ear.

CONSTITUENTS OF CURRENT ASSETS

'( ash in hand and cash at bank

)( 2ills receivables

3( 4undr debtors

5( 4hort term loans and advances.

6( nventories of stock as

a. 7aw material

b. Work in process

c. 4tores and spares


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d. Finished goods

8( $emporar investment of surplus funds.

9( :repaid e"penses

;( 1ccrued incomes.

ividends paable.

5. 2ank overdraft.

6. :rovision for ta"ation , if it does not amt. to app. ?f prot.


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8. 2ills paable.

9. 4undr creditors.

$he gross working capital concept is nancial or going concernconcept whereas net working capital is an accounting concept of

working capital. 2oth the concepts have their own merits.

T'e gro(( concept i( (ometime( preferred to t'e conceptof working capital for t'e following rea(on()

'. t enables the enterprise to provide correct amount of

working capital at correct time.

). *ver management is more interested in total current assets

with which it has to operate then the source from where it is

made available.

3. t take into consideration of the fact ever increase in the

funds of the enterprise would increase its working capital.

5. $his concept is also useful in determining the rate of return

on investments in working capital. $he net working capital

concept, however, is also important for following rea(on(

t is qualitative concept, which indicates the rmsabilit to meet to its operating e"penses and short-term

liabilities.

$ indicates the margin of protection available to the

short term creditors.


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t is an indicator of the nancial soundness of

enterprises.

t suggests the need of nancing a part of workingcapital requirement out of the permanent sources of

funds.

Cla((i*cation of working capital

Working capital ma be classied in to was

?n the basis of concept.

?n the basis of time.

?n the basis of concept working capital can be classied as gross

working capital and net working capital.

?n the basis of time, working capital ma be classied as

:ermanent or "ed working capital.

$emporar or variable working capital


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"ermanent or *+ed working capital

:ermanent or "ed working capital is minimum amount which is

required to ensure e@ective utiliAation of "ed facilities and for

maintaining the circulation of current assets.

*ver rm has to maintain a minimum level of raw material, work-

in-process, nished goods and cash balance.

$his minimum level of current assts is called permanent or "ed

working capital as this part of working is permanentl blocked in

current assets.

1s the business grow the requirements of working capital alsoincreases due to increase in current assets.

Temporar, or -aria.le working capital

$emporar or variable working capital is the amount of working

capital which is required to meet the seasonal demands and some

special e"igencies.

Bariable working capital can further be classied as seasonal

working capital and special working capital.


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$he capital required to meet the seasonal need of the enterprise

is called seasonal working capital.

4pecial working capital is that part of working capital which is

required to meet special e"igencies such as launching ofe"tensive marketing for conducting research, etc.

$emporar working capital di@ers from permanent working capital

in the sense that is required for short periods and cannot be

permanentl emploed gainfull in the business.

Importance or ad-antage of ade/uateworking capital

Sol-enc, of t'e .u(ine(()


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1 concern can face the situation during the depression.

1uick and regular return on in-e(tment()

4uCcient working capital enables a concern to pa quick andregular of dividends to its investors and gains condence of

the investors and can raise more funds in future.

2ig' morale)

1dequate working capital brings an environment of

securities, condence, high morale which results in overall

eCcienc in a business.


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E+ce(( or inade/uate working capital*ver business concern should have adequate amount of

working capital to run its business operations. t should have

neither redundant or e"cess working capital nor inadequate nor

shortages of working capital.

2oth e"cess as well as short working capital positions are bad

for an business. #owever, it is the inadequate working capital

which is more dangerous from the point of view of the rm.

3i(ad-antage( of redundant or e+ce((i-eworking capital

*"cessive working capital means ideal funds which earn no

prot for the rm and business cannot earn the required rate

of return on its investments.

7edundant working capital leads to unnecessar purchasing

and accumulation of inventories.

*"cessive working capital implies e"cessive debtors and

defective credit polic which causes higher incidence of bad

debts.

t ma reduce the overall eCcienc of the business.

f a rm is having e"cessive working capital then the

relations with banks and other nancial institution ma not

be maintained.


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>ue to lower rate of return n investments, the values of

shares ma also fall.

$he redundant working capital gives rise to speculative

transactions.

3i(ad-antage( of inade/uate working capital

*ver business needs some amounts of working capital. $he need

for working capital arises due to the time gap between production

and realiAation of cash from sales.

$here is an operating ccle involved in sales and realiAation of

cash. $here are time gaps in purchase of raw material and

productionD production and salesD and realiAation of cash.

T'u( working capital i( needed for t'e following purpo(e()

For the purpose of raw material, components and spares.

$o pa wages and salaries

$o incur da-to-da e"penses and overload costs such as

oCce e"penses.

$o meet the selling costs as packing, advertising, etc.


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$o provide credit facilities to the customer.

$o maintain the inventories of the raw material, work-in-

progress, stores and spares and nished stock.

For studing the need of working capital in a business, one has to

stud the business under varing circumstances such as a new

concern requires a lot of funds to meet its initial requirements

such as promotion and formation etc. $hese e"penses are called

preliminar e"penses and are capitaliAed.

$he amount needed for working capital depends upon the siAe of

the compan and ambitions of its promoters.

/reater the siAe of the business unit, generall larger will be the

requirements of the working capital.

$he requirement of the working capital goes on increasing with

the growth and e"pensing of the business till it gains maturit.

1t maturit the amount of working capital required is callednormal working capital.

$here are others factors also in!uence the need of working capital

in a business.


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Factor( determining t'e working capital

re/uirement(

4 Nature of .u(ine(()$he requirements of working is ver limited in public utilit

undertakings such as electricit, water suppl and railwas

because the o@er cash sale onl and suppl services not

products, and no funds are tied up in inventories and

receivables.

?n the other hand the trading and nancial rms requires

less investment in "ed assets but have to invest large amt.

of working capital along with "ed investments.

5 Si6e of t'e .u(ine(()


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/reater the siAe of the business, greater is the requirement

of working capital.

3 "roduction polic,

f the polic is to keep production stead b accumulatinginventories it will require higher working capital.

5 #engt' of production c,cle)$he longer the manufacturing time the raw material and

other supplies have to be carried for a longer in the process

with progressive increment of labor and service costs before

the nal product is obtained.

4o working capital is directl proportional to the length of the

manufacturing process.

6 Sea(onal -ariation()/enerall, during the bus season, a rm requires larger

working capital than in slack season.

8 Working capital c,cle)$he speed with which the working ccle completes one ccle

determines the requirements of working capital. +onger the

ccle larger is the requirement of working capital.


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ash

7aw=aterial

Work inprogress

Finished/oods

>ebtors& 2ills

7eceivables

7 Rate of (tock turno-er)$here is an inverse co-relationship between the question of

working capital and the velocit or speed with which the

sales are a@ected. 1 rm having a high rate of stock

turnover will needs lower amt. of working capital ascompared to a rm having a low rate of turnover.

8 Credit polic,)1 concern that purchases its requirements on credit and

sales its product E services on cash requires lesser amt. of

working capital and vice-versa.

9 &u(ine(( c,cle)


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n period of boom, when the business is prosperous, there is

need for larger amt. of working capital due to rise in sales,

rise in prices, optimistic e"pansion of business, etc. ?n the

contrar in time of depression, the business contracts, sales

decline, diCculties are faced in collection from debtor andthe rm ma have a large amt. of working capital.

4: Rate of growt' of .u(ine(()n faster growing concern, we shall require large amt. of

working capital.

44 Earning capacit, and di-idend polic,)

4ome rms have more earning capacit than other due toqualit of their products, monopol conditions, etc. 4uch

rms ma generate cash prots from operations and

contribute to their working capital. $he dividend polic also

a@ects the requirement of working capital.

1 rm maintaining a stead high rate of cash dividend

irrespective of its prots needs working capital than the rm

that retains larger part of its prots and does not pa so high

rate of cash dividend.

45 "rice le-el c'ange()hanges in the price level also a@ect the working capital

requirements. /enerall rise in prices leads to increase in

working capital.

Ot'er Factor( are)

?perating eCcienc. =anagement abilit.

rregularities of suppl.

mport polic.

1sset structure.

mportance of labor.


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2anking facilities, etc.

Management of working capital

=anagement of working capital is concerned with the

problem that arises in attempting to manage the current

assets, current liabilities.

$he basic goal of working capital management is to manage

the current assets and current liabilities of a rm in such a

wa that a satisfactor level of working capital is maintained,

i.e. it is neither adequate nor e"cessive as both the

situations are bad for an rm.

$here should be no shortage of funds and also no working

capital should be ideal.

W?70/ 1:$1+ =101/*=*0$ :?+*4 of a rm has a

great on its probabilit, liquidit and structural health of the

organiAation.

4o working capital management is three dimensional in

nature as

' t concerned with the formulation of policies with regard to

protabilit, liquidit and risk.

) t is concerned with the decision about the composition

and level of current assets.

3 t is concerned with the decision about the composition

and level of current liabilities.


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Working capital anal,(i(

1s we know working capital is the life blood and the centre ofa business.

1dequate amount of working capital is ver much essential

for the smooth running of the business.

1nd the most important part is the eCcient management of

working capital in right time.

$he liquidit position of the rm is totall e@ected b themanagement of working capital.

4o, a stud of changes in the uses and sources of working

capital is necessar to evaluate the eCcienc with which the

working capital is emploed in a business.

$his involves the need of working capital analsis.

$he analsis of working capital can be conducted through anumber of devices, such as 7atio analsis, Fund !ow

analsis, 2udgeting etc


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4 RATIO ANA#;SIS

1 ratio is a simple arithmetical e"pression one number to

another. $he technique of ratio analsis can be emploed for

measuring short-term liquidit or working capital position of

a rm.

$he following ratios can be calculated for these purposes

'. urrent ratio.

). Guick ratio

3. 1bsolute liquid ratio

5. nventor turnover.

6. 7eceivables turnover.

8. :aable turnover ratio.

9. Working capital turnover ratio.

;. Working capital leverage


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$he ob%ective working capital budget is to ensure availabilit

of funds as and needed, and to ensure e@ective utiliAation of

these resources.

$he successful implementation of working capital budgetinvolves the preparing of separate budget for each element

of working capital, such as, cash, inventories and receivables

etc.

introduction of working capital management

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