Working Capital: Definition, Classification and Sources

After reading this article you will learn about Working Capital:- 1. Definition of Working Capital 2. Need for Working Capital 3. Classification 4. Determinants 5. Components 6. Financing 7. Inadequacy 8. Remedies 9. Assessing Working Capital Requirements 10. Operating Cycle (O. C.) Approach or Cash Working Capital Approach 11. Financing Working Capital.

Contents:

  1. Definition of Working Capital
  2. Need for Working Capital
  3. Classification of Working Capital
  4. Determinants of Working Capital
  5. Components of Working Capital
  6. Financing of Working Capital
  7. Inadequacy of Working Capital
  8. Remedies of Working Capital
  9. Assessing Working Capital Requirements
  10. Operating Cycle (O.C.) Approach or Cash Working Capital Approach
  11. Financing Working Capital



1. Definition of Working Capital:

In order to maintain flows of revenue from operations, every firm needs certain amount of current assets. For example, Cash is required either to pay for expenses or to meet obligations for service received or goods purchased etc., by a firm. On the identical plane, inventories are required to provide the link between production and sale.

Similarly, accounts receivables generate when goods are sold on credit. Needless to mention Cash, Bank, Debtors, Bills Receivables, Closing Stock (including Raw Materials, Work-in-Progress and Finished goods). Prepayments and certain other Deposits and Investments which are temporary in nature, represent Current Assets of a firm.

Economists like Mead, Mallot, Backer and Field are of the opinion that the whole of these current assets from the Working Capital of a firm. And this concept of Working Capital of a firm is frequently termed as Gross Working Capital in the arena of Financial Management.

Gross Working Capital = Total Current assets.

or, Gross Working Capital = Long-term internal liabilities plus Long-term debts plus the Current liabilities minus the amount blocked in the Fixed Assets.

There is also another opinion regarding the concept of working capital. Prof. H. G. Guthmann and H. E. Dougall. For example, define working capital as the excess of current assets over current liabilities. That is, the amount of current assets that would remain in a firm if all its current liabilities are paid.

This concept of working capital is known as Net Working Capital in the contemporary literature on Financial Management. Of course, this aspect of working capital is a more realistic approach than the Gross Working Capital concept.

Net Working Capital = Current Assets minus Current Liabilities,

or Net Working Capital = Equity plus long-term debts minus as much as blocked in Fixed Assets.



2. Need for Working Capital
:

In order to earn sufficient profits, a firm has to depend on its sales activities apart from others. We know that sales are not always converted into cash immediately, i.e., there is a time-lag between the sale of a product and the realization of cash.

So, an adequate amount of working capital is required by a firm in the form of different current assets, for its activities to continue uninterrupted and to tackle the problems that may arise because of the time-lag.

Practically, this happens simply owing to the ‘Operating cycle or ‘Cash cycle’. “Cash cycle’ or ‘Operating cycle’ involves the following steps:

(a) Conversion of Cash into Inventory;

(b) Conversion of Inventory into Receivable,

(c) Conversion of Receivables into Cash.



3. Classification of Working Capital
:

The working capital admits of two broad classifications, viz:

(a) Regular or Fixed or Core or Permanent Working Capital;

(b) Variable or Seasonal or Temporary Working Capital.

(a) Regular or Fixed or Core or Permanent Working Capital:

The amount of current assets which are kept by a firm in hand day-in and day out, i.e., throughout the year is designated as Regular or Fixed Working Capital.

In other words, in order to maintain the normal day-to-day activities, a certain minimum level of working capital is required on a continuous and uninterrupted basis which will have to be met permanently along with other fixed assets; they are considered as fixed working capital.

On the other hand, due to seasonal variation/fluctuation, investment in raw materials, W-I-P, finished products will fluctuate or fall In consequence, this portion of the working capital is required in order to meet such fluctuation. It can also be stated that any amount over and above the permanent level of working capital is Variable or Seasonal or Temporary Working Capital.

We know that both fixed and variable working capital is required to maintain the production and sales activities. Practically, variable working capital is required to meet the liquidity requirements for short-term obligation.

The difference between the fixed and variable working can better be represented with the help of the following diagram:

Showing the Permanent and Temporay Working Capital

It is quite clear from the Fig. 8.1 that permanent working capital is constant but variable working capital fluctuates i.e., sometimes increasing or sometimes decreasing according to seasonal demands of the product.

For a growing/expanding firm, the permanent working capital line may not be horizontal since demand for permanent current assets is increasing or decreasing.

Thus, the difference between the permanent and temporary working capital for an expanding firm can be depicted as under:

Showing the Permanent and Temporary Working Capital

Sources of Regular or Fixed or Core or Permanent Working Capital:

Every firm has to anticipate at the time of planning the initial capital structure of the company, the minimum amount of working capital that it would require to support is projected level of operation.

This minimum working capital a firm has to provide out of long-term sources, such as:

(i) Issue of Shares;

(ii) Issue of Debentures; and

(iii) Retention in various forms (i.e., Ploughing back of profits. General Reserves etc.)

(i) Issue of Shares:

As raising of funds by the issue of shares has certain distinct edges over other sources, especially, the borrowed capital, namely, once procured it is non-refundable except in case of liquidation, does not create any charge or any encumbrances on the assets of the company, and does not impose any fixed charge for its use, it is advantageous for a firm to finance its Fixed or Regular or Core working capital requirements out of the proceeds of the issue of shares which in common parlance goes by the name of ownership capital.

(ii) Issue of Debentures or Long-Term Borrowings:

Fixed or Regular or Core working capital may also be procured by issuing Debentures. As Debentures are fixed charge securities, besides being redeemable at the option of the company, the entire surplus after the payment of Debenture interest, goes to the credit of equity shareholders either in the form of increased rate of dividend or in the form of increased retention.

Similar advantages also accrue if working capital is financed by long-term borrowings in other forms. But Debentures or long-term borrowings being non-starter, it is difficult for a new firm to raise its working capital by resorting to these techniques.

Besides, the redemption features of long-term loans and Debentures may create the problem of working capital finance, unless specific provision is made for their redemption and said provision is kept invested in outside securities.

(iii) Retention:

Retention in the garb of free or General Reserve and/or credit balance of Profit and Loss Account may also become a source of working capital for an established company.

Although it is essentially a means of financing for extension and devel­opment of a firm and its availability depends upon a host of factors, such as, the rate of taxation, the dividend policy of the firm, Government policy on the payment of dividend by the corporate sector, extent of available surplus and upon the firm’s appropriation policy, it is very often used to finance the working capital requirements of a firm.

(b) Sources of Seasonal or Variable Working Capital:

The firms which are seasonal in character in their business need a large amount of working capital for holding inventory during the peak period. But, as soon as the peak period is over, their working capital becomes idle.

In the circumstances, such firms do not prefer to finance working capital by long-term sources as this exposes them to cost with no return therefore — during the slack session. Therefore, firms having seasonality in their business find it convenient to meet their working capital requirements by resorting to short-term sources, such as:

(i) Bank Loan;

(ii) Public Deposits;

(iii) Trade Credit and Other Payables;

(iv) Provision for Taxation;

(v) Depreciation Provisions, etc.

(i) Bank Loan (Including Cash Credit/Overdraft):

Firms usually prefer to use Bank Loan in the form of Cash Credit and/or Over­drafts by means of unsecured Promissory notes for 90 to 180 days or against hypoth­ecation of inventories or against endorsement of accounts receivable for financing their working capital.

The advantages of obtaining working capital finance by Bank borrowings in the form of cash credit or overdrafts are that the borrower need not draw at once the whole amount of credit granted to him, but can do so by instalment as and when required.

Secondly, he can put back any surplus amount which he may find with him for the time being. Finally, interest payable by the borrower only on the amount to his debit at the end of each day business. But, to what extent a firm can raise its working capital by resorting to these techniques of financing depends, apart from its ability to hypotheticate or pledge securities, upon the credit policy of the Government.

(ii) Public Deposits:

Another method of procuring the finance to meet the requirement of short-term or seasonal working capital is public deposits. It has been a major source of finance for working capital in the field of cotton-textile mills of Bombay and Ahmedabad though it did not obtain in Delhi, Madras and in other parts of India.

Further, being essentially, an unsecured loan in the past, it was found, to arouse temptation for overtrading by borrowers with all grave consequence in its trail.

Consequently, with the growth of practice of making funds available for working capital purposes in India by Commercial Banks, the system of inviting public deposits for financing working capital requirements went into oblivion till the seventies.

After seventies, however, there has again been resurgence of public deposits as a source of working capital finance to industries in India as the same are finding it increasingly difficult to obtain their necessary working capital finance from banks.

(iii) Trade Credit and Other Payables:

Trade Credit is the credit granted by seller of raw materials and goods etc. to manufactures and/or wholesaler. It generally takes the form of discount for cash payment on delivery and net for future payment. The rate of discount and the period of payment may, however, vary. Among the twin objectives of trade credit and other payables, one is to serve as a source of working capital finance and is referred to as ‘financial’.

The trend and significance of trade credit as a source of working finance, however, depends on several factors, like, the size and the rate of growth of the company, its financial resources and Bank finance.

Further, since Trade Credit is costlier than Bank loans, it is used as a supplement to Bank loans for financing the short-term requirements of firms. Other payable include accrued wages and salaries, commissions and dividend. These outstanding factor payments also help to provide working capital finance, however, temporary it may be.

(iv) Provision for Taxation:

Under the Income-Tax Act, firms are liable to pay income-tax on the assessable net profit as per rates prescribed for the same by Finance Act from time to time. As such, once the net profit of a firm has been ascertained, it makes provisions out of the said profit for payment of Income-tax.

Normally, there is a time-lag between the creation of the provision for taxes and their actual payment. And in the period the resources as against this provision which remain within the enterprise may be used as a source of working capital.

(v) Provision for Depreciation:

Short-term financing is less expensive than long-term one. But at the same time, short-term financing involves greater degree of risk. In the circumstances, the choice of sources between short-term and long-term for financing working capital of a firm has to be decided with reference to the risk-return trade off.

Generally, however, in view of lower cost and flexibility, management usually finds it more convenient to finance their working capital requirements by relying more on short-term sources than on long-term sources.

In India, recently, the role of Bank in relation to working capital finance to industries, among others, was reviewed at the instance of Reserve Bank of India by a study group under the chairmanship of Mr. P L. Tandon, as an imbalance was noticed between the growth of Bank credit and industrial production within the country.

The study group in its report, not only suggested three distinct methods of working out the working capital gap of firms, but also mentioned that borrowers must provide 25% of total current assets out of long-term funds, i.e., owned funds plus long- term borrowings. The said 25% being calculated differently at the aforesaid three distinct stages.



4. Determinants of Working Capital
:

Needless to mention here that there is no such hard and fast formulae for ascertaining the proper requirements of working capital. Because, it varies from firm to firms, industry to industry and even in the different seasons of the same firm. Of course, a large number of factors influence the requirement of working capital, i.e., it depends upon a host of factors.

They are discussed hereunder one by one:

(a) Nature and Size of Business:

The requirements of working capital of a firm are widely related to the nature and size of the business unit. For example, trading and financial firms require a large amount of investment in working capital but a significantly smaller amount of investment in fixed assets.

Similarly, a service oriented firm, e.g., transport or electricity generation, needs a modest working capital requirement since it has a very short operating cycle and sales are made on cash basis.

But in the case of manufac­turing concern which sells its product on credit basis and has a long operating cycle, needs a large amount of working capital. Moreover, the size of the firm is also an important factor. Because, a smaller firm needs smaller amount of working capital on the basis of its production activities and vice-versa in the opposite case.

We know that the proportion of current asset to total asset determines the relative requirements of working capital. The following table shows the relative proportion of current asset to fixed asset/total asset investment in various industries which confirm the wide variation in working capital requirement.

(b) Production/Manufacturing Cycle:

The production cycle involves the time lag which require from the manufacture of goods to the finished product. Here, time-lag includes from the procurement of raw materials (including processing time) to the production of finished goods and thus funds are blocked in materials, labour and overhead till the finished products are come out.

In short, there is a time-lag or gap between the procurement of raw materials and the production/sale of finished goods. For this purpose, working capital is absolutely required. Thus, the longer the time-lag either in the storage of raw material, or in the processing period or in the finished product, the more will be the requirements of working capital and vice-versa in the opposite case.

It may be remembered in this respect that if there is any alternative method for manufacturing a product which requires a shortest manufacturing cycle, that should be accepted Needless to say here that sometimes, some firms which produce heavy machinery or capital goods take some advance from their customer in order to minimize their investment in working capital.

(c) Business Fluctuation/Cycle:

The requirements of working capital of a firm are largely affected by the seasonal and cyclical fluctuations which have a direct impact, particularly on the temporary working capital.

Such situation is of two types viz.:

(i) Where there is upward swing, and

(ii) Where there is downward swing.

In the case of former, turnover will rapidly be increased and as a result, investment in inventories and debtors will correspondingly be increased in addition to the additional investment in fixed assets for increased productivity. For the purpose of additional investment by way of fixed capital and working capital, temporary borrow­ings can be obtained from the market.

Similarly, in case of later i.e., where there is a declining trend, opposite situation will arise. In short, turnover will be reduced so as to reduce the investment in inventories and book-debts etc. and as such, short-term borrowings are not required. Thus, business fluctuations affect the size of working capital requirements and so also the seasonal fluctuations.

(d) Production Policy:

The requirements of working capital are also largely affected by the production policy of the firm. Because in the case of a seasonal product, the firm has to concentrate on the two options — viz., either to purchase raw materials for manu­facturing finished products for certain months of the year when the market is ready for sale, or, to produce articles throughout the year.

In the later case, however, the firms must have to concentrate for manufacturing varied products when there is off­season for the original product. In other words, in order to utilize the physical resource and working force, this policy is quite justified although a greater amount of working capital is required for the purpose.

(e) Growth and Expansions:

It is needless to say that if a firm extends its production capabilities, more additional funds are required by way of fixed capital investments and current assets investments as well although it is really difficult to ascertain precisely the relationship between the production volume and the needs of working capital.

The critical fact, however, is that the need for increased working capital funds does not follow growth business activities but precedes it. As such, advance planning of working capital is absolutely necessary on a continuous basis in these cases.

(f) Credit Policy of the Firms:

We know amount of book-debts depend on the credit period allowed by the firm to its customer. If more credit period is allowed, the more will be the requirement of working capital.

From the stand-point of liquidity and financial strength, we should grant always less credit period i.e., the firm should be prompt in making collections. Industry average norms should be followed although it may be varied from the customer to customer depending on their personal behaviour and trend.

Thus, every firm should follow a rationalized credit policy depending upon the credit status of the customers and some factors. Sometimes the firm should analyze the existing credit policy and modify the same, if necessary, by reviewing the credit worthiness of various customers Thus, credit policy of the firm affects the requirement of working capital.

(g) Operating Efficiency:

We know that the management of every firm may contribute to a great extent to the working capital position by operating efficiency in the form of efficient utilization of existing resources, improving co-ordination, eliminating waste etc. This operating efficiency accelerates the pace of the cash cycle and improves the working capital position.

It is known to us that proper utilization of resources, no doubt, improves the profitability of the firm and reduces the pressure on working capital. Thus, the management can effectively use of its materials, labours and overheads although they have nothing to do to control the prices of materials, labours and overheads.

(h) Profit Element:

The amount of net profit which has been realized in cash, is a source of working capital. Such realized cash profit can be determined after adjusting non-cash items, viz. depreciation, outstanding expenses etc. from the net profit. Practically, the net cash flow from operation must not be considered as they are available for use at the end of the financial year.

Even as the company’s operations are in progress, cash is used up for augmenting stocks, book-debts or fixed assets. So, it is the duty of the financial manages to sell whether the said cash which is generated is used for right purpose in an efficient manner.

We also know that if net profits are earned in cash, the entire amount cannot be utilized by way of working capital would be affected accordingly. Thus, the cash which is generated from operation depends on some policy of the firm viz., taxation, depreciation, dividend etc.

The requirements of working capital also depend on whether the profit is retained or distributed by way of dividends. Because, if dividend is paid out of profit, cash reserves of the firm is reduced to that extent for which amount of working capital is reduced by that amount.

On the contrary, if the said profit is not distributed by way of dividend but retained, no doubt, the working capital position will improve. Thus, whether the profit shall be retained or distributed depends upon some factors which are to be carefully studied by the financial manager.

Besides the above factors there are some factors which have direct bearing on working capital requirements of a firm. They are Dividend Policy, Depreciation Policy. Availability of Raw Materials. Thus, from the above discussion it becomes clear that the level of working capital requirements depends upon a host of factors which are partly internal and partly external.

Effect of Inflation or Price Level Changes:

It is needless to mention that the financial manager will experience a serious problem if the price level increases. He must anticipate such change while ascertain­ing the requirements of working capital. We know that under changing price level, a firm must have to maintain a higher level of working capital with its various components.

In other words, in order to maintain the same level of current asset, a firm will need increased investment in different components if price level increases. But, a firm who can immediately increase the value of each product as a result of increased prices, will not experience a serious problems relating to current assets investment but vice-versa in the opposite case.

Moreover, the effect of increased prices will be felt by various firms in a different way since individual prices may not move in the identical manner.

That is, it may so happen that some firms do not fall a serious problem in working capital management as a result of inflation while the others are affected badly by it. So, the effect of inflation will not be the same in the case of all the firms, i.e., some will face a serious problem while the other do not.



5. Components of Working Capital
:

There are two components of working capital; viz., Current Assets and Current Liabilities.

(a) Current Assets:

An asset is termed as current asset when it is acquired either for the purpose of selling or disposing of after taking some required benefit through the process of manufacturing or which constantly changes in form and contributes to transactions take place with the operation of the businesses, although such asset does not continue for long in the same form As for instance.

Cash is often parted with in exchange of goods or services or in repayment of certain liability, say Creditor. Similarly, Debtors as asset yield place to Cash on realization or Sock-in-trade is replaced by Cash or Debtors on its sale, the former in case of cash sales and the latter is case of credit sales.

So, they are not only short lived but also change their form and one type of assets can easily be converted into another, say Cash is converted into Raw Materials, Raw Materials into Work-in-Progress, Work-in-Progress into Finished Products and Finished Products into Debtors in case of credit sales and Debtors into Cash.

That is why, they are also defined as circulating assets. The aforesaid conver­sion of one item of current asset into another in a manufacturing concern has been depicted in Figure 8.3.

clip_image010Conversion of current Assets

Time required for ultimate conversion of any component of current assets into cash is normally taken to be one year or less. Now-a-days, this concept has suffered a little bit of change. It is not essential that current assets should always be converted into cash immediately.

0It may also be lost or consumed. For example, when salaries and wages are paid in cash, a part of cash is consumed and does not create any current asset through transformation directly.

But when Cash is received from Debtors, Debtors are converted into Cash, Debtors here are not consumed but transformed or rather converted. The period of conversion in this case is also reckoned to be one operating cycle of the business instead of one year.

The list of current assets comprises:

Inventories (including Raw Materials, Work-in-Progress and Finished Goods and Spares), Sundry Debtors including Receivables (but net of provisions), Readily Realizable Securities and Tax Reserve Certificates, Short-term Investments, Accrued Incomes, Prepaid Expenses (not in the nature of ‘deferred charge’) Cash at Bank and Cash in hand.

(b) Current Liabilities:

Current liabilities are those which are repayable or liquidated within a short period of time by the use of the existing resources of current assets or by the creation of similar current liabilities. The short-period concerned is used to refer to a period not exceeding one year from the Balance Sheet date.

But accountants at present, as in the case of current assets, are inclined to assess current liabilities also with reference to the normal operating cycle of the business so far as the time period is concerned.

Liabilities which fall due after a comparatively long period are known as fixed or long-term liabilities. As distinguished from current liabilities, fixed liabilities are, therefore, those which are not repayable within one year of the Balance Sheet date’, or normal operating cycle of the business.

But a closer examination would reveal that towards the end of their lives fixed liabilities also may be treated as current liabilities,’ Debenture is a typical example of this type of liability, as the identification of the maturity of the same cannot be a problem in view of the legal requirements relating to the Balance Sheet of the corporate enterprise.

List of current liabilities, therefore, includes, Trade Creditors, Accounts Payable. Outstanding or Accrued expenses. Bank Overdraft (of temporary nature). Outstanding Liabilities (e.g., compensation payable) short-term loans and borrowings and certain other obligations including different provisions, i.e. Provision for Taxation, Proposed Dividend etc.

In order to ascertain the real position of wording capital, certain adjustments, which are abnormal in nature, are to be adjusted against each component of current assets and current liabilities. At the same time, it is also to be looked into whether or not, the current assets or current liabilities are window-dressed.

Working Capital: Positive or Negative:

If current assets exceed current liabilities, it is called positive working capital and if current liabilities exceed current assets, it is called negative working capital. Needless to mention, if gross concept of working capital is used, there will always be positive working capital (since current liabilities are not deducted from current assets).

On the other hand, if net concept of working capital is used, there may be positive, negative or nil (current asset = current liabilities) working capital. It can also be explained from another standpoint. If current assets are financed from long- term sources, working capital will always be positive one. On the contrary, if fixed assets are financed from short-term sources, working capital will always be negative one.

The following example will make the principle clear:

Working Capital:

Firm A = Rs. 8,000 — Rs. 5,000 = Rs. 3,000 (Positive)

Firm B = Rs 8,000 — Rs. 10,000 = (-) Rs. 2,000 (Negative)

In Firm A, Current assets are financed from long-term sources to the extent of Rs. 3,000 (Rs. 15,000 – Rs. 12,000); whereas in Firm B, Fixed assets are financed from short-term sources to the extent of Rs. 2,000 (Rs. 10,000 – Rs 8,000).



6. Financing of Working Capital
:

The working capital financing in private sector undertakings. Public sector undertakings also apply some of the said techniques for working capital requirements of private sector. For this, it can be stated that the public sector undertakings take the advantages of internal sources and from various commercial banks in order to meet this working capital requirements.

Needless to say that major bulk of working capital is needed for financing inventories and followed by accounts receivables, loans and advances and liquid cash. However, the net requirement of working is ascertained after adjusting the credit allowed by supplies and the credit allowed to the customers.

It has also been explained earlier that proper requirements of working capital depends upon certain factors, viz., types, nature, size of the firm i.e., it differs from one firm to another. It may so happen that a certain minimum amount of working remain fixed throughout the year (say, inventory) i.e., it never comes down below that level, the said minimum level of working capital may be considered as fixed.

Moreover, if the production cycle of a sector is long, more amount of working capital will be needed as the same will be blocked in work-in-progress and in the opposite case, if the production cycle in short, a small amount of working capital will suffice.

In addition, we know that public sector undertakings are capital intensive and as such, the ratio of current assets to fixed assets is very low. But it is interesting enough that cash locked up in the form of working capital is very high. The entire requirements of working capital of public sector undertakings were financed by the Government until recently.

At present, the public sector undertakings are meeting working capital requirements from nationalized banks. The banks also do not rigidly follow the norms of lending credit like private sector undertakings. However, due to the under-mentioned features, the management of working capital in public sector undertakings is not effectively used:

(i) Percentage of safety stock level is very high so that a large amount of working capital is blocked in inventory.

(ii) Maintaining a high debtors turnover ratio due to the delay of preparing and passing bills to customers, e.g.: BHEL.

(iii) Delays while processing of papers which invite abnormal lead time for placing orders for materials.

(iv) A high level of inventory of raw materials is maintained for an optimistic approach for capacity utilization for the same.

(v) As most of the public sector undertakings are capital intensive (already referred to above), the ratio of current assets to fixed assets is very low e.g., heavy engineer­ing, oil refining etc.

(vi) Public sector undertaking at present, use short-term financing from nationalized bank as they seem to be quite liberal while extending credit to the public sector undertaking as the risk involved here is minimum.

(vii) Public sector undertakings do not make usually any provision for working capital, as such, financing for working capital is made from short-term sources. Because long-term sources are used for acquiring fixed asset.

(viii) The manufacturing cycle is longer than what it should be due to non-synchronization of different inputs, non-availability of some key factors etc.

(ix) Public sector undertaking cannot manipulate the variables relating to the accounts receivable, viz., allowing excessive discount, extending credit period or reducing credit standard as they sell their products to the Government directly.




7. Inadequacy of Working Capital
:

Inadequacy of working capital is the usual practice almost all public sector undertak­ings. While planning for a capital project, funds are provided from long-term sources and no provision is made for working capital require­ments. It is, therefore, as far as possible, procured from short-term sources.

Thus, the public sector undertakings suffer greatly from under-utilisation of the capacity due to lack of required funds. Needless to mention that when such acute working capital deficit arises and the firm operates its resources below the break-even point of utilisation, it experiences deficit instead of creating surplus/profit.

For this purpose, many public sector undertakings appear in the market on the basis of poor market estimate as a result of improper formulation of policies, Even in some cases it was found that the demand for the product is far from what it was expected.

Thus, the public sector undertakings increase its debts to The Government and find greater shortage of working capital When input control was strictly maintained sometimes in the past, many public sector undertakings hold their imported stock of raw materials at a maximum level than their real requirements which brought unnecessary engagement of working capital, i.e., working capital was blocked in the form of raw materials and experience an acute shortage of funds for net working capital.




8. Remedies of Working Capital
:

The following points should carefully be considered while estimating working capital requirements of a public sector undertakings:

(i) While formulating policy, proper provision must be made for the requirement of working capital so that production will not be interrupted.

(ii) Before extension of the project, public sector undertakings should use or operate full capacity utilisation in order to take the benefit of past investment and also to present any deterioration in the working capital components that may be experienced.

(iii) It should not be the practice of any firm to use working capital funds for acquiring fixed assets. Because while liquidating such short-term liabilities, the firm will experience a different working capital. Same principle is also applicable in case of public sector undertakings.

(iv) In order to meet the requirement of working capital public sector undertakings should introduce an efficient cash flow analysis technique by which they can easily understand the immediate requirement of working capital well in advance.




9. Assessing Working Capital Requirements
:

It is not so easy to estimate the amount of Working Capital that may be required by a firm in order to maintain a particular level of operation. In other words, every firm finds it difficult to ascertain the Working Capital requirements which are a very practical and important problem.

While inadequate Working Capital creates a lot of problems, an amount in excess of the requisite Working Capital which is not utilized properly and remains idle, can also increase the cost. Therefore, in order to avoid both these difficulties, a Working Capital Requirement Forecast is prepared after scrutinizing and analysing every aspect of business activity.

A. Trading Concern:

(a) Where the Balance Sheet of the Earlier Period is Available:

The estimated requirement of Working Capital for the budget period can be determined on the basis of the data contained in the Balance Sheet of the earlier or previous period.

The current assets and current liabilities are to be adjusted in relation to the budget period and the Working Capital requirement can easily be determined by deducting the estimated total value of current liabilities from the estimated total value of current assets.

Illustration:

From the following information presented by X Ltd., a trading concern, you are asked to ascertain the estimated additional requirements of Working Capital.

Additional information:

(a) It is estimated that the company will be able to increase sales by 25% in the following year.

(b) Maximum limit of Overdraft facility granted by the Bank is Rs. 1,50,000.

(c) Credit period allowed to customers and the level of stock will remain unaltered

Solution:

D. Requirement of additional Working Capital Rs. 1,00,000 (Rs. 4.00,000 – Rs. 3,00,000)

(b) Where the Balance Sheet of the earlier period is not available

In that case, the amount of current liabilities for the budget period should be ascertained on the basis of the given data and deduct the current liabilities from current assets in order to get the estimated requirement of working capital.

Illustration:

EXE Ltd., are engaged in large-scale consumer retailing. From the following information, you are required to forecast their working capital requirement:

Projected annual Sales — Rs. 65 lakhs.

Percentage of Net Profit on Cost of sales — 25%.

Average credit period allowed to Debtors — 10 weeks.

Average credit period allowed by Creditors — 4 weeks

Average stock carrying (in terms of sales requirements) — 8 weeks.

Add 10% to compute figures to allow for contingencies.

Solution:

Working Capital Requirement Forecast

B. Manufacturing Concern:

The following items are taken into consideration at the time of ascertaining the requirement of Working Capital:

(a) Total quantity of units to be produced throughout the year;

(b) The cost of raw materials, wages and overheads for each unit;

(c) Information about the period during which raw materials will remain in stock on an average before the same are issued to production — the longer the period the more will be the requirement of working capital;

(d) Information about the period during which the product will be processed in the factory’— the longer the period the larger will be the requirement of working capital;

(e) Information about the period during which finished products will remain in warehouse, i.e., the length of sales cycle — the longer the period of stay, the more will be the requirement of working capital;

(f) Information about the period of credit allowed to Debtors — the longer the period allowed to customers, the more will be the requirement of working capital,

(g) Information about the period of credit allowed by suppliers — the longer the period, the less will be the requirement of working capital;

(h) Information about the lag in payment of wages and overheads — the longer the period the less will be the requirement of working capital.

After ascertaining the proper requirement of Working Capital, a certain amount, say 10% of Working Capital may be added to cover contingencies.

One is to remember that the facts which are based on estimates may not be cent per cent accurate, but by careful observation it is possible to make a reasonable assessment. The provision for contingency is made for this purpose.

Problems Relating to Profit Element:

Whether or not working capital is required to be raised for the profit element involved in the sale price of goods, depends upon various factors. The main consid­eration is the policy adopted by the firm as to whether or not they said profit is retained for the purpose of re-investing in the business.

If profit is re-invested, the seasonal demand for working capital at the time of increasing demand can easily be met. But on the contrary, if the same is distributed immediately after its creation, funds for additional working capital will be required at the time of seasonal demand.

Besides, if the profit is not retained in the business a problem will arise as to at what time it has been distributed. Here, two points are to be noted. The first one relates to the time when the sales are completed and the second is at what time Cash is realized from Debtors. If profit is distributed immediately after the sales, no doubt.

Cash is required for this purpose since Cash is not realised from customers imme­diately after sales If the policy adopted by the business is that the profit will be distributed after the realisation of Cash from Debtors, no funds are required for this purpose, i.e., amount payable by Debtors (towards the cost) is to be computed on the basis of cost of production of goods only.

But in most cases, it is assumed profit is distributed immediately after sales and that is why provision should be made for dividends in this regard.



10. Operating Cycle (O. C.) Approach or Cash Working Capital Approach
:

The traditional approach towards projection of Working Capital requirement of a firm is the ‘Balance Sheet Approach’. Under this method, the Working Capital requirement of a firm is sought to be determined with reference to the position of current assets and current liabilities deducting the latter from the former.

The ‘Balance Sheet Approach’ to Working Capital is now criticised on the ground that, it does not indicate the exact position of Working Capital, as valuation put on some of the current assets items like Finished products. Work-in-progress, Inventories and Debtors include depreciation and that on Debtors include profit element.

Neither depreciation nor profit element in Debtors involve any Cash payment. Again, ‘Balance Sheet Approach’ to Working Capital includes certain non-circulating and non-con­vertible items like non-moving materials, spares.

Finished products, many of which become obsolete over a period of time, long standing receivables much of which become unrecoverable, and item of almost permanent nature, like deposits with statutory authorities.

Secondly, Working Capital derived under this approach indi­cates, the status of a firm at a particular point of time and does not reflect the movement of value occurring in the same during the entire accounting period.

Hence, the traditional ‘Balance Sheet Approach’ to project Working Capital requirements of a firm is now sought to be replaced by a modern approach which does by the name of ‘Operating Cycle Approach’ or ‘Cash Working Capital Approach’ to Working Capital requirement. Unlike the conventional approach, consistent with the defini­tion, this approach views Working Capital as a function of the volume of operating expenses.

This approach suggests that, actual level of Working Capital requirement of a firm in a period can be appropriately determined with reference to the length of Net Operating Cycle and the operating expenses needed for the period.

The net duration of operating cycle is equal to the number of days involved in the different stages of operation commencing from purchase of raw materials and ending up with collection of sale proceeds from Debtors against which the number of days credit allowed by suppliers are to be adjusted.

The number of operating cycle in a period is determined by dividing the number of days in the same by the length of Net Operating Cycle. Once the number of operating cycle has been determined, the actual Working Capital requirements is then arrived at by dividing the total operating expenses for the period by the number of operating cycle in that period.

(a) Length of Material Inventory Period:

This show the average time materials remain in stores before the same is issued to production. Method of computation:

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11. Financing Working Capital:

Once the level of working capital has been determined, a firm has to concentrate how the same will be financed, i.e., a firm must have to find out the sources of funds to finance its current assets Different financing policies, of course, may be adopted for this purpose.

Three types of financing are discussed here:

(i) Long-Term Financing:

The primary sources of long-term financing are: Shares (Equity and Preference), Debentures, Retained earnings. Debts from financial institutions and so on.

(ii) Short-Term Financing:

It includes short-term bank loan, commercial papers and factor­ing receivables etc.. A firm must have to arrange this type of finance in advance.

(iii) Spontaneous Financing:

It refers to automatic sources of short-term funds. It includes trade credit and outstanding expenses. Since the sources of this type of finance are cost free, most of the firms would prefer to use it in order to finance its current assets and try to utilize it as far as possible

Therefore, the choice of financing current assets lies in between short-term and long-term sources. It should be remembered in this respect that short-term financing is less expensive than long-term one. But at the same time. Short-time financing involves greater degree of risk.

In the circumstances, the choice of sources between short-term and long-term for financing working capital of a firm has to be decided with reference to risk returns trade-off. Generally, however, in view of lower cost and flexibility, management usually finds it more convenient to finance their working capital requirements by relying more on short-term sources than on long-term sources.

We all know that a firm requires both short-term and long-term sources for financing, its fixed and current assets Decisions for financing fixed and/or current assets are taken at the same time since they are very much interrelated. Of course, the proportion of short-term and long-term sources for financing current assets depends on so many factors, e.g. flexibility, cost, risk, demand and supply of money market and so on.

However, the following policies may be noted:

(1) Hedging or Matching Policy;

(2) Conservative Policy;

(3) Aggressive Policy; and

(4) Highly aggressive Policy.

(1) Hedging or Matching Policy:

This policy actually involves matching of assets and liability maturities, i.e., each asset would be offset with a financing instrument of the same approximate maturity with a hedging approach, short-term or seasonal variations in current asset less trade creditors and provisions — would be financed with short-term debt.

Similarly, hard core or permanent component of current assets would be financed with long-term funds — long-term debt and/or equity. In short, long-term sources should he used for the acquisition of fixed asset plus part of hard core current assets, and short- term sources should he used for the acquisition of part of hard core current asset plus fluctuating current assets.

For example, a 10-years loan may be raised to finance a plant with an expected life of 10 years; a 20-years building can be financed by, say, a 20-years mortgage debenture; Stock to be sold in 30 days may be financed by a 30-day bank loan and so on. The justification of the matching policy is that since the purpose of financing is to pay for assets, the liability should be liquidated when the asset is expected to be relinquished.

Using long-term financing for short-term assets is expensive and costly since the funds will remain idle after the expiry of assets’ lives. Similarly, financing long-term assets with short-term sources is costly and inconvenient as they are to be renewed on a continuous basis.

Thus, the following position may be shown if matching policy is followed:

Fig.8.4. shows that the fixed assets and permanent current assets are financed with long-term sources and when the level of permanent current assets increases, long- term finance also increases.

But temporary current assets are financed with short-term sources and when their level increases, the level of short-term financing also increas­es. Thus, there will be no short-term financing when there is no need for temporary current assets.

(2) Conservative Policy:

Fig. 8.4 shows the situation for a firm which attempts to match assets and liability maturities. But in practice, an exact matching plan may not always be possible. A firm may adopt a conservative policy in financing its current and fixed assets. When a firm depends more on long-term sources for financing needs, it is said to be a conservative one.

Under this policy, permanent assets and a part of temporary current assets are financed with long-term financing. Therefore, if the firm has no temporary current assets at any period, it stores liquidity by investing surplus funds into marketable securities. A firm wants to be safe by resorting to this technique since it is less risky.

The conservative policy is shown in Fig. 8 5 below:

Fig. 8.5 shows that when the firm has no temporary current assets, the long-term funds released can be invested in marketable securities to ‘store’ liquidity during off­season, i.e., a firm meets its peak requirements from short-term sources only.

Thus, in short,’ long-term sources can he used for the acquisition of fixed assets plus permanent current assets plus a part of temporary current assets and short-term sources are used only for the part of temporary current assets.

(3) Aggressive Policy:

Under this policy, a firm finances a part of its permanent current assets with short- term financing. It may rely more on short-term sources than on long-term sources for financing current assets, i.e., it is opposite to the conservative policy.

But, too much reliance on short-term sources is more risky since it will have to be renewed on a continuous basis for financing a part of permanent current assets. Fig. 8.6 shows the position of Aggressive Policy. Thus, long-term sources are used for the acquisition of fixed assets plus a part of permanent current assets and short-term sources are used for the part of permanent current assets plus temporary current assets.

Financing Current Assets: Under Aggresive Policy.

(4) Highly Aggressive Policy:

Under this method, a part of fixed assets even may be financed from short-term sources which are very much risky. Thus, long-term sources are used to acquire the major part of fixed assets plus a minor part of fixed asset and short-term sources are used to acquire a minor part of fixed asset plus the whole of current assets (i.e., permanent and temporary). It shows in Fig.8.7 below:

Financing Current Assets: Under Highly Aggresive Policy.

It is evident from Fig.8.7 above that this policy is highly risky since the short- term sources is to be renewed on a continuous basis for financing the whole of current assets plus a part of fixed assets Working Capital position under this method will always be negative. Therefore, when this policy is followed by a firm along with other symptoms, it may be assumed that the firm is going to be a ‘sick’ one.


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