Working Capital: Meaning and Components | Business

In this article we will discuss about:- 1. Meaning of Working Capital 2. Components of Working Capital 3. Gross and Net Working Capital 4. Permanent and Temporary Working Capital 5. Positive and Negative Working Capital 6. Objectives.

Meaning of Working Capital:

Working capital management is a significant in financial management due to the fact that it plays a pivotal role in keeping the wheels of a business enterprise running. Working capital management is concerned with short-term financial decisions.

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Shortage of funds for working capital has caused many businesses to fail and in many cases, has retarded their growth. Lack of efficient and effective utilization of working capital leads to earn low rate of return on capital employed or even compels to sustain losses.

The need for skilled working capital management has thus become greater in recent years. A firm invests a part of its permanent capital in fixed assets and keeps a part of it for working capital i.e., for meeting the day to day requirements. We will hardly find a firm which does not require any amount of working capital for its normal operations.

The requirement of working capital varies from firm to firm depending upon the nature of business, production policy, market conditions, seasonality of operations, conditions of supply etc. Working capital to a company is like the blood to human body. It is the most vital ingredient of a business. Working capital management if carried out effectively, efficiently and consistently, will ensure the health of an organization.

A company invests its funds for long-term purposes and for short-term operations. That portion of a company’s capital, invested in short-term or current assets to carry on its day to day operations smoothly, is called the ‘working capital’. Working capital refers to a firm’s investment in short-term assets viz., cash, short-term securities, amounts receivables and inventories of raw materials, work-in-process and finished goods.

It refers to all aspects of current assets and current liabilities. The management of working capital is no less important than the management of long-term financial investment.

Sufficient liquidity is necessary and must be achieved and maintained to provide that fund’s to payoff obligation as they arise or mature. The adequacy of cash and other current assets together with their efficient handling virtually determine the survival of the company.

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The efficient working capital management is necessary to maintain a balance of liquidity and profitability. If the funds are tied-up in idle current assets represent poor and inefficient working capital management which affects the firm’s liquidity as well as profitability.

Flow of Funds and Working Capital Changes

Working capital is defined as ‘the excess of current assets over current liabilities’. All elements of working capital are quick moving in nature and therefore, require constant monitoring for proper management. For proper management of working capital, it is required that a proper assessment of its requirement is made. Working capital is also known as circulating capital, fluctuating capital and revolving capital.

The magnitude and composition keep on changing continuously in the course of business. If the working capital level is not properly maintained and managed, then it may result in unnecessary blockage of scarce resources of the company. Therefore, the Finance managers should give utmost care in management of working capital.

Components of Working Capital:

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1. Current Assets:

Current assets are those assets which are convertible into cash within a period of one year and are those which are required to meet the day to day operations of the business. The working capital management, to be more precise the management of current assets. The current assets are cash or near cash resources.

These include:

(a) Cash and bank balances,

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(b) Temporary investments,

(c) Short-term advances,

(d) Prepaid expenses,

(e) Receivables,

(f) Inventory of raw materials, stores and spares,

(g) Inventory of work-in-progress, and 

(h) Inventory of finished goods.

2. Current Liabilities:

Current liabilities are those claims of outsiders which are expected to mature for payment within an accounting year.

These include:

(1) Creditors for goods purchased,

(2) Outstanding expenses,

(3) Short-term borrowings,

(4) Advances received against sales,

(5) Taxes and dividends payable, and 

(6) Other liabilities maturing within a year.

Gross and Net Working Capital:

Generally the working capital has its significance in two perspectives. These are gross working capital and net working capital are called ‘balance sheet approach of working capital.

Gross Working Capital:

The term ‘gross working capital’ refers to the firm’s investment in current assets. According to this concept working capital refers to a firm’s investment in current assets. The amount of current liabilities is not deducted from the total of current assets.

The concept of gross working capital is advocated for the following reasons:

(a) Profits of the firm are earned by making investment of its funds in fixed and current assets. This suggests the part of the earning relate to investment in current assets. Therefore, aggregate of current assets should be taken to mean the working capital.

(b) The management is more concerned with the total current assets as they constitute the total funds available for operating purposes than with the sources from which the funds come.

(c) An increase in the overall investment in the firm brings an increase in the working capital. Net Working Capital The term ‘net working capital’ refers to the excess of current assets over current liabilities and it is the difference between current assets and current liabilities.

The net working capital is a qualitative concept which indicates the liquidity position of a firm and the extent to which working capital needs may be financed by permanent source of funds. The concept looks into the angle of judicious mix of long-term and short-term funds for financing current assets. A portion of net working capital should be financed with permanent sources of funds.

The gross and net working capital are ascertained as shown below: (Rs.)

Gross and Net Working Capital

Permanent and Temporary Working Capital:

Considering time as the basis of classification, there are two types of working capital viz., ‘permanent’ and ‘temporary’.

Permanent and Temporary Working Capital

Permanent Working Capital:

The magnitude of investment in working capital may increase or decrease over a period of time according to the level of production. But, there is a need for minimum level of working capital to carry its business irrespective of change in level of sales or production. Such minimum level of working capital is called ‘permanent working capital’ or ‘fixed working capital’.

It is the irreducible minimum amount necessary for maintaining the circulation of current assets. The minimum level of investment in current assets is permanently locked-up in business and it is also referred to as ‘regular working capital’. It represents the assets required on continuing basis over the entire year.

The permanent component current assets which are required throughout the year will generally be financed from long-term debt and equity. Tandon committee has referred to this type of working capital as ‘core current assets’.

Core current assets are those required by the firm to ensure the continuity of operations which represents the minimum levels of various items of current assets viz., stock of raw materials, stock of work-in- process, stock of finished goods, debtors balances, cash and bank etc. This minimum level of current assets will be financed by the long-term sources and any fluctuations over the minimum level of current assets will be financed by the short-term financing.

Temporary Working Capital:

It is also called as ‘fluctuating working capital’. It depends upon the changes in production and sales, over and above the permanent working capital. It is the extra working capital needed to support the changing business activities. It represents additional assets required at different items during the operation of the year.

A firm will finance its seasonal and current fluctuations in business operations through short-term debt financing. For example, in peak seasons, more raw materials to be purchased, more manufacturing expenses to be incurred, more funds will be locked in debtors balances etc. In such times excess requirement of working capital would be financed from short-term financing sources.

The management of working capital is concerned with maximizing the return to shareholders within the accepted risk constraints carried by the participants in the company. Just as excessive long-term debt puts a company at risk, so an inordinate quantity of short-term debt also increases the risk to a company by straining its solvency.

The suppliers of permanent working capital look for long-term return on funds invested whereas the suppliers of temporary working capital will look for immediate return and the cost of such financing will also be costlier than the cost of permanent funds used for working capital.

Positive and Negative Working Capital:

The net working capital of a firm may be positive or negative.

(a) The ‘positive net working capital’ represents the excess of current assets over current liabilities.

(b) Sometimes the net working capital turns to be negative when current liabilities are exceeding the current assets. The ‘negative working capital’ position will adversely affect the operations of the firm and its profitability. The chronic negative working capital situation will lead to closure of business and the enterprise is said to be ‘technically insolvent’.

Disadvantages of Negative Working Capital:

The disadvantages suffered by a company with ‘negative working capital’ are as follows:

(a) The company is unable to take advantage of new opportunities or adapt to changes.

(b) Fixed assets cannot be used effectively in situations of working capital shortage.

(c) The operating plans cannot be achieved and will reduce the profitability of the firm.

(d) It will stagnate the growth of the firm.

(e) Employee morale will be lowered due to financial difficulties.

(f) The operating inefficiencies will creep into daily activities.

(g) Trade discounts are lost. A company with ample working capital is able to finance large stocks and can, therefore, place large orders.

(h) Cash discounts are lost. Some companies will try to persuade their debtors to pay early by offering them a cash discount, off the price owed.

(i) The advantages of being able to offer a credit line to customers are foregone.

(j) Financial reputation is lost result in noncooperation from trade creditors in times of difficulty.

(k) There may be concerted action by creditors and will apply to court for winding up.

(l) It would be difficult to get adequate working capital finance from banks, financial institu­tions.

Objectives of Working Capital Management:

The basic objectives of working capital management are as follows:

(a) By optimizing the investment in current assets and by reducing the level of current liabilities, the company can reduce the locking-up of funds in working capital thereby, it can improve the return on capital employed in the business.

(b) The second important objective of working capital management is that the company should always be in a position to meet its current obligations which should properly be supported by the current assets available with the firm. But maintaining excess funds in working capital means locking of funds without return.

(c) The firm should manage its current assets in such a way that the marginal return on investment in these assets is not less than the cost of capital employed to finance the current assets.

(d) The firm should maintain proper balance between current assets and current liabilities to enable the firm to meet its day to day financial obligations.

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