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Working Capital Management

Working Capital Assignment / Homework Help
What is Working Capital?

The capital required for a business is of two types: these are fixed capital and working capital. Fixed capital is the capital required for acquiring fixed assets such as land, building, plant and machinery etc. Working capital refers to the funds needed to meet the day-to-day operations of the business like payment for the purchase of raw materials, payment of wages and salaries, payment of overhead expenses and so on.


Meaning of Working capital

Working capital is the funds requirement for day-to-day operations. A business need to carry on certain amount of raw material of all sorts so that commencement of production is not delayed for want of raw materials, certain amount of work-in-progress so that production operations go smoothly, certain amount of finished goods so that the supply to the market is not hampered by fluctuations in production, certain amount of book debts so that sales take place continuously and certain amount of cash and bank balance for meeting daily routine payments and for providing unforeseen contingencies. In other words, working capital refers to the investment in the current assets of the business. Working capital is also referred to as the revolving capital as current assets and current liabilities are converted from one form to other and again converted back to its original form and reconverted into other on and on. Hence it is also called as revolving capital or floating capital.


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Concepts of Working capital

There can be two concepts of working capital, namely gross concept and net concept. The term gross working capital means the total current assets. The term net working capital is the difference between current assets and current liabilities. For the purpose of working capital management, Net working capital can be said to measure the liquidity of the firm. The term Net working capital can alternatively be defined as that part of the current assets which are financed with long-term funds. This alternative decision is more useful for the analysis of the trade-off between profitability and risk.


The composition of Working capital is therefore, current assets and current liabilities:

Current assets:

Current assets are those assets which can be converted into cash or consumed within a period of one year, or whose benefits are expected to arise within a period of one year. The major current assets are cash, marketable securities, accounts receivables and inventory. The other assets which can be grouped under current assets category are prepaid expenses, office supplies etc.


Current liabilities:

Current liabilities are those obligations which have to be met within a period of one year. The basic current liabilities are accounts payable, bills and notes payable, bank overdraft and other outstanding expenses.


There should always be a positive working capital for smooth functioning of the business.

Net Working capital = Current Assets Ė Current liabilities


A sound liquidity position is when the current assets are double the amount of current liabilities. This is indicated by the current ratio of 2:1, which indicates a good short-term liquidity position.


Example:

If current assets are $5,000 and the current liabilities are $3,000, then the net working capital is:

Net working capital = $5,000 - $3,000 = $2,000.

Though adequate working capital is a must for the enterprise, any excess or inadequate working capital will have adverse results on the performance of the firm.


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Dangers of Inadequate working capital:
  • It stagnates growth and it becomes difficult for the firm to undertake profitable projects for non-availability of working capital funds.
  • Fixed assets are not efficiently utilized for the lack of working capital funds. Thus, the rate of return on investment comes down.
  • It becomes difficult to implement operating plans and achieve the firmís profit target.
  • Operating inefficiencies creep in when it becomes difficult even to meet the day-to-day commitments.
  • The firm will not be able to avail attractive credit opportunities or discounts from suppliers.
  • The firm loses its reputation when it is not in a position to honor its short term obligations. As a result, the firm faces tight credit terms.

Dangers of Excess working capital:
  • Excess working capital results in unnecessary accumulation of inventories. This would result in inventory mishandling, waste, theft, losses etc.
  • It is an indication of defective credit policy and a slack collection period. This may result in higher possibility of bad debts occurrence which would ultimately affect profits.
  • This also results into management inefficiency.
  • There would be a tendency to accumulate inventories to make speculative profits grow. This may tend to make dividend policy liberal and difficult to cope with in future when the firm is unable to take speculative profits.