Financial Management

S2 Introduction
5.1 Working Capital - An ofan enterprise can
be broadly categorized into two
requirements
management,thefund funds needed to start up and conduct
Infinancial
First is Fixed capital-fixed capital refers
is
to the
invested in fixed or permanent assets such as land,
business,
types. procured as fixed capital contracts and
most of the funds legal manufacturing equipment
trademarks and patents, of production of a good or
building, computer
servers,
continually purchased in the course
not
anythingthat is
-in other words day-to-day operations of a business as they either make it
usually vital in the
service. Fixed assets are
or allow operations, processes, and other activities to transpire
function
possible for the business to
smoothly.
also need certain funds in order carry its routis.
enterprise may
Apart from fixed capital an money a business requires to sustain its operations.
is the
operations, therefore working capital operations such as purchase of inventory- Such
routine
Working capital is utilised to manage employees, sundry debtors, and also funds needed
products, paying
raw materials, semi finished working capital is also needed to pay for planned and
for other short term expenditures. Further
short-term obligations of the business, and to build the business No
unexpected expenses, meet the capital
capital management. Sound working
business can run successfully without proper working
capital to cover the requirements that are
management ensures that a firm has sufficient working
capital a critical business skill. If
linked to its operating activities. This makes managing working
there is no working capital, there is no business.

5.1.1 Meaning
and Concept
Working Capital is fund required for meeting day to day requirement of the business concern.
However the accounting term of the working capital is current assets, Current assets are commonly
called working capital; represent the portion of investment that circulates from one form to another
in the ordinary conduct of business.
In simple words, workingcapital may be defined as "capital invested in current assets." Here current
assets are those assets, which can be converted into cash within a short period of time and the cash
received is again invested into these assets. Thus, it is constantly receiving or circulaung
working capital is also known as circulating capital or floating capital.
Definition of Working Capital
In the words of Genestenberg, "Circulating capital means current assets of a company that are changedin
the ordinary course of business from one form to another, for example, from cash to inventories,:inventories
to receivables,
receivables to cash".
J.S.Mili,Says "The sum of the current asset is
the working capital of a
Weston and Brigham are of the business . in short-term
assets, cash, short-term opinion that, "Working refers to a firm's investment
securities, accounts receivables andCapital
According to the definition of Mead, Baker and inventories.
Malott,"Working Capital means Current Assets"
 Working Capital Management
5.1.2
Classification or Types ofWorking Capital
Workingcapital isthe amount of funds needed by an
enterprise to finance its day to day operation. It
isthe part of capital employed in short-term operation such as raw products,
sundry debtors. Working Capital may be classified into materials,, semi finished discussed
below. three important types there are
Snapshot 5.0

Categories of Working Capital

Types of
Working
Capital

On the basis On the basis

On the basis
of time of concept of Operating
Cycle

Permanent Temporary Non

Working Working Gross WC Net WC |OperatingWc Operating Wc
Capital Capital

Seasonal WC Special wC

A: On the Basis of Time

basis of time.
Working Capital may be classified into three important types on the
It is the capital; that
1. Permanent Working Capital: It is also known as Fixed Working Capital. Permanent Capital
The level of
business concern must maintain at minimum level at alltimes.
Capital will not change
depends upon the nature of the business. Permanent or Fixed Working
irrespective of time or volume of sales.
2. Temporary Working Capital: The temporary or varying working capital varies with the
required to meet the Seasonal
of operations. It is the amount of capital which is
volume
working capital requirement
demands and some special purposes. As seasons vary, temporary Working Capital and Special
into Seasonal
moves up and down. It can be further clasSified
Working Capital.
Seasonal Working Capital :The capital required to meet the seasonal needs of the
(a) seasons, more production/
business concern is called as Seasonal Working Capital. During reverse is true during off
needs. The
sales take place resulting in larger working capital
seasons.
 Financial Management
additional working capital is
Working Capital : At times, required
(b) Special strikes, seasonal production and price hil to meet the
floods,
unforeseen events like
capital required to meet the special exigencies such hike tendencies
contingencies. The
conducting research,etc.
extensive marketing campaigns for
thethe
B:OnOn Basis
basis of Concept
of concept working capital can be classified or understood in the following dimensions
working of all
capital is the total lof allcurrent assets. In
In other words
Gross Working Capital : Gross
1. Gross working capital reflects thetotal working resources of a company. It does not take into
account liabilities; it simply indicates the total resources of a business. Therefore,
a company's financial situatioss$
working-capital figure doesn't provide clear insight into current liabilities. GWC =CA
investorsas Gross working capital does not account for
2, Net Working Capital : Net Working Capital 1s the speciic
Concept, which considere hot
current
current assets and current liability of the concern. Net woOrking capital is the excess of
indicator of
assets over current liabilities of a comnpany which 1s Why it 1S an important
liabilities it is said to be
company'sfinancial health. If the current assets exceed the current
positive working capital; if it is reverse, it is said to be Negative working capital. Thus. Net
NWC=CA- CL.
working capital is current assets minus current liabilities.
C: On the Basis of Operation
Operating cycle reflects the average duration consumed between buying inventory and receiving
cash proceeds from its eventual sale. working capital on the basis operating cycle can be classified in
the following way:
1. Operating Working Capital :A traditional measure of a company's liquidity and potential
for growth. Operating working capital is defined OWC= Inventories + Bills receivables - Bills
payables. Only the normal amount of operating sources of funds is included in calculations or
operating working capital. Unusually long payment periods granted by suppliers shouid no
be included as a component of normal operating working capital.
of time
2. Non-operating Working Capital : Non-Operating Working Capital is the outcome
non-recurrent
differences between purchase and payment for capital expenditures, for
Items, etc. a theoretical perspective,as it considers total of all category for items tiaid. paid,
be classified anywhere else. It includes amounts due on fixed assets, dividends to be
interest receivable/
the short-term part of fthe restructuring provision, acquisition payables, inte
restructuring provision,
payable, income tax receivable/payable,and borrowings and bank overula
 10) 9) 8) D reasons:
1)
L2) 6 S) 4) 3) 2) running
business
1) ADEQUATE
WORKING
CAPITAL
To ItWorking
To Necessary Have Acts To To assets. To
To Adequate. An
Helpful payenablepermit protect
meet enables
overcome as organization
which of
favourable a a
higher capital in current
the funds providing cushion the a would
the workingbusiness.
sufficient
excessive liabilities
management business
can if credit in affect has
capital
inventories company possible
Inadequacy
be funds
emergencies level to
to terms on from he
tmaintain
non-operating
accumulated can for is
and operate time to of importantoverall
expansion. with inventories adverse
be overcome of
fixed promptly
like adequate
its investedcustomers. functioning
working
assetslosses.
business for strikes, effects for
meeting in and
depression for an
amount
capital
requirements. non-current of
flood availcontinuous organisation of
more reduction an
future etc.
discountsperiod. organization. may of
efficiently. production. working
expensesassets. because lead
in
on the to
payment. capital
value problems
of
the for
of
following smooth
current in
the
 232 Financial Management

SlGNIFICANCE OF ADEQUATE wORKING CAPITAL

The following are Some of the reasons for maintaining adequate amount of working
capital:
production whick
1.
Aaequate working capital can provide uninterrupted flow of
strengthens the solvency of a business.
2. Suficient working capital can help the business to pay all its current liabilities and
Operating expenses in time which will enhance, create and maintain goodwill.
3.
The adequate reserve of working capital ensures asteady flow of raw materials to
production process leading to continuous production.
4. The adequate stock of working capital makes it possible for a company to purchase
the trading goods in cash and cash purchase always carries the benefit of getting
cash discount.
5. An organization can make regular payment of salaries, wages and other day-to-day
commitments only when it has sufficient working capital.
6.
A company can avail the opportunities of price fluctuations if it has adequate working
capital in business.
7. It creates ability in the business to face emergencies such as strikes, flood, fire etc..
8. It can also attract more number of investors into its business by making regular
payment of dividends. This gains the Confidence of investors which creates a
favorable market to raise additional funds in the future.
9. It enables a business to withstand periods of
depression smoothly.
10. If the company's credit standing solvency is high, it can
and others on easy and faVorable terms. arrange loans from banks
Hence, adequate working capital can help to
without any financial problems and also improves the operate of the business smoothly
wastages, enhancing production,, increasing the moraleefficiency business by reducing
of employees, and creating an
environment of security.

DISADVANTAGES OF EXCESS WORKING CAPITAL

Excess working capital is a threat to the company. The
of excess working capital: following are the disadvantages
1) Leads to low profitability even though sufficient
cash is available.
2) Outstanding liabilities and losses may be faced.
3) Creates an imbalance between liquidity and
profitability.
4) It leads to greater production level but
not having a matching demand in
5) High level of inventories and its market.
maintenance and storage cost increases.
6) It may lead to carelessness about
costs and therefore inefficiency of
7) Unwise dividend policies. operations.
 Workin

Excessive working capital is not a good indicator for future growth and profltability
. the organisation. Tne management should avoid such a condition and maintal
level of adequate working capital in the organisation.
DEMERITS OFINADEQUACY OF WORKING CAPITAL
1 The firm is unable to take advantage of new opportunities to develop new proaucts
or adapt to modification of production techniques needed when new opportunites
arise.

2. Afirm will lose its reputation when it is not in a position to honor its short term
obligations.
3. It becomes difficult for the firm to exploit favorable market situations.
4. Acompany cannot avail cash discounts facilities in case of bulk order.

5.
A company may have to borrow funds at higher rates on interest.
6. It becomes impossible to utilize the fixed assets efficiently.
time. Hence loses the confidence
7. Acompany will not be able to pay its dividends in
of investors relatively resulting in the fall of market share.
business from depression would be
8. During the period of emergencies withstanding
tough.
demoralizes its employees, decreases
9 Non-payment of wages, salaries etc. on time
efficiency, production slows down and hence affects the profitability of the
their
business.

FACTORS DETERMINING WORKING CAPITAL

another. The
amount of working capital required varies from one business to expansion of
The increases with the growth and
requirement for fixed and working capital meet current
to
Additional funds are required for upgrading the technology or evaluate the
business., Therefore it becomes important to
expand the business etc.
debts or for working capital.
that determines the need
various factors
Some of the major factors are:
1. Nature of business character
working capital largely depends upon the nature or
The reauirement of less
utility companies like railways, transport etc. emplovs
of its business. Public no funds are tied up in inventories and
receivables
amount of working capital because
requires large amount of working capital as they haye to
While the trading company inventories, cash, receivaatbles etc. whereas manufacturing
liké
Invest in current asset wWorking capital between these two extremoe
undertakings require sizeable
2. Size of business the business depends upon the size of a business
Composition of assets in Small companies require smaller proportions of
The is operating.
and the Scale in which it
 234
Financial Management

working capital than large companies. But In some cases, even smaller concern may
cu mnore working capltal due to' high overhead charges, inefficient use of available
resources etc.
3. Cash requlrements
Cash is one of the essential components for successful operation of the production
In business. Adequate cash is always required to carry on the operations and to
maintain good credit relations. But, it would be expensive to hold excessive cash.
Hence, cash is one of the important factors to determine working capital.
4. Volume of sales
This is an important factor which affects the size and components of working
capital. A firm maintains current assets as they are needed to support the operational
activities which resuts in sales. As the volume of sales increases, there is an increase
in the investment of working capital and vice versa. Hence the volume of sales
determines the amount of working capital.
5. Terms of Purchases and Sales
If the credit terms of purchases are more favorable and those of sales are less
liberal, less cash will be invested in inventory. A firm gets more time for payment to
creditors or suppliers. Hence, if the business has favorable terms and conditions of
credit, it can reduce working capital. On the other hand if the terms are unfavorable, it
increases the requirement of working capital.
6. Price level changes
The requirement of working capital is also affected by the changes in price levels.
The rise in prices will require the organization to maintain larger amount of working
capital as they have to meet the needs of business operations.
7. Inventory turnover
If the inventory turnover is high, the working capital requirement will be low. Thus
the finance manager should determine the minimum level of stock to be maintained
throughout the period of operations.
8. Receivables turnover
A prompt collection of receivables and good facilities for setting payables results in
low working capital requirements. Hence, it is necessary to have an effective control of
receivables.
9. Production schedule
The availability of working capital ensures the continuity of production schedule.
Delay in production slows down the operations of business. So an organization should
have a systematic planning and smooth flow of production from raw materials stage to
the end of production.
10. Business cycle
The requirements of working capital depend upon the stage of business cycle.
During the period of prosperity, the requirement of working capital will be more since
the business expands and less during the period of depression. In the growth stage of
business, there is a need for large amount of capital to cover the needs of business
 Working Capital Management 235

whereas in decline stage, faces

Cyde there may be a brief period when business
organization
difficulties in collection and sales. Thus,
sficulties onon the phase, the
depending
should make the availability of funds.
44. Production cycle
11.
Production ycde refers to the period taken to convert raw materials into finisned
goods. The longer the production cycle the greater is the requirement of working
nital. To minimize the requirement, the production cycle should be shortened without
affecting the manufacturing process.
42. Seasonal fluctuations
The organizations which produce seasonal products require adequate working
apital during one period and less in the other period. In some cases the raw material
be
may not be available throughout the year. Hence huge amount of inventory has to
Durchased during such seasons which give rise to more working capital requirements.
13. Repayment ability
will determine the level of working capital it employs.
An organization's ability
fix working capital
Based on repayment plans, it prepares cash flow projections to
accordingly.
14. Changes in technology
impact on the need
Technological developments related to production can have an
for working capital.
15. Firm's polices
production policy etc which will
There are various firms' policies like credit policy,
affect the size of working capital.
 5.2 Working Capital Management
Working capital Management refers to management of currentassets and current liabilities, Workino
capital management involves the relationship between a firm'sshort-term assets and its short-term
liabilities. The basic objective of managing working capital is to enable afirm to continuously carry its
routine operations i.e. toensure that a firm has sufficient ability to satisfy both maturing short-term
debt and upcoming operational expenses. The management of working capital involves managing
Inventories, accounts receivable and payable, and cash.
 Components of Working Capital operations and sustainably
ost cash locked up in

hapir teaalsecompatheirniesprofitability and company value by managing working liabilities. The following
of
release significant amounts
can release capital more actively. Working
current liabilities. WCM is an
assets and
management of current
Management
Mgaeging 8process that must be refers evaluated
level
using the current of assets and
the key
Components of working capital.
 Financial Management
5.16
Current
Gurrent Liabilities
Assets

Marketable
securities
Short term
Loans
Accounts
receivables
Expenses
payable
Inventories

Creditors
Cash and
equivalents

|Snapshot 5.2 Components of Working Capital

assets that are reasonably expected
Current assets are resources held by a firm in terms of
the normal course of business. In other words
to be converted into cash within one year in
year or within the operating
Assets, which can normally be converted into cash within a
current assets are cash on hand, short-term
cycle, are grouped as current assets. Examples of
investments, inventory and accounts receivable.
within one year. In other words,
Current Liabilities represents a company's debts or obligationsthat are due
of the business. Examples of
these liabilities are due within the accounting period or the operating cycle
current liabilities are inventory purchases, employee wages, taxes and accounts payable.
describes the amount
Working capital is a financial thermometer that determines operating liquidity which
measurement of working
of cash tied up in operations and defines the short term condition of a company. The
capital position is assessed by applying the following equation:
Working Capital = Current Assets - Current Liabilities
Apositive working capital position is required for the continuous running of a company's operations, le. to
pay short term debt obligations and to cover operational expenses. Acompany with anegative working cap
balance is unable to cover its short-term liabilities with its current assets. Thus management of current as
and liabilities are important and must be achieved and maintained to provide the funds to pay off oblg
as they arise or mature. The adequacy of cash and other current assets together with their efficient hanau
virtually determine the survival or demise of the company.
5.18 Financial Management

Working Capital
Sourcesof
Working capital is
5.2.3 utilized to manage routÉne operations such as purchase of inventory such as raw
materials, semi finished products, payingemployees,sundrydebtors, and also funds needed for other
short term expenditures. Further working capitalis also needed to pay for planned and unexpected
expenses, meet the short-term obligations of the business, and to build the business. No business
canrun successfully without proper workingcapital management. Working capital may be procured
from different sources. Some of these common sources of working capital are discussed as follows:

Working Capital:
1. Permanent Capital. It is the capital; the business Concern must
Working
Itis
certain as Fixed
known of capital at minimum level at all times. The level of Permanent Capital
also amount tmaintain
depends uponthe nature of the business. Permanent or Fixed Working Capital will nottchange
irrespective of time or volume of sales. The fixed working capital can be procured through
following courses.
instrument that represents a portion af a
(a) Issue of Shares: A share is a financial
business. Issue of chav
ownership of the business for a financial investment in the
term funds. Most companies collect fvod
is the most important source of raising long
shares, these includes eguity
capital by issuing shares. Generally, there are two types of
and preference shares.
borrowed capital of the company.
(b) Issue of Debentures: A Debenture represents the
debenture is defined as a
Fixed capital is also collected from issue of debentures, a
certificate of acceptance of loans which is given under the company's stamp and carriesof
return (fixedon the basis
an undertaking that the debenture holder will get a fixed
interest rates) and the principal amount whenever the debenture matures.
(c) Loan from Financial Institutions: Aloan paid back over an agreed period (term] where
tixed or
principal and interest are paid off in monthly repayments. This interest may be
Commercial
varíable. Banks and other commercial lenders are popular sources of loans.
to secure financing
finance companies may be considered when the business is unable
from other commercial sources.
earned bythe
(d) Retained Earnings: Retained earnings are a part of undistributed profits shareholders.
company. Since, the company does not distribute all of its profits to the no interest
This saved profit is called retained earnings. It is very economical becausecapital.
fixed
payment is to be made. Retained earnings are the cheapest source of that are
of afirm's assets
(e) Sale of Capital Assets: Another way of raising fundssisthe sale termand
bigger
long
no longer needed, selling land, buildings, or machinery can cater to
benefits of useful
assets
finance needs. A major drawback in this type of financing is the
which are sold can no more accrue to the business.
2. Temporary Working Capital: the
operations.Itis
The temporary or varying working capital varies with the volume of specialpurposes.
amount of capital which is required to meet the Seasonal demands and some
As seasons vary, temporary working capital requirement moves up and down.
 Working Capital Management 5.19
(a) Invoice Discounting: Invoice or billdiscounting is a process in which
goods and Serveo
sold to customer on the basis of credit is en cashed through a bank before the maturity
date of the bill at avalue less than the par value of the bill. While discounting a bill, the
Bank buys the bill before it is due and credits the value of the bill after a discount charge
tothe business concern's account. The bank then collects fullvalue on the draft or bill of
exchange when payment comes due. The amount of the discount in the form of interest
depends on the amount of time left before the bill matures, and on the perceived risk
attached to the bill.
(b) Installment Credit: Installment credit is a form of finance to pay for goods or services
over a period through the payment of principal and interest in regular payments. The
loan is made on the basis of the borrower's integrity and ability to pay.
(c) Factoring: it is an arrangement in which a business sells of accounts receivable on a
contract basisto an agency known as a factor in order to obtain cash payment before the
accounts come due. The factor alsoundertakes exclusive responsibility for credit analysis
of new accounts, payments collection, and credit losses. Afactoring agreement normally
states the exact conditions and procedures for the purchase of an account. The factor,
like a lender against a pledge of accounts receivable, chooses accounts for purchase,
selecting only those that appear to be acceptable credit risks. Where factoring is to be on
a continuing basis, the factor will actually make the firm's credit decisions because this
will guarantee the acceptability of accounts. Factoring is normally done on a notification
basis, and the factor receives payment of the account directly from the customer.
(d) Bank Loans: In order to meet temporary working capital requirement another channel
is borrowing Short-term loans from banks, these loans are to be repaid within a shorter
duration from the time they are borrowed. Usually bankloan involves high rate of interest.
(e) Bank Loans: In order to meet temporary working capital requirement another channel
is borrowing Short-term loans from banks, these loans are to be repaid within a shorter
duration from the time they are borrowed. Usually bankloan involves high rate of interest.
a
() Trade Finance: Trade credit is an important external source of working capital for
in made in which
company, In trade finance or credit an arrangement between two firms
services without
one firm grants credit to another firm for the purchase of goods or
purchases
making immediate full payment. It is credit obtained through open-account
receivable by the
represented by an accounts payable by the buyer and an accounts
discount if paid within 10
seller. For example, a credit of 2/10 net 30 indicates 2% cash if the cash
annual interest rate
days, otherwise due in 30 days, this translates into a 37%
discount is foregone.
financial instruments issued in
(g) Commercial Papers: Commercial paper is a short-term get
the form of an unsecured promissory by large corporations with high credibility to
Commercial Paper was introduced
funds on order to meet short term debt obligations.
in India in 1990 with a objective to enable highly reputed and creditworthy corporate
a short
borrowers to raise short term funds. Commercial paper generally matures in
more than 270 days.
periodof time and usually does not exist for
/5.20 Financial Management
(h) Letter of Credit: Aletter of credit is a promise to pay documenttthat aafinancial institution
l
issues to a seller of goods or services which says that the issuer will
pay the
goods/services after performing specific actions that the buyer and seller agree a seller
to.
for
The
issuer then seeks reimbursement from the buyer or from
from the buyer's bank. In
that the buyer is unable to make payment on the purchase, the bank will be the event
cover the full or remaining amount of the purchase. Thus the document ís requiredto
guarantee to the seller that it will be paid by the issuer of the rof credit essential y
regardless
a
of
whether the buyer ultimately fails to pay.
() Bank Overdraft: Abank overdraft is an arrangement between business and Concern
and bank in which bank allowsa business concern towithdraw from account when the
available balance goes below zero. In other words a bank overdraft is when bt
concern is able to spend more than what is actually in their bank account. Thus a benl
interoct
Overdraft is also a type of loan as the money is technically borrowed, usually
money
charge for this facility is high and the bank can change limit at any time or ask for
to be paid back sooner than expected.