SHAH SIR’S

ARIHANT COMMERCE CAREER ACADEMY

Class: - MBA 1st 1SEM Subject:- Working Capital Management

Introduction
Working capital can be understood as a measure of both a company’s efficiency and its
short-term financial health. For a layman, it simply means the difference between the
current assets and current liabilities. It is the firm’s holdings of current, or short-term,
assets (such as cash). Working capital is generally divided in two types, viz. gross
working capital and net working capital. Gross Working Capital (GWC) is nothing but
the total current or circulating assets. Net working capital, NWC (current assets minus
current liabilities), provides an accurate assessment of the liquidity position of firm with
the liquidity-profitability dilemma solidly authenticated in the financial scheme of
obligations which mature within a twelve-month period. As we have seen, the two main
components of the working capital are assets and liabilities. First, short-term, or current
liabilities constitute the portion of funds which have been planned for and raised. Since
management must be concerned with proper financial structure, these and other funds
must be raised judiciously. Short-term or current assets constitute a part of the asset-
investment decision and require diligent review by the firm’s executives. Further, since
there exists a close correlation between sales fluctuations and invested amounts in current
assets, a careful maintenance of the proper asset and funds should be ensured.
Concept of Working Capital
Working capital typically means the firm’s holdings of current, or short-term, assets such
as cash, receivables, inventory, and marketable securities. Working capital refers to that
part of firm’s capital which is required for financing short-term or current assets such as
cash, marketable securities, debtors, and inventories. In other words working capital is the
amount of funds necessary to cover the cost of operating the enterprise.
Working capital means the funds (i.e.; capital) available and used for day-to-day
operations (i.e.; working) of an enterprise. It consists broadly of that portion of assets of a
business which are used in or related to its current operations. It refers to funds which are
used during an accounting period to generate a current income of a type which is
consistent with major purpose of a firm existence.
Working Capital is the money used to make goods and attract sales. The less
Working Capital used to attract sales, the higher is likely to be the return on investment.
Working Capital management is about the commercial and financial aspects of Inventory,
credit, purchasing, marketing, and royalty and investment policy. The higher the profit
margin, the lower is likely to be the level of Working Capital tied up in creating and
selling titles. The faster that we create and sell the books the higher is likely to be the
return on investment. Thus, when we have been using.
The larger the percentage of funds obtained from short-term funds, the more aggressive
(and risky) in firm’s working capital policy and vice-versa.
There are two possible interpretations of working capital concept:
l. Balance Sheet Concept
2. Operating Cycle
Concept It goes without saying that the pattern of management will be very largely
influenced by the approach taken in defining it. Therefore, the two concepts are discussed
separately in a nutshell.
Balance Sheet Concept
There are two interpretations of working capital under the balance sheet concept. It is
represented by the excess of current assets over current liabilities and is the amount
normally available to finance current operations. But, sometimes working capital is also
used as a synonym for gross or total current assets. In that case, the excess of current
assets over current liabilities is called the net working capital or net current assets.
Economists like Mead, Malott, Baket and Field support the latter view of working capital.
They feel that current assets should be considered as working capital as the whole of it
helps to earn profits; and the management is more concerned with the total current assets
as they constitute the total funds available for operational purposes. On the other hand,
economists like Lincoln and Salvers uphold the former view. They argue that
1. In the long run what matters is the surplus of current asserts over current liabilities;
2. It is this concept which helps creditors and investors to judge the financial soundness
of the enterprise;
3. What can always be relied upon to meet the contingencies, is the excess of current
assets over the current liabilities since this amount is not to be returned; and
4. This definition helps to find out the correct financial position of companies having the
same amount of current assets.
Institute of Chartered Accountants of India, while suggesting a vertical form of balance
sheet, also endorsed the former view of working capital when it described net current
assets as the difference between current assets and current liabilities.
The conventional definition of working capital in terms of the difference between the
current assets and the current liabilities is somewhat confusing. Working capital is really
what a part of long-term finance is locked in and used for supporting current activities.
Consequently, the larger the amount of working capital so derived, greater the proportion
of long-term capital sources siphoned off to short-term activities. It is about tight working
capital situation, the logic of the above definition would perhaps indicate diversion to
bring in cash, under the conventional method, working capital would evidently remain
unchanged. Liquidation of debtors and inventory into cash would also keep the level of
working capital unchanged. A relatively large amount of working capital according to
this definition may produce a false sense of security at a time when cash resources may
be negligible, or when these may be provided increasingly by long-term fund sources in
the absence of adequate profits. Again, under the conventional method, cash enters into
the computation of working capital. But it may have been more appropriate to exclude
cash from such calculations because one compares cash requirements with current assets
less current liabilities. The implication of this in conventional working capital
computations is that during the financial period current assets get converted into cash
which, after paying off the current liabilities, can be used to meet other operational
expenses. The paradox, however, is that such current assets as are relied upon to yield
cash must themselves to be supported by long-term funds until are converted into cash.
At least, three points seem to emerge from the above. First, the balance sheet definition of
working capital is perhaps not so meaningful, except as an indication of the firm’s current
solvency in repaying its creditors. Secondly, when firms speak of shortage of working
capital, they in fact possible imply scarcity of cash resources. Thirdly, in fund flow
analysis an increase in working capital, as conventionally defined, represents employment
or application of funds.
Operating Cycle Concept
A company’s operating cycle typically consists of three primary activities; purchasing
resources, producing the product, and distributing (selling) the product. These activities
create funds flows that are both unsynchronized because cash disbursements usually take
place before cash receipts.
They are uncertain because future sales and costs, which generate the respective receipts
and disbursements, cannot be forecasted with complete accuracy. If the firm is to
maintain a cash balance to pay the bills as they come due. In addition, the company must
invest in inventories to fill customer orders promptly. And, finally, the company invests
in accounts receivable to extend credit to its customers.
Figure 1.1 shows the operating cycle of a typical firm. The operating cycle is equal to the length
of the inventory and receivables conversion periods:
Operating cycle = Inventory conversion period + Receivables conversion period
The inventory conversion period is the length of time required to produce and sell the product. It
is defined as follows:

The payables deferral period is the length of time the firm is able to defer payment on its various
resource purchases (for example, materials, wages, and taxes). Equation is used to calculate the
payables deferral period:

Finally, the cash conversion cycle represents the net time interval between the collection of cash
receipts from product sales and the cash payments for the company’s various resource purchases.
It is calculated as follows:
Cash conversion cycle = Operating cycle – Payable deferral period
Importance of Working Capital
Working capital is the life blood and nerve centre of a business. Just as circulation of blood is
essential in the human body for marinating life, working capital is very essential to maintain the
smooth running of a business. No business can run successfully without an adequate amount of
working capital. The main advantages of maintaining adequate amount of working capital are as
follows:
1. Solvency of the business: Adequate working capital helps in maintaining solvency of the
business by providing uninterrupted flow of production.
2. Goodwill: Sufficient working capital enables a business concern to make prompt payments
and hence helps in creating and maintaining goodwill.
3. Easy Loans: A concern having adequate working capital, high solvency and good credit
standing can arrange loans from banks and other on easy and favourable terms.
4. Cash discounts: Adequate working capital also enables a concern to avail cash discounts on
the purchases and hence it reduces costs.
5. Regular supply of raw materials: Sufficient working capital ensures regular supply of raw
materials and continuous production.
6. Regular payment of salaries, wages and other day-to-day commitments: A company
which has ample working capital can make regular payment of salaries, wages and other day-to-
day commitments which raises the morale of its employees, increases their efficiency, reduces
wastages and costs and enhances production and profits.
7. Exploitation of favourable market condition: Only concern with adequate working capital
can exploit favourable market conditions such as purchasing its requirements in bulk when the
prices are lower and by holding its inventories for higher prices.
8. Ability to face crisis: Adequate working capital enables a concern to face business crisis in
emergencies such as depression because during such periods, generally, there is much pressure
on working capital.
9. Quick and regular return on investments: Every investor wants a quick and regular return
on his investments. Sufficiency of working capital enables a concern to pay quick and regular
dividends to its investors as there may not be much pressure to plough back profits. This gains
the confidence of its investors and creates a favourable market to raise additional funds ion the
future.
10. High morale: Adequacy of working capital creates an environment of security, confidence,
and high morale and creates overall efficiency in a business.
Factors determining Working Capital Requirements
The working capital requirement of a concern depends upon a large numbers of factors such as
nature and size of business, the character of their operations, the length of production cycles, the
rate of stock turnover and the state of economic situation. It is not possible to rank them because
all such factors of different importance and the influence of individual factors changes for a firm
overtime. However the following are important factors generally influencing the working capital
requirement:
1. Nature or Character of Business: The working capital requirement of a firm basically
depends upon the nature of this business. Public utility undertakings like electricity water supply
and railways need very limited working capital because they offer cash sales only and supply
services, not products and as such no funds are tied up in inventories and receivables. Generally
speaking it may be said that public utility undertakings require small amount of working capital,
trading and financial firms require relatively very large amount, whereas manufacturing
undertakings require sizable working capital between these two extremes.
2. Size of Business/Scale of Operations: The working capital requirement of a concern is
directly influenced by the size of its business which may be measured in terms of scale of
operations.
3. Production Policy: In certain industries the demand is subject to wide fluctuations due to
seasonal variations. The requirements of working capital in such cases depend upon the
production policy.
4. Manufacturing Process/Length of Production Cycle: In manufacturing business the
requirement of working capital increases in direct proportion of length of manufacturing process.
Longer the process period of manufacture, larger is the amount of working capital required.
5. Seasonal Variation: In certain industries raw material is not available through out the year.
They have to buy raw materials in bulk during the season to ensure and uninterrupted flow and
process them during the entire year.
6. Rate of Stock Turnover: There is a high degree of inverse co-relationship between the
quantum of working capital; and the velocity or speed with which the sales are affected. A firm
having a high rate of stock turnover will need lower amount of working capital as compared to
affirm, having a low rate of turnover.
7. Credit Policy: The credit policy of a concern in its dealing with debtors and creditors
influence considerably the requirement of working capital. A concern that purchases its
requirement on credit and sell its products/services on cash require lesser amount of working
capital.
8. Business Cycle: Business cycle refers to alternate expansion and contraction in general
business activity. In a period of boom i.e., when the business is prosperous, there is a need of
larger amount of working capital due to increase in sales, rise in prices, optimistic expansion of
business contracts sales decline, difficulties are faced in collection from debtors and firms may
have a large amount of working capital lying idle.
9. Rate of Growth of Business: The working capital requirement of a concern increase with the
growth and expansion of its business activities. Although it is difficulties to determine the
relationship between the growth in the volume of business and the growth in the working capital
of a business, yet it may be concluded that of normal rate of expansion in the volume of
business, we may have retained profits to provide for more working capital but in fast growth in
concern, we shall require larger amount of working capital.
10. Price Level Changes: Changes in the price level also effect the working capital requirement.
Generally the rising prices will require the firm to maintain larger amount of working capital as
more funds will be required to maintain the same current assets.
Optimal Level of Working Capital Investment
The optimal level of working capital investment is the level expected to maximize shareholder
wealth. It is a function of several factors, including the variability of sales and cash flows and the
degree of operating and financial leverage employed by the firm. Therefore no single working
capital investment policy is necessarily optimal for all firms.
Proportions of Short-term Financing
Not only a firm have to be concerned about the level of current assets; it also has to determine
the proportions of short-and long-term debt to use in financing use in these assets. The decision
also involves trade-offs between profitability and risk. Sources of debt financing are classified
according to their maturities. Specifically, they can be categorized as being either short-term or
long-term, with short-term sources having maturities of one year or less and long-term sources
having maturities of greater than one year.
Cost of Short-term versus Long-term
Debt Historically long-term interest rates normally exceeds short-term rate because of the reduce
flexibility of long-term borrowing relative to short-term borrowing. In fact, the effective cost of
long-term debt, even went short-term interest rates are equal to or greater than long-term rates.
With long-term debt, a firm incurs the interest expense even during times went it has no
immediate need for the funds, such as during seasonal or cyclical downturns. With short-term
debt, in contrast, the firm can avoid the interest costs on unneeded funds by playing of (or not
renewing) the debt. Therefore, the long-term debt generally is higher than the cost of short-term
debt.
Risk of Long-term versus Short-term
Debt Borrowing companies have different attitudes toward the relative risk of long-term versus
short-term debt then lenders. Whereas lenders normally feel that risk increases with maturity,
borrowers feel that there is more risk associated with short-term debt. The reasons for this are
two fold.
First, there is always the chance that a firm will not be able to refund its short-term debt. When a
firm’s debt matures, it either pays off the debt as part of a debt reduction program or arranges
new financing. At the time of maturity, however, the firm could faced with financial problems
resulting from such events as strikes, natural disasters, or recessions that cause sales and cash
inflows to decline. Under these circumstances the firm may find it very difficult or even
impossible to obtain the needed funds. This could lead to operating and financial difficulties.
Second, short-term interest rates tend to fluctuate more over time than long-term interest rates.
As a result, a firm’s interest expenses and expected earnings after interest and taxes are subject
to more variation (risk) over time with short-term debt than with long-term debt.
Types of Working Capital
The concept of Working Capital includes current assets and current liabilities both. There are
two concepts of working capital. They are Gross and Net Working Capital.
1 Gross Working Capital
Gross Working Capital refers to the firm’s investment in Current Assets. Current assets are the
assets, which can be converted into cash within an accounting year or operating cycle. It includes
cash, short-term securities, debtors (account receivables or book debts), bills receivables and
stock (inventory). The concept of Gross Working Capital focuses attention on two aspects of
current assets’ management.
They are: 1. Way of optimizing investment in Current Assets.
2. Way of financing current assets.
1. Optimizing Investment in Current Assets:
Investment in Current Assets should be just adequate i.e., neither in excess nor deficit because
excess investment increases liquidity but reduces profitability as idle investment earns nothing
and inadequate amount of working capital can threaten the solvency of the firm because of its
inability to meet its obligation. It is taken into consideration that the Working Capital needs of
the firm may be fluctuating with changing business activities which may cause excess or
shortage of Working Capital frequently and prompt management can control the imbalances.
2. Way of Financing Current Assets:
This aspect points to the need of arranging funds to finance Country Assets. It says whenever a
need for working Capital arises; financing arrangement should be made quickly. The financial
manager should have the knowledge of sources of the working capital funds as wheel as
investment avenues where idle funds can be temporarily invested.
2 Net Working Capital
Net Working Capital refers to the difference between Current Assets and Current Liabilities are
those claims of outsiders, which are expected to mature for payment within an accounting year.
It includes creditors or accounts payables, bills payables and outstanding expenses.
Net Working Capital can be positive or negative. A positive net working capital will arise when
current assets exceed current liabilities and vice versa.
As compared with the gross working capital, net is a qualitative concept. It indicates the liquidity
position of and suggests the extent to which working Capital needs may be financed by
permanent sources of funds. Current Assets should be optimally more than Current Liabilities. It
also covers the point of right combination of long-term and short-term funds for financing
current assets. For every firm a particular amount of net Working Capital is permanent.
Therefore it can be financed with long-term funds.
Thus both concepts, Gross and Net Working Capital, are equally important for the efficient
management of Working Capital. There are no specific rules to determine a firm’s Gross and Net
Working Capital but it depends on the business activity of the firm.
Every business concern should have neither redundant nor cause excess WC nor it should be
short of WC. Both conditions are harmful and unprofitable for any business. But out of these
two, the shortage of WC is more dangerous for the well being of the firms.
Working capital may be of many types, but the most important of them all are equity capital,
debt capital, speciality capital and sweat equity. Each of these is a separate category of financial
and has its own benefits and characteristics.
Operating Cycle
The extent to which profits can be earned will naturally depend, among other things, upon the
magnitude of the sales. A successful sales programme is, in other words, necessary for earning
profits by any business enterprise. However, sales do not convert into cash instantly: there is
invariably a time-lag between the sale of goods and the receipt of cash. There is, therefore, a
need for working capital in the form of current assets to deal with the problem arising out of the
lack of immediate realisation of cash against goods sold. Therefore, sufficient working capital is
necessary to sustain sales activity. Technically, this is referred to as the operating or cash cycle.
Meaning of Operating Cycle
The simplest definition of the term operating cycle is, “The average time between purchasing or
acquiring inventory and receiving cash proceeds from its sale.” The operating cycle can be said
to be at the heart of the need for working capital. The continuing flow from cash to suppliers, to
inventory, to accounts receivable and back into cash is what is called the operating cycle.
In other words, the term cash cycle refers to the length of time necessary to complete the
following cycle of events:
1. Conversion of cash into inventory
2. Conversion of inventory into receivables
3. Conversion of receivables into cash.
The operating cycle, which is a continuous process, is shown in Figure 2.1

If it were possible to complete the sequences instantaneously, there would be no need for current
assets (working capital). But since it is not possible, the firm is forced to have current assets.
Since cash inflows and outflows do not match, firms have to necessarily keep cash or invest in
short-term liquid securities, so that they will be in a position to meet obligations when they
become due. Similarly, firms must have adequate inventory to guard against the possibility of
not being able to meet demand for their products. Adequate inventory, therefore, provides a
cushion against being out of stock. If firms have to be competitive, they must sell goods to their
customers on credit which necessitates the holding of accounts receivable. It is in these ways that
an adequate level of working capital is absolutely necessary for smooth activity which, in turn,
enhances the owner’s wealth.
The operating cycle consists of three phases.
Phase I
In phase I, cash gets converted into inventory. This includes purchase of raw materials,
conversion of raw materials into work-in-progress finished goods and finally the transfer of
goods to stock at the end of the manufacturing process. In the case of trading organizations, this
phase is shorter as there would be no manufacturing activity and cash is directly converted into
inventory. The phase is, of course, totally absent in the case of service organisations.
Phase II
In phase II of the cycle, the inventory is converted into receivables as credit sales are made to
customers. Firms which do not sell on credit obviously do not have phase II of the operating
cycle.
Phase III
The last phase, phase III, represents the stage when receivables are collected. This phase
completes the operating cycle. Thus, the firm has moved from cash to inventory, to receivables
and to cash again.
Significance of Operating Cycle
The operating cycle is conceptually simple but critically important.
Example: Let’s take the example of a greengrocer, who is ‘’cashing up’’ one evening. What
does he find? First, he sees how much he spent in cash at the wholesale market in the morning
and then the cash proceeds from fruit and vegetable sales during the day. If we assume that the
greengrocer sold all the produce he bought in the morning at a mark-up, the balance of receipts
and payments for the day will deliver a cash surplus.
Unfortunately, things are usually more complicated in practice. Rarely is all the produce bought
in the morning sold by the evening, especially in the case of a manufacturing business.
A company processes raw materials as part of an operating cycle, the length of which varies
tremendously, from a day in the newspaper sector to 7 years in the cognac sector. There is thus a
time lag between purchases of raw materials and the sale of the corresponding finished goods.
And this time lag is not the only complicating factor. It is unusual for companies to buy and sell
in cash. Usually, their suppliers grant them extended payment periods, and they in turn grant
their customers extended payment periods. The money received during the day does not
necessarily come from sales made on the same day.
As a result of customer credit, supplier credit and the time it takes to manufacture and sell
products or services, the operating cycle of each and every company spans a certain period,
leading to timing differences between operating outflows and the corresponding operating
inflows.
Each business has its own operating cycle of a certain length that, from a cash flow standpoint,
may lead to positive or negative cash flows at different times. Operating outflows and inflows
from different cycles are analysed by period, e.g., by month or by year. The balance of these
flows is called operating cash flow. Operating cash flow reflects the cash flows generated by
operations during a given period.
In concrete terms, operating cash flow represents the cash flow generated by the company’s day-
to-day operations. Returning to our initial example of an individual looking at his bank
statement, it represents the difference between the receipts and normal outgoings, such as on
food, electricity and car maintenance costs.
Naturally, unless there is a major timing difference caused by some unusual circumstances (start-
up period of a business, very strong growth, very strong seasonal fluctuations), the balance of
operating receipts and payments should be positive.