2 Marks Questions

1. Discuss the two concept of working capital?

1. Gross Working Capital

This concept refers to the total current assets of a business.

 Current assets include cash, accounts receivable, inventory, short-term

investments, and other assets that are expected to be converted into cash
within a year.

 Gross working capital focuses on the company’s investment in short-term

assets to ensure smooth operations.

2. Net Working Capital

This concept refers to the difference between current assets and current
liabilities:

 Net working capital shows the liquidity position of the company — whether
it can meet its short-term obligations.

Summary:

Concept Definition Focus

Gross Working Total current assets Asset

Capital management

Net Working Capital Current assets – current Liquidity &

liabilities solvency

2. Enumerate the factors affecting working capital

i. Length of Operating Cycle
ii. Nature of Business
iii. Scale of Operation
iv. Business Cycle Fluctuation
v. Market Conditions
vi. Conditions of Supply
vii. Business Cycle
viii. Growth and Expansion Activities
 3. Elucidate the concept of working capital management
a) Working capital management is a business strategy designed to ensure that
a company operates efficiently by monitoring and using its current assets and
liabilities to the best effect.
b) The primary purpose of working capital management is to enable the
company to maintain sufficient cash flow to meet its short-term operating
costs and short-term debt obligations
c) It is concerned with short term financing decisions.
d) A company's working capital is made up of its current assets minus its
current liabilities.
e) Working Capital = Current Assets – Current Liabilities

4. Discuss the objectives of working capital management?

a) Improvement in the Credit Profile and Solvency of the Company
b) Use of Fixed Assets Efficiently
c) Ability to Face Crises
d) Expansion

5. Explain Concepts of networking capital

Net Working Capital (NWC) is a key financial metric that shows a company’s
ability to meet its short-term obligations with its short-term assets. It is calculated
as:

NET WORKING CAPITAL = Current assets – current liabilities

5 Marks Questions

1. “Working capital must be adequate but at the same time not excessive.”
Comment?

Conclusion/Summary

Working capital must be balanced — enough to support operations but not so

much that it leads to inefficiency.

An optimal level of working capital depends on:

 The nature of the business (retail vs. manufacturing)

 Business size and growth stage

  Industry trends and market conditions

Adequate Working Capital

 Ensures smooth operations: A business needs enough working capital to

pay day-to-day expenses like wages, rent, and supplier payments.

 Improves creditworthiness: Suppliers and lenders view companies with

good liquidity more favorably.

 Prevents disruptions: Adequate working capital helps avoid production

delays due to a lack of raw materials or funds.

Example: A company with enough cash and inventory can meet customer demands
quickly and pay bills on time.

Excessive Working Capital

 Idle funds: Excess cash or inventory means resources are not being used
productively.

 Lower profitability: Money tied up in working capital could be invested

elsewhere for higher returns.

 Storage and management costs: Too much inventory increases

warehousing costs and risk of obsolescence.

Example: A company with large amounts of unsold stock may face losses if the
products become outdated.

Inadequate Working Capital

 Liquidity issues: The business may struggle to pay bills or buy materials.

 Loss of reputation: Late payments can damage relationships with suppliers

and creditors.

 Lost opportunities: Lack of funds may prevent the business from taking
advantage of bulk discounts or sudden opportunities.

2. Note on operating cycle

Definition

The operating cycle is the period between the purchase of raw materials and the
collection of cash from the sale of finished goods.

Key Components of the Operating Cycle

1. Inventory Conversion Period

o Time taken to convert raw materials into finished goods and sell them.

Inventory Conversion Period=

Average Inventory / Cost of goods sold per day

Receivables Conversion Period (also called Debtors Collection Period)

o Time taken to collect cash from customers after sales.

Receivables Conversion Period=

Average accounts receivable / Credit sales per day

Payables Deferral Period

o Time the company takes to pay its suppliers.

Payables Deferral Period=

Average accounts payable / Credit Purchases per day

Operating Cycle Formula

Operating Cycle=

Inventory period + Receivables period – Payables period

Importance of Operating Cycle

 Helps in understanding liquidity and working capital needs

 A shorter cycle means the company can quickly recover cash from its
investments — ideal for good cash flow.

 A longer cycle may indicate capital is tied up for too long, increasing the
need for external financing.

3. Note on factors affecting working capital management

1. Length of Operating Cycle:
 Operating cycle refers to the time period involved in production.
 Operating cycle is long then more working capital is required, and short
operating cycle; the working capital requirement is less
2. Nature of Business:
 Trading concern or retail shop - Less Working capital required , wholesalers
and manufacturing company - More Working Capital required
3. Scale of Operation:
 The firms operating at large scale need to maintain more inventory, debtors,
etc.
 So they generally require large working capital whereas firms operating at
small scale require less working capital
4. Business Cycle Fluctuation:
 During boom period the market is flourishing so more demand, more
production, more stock, and more debtors which mean more amount of
working capital is required.
 Whereas during depression period low demand less inventories to be
maintained, less debtors, so less working capital will be required.
5. Market Conditions:
 In case of competitive pressure, large inventory is essential, as delivery has
to be off the shelf or credit has to be extended on liberal terms.
6. Conditions of Supply:
 If prompt and adequate supply of raw materials, spares ,stores, etc., is
available it is possible to manage with small investments in inventory or work
on Just- In-Time (JIT) inventory principles.
 However, if supply is erratic, scant, seasonal, channelized through
government agencies etc. it is essential to keep larger stocks increasing
working capital requirements.
7. Business Cycle:
 Business fluctuations lead to cyclical and seasonal changes in the production
and sales and affect the working capital requirements.
8. Growth and Expansion Activities:
 The working capital of the firm increases as it grows in terms of sale or fixed
assets.

4. Differentiate between working capital and fixed capital?

Basis of Working Capital Fixed Capital

Difference
 Meaning Funds used for day-to-day operations Funds invested in long-term assets
Purpose To finance current assets like To acquire fixed assets like land,
inventory, receivables, etc. buildings, machinery
Nature Short-term Long-term
Duration Circulates within a short period (less Remains invested for a long time
than a year)
Examples Cash, stock, debtors, bills receivable Land, plant, equipment, vehicles
Return Generates quick and recurring Generates returns over a longer
returns period
Liquidity Highly liquid Less liquid (difficult to convert
quickly into cash)
Risk Involved Higher due to market fluctuations Lower risk, more stable
Accounting Recorded as current assets and Recorded as non-current (fixed)
Treatment liabilities assets

5. Discuss the method of working capital assessment

Methods of Working Capital Assessment

Working capital assessment refers to the process of estimating the amount of

working capital a business needs to run its day-to-day operations efficiently. Various
methods are used depending on the nature of the business, industry norms, and
banking guidelines.

1. Operating Cycle Method (Traditional Method)

 Based on the length of the operating cycle (time taken from purchase of raw
materials to collection of cash from sales).

 It calculates the working capital required to cover all stages of the cycle: raw
materials, WIP, finished goods, receivables, and payables.

Suitable for manufacturing businesses

2. Percentage of Sales Method

 Assumes working capital is a fixed percentage of projected or actual sales.

 The percentage is determined based on past trends or industry benchmarks.

Useful for businesses with stable sales patterns

3. Cash Budgeting Method

 Used when cash inflows and outflows are forecasted for a specific period
(weekly/monthly).

 Helps assess the minimum cash required to maintain operations.

Common for seasonal businesses or businesses with fluctuating cash flows.

4. Turnover Method (Nayak Committee Recommendation)

 Recommended by the RBI's Nayak Committee for small businesses with

working capital needs up to ₹5 crore.

 Working capital is assessed as 25% of projected annual turnover, of

which minimum 5% must be brought in by the borrower.

Used by banks for loans to MSMEs (Micro, Small & Medium Enterprises).

5. Current Assets to Current Liabilities Method (Tandon Committee)

Tandon Committee recommended three methods:

 First Method: Borrower brings in 25% of working capital gap (CA - CL).

 Second Method: Borrower brings in 25% of current assets from long-term

sources.

 Third Method: Core current assets are fully financed by long-term funds;
balance current assets financed partly by bank.

Conclusion:

Method Best For

Operating Cycle Manufacturers with detailed costing

% of Sales Businesses with predictable turnover

Cash Budgeting Seasonal/irregular cash flow

businesses

Turnover (Nayak) Method Small businesses (MSMEs)

Tandon Committee Medium to large enterprises

Methods

10 Marks Questions

1. Define working capital cycle? Discuss the various factors help to determine
working capital?
Refer q3 in previous section

2. Define working capital cycle? Discuss the various factors affecting to working
capital?

Refer q2 in previous section

3. Why do we distinguish between permanent and variable working capital?

Aspect Permanent Working Variable Working Capital

Capital

Purpose Day-to-day base Seasonal or temporary needs

operations

Stability Relatively stable Fluctuates with business

activity

Financing Long-term funds Short-term borrowings

source

Risk Level Lower Higher

Distinguishing between permanent and variable (also called temporary) working

capital is important because it helps businesses plan, finance, and manage their
short-term resources efficiently.

1. Better Financial Planning

 Permanent Working Capital refers to the minimum level of current assets a

business needs at all times to continue operations (e.g., basic inventory,
minimum cash).

 Variable Working Capital is the extra working capital needed during peak
seasons, sudden demand, or business expansion.

By separating the two, a business can make more accurate forecasts and plan
accordingly.

2. Different Financing Needs

 Permanent Working Capital is usually financed by long-term sources (like

equity or long-term loans) because it is needed continuously.

 Variable Working Capital is generally financed by short-term sources (like

overdrafts or short-term loans) since it fluctuates.
This helps the company match the duration of funds with the use, reducing
financing risk and cost.

3. Efficient Use of Funds

 Knowing how much capital is fixed and how much varies allows better cash
flow management.

 Avoids idle funds from over-financing or liquidity crunches from under-

financing.

4. Risk Management

 Temporary working capital involves more risk due to market fluctuations or

seasonality.

 Permanent working capital is more stable and predictable.

Distinguishing helps businesses develop strategies for handling uncertainties in

cash flow and demand.

4. What two processes are accomplished in the management of working capital?

Process Focus Area Objective

1. Management of Current Cash, inventory, Ensure liquidity &

Assets receivables profitability

2. Management of Current Payables, short-term Ensure timely payments &

Liabilities loans, expenses control costs

1. Management of Current Assets

This involves ensuring that the company has the right amount of current assets
(resources that can be converted into cash within a year). Key areas include:

 Cash Management: Maintaining optimal cash levels — enough to meet

obligations but not excessive to avoid idle funds.

 Inventory Management: Keeping the right amount of raw materials, work-

in-progress, and finished goods to avoid overstocking or stockouts.

 Accounts Receivable Management: Ensuring timely collection from

customers, setting credit policies, and minimizing bad debts.

Goal: Maximize returns from assets while maintaining liquidity.

2. Management of Current Liabilities

This focuses on efficient handling of short-term obligations. Key areas include:

 Accounts Payable Management: Making timely payments to suppliers

while taking advantage of credit terms.

 Short-term Borrowing: Managing bank loans, overdrafts, and other short-

term liabilities in a cost-effective way.

 Accrued Expenses & Provisions: Monitoring upcoming liabilities like

wages, taxes, and utilities.

Goal: Optimize payment timings to improve cash flow and reduce cost of capital.

5. What is concept of operating cycle? Explain the reasons for Prolonged

Operating cycle and factors to be consider for reducing operating cycle?

Refer q2 in previous section

Reasons for a Prolonged Operating Cycle

A prolonged (long) operating cycle means it takes a business more time to

convert its investments in inventory and other resources into cash. This ties up
capital and affects liquidity. Here are some common reasons:

1. High Inventory Levels

 Excessive stock due to overproduction or low demand increases the inventory

holding period.

 Poor inventory management or lack of demand forecasting contributes to

this.

2. Slow Production Process

 Delays in manufacturing or processing increase the time it takes to turn raw

materials into finished goods.

3. Inefficient Sales Process

 Low sales volume or long sales cycles extend the time taken to move
inventory.

4. Liberal Credit Policy

 If the company allows customers too much time to pay (long credit periods),
it increases the receivables collection period.
5. Poor Receivables Management

 Delays in collecting dues from customers due to weak follow-up or ineffective

credit control systems.

6. Delays in Raw Material Supply

 If suppliers take time to deliver materials, the production cycle is delayed,

affecting the whole operating cycle.

7. Seasonal Business Operations

 Some businesses stock up heavily before peak seasons, leading to longer

cycles during off-season periods.

Factors to Consider for Reducing the Operating Cycle

To shorten the operating cycle and improve cash flow, businesses can focus on the
following:

1. Efficient Inventory Management

 Use techniques like Just-in-Time (JIT), ABC analysis, and demand

forecasting to reduce inventory holding time.

2. Speed Up Production

 Improve productivity through automation, better planning, and reducing

process bottlenecks.

3. Improve Sales and Demand Forecasting

 Analyze market trends and align production/sales strategies accordingly to

avoid overstocking or underproduction.

4. Tighten Credit Policy

 Offer shorter credit terms and provide incentives for early payment (e.g.,
discounts).

5. Strengthen Receivables Collection

 Set clear collection policies, follow up regularly, and use reminders or

automated systems to recover dues quickly.

6. Negotiate Better Credit Terms with Suppliers

 Delaying payments to suppliers without incurring penalties helps improve

cash flow and reduce net operating cycle
7. Adopt Technology and ERP Systems

 Automate inventory, billing, and cash management to increase efficiency and

reduce delays.