UNIT –V WORKING CAPITAL MANAGEMENT

MEANING

Working capital is defined as the excess of current assets over current liabilities. It forms a part
of the aggregate capital of the business. a firms with an optimum level of working capital
indicate efficiency in managing its operations.
It is the capital of a business which is used in its day-to-day trading operations
ie Working Capital = Current Assets – Current Liabilities

Components of Working Capital

 Cash and cash equivalents: This includes cash, money market funds, and certificates of deposit.
 Accounts receivable: The amount owed to the company by customers for credit purchases.
 Inventory: The raw materials, work-in-progress, and finished goods a company holds for sale.
 Accounts payable: The amount a business owes to its vendors.

Current Assets
Current Assets are the assets of the business that can be easily converted into cash within a year
or normal operating cycle of the business, whichever is greater. These assets typically include:

 Cash and cash equivalents

 Inventory
 Accounts Receivable
 Investments
 Marketable Securities
 Prepaid Expenses
 Other Liquid Assets
 Cash: This is the most obvious type of current asset. It includes cash on hand, as well as money in checking
and savings accounts.
 Inventory: Inventory refers to the raw materials or finished products that a company has on hand. The cost of
inventories is a non-liquid asset because it takes time to sell, and the value may fluctuate
 Accounts receivable: This refers to the money owed to a company by its customers. It is an asset because it
will eventually get paid, although it may take longer than a year.
 Investments: These are another type of liquid asset, and include things like stocks, bonds, and mutual funds.
They can sell quickly to generate cash if needed.
 Marketable securities are financial assets that can be easily converted to cash within a year of investment.
 Prepaid expenses :An expense that is paid for in advance, but the benefit is received in the future,
usually within a year.

Current Liabilities
Current Liabilities are the obligations of the business that are due within one operating cycle or a
year, whichever is greater. Such liabilities are paid off by either using the current assets of the
business or by creating other current liabilities.

Therefore, Current Liabilities include:

 Accounts Payable: Accounts payable are nothing but, the money owed to the
manufacturers.

 Accrued Expenses: They are the bills which are due to a 3rd party but not payable, for
instance, wages payable.

 Accrued Interest: Accrued Interest incorporates all interest that has been accumulated
since previously paid.

 Bank account overdrafts (BAO): BAOs are the short term advances that are outlined by
the bank for the purpose of overdrafts.

 Notes payable or Bank loans: It is the existing principal part of a long term loan.

 Dividends payable: They are the dividends stated by the enterprise’s BOD (Board of
Directors) that are due to be paid to the shareholders.
  Income Taxes payable: Income tax is a kind of tax that is owed to the government that
is due to be paid.

 Wages: Wages is the money that is due to be paid to the employees.

 Current Liabilities = [Notes payable + Accounts payable + Accrued expenses + Unearned
revenue+ Current portion of long term debt + other short term debt.]

Types of Working Capital

Depending upon the Periodicity & concept working capital can be classified as below:
 Permanent Working Capital
 Regular Working Capital
 Reserve Margin Working Capital
 Variable Working Capital
 Seasonal Variable Working Capital
 Special Variable Working Capital
 Gross Working Capital
 Net Working Capital
Permanent Working Capital
It is that portion of the working capital that remains permanently tied up in current assets to
undertake business activity uninterruptedly. In other words, permanent working capital is the
least amount of current assets needed to carry out business effortlessly. Thus, it is also known as
fixed working capital.

The amount of fixed working capital required by a business depends upon the size and the
growth of the business. For instance, minimum cash or stock required by a firm to undertake the
operational activities of the business. Now, permanent working capital can be further subdivided
into two categories:
Regular Working Capital

This is defined as the least amount of capital required by a business to fund its day-to-day
operations of a business. Examples include payment of salaries and wages and overhead
expenses for the processing of raw materials.
Reserve Margin Working Capital

Apart from day-to-day activities, a business may need some amount of capital for unforeseen
circumstances. Reserve Margin Working Capital is nothing but the amount of capital kept aside
apart from the regular working capital. These pools of funds are kept separately for unforeseen
circumstances such as strikes, natural calamities, etc.
Variable Working Capital

This can be defined as the working capital invested for a temporary period of time in the
business. For this reason, it is also called as fluctuating working capital. Such a capital varies
with respect to the change in the size of the business or changes in the assets of the business.

Further, variable working capital is subdivided into two categories

 Seasonal Variable Working Capital
This refers to the increased amount of working capital a business needs during the peak season of
the year. A business may even have to borrow funds to meet its working capital needs. Such a
working capital specifically meets the demands of business having a seasonal nature.
Special Variable Working Capital
Supplementary working capital may also be required by a business to undertake exceptional
operations or unforeseen circumstances. The capital required for such circumstances is termed as
special variable working capital. Funds needed to finance marketing campaigns, unforeseen
events like accidental fires, floods, etc.
Gross Working Capital
This refers to the aggregate amount of funds invested in the current assets of the business. In
other words, Gross Working Capital is the total of the current assets of the business. These
include:

 Cash

 Accounts Receivable

 Inventory

 Marketable Securities and

 Short-Term Investments

Gross Working Capital

Gross Working Capital used alone neither shows the complete picture of the short-term financial
soundness. Nor does it showcase the operational efficiency of the business. Current assets should
be compared with the current liabilities to get a better understanding of a business’s operational
efficiency. That is, how efficiently a business utilizes its short term assets to meet its day-to-day
cash requirements.
Net Working Capital
Net Working Capital is the amount by which current assets exceed the current liabilities of a
business. Thus, the working capital equation is defined as the difference between current assets
and current liabilities. Where current assets refer to the sum of cash, accounts receivable, raw
material and finished goods inventory. Whereas, current liabilities include accounts payable.

The amount of working capital in a business is the indicator of liquidity, operational efficiency
and short-term financial soundness of the business. Businesses having adequate working capital
typically have the ability to invest and grow.

On the other hand, businesses having insufficient working capital have higher odds of going
bankrupt. This is because of their inability to pay for their short-term obligations, thus making it
difficult for them to grow.
Factors Determining Working Capital

1. Nature and Size of Business

The working capital need of a business depends a great deal on its nature and size. Let’s consider
various types of businesses to understand how the nature of business impacts its working capital
requirements.

When it comes to trading firms, they require less amount of money to be invested in fixed assets.
However, a huge pool of funds needs to be invested in the form of working capital. On the other
hand, retail stores must keep a large quantity of inventory to meet the diversified and continuous
needs of its customers.
Similarly, the need for working capital in manufacturing firms varies between small to a
substantial amount. This working capital amount depends upon the type of business a firm is
into. Likewise, public utility firms require less working capital but invest heavily in fixed assets.
This is because they have cash sales only and supply services over products. Hence, they have
fewer funds blocked in current assets such as debtors and inventories.
Finally, the size of the business also impacts the working capital needs of the business. Firms
with large scale operations need more working capital as compared to smaller firms.
2. Business Cycle
Business cycle too has a significant impact on the working capital needs of a business. During
the boom phase of the business cycle, businesses typically tend to expand thus requiring
additional working capital. These periods of increased business activity require additional funds
to meet the time lag between collection and sales. Further, funds are also needed to purchase
additional raw material needed to produce additional goods for increased sales.

Not only that, the peak period leads to the increased prices of raw material and increased wages.
Thus, additional funds are needed to provide for such operational expenses.

In contrast, there is lesser demand leading to both the decline of production and sale of goods
during periods of depression. Thus, less amount of working capital is required by the business to
carry out its operational activities.
3. Production Cycle
Production cycle, also known as the operating cycle, is the time difference between the
conversions of raw materials into final products. This too impacts the working capital
requirements of a business to a greater extent.
Businesses with longer production cycles need more working capital to fund its operational
activities. Therefore, firms adopt various measures to reduce their production cycle in order to
minimize their working capital requirements.
4. Seasonal Fluctuations
There are certain businesses that are seasonal in nature. This means there is a high demand for
their goods during a specific period of the year. In such cases, inventory of raw material needs to
be purchased during a specific period of time. This is done so that goods are produced and are
offered for sale when they are needed.
 Thus, the need for inventory increases during this period as compared to the other periods of the
year. Therefore, businesses need additional funds to purchase inventories during the specific time
of the year. As a result, the seasonality of business impacts the working capital requirements of
the business.
5. Operational Efficiency
Various businesses operate on different operational efficiencies. Thus, the operational efficiency
of a business depends upon various factors. These include:

 Short production cycles that involve less time to convert raw material into finished goods

 Achieving sales quickly

 The shorter debt collection period

Thus, businesses with increased operational efficiency are required to invest a lesser amount of
funds in working capital. In contrast, businesses that have lesser operational efficiency need
more funds to be invested in working capital.

FORECASTING OF WORKING CAPITAL REQUIREMENTS

The forecasting of working capital requirements, some popular methods are discussed below:
1. Cash Forecasting Method
2. Balance Sheet Method
3. Profit and Loss Adjustment Method
4. Percentage of Sales Method
5. Operational Cycle Method
6. Regression Analysis Method

1.Cash Forecasting Method:

In this cash forecasting method, the working capital is calculated by using the closing balance of the cash. In this
case, consider the payments and receipts are made in the same period.
2. Balance Sheet Method:
 In the balance sheet method, the forecasting is madeon the basis of difference between assets and liabilities of
the firm. This will show the cash surplus or cash deficiency of the organization.
3. Profit and Loss Adjustment Method:
This method is used to determine the forecasted profit and loss statement of the firm. The cash loss will be
adjusted with more cash supply.
4. Percentage of Sales Method:
This method has simple procedures which are easy to understand.To determine the percentage of sales, the firm
requires its past statistics of sales.
5. Operational Cycle Method:
The total operational cycle of an organization consists of several processes. To calculate the operational cycle of
an organization, the working capital of purchase of raw material to its conversion into cash is considered.
Each of this activity is evaluatedin terms ofnumbers of days and required amount of investment. The total of
each stage of investment is the overall working capital of the firm.
To express the operating cycle of an organization, it is determined by using the formula:
T = (r – c) + w + f + b
Where,
T = Total period of operating cycle in number of days
r = Number of days of raw materials and the storage consumption requirement of raw materials
c = Total number of days of credit allowed by the creditors
w = Number of days of cost of production for work in progress
f = The finished stock storage period
Or,
T = Duration of operating cycle in total number of days
r = Raw materials and the storage period
c = creditors payment period
f = Finished stock storage period
w = Work in process period
b = Debtors collection period

6. Regression Analysis Method:

In this method, statistical formula will be used to find out the value of estimated working capital. For this
purpose, the average relationship of sales and working capital of the past years are established for the current
assets.
Procedure of calculating the working capital:
Current Assets
Raw Material xx
Work in Progress xx
Finished Goods xx
Debtors’ xx
Cash xx
Total Current Assets xx
Less: Current Liabilities
Creditors’ xx
Wages xx
Any Other Expenses xx
Total Current Liabilities [TCA – TCL] xx
Working Capital xx
Add: Contingencies xx
Amount of Working Capital Required xx

Tandon Committee Report on WC

Reserve Bank of India set up a committee under the chairmanship of Shri P.L. Tandon in
July 1974. The terms of reference of the Committee were:
(1) To suggest guidelines for commercial banks to follow up and supervise credit from the point
of view of ensuring proper end use of funds and keeping a watch on the safety of advances.

(2) To suggest the type of operational data and other information that may be obtained by banks
periodically from the borrowers and by the Reserve Bank of India from the leading banks;

(3) To make suggestions for prescribing inventory norms for the different industries, both in the
private and public sectors and indicate the broad criteria for deviating from these norms ;

(4) To make recommendations regarding resources for financing the minimum working capital
requirements;
(5) To suggest criteria regarding satisfactory capital structure and sound financial basis in
relation to borrowings;

(6) To make recommendations as to whether the existing pattern of financing working capital
requirements by cash credit/overdraft system etc., requires to be modified, if so, to suggest
suitable modifications.

The committee was of the opinion that:

(i) Bank credit is extended on the amount of security available and not according to the level of
operations of the customer,

(ii) Bank credit instead of being taken as a supplementary to other sources of finance is treated as
the first source of finance.

Although the Committee recommended the continuation of the existing cash credit system, it
suggested certain modifications so as to control the bank finance. The banks should get the
information regarding the operational plans of the customer in advance so as to carry a realistic
appraisal of such plans and the banks should also know the end-use of bank credit so that the
finances are used only for purposes for which they are lent.

The recommendations of the committee regarding lending norms have been suggested under
three alternatives. According to the first method, the borrower will have to contribute a minimum
of 25% of the working capital gap from long-term funds, i.e., owned funds and term borrowing;
this will give a minimum current ratio of 1.17: 1.

Under the second method the borrower will have to provide a minimum of 25% of the total
current assets from long-term funds; this will give a minimum current ratio of 1.33: 1. In the
third method, the borrower’s contribution from long-term funds will be to the extent of the entire
core current assets and a minimum of 25% of the balance current assets, thus strengthening the
current ratio further.