Working Capital

Working capital refers to the difference between a company's current assets and current
liabilities. It represents the operational liquidity and short-term financial health of a business,
reflecting its ability to cover day-to-day operational expenses and meet short-term obligations.
Current assets include cash, accounts receivable, and inventory, while current liabilities encompass
accounts payable and short-term debt. Maintaining an adequate level of working capital is crucial
for businesses to ensure smooth operations, as it allows them to pay bills, manage inventory, and
seize new opportunities. Insufficient working capital can lead to disruptions in operations, missed
opportunities, and financial strain, while excessive working capital may indicate inefficiencies in
resource allocation.

Definition

In the words of Prof. H.G. Guthman, “Working Capital is excess of current assets over
current liabilities.”

According to Charles W. Gerstenberg, “Working Capital is circulating capital means all

current assets of a company that are changed from one form to another in the ordinary course of
business.”

L.J. Guthmann defined working capital as “the portion of a firm’s current assets which are
financed from long–term funds.” The excess of current assets over current liabilities is termed as
‘Net working capital’. In this concept “Net working capital” represents the amount of current assets
which would remain if all current liabilities were paid.

TYPES OF WORKING CAPITAL

According to the needs of business, the working capital may be classified into following two
bases:
1. On the basis of periodicity
2. On the basis of concept
On the basis of periodicity:

The requirements of working capital are continuous. More working capital is required in a
particular season or the peck period of business activity. On the basis of periodicity working capital
can be divided under two categories as under:

1. Permanent working capital

2. Variable working capital

1.Permanent working capital

This type of working capital is known as Fixed Working Capital. Permanent

working capital means the part of working capital which is permanently locked up in the
current assets to carry out the business smoothly. The minimum amount of current assets
which is required to conduct the business smoothly during the year is called permanent
working capital.

For example, investments required to maintain the minimum stock of raw materials
or to cash balance. The amount of permanent working capital depends upon the size and
growth of company. Fixed working capital can further be divided into two categories as
under:

i. Regular Working capital:

Minimum amount of working capital required to keep the primary circulation.

Some amount of cash is necessary for the payment of wages, salaries etc.

ii. Reserve Margin Working capital:

Additional working capital may also be required for contingencies that may arise
any time. The reserve working capital is the excess of capital over the needs of the regular
working capital is kept aside as reserve for contingencies, such as strike, business
depression etc.
 2. Variable or Temporary Working Capital:
The term variable working capital refers that the level of working capital is
temporary and fluctuating. Variable working capital may change from one asset to another
and changes with the increase or decrease in the volume of business.
The variable working capital may also be subdivided into following two sub-groups.

i. Seasonal Variable Working capital:

Seasonal working capital is the additional amount which is required during the
active business seasons of the year. Raw materials like raw-cotton or jute or sugarcane are
purchased in particular season. The industry has to borrow funds for short period. It is
particularly suited to a business of a seasonal nature. In short, seasonal working capital is
required to meet the seasonal liquidity of the business.

ii. Special variable working capital:

Additional working capital may also be needed to provide additional current assets
to meet the unexpected events or special operations such as extensive marketing campaigns
or carrying of special job etc.

2. On the basis of concept

On the basis of concept working capital is divided into two categories as under
i. Gross Working Capital:
Gross working capital refers to total investment in current assets. The current assets
employed in business give the idea about the utilization of working capital and idea about
the economic position of the company. Gross working capital concepts is popular and
acceptable concept in the field of finance.
ii. Net Working Capital:

Net working capital means current assets minus current liabilities. The difference
between current assets and current liabilities is called the net working capital. If the net
working capital is positive, business is able to meet its current liabilities. Net working
capital concept provides the measurement for determining the creditworthiness of
company.
Factors Affecting Quantum of Working Capital Requirements

In general, following factors are affecting the requirement of working capital

1. Nature of Industry

The main factor which affects the requirement is the nature of the industry Le if the industry
is of small type there may be less need of cash, investment. On the other hand, if the industry is of
large type, the block cash etc., are kept on large basis. Even the goods and raw materials are
purchased and supplied on credit basis. Investing huge amount in fixed assets have the lowest
needs for current assets, partly because of the cash nature of their business and partly because of
selling services instead of products. Thu no funds will be tied up in accounts receivables and
inventories. On the other hand, trading and financial firms have a very low investment in fived
assets but huge amount to be invested in working capital.

2.Credit Policy

The credit policy relating to sales and purchases also affects the working capital. The credit
policy influences the requirement of working capital in two ways:

1. through credit terms granted by the firm to its customers/buyers of goods

2. credit terms available to the firm from its creditors.

The credit terms granted to customers have a bearing on the magnitude of working capital
by determining the level of book debts. The credit sales result in higher book debts (receivables).
Higher book debts mean more wording capital. On the other hand, if liberal credit terms are
available from the suppliers of goods (trade creditors), the need for working capital is less. The
working capital requirements of a business are, thus, affected by the terms of purchase and sale,
and the role given to credit by a company in its dealings with creditors and debtors.

Credit terms fixed by an enterprise are affected by the prevailing trade practices as well as
changing economic conditions. II, for example, competition is keen, there would be pressure to
grant generous credit terms. Nevertheless, there is wide scope for managerial discretion in working
out a suitable credit policy relevant to each customer based on the merits of each case. For instance,
liberal credit facilities can be extended on the basis of credit rating. This will avoid the problem of
having excess working capital.

Similarly, the collection procedure can be so framed that funds, which would otherwise
be available for meeting operating needs are not locked up. Thus, adoption of nationalized credit
policies would be a significant factor in determining the working capital needs of an enterprise.
Such discretion may, however, not be available to a company which operates in a highly
competitive market. To win and retain customers, it may be forced, among other things, to offer
generous credit terms to them. The investment in book debts will consequently be of a higher
order, necessitating large working capital in another way. To be able to enjoy consumer patronage
on a continuous basis, a firm will have to offer a variety of products quite unlike a firm which has
a hold on the market and, hence, does not need special efforts to satisfy customer requirements.
The consequence of a higher level of inventories would be an additional need for working capital.
The degree of competition is, therefore, an important factor working capital requirements.

3.Cash Requirement

Cash in a part of current assets. The company should maintain the minimum cash level It
helps in the smoother functioning of business operation. It should be adequate and properly
utilized. It is both the means and end of enterprise. Just an blood, gives life to the human body, in
the same way cash gives profit and solvency to the working capital structure of an enterprise.

4. General Nature of Business

The working capital requirements of an enterprise are basically related to the conduct of
business. Enterprises fall into some broad categories depending on the nature of their business For
instance, public utilities have certain features which have a bearing on their working capital needs.
The two relevant features are:

i) the cash nature of business, that e, cash sale,

ii) sale of services rather than commodities.

In view of these features, they do n maintain big inventories and have, therefore, probably
the least requirement of working capital are the other extreme are trading and financial enterprises.
The nature of their business is such that they have to maintain a sufficient amount of cash,
inventories and book debts. They have necessarily to invest proportionately large amounts in
working capital. The manufacturing enterprises fall in a sense, between these two extremes. The
industrial concerns require fairly large amounts of working capital though it varies from industry
to industry depending on their asset structure. The proportion of current assets to total assets
measures the relative requirements of working capital of various industries.

Available data in respect of companies in India confirm the wide variations in the use of
working capital by different enterprises. The percentage of current assets to total assets was found
to be the lowest in hotels, restaurants and eating houses (10-20 per cent range, while in electricity
generation and supply it was in the range of 20-30 per cent. The enterprises in the tobacco,
construction and trading groups had, as is to be expected, the highest component of working capital
(80-90 per cent range). The other industrial groups fall between these limits though there are very
wide inter-industry variations."

5. Time

This is also an important factor that affects the requirement of working capital. If the time
required in manufacturing goods is more (large), the investment in working capital is also greater
and if the time is less than the amount invested in working capital is also less. Moreover, the
amount of working capital depends upon inventory turnover and the unit cost of goods that are
sold. The greater the cost the larger is amount of working capital.

6. Volume of Sales

This is the most important factor affecting the requirement of working capital. A firm
maintains current assets because they are needed to support the operational activation, which result
in sales. The volume of sale and the size of the working capital are directly related to each other.
As the volume of sale increases the working capital investment increases and vices

7. Terms of Purchase and Sale

If the credit terms of purchases are more favorable and those of sales less liberal, less cash
is invested in inventory With more favorable credit terms, working capital requirements can be
reduced as the firms do get more time for payment to creditors or suppliers The credit granting
policy of a firm affects the working capital requirement by influencing the size of account
receivables.

8. Inventory Turnover

If it is high, the working capital requirement will be low If it is low, working capital
requirement reduces. Managing working capital is synonymous with controlling inventories. Good
inventory management is helpful for the structure of working capital

9. Receivable Turnover

It is necessary to have an effective control over receivables Prompt collection of

receivables and good facilities for setting payables result into low working capital requirements
obtain maximum sales keep bad debt losses to minimum. Minimize the cost of investment etc. are
the objectives of receivables management

10. Business Cycle

The working capital requirements are also determined by the nature of the business cycle,
Business fluctuations lead to cyclical and seasonal changes which, in turn, cause a shift in the
working capital position, particularly for temporary working capital requirements The variations
in business conditions may be in two directions:

1. upward phase when boom conditions prevail, and

2. downswing phase when economic activity is marked by a decline

During the upswing of business activity, the need for working capital is likely to grow to
cover the lag between increased sales and receipt of cash as well as to finance purchases of
additional material to cater to the expansion of the level of activity. Additional funds may be
required to invest in plant and machinery to meet the increased demand. The downswing phase of
the business cycle has exactly an opposite effect on the level of working capital requirement. The
decline in the economy is associated with a fall in the volume of sales which, in turn, leads to a
fall in the level of inventories and book debts. The need for working capital in recessionary
conditions is bound to decline. In brief, business fluctuations influence the size of working capital
mainly through the effect on inventories. The response of inventory to business cycles is mild or
violent according to nature of the business cycle.
11. Level of Taxes

The first appropriation out of profits is payment or provision for tax. The amount of taxes
to be paid is determined by the prevailing tax regulations. The management has no discretion in
this respect. Very often, taxes have to be paid in advance on the basis of the profit of the preceding
year. Tax liability is, in a sense, short-term liability payable in cash. An adequate provision for tax
payments is, therefore, an important aspect of working capital planning. If tax liability increases,
a leads to an increase in the requirement of working capital and vice versa. Management has no
discretion in regard to the payment of taxes, in some cases non-payment may invite penal action.
There is, however, wide scope to reduce the tax liability through proper tax planning. The service
of tax experts can be availed of to take advantage of the various concessions and incentives through
avoidance as opposed to evasion of taxes. Tax planning can, therefore, be said to be an integral
part of working capital planning.

12. Production Cycle

Another factor which has a bearing on the quantum of working capital is the production
cycle. The term 'production or manufacturing cycle' refers to the time involved in the manufacture
of goods. It covers the time-span between the procurement of raw materials and the completion of
the manufacturing process leading to the production of finished goods. Funds have to be
necessarily tied up during the process of manufacture, necessitating enhanced working capital. In
other words, there is some time gap before raw materials become finished goods. To sustain such
activities the need for working capital is obvious. The longer the time-span (i.e., the production
cycle), the larger will be the tied-up funds and, therefore, the larger is the working capital needed
and vice versa. There are enterprises which, due to the nature of business, have a short operating
cycle. A distillery, which has an ageing process, has generally to make a relatively heavy
investment in inventory. The other extreme is provided by a bakery. The bakeries sell their
products at short intervals and have a very high inventory turnover. The investment in inventory
and, consequently, working capital is not very large.

Further, even within the same group of industries, the operating cycle may be different due
to technological considerations. For economy in working capital, that process should be selected
which has a shorter manufacturing process. Having selected a particular process of manufacture,
steps should be taken to ensure that the cycle is completed in the expected time. This underlines
the need for effective organization and coordination at all levels of the enterprise. Appropriate
policies concerning terms of credit for raw materials and other supplies can help in reducing
working capital requirements. Often, companies manufacturing heavy machinery and equipment
minimize the investment in inventory or working capital by requiring advance payment from
customers as work proceeds against orders. Thus, a part of the financial burden relating to the
manufacturing cycle time is passed on to others.

13. Liquidity and Profitability

If firm is interested in maintaining the liquidity and wants to improve the liquidity, more
working capital is required. If a firm desire to take a greater risk for bigger gains and losses, it
reduces the size of its working capital in relation to its sales. A firm therefore should choose
between liquidity and profitability and decides about its working capital requirement accordingly

14. Profit Level

The level of profits earned differ from enterprise to enterprise. In general, the nature of the
product, hold on the market, quality of management and monopoly power would by and large
determine the profit earned by a firm. A priori, it can be generalized that a firm dealing in a high-
quality product, having a good marketing arrangement and enjoying monopoly power in the
market is likely to earn high profits and vice versa. Higher profit margin would improve the
prospects of generating are internal funds thereby contributing to the working capital pool. The
net profit a source of working capital to the extent that it has been earned in cash. The cash profit
can be found by adjusting non-cash items such as depreciation, outstanding expenses and lasses
written off, in the net profit. But, in practice, the net cash inflows from operations cannot be
considered as cash available for use at the end of cash cycle. Even as the company's operations are
in progress cash is used for augmenting stock, book debts and fixed assets. It must, therefore, be
seen that cash generation has been used for furthering the interest of the enterprise. It is in this
context that elaborate planning and projections of expected activities and the resulting cash inflows
on a day-to day, week to-week and month-to-month basis assume importance because steps can
then be taken to deal with surplus and deficit cash.
 The availability of internal funds for working capital requirements is determined not
merely by the profit margin but also by the manner of appropriating profits. The availability of
such funds would depend upon the profit appropriations for taxation, dividend, reserves and
depreciations

15. Activities of the Firms

A firm policy regarding the sale also depends upon the requirement of working capital. If
a firm's sells its goods to customer on credit basis, it requires more working capital as compared
to cash sales

16. Production Policy

The quantum of working capital is also determined by production policy. In the case of
certain lines of business, the demand for products is seasonal, that is, they are purchased during
certain months of the year. What kind of production policy should be followed in such cases?
There are two options open to such enterprises: either they confine their production only to periods
when goods are purchased or they follow a steady production policy throughout the year and
produce goods at a level to meet the peak demand. In the former case, there are serious production
problems. During the slack season, the firms have to maintain their working force and physical
facilities without adequate production and sale. When the peak period arrives, the firms have to
operate at full capacity to meet the demand. This kind of arrangement would not only be expensive
but also inconvenient. Thus, serious difficulties will be encountered in trying to match production
to the ebb and flow of the seasonal demand pattern.

A better alternative is a steady production policy independent of shifts in demand for the
finished goods. This means a large accumulation of finished goods (inventories) during the off-
season and their abrupt sale during the peak season. The progressive accumulation of stock
naturally requires an increasing amount of working capital which remains tied up for some months.
Working capital planning has to incorporate this pattern of requirement of funds when production
and seasonal sales are steady. This strategy (steady production policy) is, however, not necessarily
adopted by everyone. It may be possible, for instance, for some to follow a policy of diversification
which enables them to engage the working force and the physical facilities in some other activity.
If this is possible, there will be no major working capital problem. Moreover, the nature of some
products may be such that accumulation of inventories may create special risk and cost problems.
For them, a production policy in tune with the changing demands may be preferable. Therefore,
production policies have to be formulated on the basis of the individual setting of each enterprise
and the magnitude and dimension of the working capital problems will accordingly vary.

17. Turnover of Circulating Capital

Conversion of cash to inventory, inventory to finished goods, finished good to book debts
of account receivables, book debt to cash account play an important role in judging the working
capital requirement

18. Growth and Expansion

As a company grows, it is logical to expect that a larger amount of working capital is

required. It is, of course, difficult to determine precisely the relationship between the growth in the
volume of business of a company and the increase in its working capital. The composition of
working capital in a growing company also shifts with economic circumstances and corporate
practices. Other things being equal, growth industries require more working capital than those that
are static. The critical fact, however, is that the need for increased working capital funds does not
follow the growth in business activities but precedes it. 10 Advance planning of working capital
is, therefore, a continuing necessity for a growing concern. Or else, the company may have
substantial earnings but little cash.

19. Vagaries in the Availability of Raw Material

The availability or otherwise of certain raw materials on a continuous basis without

interruption would sometimes affect the requirement of working capital. There may be some
materials which cannot be procured easily either because of their sources are few or they are
irregular. To sustain smooth production, therefore, the firm might be compelled to purchase and
stock them far in excess of genuine production needs. This will result in an excessive inventory of
such materials. The procurement of some essential raw materials is difficult because of their
sporadic supply. This happens very often with raw materials which are in short supply and are
controlled to ensure equitable distribution. The buyer has in such cases very limited options as to
the quantum and timing of procurement. It may so happen that a bulk consignment may be
available but the firm may be short of funds, while when surplus funds are available the
commodities may be in short supply. This element of uncertainty would lead to a relatively high
level of working capital. Finally, some raw materials may be available only during certain seasons.
They would have to be necessarily obtained, when available, to provide for a period when supplies
are lean. This will cause seasonal fluctuations in working capital requirements.

20. Operating Efficiency

The operating efficiency of the management is also an important determinant of the

level of working capital. The management can contribute to a sound working capital position
through operating efficiency. Although the management cannot control the rise in prices, it can the
efficient resources by eliminating waste, improving coordination, and a fuller utilisation of existing
resources, and so on. Efficiency of operations accelerates the pair of cash cycle and improves the
working capital turnover. It releases the pressure on working capital by improving profitability
and improving the internal generation of funds.

21. Depreciation policy

Depreciation policy also exerts an influence on the quantum of working capital

Depreciation charges do not involve any cash outflows. The effect of depreciation policy on
working capital is, therefore, indirect. In the first place, depreciation affects the tax liability and
retention of profits. Depreciation is allowable expenditure in calculating net profits. Enhanced
rates of depreciation lower the profits and, therefore, the tax liability and, thus, more cash profits.
Higher depreciation also means lower disposable and, therefore, a smaller dividend payment.
Thus, cash is preserved in the second place, the selection of the method of depreciation has
important financial implications.

If current capital expenditure falls short of the depreciation provide working capital
position is strengthened and there may be no need for short-term forming In the other hand, the
current capital expenditure exceeds the depreciation provision, ether outside borrowing will have
to be resorted to or a restriction on dividend payment coupled with retention of proles will have to
be adopted to prevent the working capital position from being adversely affected. It is in these
ways that depreciation policy is relevant to the planning of working capital
22.Dividend Policy

Another appropriation of profits which has a bearing on working capital is dividend

payment. The payment of dividend consumes cash resources and, thereby, affects working capital
to that extent. Conversely, if the firm does not pay dividend but retains the profits, working capital
increases. In planning working capital requirements, therefore, a basic question to be decided is
whether profits will be retained or paid out to shareholders. In theory, a firm should retain profits
to preserve cash resources and, at the same time, it must pay dividends to satisfy the expectations
of investors. When profits are relatively small, the choice is between retention and payment. The
choice must be made after considering all the relevant factors.

There are wide variations in industry practices as regards the interrelationship between
working capital requirements and dividend payment. In some cases, shortage of working capital
has been a powerful reason for reducing or even skipping dividends in cash. There are occasions,
on the other hand, when dividend payments are continued in spite of inadequate earnings in a
particular year because of sound liquidity, Sometimes, the dilemma is resolved by the payment of
bonus shares This enables the payment of dividend without draining away the cash resources and,
thus, without reducing working capital. Dividend policy, is thus, a significant element in
determining the level of working capital in an organization.

To conclude, the level of working capital is determined by a wide variety of faction which
are partly internal to the firm and partly external (environmental) to it. Efficient working capital
management requires efficient planning and a constant review of the needs for an appropriate
working capital strategy