What is Working Capital?- Definition
The term working capital refers to the portion of total capital which is used to run the business efficiently and regularly. It is also known as short term capital, circulating capital or liquid capital.
Working capital, in other words, means management of Current Assets: Cash in hand, Cash at Bank, Bill Receivables, closing stock and Debtors, etc. The current liabilities: Sundry creditors, Bills payable, outstanding creditors, Bank overdraft, etc.
The working capital is out of total current assets minus current liabilities. The problem of working capital management involves the problem of decision making regarding investment in various current Assets with an objective of maintaining liquidity of funds of the firm to meet its obligation of payment as and when due.
The chief definitions of working capital are as under.
(i) Need Molottand Field, “Working Capital means Current Assets.”
(ii) J.S. Mill. “The sum of the current Assets is the working capital of business”.
(iii) C.W. Gutenberg. “Working capital has been defined as the excess of current Assets over current liabilities”.
(i) Bonneville and Dewecy. “Any Acquisition of funds which increases the current Assets, increases working capital.
Why a business needs working capital?
The basic objects for which a business unit needs working capital are :
(a) For acquiring fixed Assets that are financed through long term sources.
(b) For current requirements or for acquiring current Assets which is partly raised from long term funds and partly from short term funds.
The fund acquiring for current Assets are known as the need for working capital. The management of working capital is very useful for day to day finance for a business, proper cash management is needed for every unit in absence of proper cash planning running the business unit will pose many problems such as lack of cash for the payment of creditors and suppliers of raw materials.
Working capital is required to make the payment of day to day expenses of the organization as well as the financial requirement between the gap period of production to sales. It is also needed to maintain the liquidity of the organization. In this article, an attempt is made to discuss the nature, scope, and importance of working capital.
Formula to calculate Working Capital
Working capital can be calculated from the following formula:
Working Capital = Current assets – Current liabilities
The management of working capital possess the following problem:
(i) To decide the optimum level of investment in various current Assets.
(ii) The problem of the capital mix: short term and long term funds their Ratio.
(iii) To decide the appropriate means of short term financing.
Objects/Needs/importance of Working Capital
The following are the points in support of the above:
(i) Facility of Cash Discount. When sufficient cash balance is maintained the firm can avail the merit of cash discount by paying in cash for the purchases of materials and other fixed assets.
(ii) Safety to Creditors. The management will work carefree when they have sufficient working capital, they can pay their creditors on due date, thus, the creditability of the firm will increase.
(iii) Debt Securing Capacity. This is no secret when a firm pays its creditors, customers on due date its creditability in the market goes up such a firm can raise funds from the market, it can purchase goods on credit and can borrow funds from Bank for short term.
(iv) High rate Dividend. When a firm has adequate resources it can pay a high rate of dividends to its shareholders. Projects are retained in business when the need for additional financial arises the same can be applied.
Techniques/methods of Calculating Working Capital
The following are the important techniques/methods of calculating Working Capital.
1. Operating cycle method.
2. Working capital method.
3. Cash forecasting method.
4. Projected Balance Sheet method.
5. P & L Adj. method.
Working Capital Cycle
Definition and explanation
Working capital cycle is the period that a business takes to convert its cash (that has been invested in goods) back into cash. A business unit buys goods and keeps them for a period before they are sold (Average stock retention period). In case of a manufacturing business, the average stock retention period needs to be calculated for each type of stock, i.e. raw material, work in progress and finished goods. After the finished goods are sold (frequently on credit), debtors take some time to pay for them (Average credit
The total time taken to:
(a) convert raw material into work in progress (i.e. average stock retention period for raw material)
(b) convert work in progress into finished goods (i.e. average stock retention period for WIP)
(c) convert finished goods into debtors (i.e. average stock retention period for finished goods)
(d) convert debtors into cash (i.e. average credit allowed period).
represents the period taken by a business to collect its revenue from the point of purchase of raw
material to the point of receipt of cash from debtors.
However, since the business also gets credit from its suppliers (i.e. average credit received period), the actual period for which it funds its working capital is arrived at as follows:
Working capital as a percentage of capital employed
It shows what portion of the total capital employed is held in the form of working capital. Clearly, a trading concern would have a larger portion of its capital employed in the form of working capital, while a manufacturing company would not. However, often the best indicator of a suitable division of capital employed between fixed assets and working capital is provided by the industry average.