Working Capital: Meaning, Types, Operating Cycle and Factors Affecting the Working Capital
We all know that finance is essential for running a business. Business enterprises require careful financial planning and understanding of the resultant capital structure, risks, and profitability that they may have. All these have an effect on shareholders as well as the employees. They require an understanding of business finance, major financial decision areas, financial risk, and the business’s working capital requirements. The success of a business depends on how well finance is invested in assets and operations and how timely and cheaply the finance is arranged from different sources. Financial Management is concerned with the management of the flow of funds and involves decisions related to the acquisition and application of funds in long-term and short-term assets. It is concerned with two aspects: procurement of funds as well as usage of finance.
What is Working Capital?
Excess of current assets of an organisation over its current liabilities is known as Working Capital. It can also be defined as that part of total capital, which is required for holding current assets.
Current Assets are the assets, which can be converted into cash and cash equivalents within a period of one year. Investment in these assets helps an organisation in its day-to-day operations. They also provide liquidity to the business but does not contribute much to its profits. Therefore, an organisation has to maintain a balance between the liquidity and profitability. For example, cash in hand, debtors, bills receivables, etc.
Current Liabilities are the liabilities of a firm which are payable within a period of one year. For example, creditors, bills payable, advance received, outstanding expenses, etc.
i) Gross Working Capital
The investment in all the current assets like prepaid expenses, cash, inventories, bills receivables, etc., is known as Gross Working Capital. The gross working capital of an organisation gets converted into cash within an accounting year.
The list of current assets in order of their liquidity is as follows:
- Cash in hand/Cash at bank
- Marketable Securities
- Finished goods inventory
- Bills Receivable
- Work in progress
- Raw Materials
- Prepaid Expense
Gross Working Capital = Sum total of all Current Assets
ii) Net Working Capital/Working Capital
Excess of current assets over current liabilities is known as Net Working Capital. Current liabilities are a source of funds for acquiring current assets and are to be paid within an accounting year. For example. Tanya gets credit for maintaining stock. Now, the stock (which is a current asset) is created by her through credit purchase (which is her current liability). When the current liabilities of an organisation exceed its current assets, then the net working capital of the firm will be negative. The net working capital of an organisation depicts its liquidity position. The negative net working capital of an organisation indicates a poor and weak liquidity position; however, a positive net working capital indicates a positive liquidity position.
Net Working Capital = Current Assets – Current Liabilities
Gross Working Capital is different from Net Working Capital. It can be proved with the help of the following example:
Let’s say, the Current Assets of an organisation are as follows:
Cash = ₹60,000
Debtors = ₹90,000
Inventory = ₹2,20,000
Gross Working Capital = Cash + Debtors + Inventory
= 60,000 + 90,000 + 2,20,000
Now, the Current Liabilities of the organisation are as follows:
Bills Payable = ₹50,000
Creditors = ₹20,000
Outstanding Expenses = ₹30,000
Net Working Capital = Current Assets – Current Liabilities
= 3,70,000 – (50,000 + 20,000 + 30,000)
= 3,70,000 – 1,00,000
In a business, there is always a time gap between the sale of goods and the receipt of cash. In technical terms, this time gap is known as Operating Cycle. A firm needs working capital for this time period so that it can maintain sales activity.
An Operating Cycle can be defined as the time duration that starts from the procurement of raw materials or goods and ends with the sales realisation. The nature and length of an operating cycle vary from one firm to another as it depends upon its size and nature.
In a manufacturing company, the operating cycle is the length of time required to complete a series of events described as follows:
- Conversion of cash into raw materials.
- Conversion of raw materials into work-in-progress.
- Conversion of work-in-progress into finished goods.
- Conversion of finished goods into accounts receivable.
- Conversion of accounts receivable into cash.
In a trading company, the operating cycle is the length of time taken for Procurement of Goods and Realisation of Sales Revenue.
Factors Affecting the Working Capital
1. Nature of Business
The first factor which helps in determining the requirement of working capital is the type of business in which the company is involved. A trading company or a retail shop requires less working capital as the length of the operating cycle of these types of businesses is small. However, the wholesalers require more working capital, as they have to maintain a large stock and generally sell goods on credit, increasing the length of the operating cycle. Besides, a manufacturing company requires a huge amount of working capital as it has to convert its raw material into finished goods, sell the goods on credit, maintain the inventory of raw materials and finished goods.
2. Scale of Operation
The firms that are operating at a large scale need to maintain more debtors, inventory, etc. Hence, these firms generally require a large amount of working capital. However, the firms that are operating at a small scale require less working capital.
3. Business Cycle Fluctuation
A market flourishes during the boom period which results in more demand, more stock, more debtors, more production, etc., ultimately leading to the requirement for more working capital. However, the depression period results in less demand, less stock, fewer debtors, less production, etc., which means that less working capital is required.
4. Seasonal Factors
The companies which sell goods throughout the season require constant working capital. However, the companies selling seasonal goods require a huge amount of working capital during the season, as at that time there is more demand and the firm has to maintain more stock and supply the goods at a fast speed, and during the off-season, it requires less working capital as the demand is low.
5. Technology and Production Cycle
A company using labour-intensive techniques requires more working capital because it has to maintain enough cash flow for making payments to labour. However, a company using capital-intensive techniques requires less working capital because the investment made by the company in machinery is a fixed capital requirement, and also there will be less operating expenses.
6. Credit Allowed
The average period for collection of the sale proceeds is known as the Credit Policy. The credit policy of a company depends on various factors like the client’s creditworthiness, industry norms, etc. A company following a liberal credit policy will require more working capital, as it is giving more time to the creditors to pay for the sale made by the company. However, if a company follows a strict or short-term credit policy then it will require less working capital.
7. Credit Avail
The time period that a company is getting credit from its suppliers also affects the requirement for working capital. If a company is getting long-term credit on raw materials from its supplier, then it can manage well with less working capital. However, if a company is getting a short period of credit from its suppliers, then it will require more working capital.
8. Operating Efficiency
If a company has a high degree of operating efficiency then it will require less working capital; however, if a company has a low degree of operating efficiency then it will require more working capital. (Operating cycle of a firm is the time period from the purchase of raw material to the realisation from debtors). Hence, it can be said that the length of the operating cycle directly affects the requirements of the working capital of an organisation.
9. Availability of Raw Materials
If the raw material is easily available to the firm and there is a ready supply of inputs and raw material, then the firm can easily manage with less working capital. Also, as the firm does not need to maintain any stock of raw materials, they can manage with less stock, and hence less working capital. However, if there is a rough supply of raw materials, then the firm will have to maintain a large inventory to carry on the operating cycle smoothly. Therefore, the firm will require more working capital.
10. Level of Competition
If there is competition in the market, then the company will have to follow a liberal credit policy for supplying goods on time. For this, it will have to maintain higher inventories, resulting in more working capital requirements. However, if there is less competition in the market or a company is in a monopoly position, then it will require less working capital, as it can dictate its own terms according to its requirements.
A rise in the price increases the price of raw materials and the cost of labour, resulting in the increasing requirement for working capital. However, if a company is able to increase the price of its goods also, then it will face less problem with working capital. A rise in price has a different effect on the working capital of different businesses.
12. Growth Prospects
If a firm is planning on expanding its activities then it will require more working capital, as it needs to increase the scale of production for expansion, resulting in the requirement of more inputs, raw materials, etc., ultimately increasing the need for more working capital.
|Name of the Factor||Requirement for More Working Capital||Requirement for Less Working Capital|
|Nature of Business||Manufacturing Concern because of processing work||Trading Concern because of no production|
|Scale of Operation||Large Scale of Operation because of huge inventory||Small Scale of Operation because of small inventories|
|Business Cycle||During the boom period because there is more production||During the depression period because there is less production|
|Seasonal Factors||Peak season because there is more demand||Lean season because there is less demand|
|Credit allowed to Customers||Sales on Credit Basis||Sales on Cash Basis|
|Credit availed from Suppliers||Purchase on Cash Basis||Purchase on Credit Basis|
|Inflation v/s Deflation||During inflation because of high price levels for wages, raw materials, etc.||During deflation because of the low price level|
|Operating Cycle/Turnover of Working Capital||Long Operating Cycle||Short Operating Cycle|
|Growth Prospects||Higher growth prospects||Lower growth prospects|
|Availability of Raw Material||Higher Lead Time||Lower Lead Time|
|Level of Competition||High competition||Low competition|
|Productive Cycle||Long Production Cycle||Short Production Cycle|
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