It is the capital required to meet day to day expenses like wages, rent, electricity and water charges, and to be invested in the current assets, such as stock of raw materials, semi finished goods, finished goods etc.
Working capital is also called circulating capital. This is because investment in current assets are recovered and reinvested repeatedly in course of business operations. Its requirements may be met by short term funds. However, since the business is a continuing concern it must at all times have a certain amount of working capital which would be needed again and again. This may be regarded as the permanent part of working capital.
Factors that determine working capital needs:
Following are the factors that need to be considered to estimate the amount of working capital needed.
Proportion of cost of raw materials to total cost: If the raw materials account for a major portion of the total cost of the finished product, more working capital is required.
Cost of labour: If labour intensive methods of production are used more working capital will be required.
Length of operating cycle: If more time is taken in the completion of the production process and the sale of the products, higher investment will be required in inventories and wage bills and hence more working capital will be needed.
Terms of purchase and sale: If raw materials and other services are available on credit and goods produced are sold for cash, less working capital investment will be involved. On the other hand, if raw material is to be purchased in cash and goods produced are sold on credit, larger working capital will be necessary.
Current Assets turnover: The current assets turnover is measured by the ratio of sales to current assets. In other words, more rapid is the use of raw materials in the production process and more rapid the sale of goods produced, lesser will be the amount of working capital needed.
Cash requirements: Needs for cash to meet the operating expenses like wages, rent, freight, taxes etc, also determine the amount of working capital requirement.
- Seasonal operations: Enterprises engaged in manufacturing seasonal goods are required to have a relatively larger amount of working capital. The recovery of working capital through sales of such products is limited to a particular period, and hence a large amount of working capital is required to meet off–season requirements.
Sources of short term finance/working capital
Following are the main sources of raising finance to meet working capital requirements:
It is the credit extended by sellers to the buyers. Raw material in case of manufacturing business and finished goods in case of trading business may be purchased on credit. The period of credit depends upon the prevailing custom and trade practices and terms of supply, but it generally ranges from 15 days to 3 months. No security is required for availing of trade credit.
Commercial banks are the most important sources of short term finance. The various types of short term credit facilities that banks provide are:
for credit instruments like bills of exchange, promissory notes, hundis, etc.
- Outright loans to be paid back in one single installment,
- Cash credit which is a facility of borrowing up to a certain limit,
- Overdraft which is a facility given to firms having current accounts to overdraw,
- Discounting of bills implying procurement of cash from a bank in exchange
- Advances from Customers: Customers may pay in advance a part of the price of the goods ordered to be supplied later.