Financial Management & Cost Accounting

Module 6. Working capital Management

Lesson 30
WORKING CAPITAL

30.1 Meaning of Working Capital

The term working capital refers to the capital required for day-to-day operations of a business enterprise. It is represented by excess of current assets over current liabilities. There are two concepts of working capital: Gross and Net.

The term “gross working capital”, also referred to as working capital, means the total current assets. The term "net working capital" can be defined in two ways: (i) the most common definition of net working capital (NWC) is the difference between current' assets and current liabilities; (ii) and alternate definition of NWC is that portion of a firm's current assets which is financed with long-term funds.

The task of the financial manager in managing working capital efficiently is to ensure sufficient liquidity in the operations of the enterprise. The liquidity of a business firm is measured by its ability to satisfy short-term obligations as they become due. The three basic measures of a firm's over-all liquidity are: (i) the current ratio, (ii) the acid-test ratio, and (iii) net working capital. The NWC helps in comparing the liquidity of the same firm over time. For purposes of working capital management, therefore, NWC can be said to measure the liquidity of the firm. In other words, the goal of working capital management is to manage the current assets and liabilities in such a way that an acceptable level of NWC is maintained.

30.1.1 Constituents of working capital

The two concepts of working capital-gross and net-are not exclusive rather they have equal significance from management View point. The gross working capital concept focuses attention on two aspects of current assets management: (a) optimum investment in current assets and (b) financing of current assets. The consideration of the level of investment in current assets should avoid two danger points -excessive and inadequate investments in current assets. The investment in current assets should be just adequate not more, not less to the needs of the business firm. Excessive investment in current assets should be avoided because it impairs firm's profitability as idle investment earns nothing. On the other hand, inadequate amount of working capital can threaten the solvency of the firm, if it falls to meet its current obligations. It should be realized that the working capital needs of the firm may be fluctuating with changing business activity. This may cause excess or shortage of working capital frequently. The management should be too prompt to initiate action and correct the imbalances.

The gross working capital needs for arranging funds to finance current assets. Whenever a need for working capital funds arises due to the increasing level of business activity or for any other reason, the arrangement should be made quickly. Similarly, if suddenly some surplus funds arise, they should not be allowed to remain idle, but should be invested in short- term securities. Thus, the financial manager should have knowledge of the sources of Working capital funds as well as the investment avenues where the idle funds may be temporarily invested.

The net working capital being the difference between current assets and current liabilities is a qualitative concept. It indicates (a) the liquidity position of the firm and (b) suggests the extent to which working capital needs may be financed by permanent sources of funds. Current assets should be sufficiently excess of current liabilities to constitute a margin or buffer for maturing obligations within the ordinary operating cycle of a business. In order to protect their interests, short-term creditors always like a, company to maintain current assets at a higher level than current liabilities. It is a conventional rule to maintain the level of current assets twice of the level of current liabilities. However, the quality of current assets should be considered in determining the level of current assets vis-a-vis current liabilities. A weak liquidity position poses a threat to the solvency of the company and makes it unsafe and unsound. A negative working capital 'means a negative liquidity and may prove to be harmful for the company. Excessive liquidity is also bad. It may be due to mismanagement of current assets. Therefore, prompt and timely action should be taken by management to improve and correct the imbalance in the liquidity position of the firm.

The net working capital concept also covers the question of judicious mix of long-term and short-term funds for financing current assets. For every firm, there is a minimum amount of net working capital which is permanent. Therefore a portion of the working capital should be financed with the permanent sources of funds such as owner's capital, debentures, long-term debt, preference capital or retained earnings. Management must, therefore decide the extent to which current assets should be financed with equity capital and/or borrowed capital.

In summary, it may be emphasized that 'gross and net concepts of working capital are two important facets of the working capital management. There is no precise way to determine the exact amount gross or net, working capital for every firm. The data and problems of each company should be analyzed to determine the amount of working Capital. It is not feasible in practice to finance current assets by short-term sources only. Keeping in view the constraints other individual company, a judicious mix of long-term finances should be invested in current assets.