Working Capital – Meaning, Types, Needs, Sources and Calculation | Management Notes

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What is Working Capital

A working capital is another component of the capital that the business needs to meet its day-to-day requirements. Payments to creditor, salaries to workers, raw material purchases, etc., are generally recurring in nature. They can be easily converted to cash. Hence, short-term capital is also known as working capital. A key aspect of financial management is the management of working capital. Short-term finance is primarily concerned with the liquidity and profitability of the business concern. Working capital management helps business concerns improve their operating performance, as well as meet their short-term liquidity needs.

Therefore, it is not only a part of financial management but also the overall management of a business concern to study working capital management. According to the definition, working capital refers to the capital that is not fixed but it is usually defined as the difference between current assets and current liabilities.

Gross Working Capital

The concept of gross working capital determines the concept of working capital. A business concerns gross working capital is the amount invested in its total current assets. The total current assets of the business concern is known as the gross working capital.

Gross Working Capital (GWC) = Current Assets

Net Working Capital

Net working capital is defined as the concept that considers both current assets and current liabilities. A concerns net working capital is its excess of current assets over current liabilities over a given period of time. Positive working capital is when the current assets exceed current liabilities; negative working capital is when the opposite is true.

Net Working Capital Formula,

Net Working Capital (NWC) = Current Assets(CA) - Current Liabilities (CL )

Difference between Gross Working Capital and Net Working Capital

ParametersGross Working CapitalNet Working Capital
DefinitionGross working capital refers to the total value of all current assets of an organization.   A companys net working capital is the difference between its current assets and current liabilities.
ConceptGross Working capital is a quantitative concept.Net Working Capital is a qualitative concept.
IndicatorIt indicates how much money is available for funding current assets and other obligations.This demonstrates a companys capability to pay off operating costs and existing obligations without difficulty.
Increase in valueGross working capital increases as borrowing increases.Working capital cannot be raised by increasing debt. It can only be raised through the sale of fixed assets and an increase in retained income.
FormulaGross Working Capital (GWC) = Current Assets

GWC = Receivables + Cash and Marketable Securities + Inventory + Short Term Investments + Other Current Assets

Net Working Capital (NWC)  = Current Assets(CA) - Current Liabilities (CL )
SuitabilityIt is appropriate for businesses to have gross working capital.Suitable for sole proprietors and partnership firms.
UsageGross working capital is one of the financial measures used to determine a companys financial health.A companys net working capital is a useful metric for estimating its financial position.
PopularityIn financial management, the concept of gross working capital is well known.The concept of Net Working Capital widely applied in accounting.

Working Capital Ratio

A working capital ratio can be calculated by dividing total current assets by total current liabilities. That is why it is often referred to as the current ratio. It refers to the businesss ability to make timely payments as they become due.The working capital ratio is calculated as follows:

Working Capital Ratio = Current Assets / Current Liabilities

Generally, the higher the ratio, the more flexible you are to expand operations. You should understand why the ratio is dropping. The ideal ratio will vary according to your industry and circumstances.

a) If it is less than 1:1, it usually means you are having trouble paying your bills.

b) difficulty may arise even when the ratio is higher than 1:1, depending on how quickly inventories can be sold and accounts receivable collected.

c) In general, a 2:1 ratio provides a reasonable level of comfort.

Types of Working Capital

  1. Permanent Working Capital
  2. Temporary Working Capital
  3. Semi Variable Working Capital

A) Permanent Working Capital

Fixed Working Capital is another name for permanent working capital. It is the capital, which must be maintained at a minimum level at all times. The level of Permanent Capital varies with the type of business. Regardless of time or volume of sales, permanent working capital will not change. Due to the fact that it is impossible to determine the exact amount of permanent working capital, it can also be divided into two categories:

• Regular Working Capital : A regular working capital is the type of permanent working capital necessary to keep the cycle of working capital flowing smoothly during the normal course of business.
• Reserve Working Capital: Reserve Working Capital is a type of working capital cushion that needs to be maintained above and beyond regular working capital in case unexpected situations result in a need for additional working capital.

B) Temporary Working Capital

Temporary Working Capital is also known as variable working capital. In this context, seasonal demands and some special purposes are met by seasonal capital. It is further divided into seasonal working capital and special working capital. Seasonal Working Capital refers to the capital required to meet the seasonal needs of a business concern. For example, launching extensive marketing campaigns for conducting research will require a certain amount of capital.

C) Semi Variable Working Capital

There is a certain amount of Working Capital at the field level up to a certain point after which it will increase based on sales or time.

Needs of Working Capital

  1. Purchase of raw materials and spares.
  2. Payment of wages and salary.
  3. Day-to-day expenses.
  4. Provide credit obligations.

Working Capital is crucial to the success of any business concern. In order to meet daily needs and short-term obligations, every business concern must maintain a certain amount of Working Capital. There are several uses for Working Capital.

a) Purchase of raw materials and spares: Raw materials are the foundation of manufacturing. The company should purchase raw materials frequently according to its needs. Every business company needs a certain amount of Working Capital to buy raw materials, components and spare parts.

b) Payment of wages and salary: Payment of wages and salaries to labor and employees is the next component of Working Capital. Periodic payments enable employees to be more efficient in their work. The working capital of the business concern must be sufficient to pay salaries and wages.

c) Day-to-day expenses: On a daily basis, a business has to pay various expenses related to its operations, such as fuel, electricity, and office expenses.

d) Provide credit obligations: Businesses that provide credit to their customers and meet their short-term obligations. The concern thus needs sufficient Working Capital.

Working Capital Position/ Balanced Working Capital Position

In order to improve the efficiency of business operation and the management of finance, a business concern must maintain a sound Working Capital position. A large amount of working capital, or an inadequate amount, can be problematic for a business concern.

Causes and effects of Excessive Working Capital.Causes and effects of Inadequate Working Capital
a) As a result of excessive Working Capital, raw materials, components, and spare parts are accumulated unnecessarily.

b) The excess Working Capital is locked up when the working capital is excessive.

c) It creates bad debts, shortens the collection period, etc.

d) It results in a reduction in profits.

a) An insufficient working capital prevents the company from buying its requirements in bulk.

b) Implementing operating plans and activating the firms profit target becomes challenging.

C) The fixed assets cannot be utilized efficiently.

d) Investment returns also fall if there is a lack of Working Capital.

e) It reduces the business overall operations.

Factors determining Working Capital

  1. Nature of business
  2. Production cycle
  3. Business cycle
  4. Production policy
  5. Credit policy
  6. Growth and expansion
  7. Availability of raw materials
  8. Earning capacity

Various factors determine how much working capital is required. A business concerns Working Capital needs cannot be determined by any formula or set of rules. Listed below are a few of the major factors influencing Working Capital requirements.

a) Nature of business: The nature of the business greatly affects the working capital of the business. Working Capital can be maintained at a lower level if a business follows a rigid credit policy and only sells for cash. Construction companies maintain larger amounts of Working Capital than transport companies.

b) Production cycle: Production cycle determines the amount of Working Capital required. A company that has a short production cycle will require less Working Capital. A company that does not have a short production cycle will need a large amount of Working Capital.

c) Business cycle: Working Capital requirements change cyclically and seasonally as a result of business fluctuations. A companys Working Capital requirement increases when the economy is booming, and reduces when the economy is in a depression. Increased profits also increase working capital requirements.

d) Production policy: Working Capital requirements are also determined by this factor. Maintaining the companys continuous production policy requires regular working capital. Working Capital requirements will depend on the conditions outlined by the company, based on its production policy.

e) Credit policy: Working Capital is also affected by the credit policy of sales and purchases. Having a liberal credit policy means that the company needs to keep a larger working capital to pay its customers. The company will maintain cash in hand and in the bank if the dues are paid on the last date.

f) Growth and expansion: As a business concern grows and expands, working capital requirements rise, since it requires additional working capital at the outset and incurs some additional expenses.

g) Availability of raw materials: Raw materials provide the major part of the Working Capital requirement. These components are vital to production. Production stops when raw materials are not readily available. To maintain an adequate level of raw material, the concern has to use some Working Capital.

h) Earning capacity: Cash from operations can generate more Working Capital if the business concern is able to earn higher earnings. Working Capital is also determined by the earnings capacity of the business.

Computation of Working Capital

Work capital requirements depend on a number of factors, which were already discussed in previous sections. Now its time to discuss how to calculate the Working Capital needs of a business concern. To estimate the Working Capital, a variety of methods are generally used.

A) Estimation of components of working capital method

A companys working capital is made up of a variety of current assets and current liabilities. So, the amount of current assets and inventories needed as well as the cash required to meet short term obligations is estimated. Financial Manager first determines assets and required working capital for a specific period.

B) Percent of sales method

A formula for estimating the future Working Capital requirement can be derived from the past experience with Sales and Working Capital requirements. This is a simple and traditional way to estimate Working Capital requirements. With this method, we have to first determine the sales to Working Capital ratio, and then we estimate the Working Capital requirements based on that. Working Capital and Sales also relate to each other using this method.

C) Operating cycle 

Depending on the businesss operating cycle, capital requirements vary. Raw materials are acquired and receivables are collected as part of the operating cycle. The following important stages are included in the operating cycle:

  • Raw Material and Storage Stage, (R)
  • Work in Process Stage, (W)
  • Finished Goods Stage, (F)
  • Debtors Collection Stage, (D)
  • Creditors Payment Period Stage. (C)

Working Capital FAQs

Which one of the following statements concerning net working capital is correct?

The change in net working capital when evaluating a capital budgeting decision is

A firm has net working capital of $6,800 and current assets of $21,800. what is the current ratio?

Other things held constant, which of the following will cause an increase in net working capital?

A firm has net working capital of $3,800 and current assets of $11,700. what is the current ratio?

Denna company’s working capital accounts at the beginning of the year follow:

when constructing a pro forma statement, net working capital generally:

The working capital turnover of tesva systems corp. is 6.0. what does this financial data suggest?

Based on the data for harding company, what is the amount of working capital?

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