Working Capital: Meaning, Concepts and Diagrams

The below mentioned article provides a study note on Working Capital:- 1. Meaning of Working Capital 2. Concepts of Working Capital 3. Permanent and Temporary 4. Adequate but Not Excessive.

Meaning of Working Capital:

Working capital is that part of a firm’s capital which is required to hold current assets of the firm. Examples of current assets are raw material, semi-finished goods, finished goods, debtors, bills receivable, prepaid expenses, cash at bank and cash in hand. The firm requires cash to pay various expenses like wages, salaries, rent, advertising etc. current assets have a short life span.

They are swiftly transformed into other current-asset forms and ultimately in cash. In other words, funds invested in current assets are constantly converted into cash. This cash again flows out in exchange for other current assets.

There is an operating cycle. Cash is used to buy raw material. Various manufacturing expenses are incurred to convert raw material into semi-finished goods and then into finished goods. On sale of finished goods on credit, trade debtors or bills receivable result.

On receipt of payment, trade debtors and bills receivable are converted into cash and a cycle of working capital is completed. In case of cash sales, finished goods will directly be converted into cash. The cash is once again used to buy raw material to start another cycle.

It can be shown by means of the following diagram:—

As current assets keep circulating or revolving fast, working capital is also called circulating capital, revolving capital or short-term capital.

Concepts of Working Capital:

There are two concepts of working capital namely gross working capital and net working capital.

(i) Gross Working Capital:

It is also called simply ‘working capital’. It refers to the total of all the current assets of the firm. Current assets are the assets which are meant to be converted into cash within a year or an operating cycle. Stock of raw materials, stock of semi-finished goods, stock of finished goods, trade debtors, bills receivable, prepaid expenses, cash at bank and cash in hand are examples of current assets.

(ii) Net Working Capital:

For financing current assets, long-term funds as well as short term funds are used. Short-term funds are provided by current liabilities i.e. claims of outsiders which are expected to mature for payment within a year. Trade creditors, bills payable and outstanding expenses are examples of current liabilities. Net working capital refers to the excess of current assets over current liabilities.

Suppose the total current assets and total current liabilities of a firm amount to Rs 90,000 and Rs 40,000 respectively. Then, gross working capital of the firm is Rs 90,000 while net working capital of the firm is Rs 50,000 and this sum of Rs 50,000 will be financed by long-term funds. Thus, net working capital is that part of the working capital which is financed by long-term funds.

Generally, current assets far exceed current liabilities. It is considered ideal those current assets are twice as much as current liabilities. Even in unfavourable situations, current assets are likely to be more than current liabilities.

In a very rare case, current liabilities may be more than current assets. It means that there is a negative net working capital. It is a very serious situation indicating that short- term funds are being used to meet a part of the long-term capital requirements.

Permanent and Temporary Working Capital:

From the point of view of the period for which capital is required, working capital can be divided into two categories namely permanent working capital and temporary working capital.

(i) Permanent Working Capital:

It refers to that minimum amount of investment in current assets that has always to be true. It is the working capital required to carry out the minimum level of activities of the business. It is also called core working capital, regular working capital or fixed working capital.

(ii) Temporary Working Capital:

It refers to that part of total working capital which is required by a firm over and above its permanent working capital. It is required because the actual level of activities of the business most of the time exceeds the minimum level of activities.

As the level of business activities fluctuates, the volume of temporary working capital also may keep fluctuating. Temporary working capital is also known as fluctuating or variable or circulating working capital.

The management has to provide for both kinds of working capital—permanent working capital and temporary working capital. But the period for which temporary working capital is required is rather short and the amount is also fluctuating whereas the amount of permanent working capital is stable and it is permanently needed.

The following figure shows these facts:

OA is the amount of permanent working capital. Straight line AB shows that the amount remains the same over a period of time. Curve CD shows the total working capital requirement which varies from time to time because temporary working capital goes on changing.

Requirement over and above the permanent working capital requirement is the temporary working capital requirement and has been marked as such in the figure.

It should be noted that as the business of a firm grows, the amount of its permanent working capital will also increase. Thus for a growing business firm, the difference between permanent working capital and temporary working capital may appear as follows:—

Working Capital to be Adequate but Not Excessive:

The management is to ensure that the firm has adequate working capital to run its business operations smoothly. Inadequate working capital results in inefficiency and consequently decreased profitability.

The following are the disadvantages of inadequate working capital:—

(i) It renders the firm unable to avail itself of attractive discounts from suppliers.

(ii) As the firm is found unable to honour its short-term obligations in time, it loses some of its creditworthiness. As a result it faces tight credit terms.

(iii) The firm finds it difficult to grow, profitable projects are not undertaken due to paucity of working capital.

(iv) Fixed assets are not fully and efficiently utilised because of inadequacy of working capital. It decreases firm’s profitability.

(v) Operating inefficiencies creep in. There may be interruptions in production. The result is that the profit targets are not met.

But excessive working capital has also to be avoided. Excessive working capital means idle funds earning no profits for the firm. It also lowers profitability.

The following are the disadvantages of excessive working capital:—

(i) It may mean unnecessary accumulation of inventories which increases the chances of inventory mishandling, waste, theft and accumulation of old items which are ultimately disposed of at low prices or just discarded.

(ii) It may be an indication of excessively liberal credit policy and slack collection from customers resulting in higher incidence of bad debts.

(iii) Excessive working capital makes management complacent ultimately resulting in managerial inefficiency.

(iv) It may also lead to speculative transactions.