Working Capital: Meaning, Sources and Uses

In this article we will discuss about Working Capital:- 1. Meaning of Working Capital 2. Sources of Working Capital 3. Uses.

Meaning of Working Capital:

In common usage, the term funds means cash. However, accountants and financial executives think of ‘funds’ in a broader sense. They view the funds available to a business enterprise as its working capital, Working capital is defined as current assets minus current liabilities and thus, is a broader definition of funds than is cash.

Since funds have been defined as the difference between current assets and current liabilities, it is necessary to know which accounts are covered and which are not covered by this definition.

(1) Current Assets:

The term current assets is used to mean cash and other assets or resources generally identified as those which are reasonably expected to be realised in cash or sold or consumed during the normal operating cycle of the business.

These include:

(1) Cash and bank balances;

(2) Temporary investments, bills receivables, debtors, and stock in trade;

(3) Prepayments like salary paid in advance, unexpired insurance, prepaid rent, prepaid interest, which can be consumed during the normal operating cycle of business.

(2) Current Liabilities:

The term ‘current liabilities’ is used to denote obligations such as:

(i) Ones which are payable within one year, and

(ii) Which are paid out of current assets or by clearing current liabilities.

These include amounts payable to:

(a) Creditors,

(b) Bills payable,

(c) Bank overdraft, and

(d) Outstanding bills on account of wages, salary, commission, rent, royalties, etc.

(3) Non-Current Accounts:

For the purpose of preparing funds flow statement, all accounts which are not current accounts are treated as non-current accounts.

Examples of such accounts are included in the following list:

Non-current accounts on the liabilities side of the balance sheet:

1. Equity share capital,

2. Preference share capital,

3. Redeemable preference share capital,

4. Long-term loans,

5. Debentures,

6. Security premium account,

7. Share forfeited account,

8. Profit and loss account (credit balance),

9. Appropriation of profit, e.g., transfer to general reserve, dividend equalisation fund, insurance fund, compensation fund, debentures sinking fund, capital redemption reserve account,

10. Provisions like provision for tax, provision for depreciation on fixed assets, proposed dividend, and

11. Preliminary expenses.

Non-current accounts on the assets side of the balance sheet:

1. Goodwill,

2. Land,

3. Building,

4. Machinery,

5. Furniture,

6. Long-term investments,

7. Patent right,

8. Trade mark,

9. Profit and loss account (deb’ it balance),

10. Discount on issue of shares and debentures,

11. Capital reserve, and

12. Other deferred expenditure like advertisement cost.

The basic objective of the statement of changes in financial position, working capital basis, is to explain the changes in the working capital for a specified period of time. In the process of achieving this objective, the statement should enable the user to identify the changes as they relate to three basic causes.

(а) Amount of changes in working capital associated with the operating activities of the firm.

(b) Long-term financing or other sources that cause an increase in the working capital.

(c) Long-term investment activities or other uses that cause a reduction in the working capital.

If the amount of working capital increased during a given fiscal period, this means that more working capital was generated than was used for various business purposes; if a decrease in working capital occurred, the reverse is true. One of the key purposes of statement of changes in financial position is to explain fully the increase or decrease in working capital during an accounting period.

Sources of Working Capital:

The following are the sources of working capital:

1. Funds from Business Operations:

If the inflow of funds from sales exceeds the outflow of funds to cover the cost of merchandise purchases and expenses of doing business, current operations will provide a net source of funds. If the inflow of funds from sales is less than these outflows, operation will result in a net use of funds.

Working capital provided by operations is the net increase or decrease in working capital resulting from the normal business activities of earning revenue and paying expenses. However, not all the expenses require the use of funds in the current period; therefore the amount of funds provided by operations is not the same as the amount of net income earned during the period.

The following points explains this situation:

(i) Some expenses do not reduce working capital. Some expenses, such as depreciation and amortisation of intangible assets reduce net income but have no immediate effect on the amount of working capital provided by operations, i.e., these items do not reduce working capital. The net income figure therefore understates the amount of working capital provided by operations by amount of depreciation expenses recorded during the period.

Thus funds provided by operations would be computed in the following manner:

The addition of depreciation expenses to the net income figure has led some people to believe that depreciation expenses is a source of funds. However, it is important for the users of financial statement to understand that depreciation is neither a source nor a use of working capital (funds).

No funds flow into business as a result of recording depreciation expense. It is shown in the statement of changes in financial position merely to explain one of the differences between the concept of net income and the concept of working capital provided by operations.

(ii) Some items increase income but do not increase working capital—some items in the income statement increase net income without increasing working capital; such items must be deducted from net income in arriving at working capital provided by operations.

(iii) Non-operating gains and losses—non-operating gains and losses, if material in amount, should be eliminated from net income in order to show the working capital provided by ‘normal’ operations. For example, assume that plant costing Rs. 1,00,000 is sold at Rs. 1,20,000, at a net gain of Rs. 20,000. In the statement of changes in financial position, the entire Rs. 1,20,000 as proceeds from sale will be reported as funds provided by the sale of plant.

The Rs. 20,000 non-operating gain, however, is included in the net income for the period. In determining the amount of working capital provided by operations, this Rs. 20,000 non-operating gain must be deducted from the net income figure because the entire proceeds from sale of the plant are reported elsewhere in the statement of changes in financial position.

As a separate example, assume that the same plant is sold for Rs. 90,000; then the non-operating loss of Rs. 10,000 should be added back to net income to arrive at working capital provided by operations and the working capital provided through sale of plant should be reported at Rs. 90,000.

Briefly, the procedure of computing funds provided by operations can be summarised as follows:

Funds from Operations:

Net profit (or loss) as per the profit and loss account:

Add:

(i) Depreciation expense.

(ii) Amortisation of goodwill, patents and other intangible assets.

(iii) Amortisation of extraordinary losses occurred in previous periods.

(iv) Amortisation of discount on debentures.

(v) Loss on sale of non-current assets such as plant, equipment etc.

Less:

(i) Gain on sale of non-current assets such as plant, equipment etc.

(ii) Profit or revaluation surplus of non-current assets.

(iii) Dividends and interest on investments (earned but not received)

(iv) Amortisation of premium received on debentures = Funds from Business Operations

2. Sales of Non-Current Assets:

A business may obtain working capital by selling noncurrent assets, such as plant and equipment or long-term investments, in exchange for current assets. As long as current assets are received, the sale is a source of funds regardless of whether the non-current assets are sold at a gain or loss.

For example, assume that a business form sells for Rs. 2,50,000 a plant which cost Rs. 3,00,000. Although the plant was sold at a loss, the firm has increased its current assets by Rs. 250,000 by selling the plant. Thus, the transaction is a source of working capital.

3. Long-Term borrowing:

Long-term borrowing, such as issue of debentures and bonds result in an increase in current assets, thereby increasing working capital. Short-term borrowing, however, does not increase working capital.

When a company borrows cash on short term credit or by signing a short-term note payable, working capital is unchanged because the increase in current assets is offset by an increase in current liabilities of the same amount.

4. Issue of Additional Equity Capital:

The issue of additional equity shares results in an inflow of current assets, thereby increasing working capital. In a similar manner, additional investments of current assets by owners represent source of funds in single proprietorship and partnership.

Uses of Working Capital:

The following are the uses of working capital:

1. Declaration of Cash dividend:

The declaration of cash dividend results in a current liability (dividend payable) and is therefore a use of funds. It should be understood that it is the declaration of dividend, rather than the payment of the dividend, which is the use of funds.

Actual payment of the dividend reduces current assets and current liabilities by the same amount and thus has no effect upon the amount of working capital. Issue of shares in lieu of dividend does not involve any distribution of assets and, therefore, are not a use of funds.

2. Purchase of Non-Current Assets:

Purchase of non-current assets, such as plant and equipment, reduce current assets or increase current liabilities. In either case, working capital is reduced.

3. Repayment of Long-Term Debt:

Working capital is decreased when current assets are used to repay long-term debt. However, repayment of short-term debts is not a use of funds, since current assets and current liabilities decrease by the same amount.

Effect of Transactions on Working Capital:

In preparing a statement of changes in financial position, on working capital basis, or funds flow statement it is convenient to classify business transactions into three categories:

(a) Both debit and credit aspects of the transaction affecting current accounts only,

(b) Both debit and credit aspects of the transaction affecting non-current accounts only, and

(c) One aspect of the transaction affecting current account and another aspect affecting a non-current account (non-current asset or non-current liability).

The effect of above mentioned categories of transactions on the funds flow statement can be analysed with the help of following examples:

1. Transactions affecting current accounts only—do not result in flow of fund:

These transactions produce changes in working capital accounts but do not change the amount of working capital.

Few examples of such transactions are given below:

Hence, such transactions would not be reflected as a source or use in a working capital basis statement of changes in financial position.

2. Transactions affecting non-current accounts only—do not result inflow of fund:

These transactions have no direct effect on the amount of working capital. The entry to record depreciation is an example of such a transaction. Such transactions may not be considered in preparing a statement of changes in financial position on working capital basis.

Few examples of such transactions are:

3. Transactions affecting non-current account and current account—Result in flow of fund resulting either in a source of fund or application of fund: These transactions bring about either an increase or a decrease in the amount of working capital. If changes in non-working capital accounts are analysed, these events are brought to light, and their effect on working capital will be reported in the statement of changes in financial position.

Some examples of such transactions and their effects on working capital are shown below:

Schedule of Changes in Working Capital:

Many business enterprises prefer to prepare another statement, known as schedule of changes in working capital, while preparing a funds flow statement, on a working capital basis. This schedule of changes in working capital provides information concerning the changes in each individual current assets and current liabilities accounts (items).

This schedule is a part of the funds flow statement and increase (decrease) in working capital indicated by the schedule of changes in working capital will be equal to the amount of changes in working capital as funds flow statement. The schedule of changes in working capital can be prepared by comparing the current assets and current liabilities at two periods.

The format of schedule of changes in working capital is as follows (Exhibit 16.1):