Working capital: concepts, types, determinants, cycle and financing
Financial Management · Unit III · Topic 9 of 16 · 4 min read
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1. Meaning and concepts
Working capital is the capital needed for day-to-day operations: to hold stocks, give credit to customers and keep cash. Gross working capital is the total of current assets. Net working capital is current assets minus current liabilities; it is the part of current assets financed by long-term funds. Working capital management is the management of current assets and current liabilities so that the firm stays liquid without holding idle funds: the balance between liquidity and profitability.
2. Types
- Permanent (fixed) working capital: the minimum level of current assets always needed, however low activity falls. It grows with the firm.
- Temporary (variable, fluctuating) working capital: the extra needed in peak seasons or for special orders: seasonal and special working capital.
- By concept: gross and net (section 1); by balance-sheet position: positive or negative net working capital.
3. Importance
- keeps production running without interruption for want of materials;
- allows cash discounts on purchases and prompt payment of wages and bills;
- builds the firm’s credit standing with banks and suppliers;
- lets the firm meet seasonal peaks, crises and price rises;
- allows regular dividends and raises morale of staff and confidence of investors.
Too much working capital means idle funds, slack credit control and lower return; too little means missed sales, lost discounts and possible default. Both are harmful.
4. Factors determining working capital
- Nature of business: trading and manufacturing firms carry large stocks and debtors, so they need much working capital; public utilities (electricity, transport) sell services for cash and need little.
- Size and scale of operations.
- Length of the production cycle: the longer the process, the larger the work-in-progress.
- Seasonal nature of supply or demand (sugar, woollens).
- Credit policy: credit allowed to customers raises it; credit obtained from suppliers lowers it.
- Turnover of inventory and receivables.
- Growth and expansion plans.
- Price level changes: inflation needs more funds for the same physical stock.
- Operating efficiency and the firm’s dividend and depreciation policy.
- Availability of bank credit and the conditions of supply of raw materials.
5. The working capital (operating) cycle
Cash is converted into raw materials, raw materials into work-in-progress, work-in-progress into finished goods, finished goods into debtors (by credit sales), and debtors back into cash. The time this takes is the operating cycle. The longer the cycle, the more working capital is needed.
Gross operating cycle = R + W + F + D; net operating cycle = R + W + F + D − C, where
- R = raw material holding period = average RM stock ÷ RM consumed per day;
- W = work-in-progress period = average WIP ÷ cost of production per day;
- F = finished goods period = average FG stock ÷ cost of sales per day;
- D = debtors collection period = average debtors ÷ credit sales per day;
- C = creditors payment period = average creditors ÷ credit purchases per day.
| Stage | Days |
|---|---|
| Raw materials held | 30 |
| Work-in-progress | 15 |
| Finished goods held | 20 |
| Debtors collection | 45 |
| Gross operating cycle | 110 |
| Less creditors payment period | 30 |
| Net operating cycle | 80 |
If annual cash operating cost is Rs. 36,50,000 (Rs. 10,000 a day), working capital needed is about 80 × 10,000 = Rs. 8,00,000. The number of cycles in a year is 365 ÷ 80 = 4.56.
6. Determining the optimal sources of funds
- Matching (hedging) approach: permanent working capital is financed by long-term funds and temporary working capital by short-term funds. Each asset is financed by a source of similar maturity.
- Conservative approach: long-term funds finance permanent and part of temporary needs; safe but costly, with idle cash in slack seasons.
- Aggressive approach: short-term funds finance temporary and part of permanent needs; cheap but risky, because loans must be renewed.
Sources. Long-term: shares, debentures, retained earnings, term loans. Short-term: trade credit, bank overdraft and cash credit, bill discounting, commercial paper, factoring, public deposits, accrued expenses. In India, bank finance for working capital was shaped by the Tandon Committee (1975), which gave three methods of maximum permissible bank finance — (I) 75% of the working capital gap (current assets less current liabilities other than bank borrowing); (II) 75% of current assets less current liabilities; (III) 75% of current assets after excluding core current assets, less current liabilities — and by the Chore Committee (1979), which favoured the second method.
How this is examined
The 6-mark note on the working capital cycle is section 5 with its table; draw the cycle as a circle (cash, raw materials, WIP, finished goods, debtors, cash). The 10-mark essays are sections 1–4. A question on “optimal sources” or financing is section 6. Expect the Unit III problem (estimation of working capital) as the alternative; it is solved in the next note.
Now try the real questions: Financial Management past question papers.