Working Capital

Topics: Inventory, Balance sheet, Accounts receivable Pages: 62 (19341 words) Published: April 20, 2011

1. Concept And Definition Of Working Capital

There are two concept of Working Capital : gross and net .
a) The term gross working capital , also referred to as working capital , means the total current assets . b) The net working capital can be defined in two ways :
1.The most common definition of net working capital ( NWC ) is the difference between current assets and current liabilities ; and 2.Alternate definition of NWC is that portion of current assets which is financed with long term funds . The task of financing manager in managing working capital efficiently is to ensure sufficient liquidity in the operations of the enterprise . Net working capital , as a measure of liquidity is not very useful for comparing the performance of different firms , but it is quite useful for internal control . The NWC helps in comparing the liquidity of the same firm over time . For the purpose of working capital management , therefore , NWC can be said to measure the liquidity of the firm . In the 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 .

2. Components Of Working Capital

The basic components of working capital are ,
Current Assets :
a) Inventories
i) Raw Materials and Components
ii) Work in Progress
iii) Finished Goods
iv) Others
a) Trade Debtors
b) Loans And Advances
c) Investments
d) Cash And Bank Balance

Current Liabilities:
a) Sundry Creditors
b) Trade Advances
c) Borrowings
d) Commercial Banks
e) Provisions

3. Need For Working Capital

Given the objective of financial decision making to maximise the shareholders’ wealth , it is necessary to generate sufficient profits . The extent to which profits can be earned will naturally depend , among other things , upon the magnitude of sales . A successful sales program is , in other words , necessary for earning profits by any business enterprise . However , sales do not convert into cash instantly ; there is invariably a time lag between sale of goods and the receipt of cash . There is therefore , a need for working capital in the form of current assets to deal with the problem arising out of the lack of immediate realisation of cash against goods sold . Therefore sufficient working capital is necessary to sustain sales activity . Technically this is referred to s operating cycle . The operating cycle can be said to be at the heart of the need for the working capital . In other words the operating cycle refers to the length of time necessary to complete the following cycle of events : a) Conversion of cash into raw materials;

b) Conversion of raw materials to inventory ;
c) Conversion of inventory into receivables ;
d) Conversion of receivables into cash .
If it were possible to complete the sequences instantaneously , there would be no need for current assets (working capital) . But since it is not possible , the firm is forced to have current assets . Since the cash inflows and outflows do not match , firms have to necessarily keep cash or invest in short term liquid securities so that they will be in position to meet obligations when they become due . Similarly , firms must have adequate inventory to guard against the possibility of not being able to meet demand for their products . Adequate inventory , therefore, provides a cushion against being out of stock . If firms have to be competitive , they must sell goods to their customer on credit which necessitates the holding of accounts receivables . It is in these ways that an adequate level of working capital is absolutely necessary for smooth sales activity which , in turn , enhances the owner’s wealth .

4. Characteristics Of Current Assets

In management of working capital two characteristics of current assets must be borne in mind : a) short life span and b) swift...
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