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Working Capital Management

Working capital is a short-term investment that provides liquidity and signals a firm's financial health. There are two types of working capital: gross, which refers to investment in current assets like inventory, and net, which is current assets minus current liabilities. Working capital is important because it allows for smooth operations, regular supply of raw materials, goodwill with customers and suppliers, creditworthiness, and ability to handle unexpected issues. A firm's operating cycle converts raw materials to finished goods to cash, and its cash cycle considers the time from sale to collection minus time to pay creditors. Many factors influence working capital needs, like industry, demand, technology, credit terms, supplier relationships, and operational efficiency.

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27 views3 pages

Working Capital Management

Working capital is a short-term investment that provides liquidity and signals a firm's financial health. There are two types of working capital: gross, which refers to investment in current assets like inventory, and net, which is current assets minus current liabilities. Working capital is important because it allows for smooth operations, regular supply of raw materials, goodwill with customers and suppliers, creditworthiness, and ability to handle unexpected issues. A firm's operating cycle converts raw materials to finished goods to cash, and its cash cycle considers the time from sale to collection minus time to pay creditors. Many factors influence working capital needs, like industry, demand, technology, credit terms, supplier relationships, and operational efficiency.

Uploaded by

Soumya Mishra
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Working Capital Management

Working Capital is an important short term investment for all businesses, regardless of their size
that gives a signal of a firm’s operating liquidity.

There are two concepts of working capital:


a) Gross Working Capital
b) Net Working Capital.

Gross Working Capital- ​It refers to the ​firm’s investment in current assets​. Current Assets are
the assets which can be converted into cash within an accounting year and include cash, short
term securities, debtors, bills receivable and stock.

Net Working Capital- ​It refers to the ​difference between current assets and current liabilities.
Current liabilities are those claims of outsiders which are expected to mature for payment within
an accounting year and include creditors, bills payable and outstanding expenses. Net working
capital can be positive or negative. A positive net working capital arises when current assets
exceed current liabilities. It indicates that the enterprise is able to pay off its short term liabilities.
Conversely, a negative net working capital arises when current liabilities exceed current assets,
that is, there is ​working capital deficit​. In such a case enterprise cannot survive for a long period
because realisation made through current asset is insufficient to pay off the current liabilities.

Need and Importance of Working Capital

The working capital helps in achieving the twin objectives of profitability and liquidity for an
enterprise. Therefore, working capital is important because of the following reasons:
a) Smooth business operations: Working Capital ensures the regular and timely payment of
wages and salaries, thereby improving the morale and efficiency of employees.
Purchase of raw material, overheads and other day to day financial requirements can
also be met without any delays. This helps in an uninterrupted flow of production.

b) Regular Supply of Raw Material- The payment to the suppliers of raw materials on time,
ensure a regular supply of raw materials and continuous production.

c) Enhance Goodwill- As business concern is able to make prompt payments of its


obligations, it helps in creating and maintaining goodwill.

d) Improves Creditworthiness- A firm having adequate working capital is considered


favorably by banks and financial institutions, thus making it easy for it to get credit.
e) Ability to face crisis- It provides necessary funds to meet unforeseen contingencies and
thus helps the enterprise to run successfully during periods of crisis.

Operating and Cash Conversion Cycle

The firm requires to invest enough funds in current assets for generating sales. Current assets
are needed because sales do not convert into cash instantaneously. There is always ​operating
cycle​ involved in the conversion of sales into cash.
Operating Cycle ​is the time duration required to convert sales, after the conversion of
resources into inventories, into cash. The operating cycle of a manufacturing company involves
three phases
i) ​Acquisition of Raw Materials ​such as raw material, labour, power and fuel, etc
ii) ​Manufacture of the product​ which includes conversion of raw material into work in progress
into finished goods
iii) ​Sale of the product ​either cash or on credit. Credit sales creates account receivable for
collection.

Gross Operating Cycle = Inventory Conversion Period + Debtors Conversion Period

Inventory Conversion Period = Raw Material Consumption Period + Work in progress


conversion period + Finished goods conversion period

Raw Material Conversion period = ​ Average Inventory of Raw Material* 365


Total Consumption of Raw Material

Work in Progress Conversion Period = ​ Average work in progress * 365


Cost of Production

Finished Goods Conversion Period = ​Average Finished Goods * 365


Cost of Goods Sold

Debtors Conversion Period = ​ ​Average Debtors​ * 365


Credit Sales
Cash Cycle/ Net Operating Cycle = Gross operating Cycle - Creditor’s Payment Period

Creditors’ Payment Period = ​Average Creditors * 365


Total Credit Purchase

Factors Influencing Working Capital

I. Nature of Business ​Trading firms have a very small investment in fixed assets but
require a large amount of money to be invested in working capital. Manufacturing firms,
construction firms will have to substantially invest in fixed asset and working capital.
II. Market and Demand Conditions ​Working Capital needs of a firm are related to its
sales. Sales depend on demand conditions. With the increase in sales, the firm’s
investment in inventories and debtors will also increase.
III. Technology and Manufacturing Policy ​Manufacturing cycle comprises the purchase
and use of raw materials and production of finished goods. Longer the manufacturing
cycle, the larger will be the firm's working capital requirements
IV. Credit Policy ​A liberal credit policy will lead to unnecessary funds tied up in debtors and
which will increase the chance of bad debts.
V. Availability of Credit from Suppliers ​A firm will need less working capital if liberal
credit terms granted by its suppliers.
VI. Operating Efficiency ​The operating efficiency of the firm relates to the optimum
utilisation of all its resources at minimum costs. Better utilisation of resources improves
profitability and thus helps in reducing the pressure on working capital requirements.

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