Outcome. 4
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Sohel MemonOutcome. 4
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Sohel MemonFinancial Management,
Chapter 4
(Outcome No 4 - Manage and evaluate firm’s working capital)
Meaning
Capital needs of business can be classified into two
1. Fixed capital
This is the long term funds required to facilitate production through purchase of fixed
assets like plant and machinery, land and building, furniture etc. Such funds are
blocked on permanent or fixed assets hence it is called fixed capital.
2. Working Capital
It is the investment of funds in short term purposes such as
a. purchase of current assets
b. payment of wages and
c. Other day to day expenses.
Funds invested in current assets keep on revolving fast and converted into cash and this cash
flows out again in exchange of other current assets. Hence working capital is also called
revolving capital or circulating capital.
Concepts of working capital
There are two concepts of working capital
1. Gross working capital
It refers to total of investment made in current assets by a firm. Current assets are those
assets which can be converted into cash within short period normally one year. Examples of
current assets are
- Cash and bank balance
- Receivables( Bill receivables and debtors)
- Short term investment
- Stock of raw materials, work in progress and finished goods
- Prepaid expenses and
- Accrued incomes
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Financial Management,
2. Net working capital
It is the excess of current assets over current liabilities
Net Working Capital = Current Assets - Current Liabilities
Current liabilities are those liabilities which are to be paid with in a one accounting period.
Examples of current liabilities are
- Payable (Bills Payables and sundry creditors)
- Accrued or outstanding income
- Bank overdraft
- Dividend payable
- Provision for taxation etc
Net working capital may be positive or negative. When the current assets exceed current
liabilities, the working capital is positive and the negative working capital results when
current liabilities are more than current assets.
Need for working capital
Every business needs some amount of working capital. It is due to the time gap between
production and realization of cash from sales. Therefore working capital is needed for the
following purposes
1. For the purchase of raw materials for production
2. to maintain stock of raw material, work in progress and finished goods
3. To pay salaries and wages
4. To meet day to day expenses
Factors affecting working capital
The following factors will influence the working capital requirements
1. Nature of business
Public utility units require small amount of working capital, trading and financial
firms require very large amount of working capital where as manufacturing concern
require a medium amount of working capital.
2. Size of business
When the size of the business is large, the requirements of working capital is also
large and small business require less working capital only
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Financial Management,
3. Production policy
If the production policy is to accumulate production during slack period, working
capital requirement will be more.
4. Manufacturing process
Longer the production process, larger the amount of working capital required.
5. Availability of raw material
In some industries raw material is not available through out the year. They have
to buy raw material in bulk during the season to ensure smooth production through
out the year. Such industries working capital requirement will be higher.
6. Working Capital Cycle
The working capital cycle starts with the purchase of raw material and ends with
the realisation of cash from sale of finished goods. Longer the period of cycle, larger
is the requirements of working capital
7. Credit policy
A concern that purchases its requirements on credit and sells its production on
cash requires less amount of working capital. A concern buying its requirements for
cash and allowing credit to its customers shall need large amount of working capital.
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