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Concept of Working Capital Includes Meaning of Working Essay Sample

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Concept of Working Capital Includes Meaning of Working Essay Sample

Concept of working capital includes meaning of working capital and its nature. Working capital is the investment in current assets. Without this investment, we can not operate our fixed assets properly. For getting good profits from fixed assets, we need to buy some current assets or pay some expenses or invest our money in current assets. For example, we keep some of cash which is the one of major part of working capital. At any time, our machines may need repair. Repair is revenue expense but without cash, we can not repair our machines and without machines, our production may delay. Like this, we need inventory or to invest in debtors and other short term securities.

On the basis of Concept, we can divide our working capital into two parts:

1. Gross Working Capital

In this concept of working capital, we study gross working capital. We do not deduct current liabilities in this concept but we use current liabilities as source of fund. Suppose, if we buy goods on credit, it means our save our cash and we can use this as working capital for paying other expenses.

2. Net Working Capital

Under this concept we use net working capital. For this, we first deduct all our current liabilities from our current assets. Excess of current assets over current liabilities will be current assets. We have to maintain minimum level of working capital in our business for operation of business activities. This concept is also used for preparation of balance sheet. In the vertical form of balance sheet, we show excess of current assets over current liabilities.

Operating Cycle Concept of Working Capital

In this concept of working capital, we make the operating cycle. In this cycle, we calculate inventory conversion period. To know this, we can estimate when we need cash for buying our inventory. We also calculate debtor or receivable conversion period. To know this, we can estimate when we receive cash from our debtors.

If inventory conversion period is less than debtor conversion period, we have to manage other sources for buying our inventories. If we buy good on credit, we also take care.

Definition of Working Capital

” Working capital is an excess of current assets over current liabilities. In other words, The amount of current assets which is more than current liabilities is known as Working Capital. If current liabilities are nil then, working capital will equal to current assets. Working capital shows strength of business in short period of time . If a company have some amount in the form of working capital , it means Company have liquid assets, with this money company can face every crises position in market. “

Formula of Calculating Working Capital

Working Capital = Current Assets – Current Liabilities

Current Assets

Current assets are those assets which can be converted into cash within One year or less then one year . In current assets, we includes cash, bank, debtors, bill receivables, prepaid expenses, outstanding incomes .

Current Liabilities

Current Liabilities are those liabilities which can be paid to respective parties within one year or less than one year at their maturity. In current liabilities, we includes creditors, outstanding bills, bank overdraft, bills payable and short term loans, outstanding expenses, advance incomes .

Other names of Working Capital

Some Professional accountants know working capital as operating capital, operating liquidity, positive working capital.

Important things about Working Capital

1. Working Capital can be negative. At that time, We add one word ” deficiency” in the back of working capital . It means if Current Liabilities are more than current assets, it is known as working capital deficiency or inverse working capital or negative working capital.

2. Working capital can be easily adjusted, if Accounts manager knows different techniques of managing working capital . He can try to get short term loan or he can increase working capital by proper management of inventory and outstanding incomes and debtors .

3. Working capital can also change by Changing in Cash Conversion period. Cash conversion period is a period in which company changes current assets into cash or bank.

4. Working capital can also positive by increasing growth rate of company. If company does not invest more money and increase profit, the same amount will increase in the cash position of company and with cash company can increase their working capital position.

Importance of Working Capital

Some time, If creditors demands their money from company, at this time company’s high working capital saves company from this situation . You know that selling of current assets are easy in small period of time but Company can not sell their fixed assets with in small period of time. So, If Company have sufficient working capital , Company can easily pay off the creditors and create his reputation in market. But If a company have zero working capital and then company can not pay creditors in emergency time and either company becomes bankrupt or takes loan at higher rate of Interest . In both condition , it is very dangerous and always Company’s Account Manager tries to keep some amount of working capital for creating goodwill in market . Positive working capital enables also to pay day to day expenses like wages, salaries, overheads and other operating expenses. Because sufficient working capital can not only pay maturity liabilities but also outstanding liabilities without any more delay. One of advantages of positive working capital that Company can do every risky work without any tension of self security.

Optimal level of working capital

Optimal level of working capital is that level where company is capable to pay day to day expenses and company has enough cash to buy the stocks in case if it does not receive money from debtors on the time. This level is achieved by thinking and using the techniques of working capital management. We all know that both low level or over level of working capital is harmful for development of business. If company has not enough cash to repay its liability, it will create the risk of solvency and liquidity and company may go for liquidation. In case, company has over working capital, it will be misuse of money because that money is not gaining any earning and its opportunity cost will suffer by shareholders and ultimately it will decrease the value of share in share market. So, as finance manager, you should try to create equilibrium or optimal or optimum level of working capital.

Working Capital Forecasts

Working capital forecasts means to estimate the value of working capital in one year. Following are main items which are estimated in working capital forecasts.

1. Future Operating Costs

We estimated our future operating cost, more future operating cost means more need of cash and cash is the part of working capital. It means, we need
more working capital in that situation. For estimating this, w analyze past income statements of company.

2. Forecast Revenue Growth

By sales and other revenue’s trend analysis, we can forecast revenue growth. This will tell us, how will working capital manage from revenue in future.

3. Changes of Working Capital

To analyze the past working capital changes is useful for working capital future forecast. Working capital is difference between current assets and current liabilities. If we check two years’ working capital changes, we can estimate what changes in working capital in next year.

Determinants of Working Capital

1. Small or Large Business

It is the first determinant of working capital that it is affected with the nature of business. Business may be small or large. In small business, company need high working capital because, small business is relating to trading of goods, for starting small business, you need very small fixed capital but need high working capital for paying day to day expenses. But in large business, we require more fixed capital than working capital for purchasing fixed asset.

2. Small or Large Demand

Nature of demand also absolutely affects the working capital need. Some product can be easily sold by businessman, in that business; you need small amount of working capital because your earned money from sale can easy fulfill the shortage of working capital. But, if demand is very less, it is required that you have to invest large amount of working capital because your all fixed expenses must be paid by you. For paying fixed capital you need working capital.

3. Production Policy

Production policy is also main determinant of working capital requirement. Different company may different production policy. Some companies stop or decrease the production level in off seasons, in that time, company may also reduce the number of employees or decrease the purchasing of new raw material, so, it will certainly decrease the amount of working capital but on the side, some company may continue their productions in off season, in that case, they need definitely large amount of working capital.

4. Credit Policy

Credit policy is relating to purchasing and selling of goods on credit basis. If company purchases all goods on credit and sells on cash basis or advance basis, then it is certainly company need very low amount of working capital. But if in company, goods are purchased on cash basis, and sold on credit basis, it means, our earned money will receive after sometime and we require large amount of working capital for continuing our business.

5. Dividend Policy

Dividend policy also effect working capital requirement. Company can distribute major part of net profit. But, if there is no reserve, we have to invest large amount in working capital because, lacking of reserve will affect on adversely on fulfill our liabilities. In that case, we have to yield working capital by taking short term loan for paying uncertain liability.

6. Working Capital Cycle

Working capital cycle shows all steps which starts from cash purchasing of raw material and then this converted into finished product, after this it is converted into sale, if it is credit sale, debtors will also the part of working capital cycle and when we gets money from our debtors, it is the final part of working capital cycle. If we receive fastly from our debtors, we need small amount working capital. Otherwise, for purchasing new raw material, we need more amount of working capital.

7. Manufacturing Cycle

Manufacturing cycle means the process of converting raw material into finished product. Long manufacturing cycle will create the situation in which we require large amount of working capital. Suppose, we have to construct the building, for constructing colony of buildings, it may consume the time more than 5 years, so according to this we need working capital.

8. Business Cycle

There are two main part of business cycle, one is boom and other is recession. In boom, we need high money or working capital for development of business but in recession, we need only low amount of working capital.

9. Price Level Changes

If there is increasing trend of products prices, we need to store high amount of working capital, because next time, it is precisely that we have to pay more for purchasing raw material or other service expenses. Inflation and deflation are two major factors which decide the next level of working capital in business.

10. Effect of External Business Environmental Factors

There are many external business environmental factors which affect the need of working capital like fiscal policy, monetary policy and bank policies and facilities.

Working Capital Management
>> February 22, 2010

Introduction of Working Capital Management

Working capital management is the device of finance. It is related to manage of current assets and current liabilities. After learning working capital management, commerce students can use this tool for fund flow analysis. Working capital is very significant for paying day to day expenses and long term liabilities.

Meaning and Concept of Working Capital and its management

Working capital is that part of company’s capital which is used for purchasing raw material and involve in sundry debtors. We all know that current assets are very important for proper working of fixed assets. Suppose, if you have invested your money to purchase machines of company and if you have not any more money to buy raw material, then your machinery will no use for any production without raw material. From this example, you can understand that working capital is very useful for operating any business organization. We can also take one more liquid item of current assets that is cash. If you have not cash in hand, then you can not pay for different expenses of company, and at that time, your many business works may delay for not paying certain expenses. If we define working capital in very simple form, then we can say that working capital is the excess of current assets over current liabilities.

Types of Working Capital

1. Gross working capital

Total or gross working capital is that working capital which is used for all the current assets. Total value of current assets will equal to gross working capital.

2. Net Working Capital

Net working capital is the excess of current assets over current liabilities.

Net Working Capital = Total Current Assets – Total Current Liabilities

This amount shows that if we deduct total current liabilities from total current assets, then balance amount can be used for repayment of long term debts at any time.

3. Permanent Working Capital

Permanent working capital is that amount of capital which must be in cash or current assets for continuing the activities of business.

4. Temporary Working Capital

Sometime, it may possible that we have to pay fixed liabilities, at that time we need working capital which is more than permanent working capital, then this excess amount will be temporary working capital. In normal working of business, we don’t need such capital.

In working capital management, we analyze following three points

Ist Point

What is the need for working capital?

After study the nature of production, we can estimate the need for working capital. If company produces products at large scale and continues producing goods, then company needs high amount of working capital.

2nd Point

What is optimum level of Working capital in business?

Have you achieved the optimum level of working capital which has invested in current assets? Because high amount of working capital will decrease the return on investment and low amount of working capital will increase the risk of business. So, it is very important decision to get optimum level of working capital where both profitability and risk will be balanced. For achieving optimum level of working capital, finance manager should also study the factors which affects the requirement of working capital and different elements of current assets. If he will manage cash, debtor and inventory, then working capital will automatically optimize.

3rd Point

What are main Working capital policies of businesses?

Policies are the guidelines which are helpful to direct business. Finance manager can also make working capital policies.

1st Working capital policy

Liquidity policy

Under this policy, finance manager will increase the amount of liquidity for reducing the risk of business. If business has high volume of cash and bank balance, then business can easily pays his dues at maturity. But finance manger should not forget that the excess cash will not produce and earning and return on investment will decrease. So liquidity policy should be optimized.

2nd Working Capital Policy

Profitability policy

Under this policy, finance manger will keep low amount of cash in business and try to invest maximum amount of cash and bank balance. It will sure that profit of business will increase due to increasing of investment in proper way but risk of business will also increase because liquidity of business will decrease and it can create bankruptcy position of business. So, profitability policy should make after seeing liquidity policy and after this both policies will helpful for proper management of working capital

Investment in Working Capital

Investment in working capital means to invest money in liquid and current assets. We all know that working capital is important, if we want to operate our fixed assets more efficiently. Like investment in fixed capital decision, investment in working capital decision is also important. In working capital investment, we keep our some money in cash. We also invest our some money in the form of inventory, debtors and short term securities. Value of these investment must be more than our current liabilities.

Now, important question is, “How much excess amount should be invested?” Our current assets are $ 10000 and our current liabilities are $ 7000. Our investment in working capital is $ 3000. Now, question is, whether $ 3000 investment is sufficient or not.

To know this answer, we have to study many factors which affect our investment in working capital.

{Important Note: We are studying these factors because we are interested to optimum investment in working capital. If we invested over money in working capital, it will not generate profit and our profit will decrease. If we invested under money in working capital, it will increase the risk of our solvency. Suppose, we have no money to pay our creditor on the time due to under working capital investment. It means, he has to challenge our solvency.}

1. Inventory Cycle

We need investment of working capital for buying raw material. We have to calculate inventory conversion period. It will tell us when our inventory cycle will complete. According to this, we think to invest our money in working capital.

2. Creditor Conversion Period

We have to save some money for paying our creditors. Both long term and short term creditors’ payment is from cash. Our creditor conversion period will explain when we have to pay them next.

4. Debtor Conversion Period

We also expect that our debtor will give our money after some time but when they will give our money. Up to that time, we need to invest money in debtors, after completing debtor conversion period, we need not to invest money in debtors. Suppose, our debtor will pay after 60 days. It means only for 60 days, we need money to buy goods and paying other expenses. But after 60 days, we will get money from debtors, it means no need to invest extra amount in cash because same cash we will get from debtors.

5. Unexpected Expenses

Some expenses, we do not expect due to uncertainty. Suppose, our employee is doing our company’s duty and in the market, if he faces accident and he has no money for treatment, it is the duty of company to pay his treatment bill. But company is not NGO which will help. But taking it as social responsibility, company can pay in the form of loan to employee. But for this, company has to take decision to invest his working capital for such unexpected expenses.

6. Our Approaches

Some company invest in working capital on approaches basis. For example, according to matching approach, company will invest long term finance in long term fixed assets and short term finance in short term current assets. But its opposite is conservative approach in which company invest his long term finances in long term fixed assets and also in short term current assets.

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