Working Capital Management: Nature, Significance, and Factors, Lecture notes of Working Capital Management

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Management of WorkingManagement of Working

Capital Capital

Module 5Module 5

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Nature & Significance of working

capital

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Operating Cycle

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Factors determining working

capital



Estimation of working capital

Components or Composition of

Working Capital

 (^) There are two components of working capital viz., current assets and current liabilities.  (^) Current Assets:  (^) Current assets generally mean those assets which, in the normal and ordinary course of business, will be or are likely to be converted into cash within a year.  (^) Examples of current assets are:  (^) 1. Inventories like raw materials, work-in-progress, stores and spare parts, finished goods  (^) 2. Sundry Debtors (net of provision)  (^) 3. Short-term investment or marketable securities  (^) 4. Short-term loans and advances  (^) 5. Bills receivable or accounts receivable  (^) 6. Pre-paid expenses  (^) 7. Accrued Income  (^) 8. Cash in hand and bank balances.

Contd..Contd..

 (^) Current Liabilities:  (^) Current liabilities means those liabilities repayable within the same period, i.e., a year. In other words, current liabilities are those which are to be repaid in the ordinary course of the business within a year.  (^) Examples of current liabilities are:  (^) 1. Sundry creditors  (^) 2. Bills payable  (^) 3. Outstanding expenses  (^) 4. Short-term loans, advances and deposits  (^) 5. Provision for tax 

6. Proposed dividend  (^) 7. Bank overdraft.

(i) Long-Term Sources:(i) Long-Term Sources:  (^) Every business organisation is required to maintain a minimum balance of cash and other current assets at all the times—irrespective of the ups and downs in the level of activity. The portion of working capital which is continuously maintained by the business at all times to carry on its minimum level of activities is called permanent working capital.  (^) This type of working capital should be arranged from long-term sources of fund.  (^) The following are the long-term sources of financing permanent working capital:  (^) (a) Issue of Equity shares  (^) (b) Issue of Preference shares  (^) (c) Retained earnings (ploughed-back profits)  (^) (d) Issue of Debentures and other long-term bonds  (^) (e) Long-term loans taken from financial institutions etc.

(ii) Short-Term Sources:(ii) Short-Term Sources:  (^) The short-term financing of working capital is generally used to support the temporary working capital which is usually needed to meet the seasonal increase or sudden spurt in demand.  (^) Various short-term sources of financing of temporary working capital are:  (^) (a) Bank credit (e.g., cash credit, letter of credit, bills finance, working capital demand loan, overdraft facility etc.)  (^) (b) Public deposits  (^) (c) Trade credit  (^) (d) Outstanding expenses  (^) (e) Provision for depreciation  (^) (f) Provision for taxation  (^) (g) Advances from customers  (^) (h) Loans from directors  (^) (i) Security money received from employees  (^) (j) Receipts from factoring.

Nature Of working capitalNature Of working capital

management management

 The management of fixed and current assets differs in 3 important ways: 1.In working capital management no compounding and discounting is needed as in fixed asset management. 1.Risk-Return trade-off :- The large holding of cash strengthens the firm’s liquidity position and reduces riskiness, but also reduces the overall profitability. Thus, a risk-return trade off is involved in holding current assets.

Objectives of Working capitalObjectives of Working capital management management 

1. How to optimize investment in

current assets?

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2. How should current assets be

financed?

2. Increase in Liquidity and

Solvency Position:

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It enhances the liquidity and

solvency position of the business

concern.

3. Goodwill:



A firm with sound working capital

position can make timely payment

of its outstanding bills. This

enhances the reputation of the firm.

 4. Advantages of Cash Discount It enables the firm to avail itself of the facilities like cash discount by making prompt payments.  5. Easy Loan: Adequate amount of working capital builds a sound credit-worthiness of the firm. As a result it becomes easier for the firm to obtain additional loans in favourable terms and conditions in order to meet seasonal increase in demand or to finance the increased working capital resulting from expansion.

 9. Meeting of Contingencies: It can meet unforeseen contingencies of the firm. Unforeseen contingencies like business depression, financial crisis due to huge losses etc. can easily be overcome, if adequate working capital is maintained by a firm.  10. Completing operating cycle: A sound management of working capital helps in completing the operating cycle quickly. This enables a firm to increase its profitability. 

11. Timely Payment of Dividend:  Adequate working capital ensures regular payment of dividends to the shareholders.

Determinants of Working Capital  (^) 1. Nature of Business:  (^) The working capital requirements of a firm are widely influenced by the nature of business. Public utilities like bus service, railways, water supply etc. have the lowest requirements for working capital—partly because of the cash nature of their business and partly because of their rendering service rather than manufacturing product and there is no need of maintaining any inventory or book debt except capital assets.  (^) On the contrary, trading concerns are required to maintain more working capital because they have to carry stock-in-trade, receivables and liquid cash. Manufacturing concerns also require large amount of working capital because of the time lag involved in the conversion of raw materials into finished products and, finally, into cash.

3. Production Cycle:  Production cycle is the time involved in manufacturing or processing a product. It starts when raw materials are put in the production process and ends with the completion of manufacturing of the product. Longer the production cycle, higher is the need of working capital.  This is because funds remain blocked in work-in-progress for long periods of time. For example, the working capital needs of a ship-building industry will be much longer than those of a bakery.

4. Business Cycle  The working capital requirements are also determined by the nature of the business cycle. During the boom period, the need for working capital will increase to meet the requirements of increased production and sales. On the other hand, in a slack period, the reduced volume of operation will require relatively lower amount of working capital.