Meaning of working capital (WC) Funds required for short term purposes or day to day expenses are working capital. WC refers to part of firm’s capital reqd.for financing short term or current assets also known as revolving or short term capital or circulating capital.
Concepts of Working Capital Balance sheet concept. Two interpretations of W.C. under this concept are:- gross working capital:- capital invested in total current assets of an enterprise. gross concept sometimes preferred over networking concept due to:- a). enables enterprise to provide correct amount of WC at the right time. b). every management is interested in total current assets with which it has to operate than the sources. c). gross concepts takes into considerations that every increase in the funds would increase the working capital. d). gross concepts of WC is more useful in determining rate of return on investments in WC.
Importance of Net Working Capital It is a qualitative concept which indicates firm’s ability to meet its operating expenses and short term liabilities. It indicates the margin of protection available to the short term creditors. Indicator of financial soundness of an enterprise. Net WC is refered to as working capital.
Operating cycle or circular flow concept Start with raw material. Raw material -> work in progress -> finished goods -> Sales -> debtors -> Cash -> raw material. This is a cycle.
CLASSIFICATION OF WC:- WC may be classified in two ways:- On the basis of concept - gross working capital - net working capital On the basis of time - permanent or fixed WC a). regular WC b). reserve WC - temporary or variable WC a). seasonal WC b). special WC
IMPORTANCE OR ADVANTAGES OF ADEQUATE WC:- Maintains solvency of business. Helps in creating & maintaining goodwill. Helps in arranging loans from banks & others on easy and favourable terms. Enables a concern to avail cash discount and hence reduce cost. Ensures regular supply of raw materials. Regular payment of salaries, wages & other day to day commitment. Exploitation of favourable market condition. Enables a concern to face business crisis.
EXCESS OR INADEQUATE WC:- Disadvantages of redundant or excessive WC:- Excessive WC means idle funds which earn no profit for the business & hence, business cannot earn a proper rate of return on its investments. When there is redundant WC, it may lead to unnecessary purchasing & accumulation of inventories causing more chance of theft, waste & losses. Excessive WC implies excessive debtors & defective credit policy which may cause higher incidences of bad- debts. It may result in overall inefficiency in org. When there is excessive WC, relationships with banks &other financial institutions may not be maintained due to low rate of returns on investments, the value of share may also fall.
DISADVANTAGES OR DANGERS OF INADEQUATE WC:- A concern which has inadequate WC cannot pay its short term liabilities in time. Thus, loose its reputation & shall not be able to get good credit facilities. Cannot buy its requirements in bulk & cannot avail of discounts etc. Becomes difficult for the firm to exploit favourable market conditions & undertake profitable projects. Firm cannot pay its day to day expenses and it create inefficiency. Becomes impossible to use efficiently fixed assets due to non availability of liquid funds.
THE NEED OR OBJECTS OF WC:- WC is needed for the following purposes:- For the purchase of raw material. To pay wages & salaries. To incur day to day expenses and overhead costs. To meet selling costs. To provide credit facilities to the customer. To maintain the inventories of raw material, work in progress, stores and spares and finished stock.
ANALYSIS OF WC Funds Working Ratio Flow CapitalAnalysis Analysis Budget
Ratio Analysis It is a simple arithmetical expression of one number to another. The technique of ratio analysis can be employed for measuring short term liquidity or working capital position of the firm. The following ratios may be calculated for this purpose:- Current ratio. Acid test ratio. Absolute liquid ratio. Inventory turnover ratio. Receivables turnover ratio. Payables turnover ratio. Working capital turnover ratio. Working capital leverage. Ratio of current liabilities to tangible net worth.
FUNDS FLOW ANALYSIS Fund flow analysis is a technical device designated to study the sources from which additional funds were derived and the use to which these sources were put. It is an effective management tool to study changes in the financial position (WC) of a business enterprise between beginning and ending financial statements. Funds flow analysis consists of:- Preparing schedules of changes in WC. Statement of sources and application of funds.
WORKING CAPITAL BUDGET Budget is a financial or quantitative expression ofbusiness plans & policies to be pursued in the futureperiod of time. WC budget as a part of total budgetingprocess of a business is prepared estimating future longterm & short term WC capital needs & sources to financethem & then comparing the budgeted figures with theactual performance for calculating variances. Thesuccessful implementation of WC budget involves thepreparing of separate budgets for various elements ofWC such as cash inventories and receivables etc. Theobjectives of a WC budget is to ensure availability offunds as and when needed and to ensure effectiveutilization of these resources.