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MGT601 - SME Management - Lecture Handout 25

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WORKING CAPITAL

Working capital management or current asset management is one of the most important aspects of overall financial management in an enterprise. It is basically concerned with the management of current assets and current liabilities and inter relationship between them.

Meaning of Working Capital

Working capital is the amount of funds needed by an enterprise to finance its day to day operation. It is the part of capital employed in short-term operation such as raw materials, semi finished products, sundry debtors. Because of its variable nature, the working capital is also referred to as circulating capital. It may be pointed out that the total working capital is composed of two parts.

  1. Regular Capital
  2. Variable Capital

Regular Working capital is required for permanent investment in any business for holing certain minimum quantity of raw material, finished product or cash. Such investment is irreducible minimum and remains permanently sunk into business.

The remaining portion of working capital is variable. The variable portion first gets tied up into raw materials which are then converted into finished goods. On the sale of goods it gets converted into account receivables or cash and circle is then completed. It is depicted in following figure.

Working Capital

Different Senses of “Working Capital”

The term working capital is usually used in two different senses namely.

  1. Gross Working Capital
  2. Net Working Capital

Gross Working Capital

It represents total value of current assets. In other words, it is the sum total of net working capital and current liabilities. It is a quantities concept showing the total amount available for financing the current assets. It cannot reveal the true position of the company. For instance, every increase in borrowings will increase the gross working capital but net working capital will remain the same.

Net Working Capital

It represents excess of current assets over current liabilities. Current assets include cash, debtors, stock, and bills receivable, Current liabilities include bills payable, accounts payable, expenses payable. It indicates the liquidity position of an enterprise i.e. the soundness or otherwise of the current financial position. The ratio of 2:1 between current assets and current liabilities is considered sound. The concept of net working capital is quantitative concept indicating firm’s capacity to meet operating expenses and current liabilities. Net working capital is increased only when there is an increase in current assets without corresponding increase in current liabilities.

Net Working Capital = Current assets – Current liabilities.

Significance of Working Capital

  • Conversion of cash into inventory.
  • Conversion of inventory into receivable.
  • Conversion of receivable into cash.

These events constitute operating cycle of business. If all these events could happen simultaneously, there would not arise any need for working capital. Since cash inflows and cash outflows do not match, an organization need necessary cash and liquidity to be able to meet its obligations. Thus adequate capital is required for smooth operation of any business concern.

Sound working capital management results in maximization of productivity and Profits. It requires the maintenance of proper balance between working and fixed capital, so as to maintain both profitability and solvency. Proper management synchronizes cash receipts and cash outlays.

For small concerns, efficient working capital management is still more essential to ensure purchase of inputs at competitive prices and timely payment to factors of production. It may be noted that shorter the gap between spending of money on production of goods and the recovery of money through rapid sales turnover, the better shall be the quality of working capital management.

Factors Affecting Working Capital Requirements

In case of a small enterprise, the various factors affecting its working capital requirements.

  1. Size of Business
    What are the size of unit and the volume of business?
  2. Nature of Process
    Nature of production process i.e. lengthier the duration of production, higher shall be the working capital needs and vice-versa.
  3. Proportion of Raw Materials and Total Cost
    Proportion of raw material to total cost must be decided.
  4. Terms of Sale & Purchase
    Terms of sale and purchase e.g. sales are on cash terms, lesser working capital will be sufficient.
  5. Turnover of Inventories
    If inventories are large and their turnover is slow, larger working capital would be needed.
  6. Labour Vs. Capital Intensive
    Labour vs. capital intensive, the former requiring higher amounts of working capital.
  7. Cash Requirements
    Cash requirements will have direct impact on working capital quantum.
  8. Banking Facilities
    Availability of goods and dependable banking facilities reduces working capital needed.
  9. Seasonal Requirements
    Seasonal requirements may push up the amount of working capital needed.
  10. Contingencies
    If the demand and prices for small concerns products are subject to wide fluctuation, contingency provision will have to be made for arranging higher amounts of working capital.

Determination of Working Capital Needs

Working capital requirements of a small enterprise vary from unit to unit and in accordance with the difference on the nature of the enterprise. Broadly speaking, working capital should be adequate to meet operating expenses like raw materials, labour, factory and other overheads etc. Operating expenses can be ascertained from the final accounts of the firm. But the working capital requirements needs not be equal to the level of expenses. Operating cycle is of primary significance in every case.

Working Capital Requirement Formula =

Operating EXP in Previous Year

Number of Operating Cycles in Year

Ingredients of Working Capital Management in Small Enterprise

  1. Budget the Material Requirements
    Budget the material requirements and devising a proper system of control.
  2. Production Goes on Uninterrupted
    Ensure that production goes on uninterrupted so that there id minimum blockage of working capital in the production process.
  3. Realize Cash Fast
    Expeditious dispatch the finished goods to realize cash fast.
  4. Follow the Bills
    Follow the bills for early realization of cash.
  5. Identify Surplus Cash
    In the field of cash management, clearly identify the quantum of really surplus cash which could be utilized to meet financial obligations.
  6. Working Capital Sources
    Ensure proper management of working capital sources so that there is no costly fund rising. There must be a judicious blending of different resources so that sufficient funds are raised at the cheapest cost.

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