You are on page 1of 3

EXPLAIN THE CONCEPT OF WORKING CAPITAL.

DEFINE THE NETWORK OF WORKING CAPITAL AND ITS SIMPLICATION Working capital management is concerned with the problems that arise in managing the current assets (CA), current liabilities (CL) and the interrelationships between them. Its operational goal is to manage the CA and CL in such a way that a satisfactory/acceptable level of net working capital (NWC) is maintained. Concepts and Definitions of Working Capital There are two concepts of working capital: 1) Gross and 2) Net Gross Working Capital Gross working capital means the current assets which represent the proportion of investment that circulates from one form to another in the ordinary conduct of business. Net Working Capital The term net working capital can be defined in two ways: 1) the most common definition of net working capital (NWC) is the difference between current assets and current liabilities; and 2) alternate definition of NWC is that portion of current assets which is financed with long-term funds. The task of the financial manager in managing working capital efficiently is to ensure sufficient liquidity in the operations of the enterprise. The liquidity of a business firm is measured by its ability to satisfy short-term obligations as they become due. The three basic measures of a firms overall liquidity are The Common Definition of NWC and its Implications NWC is commonly defined as the difference between current assets and current liabilities. Efficient working capital management requires that firms should operate with some amount of NWC, the exact amount varying from firm to firm and depending, among other things, on the nature of industry. The NWC is predictable the cash inflows are, the less NWC will be required and vice-versa. The NWC represents the liquidity position of a firm.necessary due to non-synchronous nature of expected cash inflows and required cash outflows. The more Alternative Definition of NWC NWC can alternatively be defined as that part of the current assets which are financed with long-term funds. Since current liabilities represent sources of short-term funds, as long as current assets exceed the current liabilities, the excess must be financed with long-term funds.

Determining Financing Mix Financing mix is the choice of sources of financing of current assets. There are three basic approaches to determine an appropriate financing mix: 1) Hedging approach, also called the Matching approach; 2) Conservative approach, and 3) Trade-off between these two. (a) Hedging Approach: The term hedging is often used in the sense of a risk-reducing investment strategy involving transactions of a simultaneous but opposing nature so that the effect of one is likely to counterbalance the effect of the other. This approach to the financing decision to determine an appropriate financing mix is, therefore, also called as Matching approach. According to this approach, the maturity of the source of funds should match the nature of the assets to be financed. For the purpose of analysis, the current assets can be broadly classified into two classes: 1.those which are required in a certain amount for a given level of operation and, hence, do not vary over time. 2. those which fluctuate over time.

(b) Conservative Approach This approach suggests that the estimated requirement of total funds should be met from long-term sources; the use of short-term funds should be restricted to only emergency situations or when there is an unexpected outflow of funds. Comparison of Hedging Approach with Conservative Approach A comparison of the two approaches can be made on the basis of 1) Cost considerations, and 2) Risk considerations. c) A Trade-off between the Hedging and Conservative Approaches It has been shown that the hedging approach is associated with high profits as well as high risk, while the conservative approach provides low profits and low risk. Obviously, neither approach by itself would serve the purpose of efficient working capital management. A trade-off between these two extremes would give an acceptable financing strategy. The third approachtrade-off between the two approachesstrikes a balance and provides a financing plan that lies between these two extremes. Acceptable financing strategy is a trade-off between matching and conservative financing strategies.

Planning of Working Capital The need for working capital (WC) arises from the cash/operating cycle of a firm. It refers to the length of time required to complete the following sequence of events: conversion of cash into inventory, inventory into receivables and receivables into cash. The operating cycle creates the need for working capital and its length in terms of time-span required to complete the cycle is the major determinant of the firms working capital needs.