LITERATURE REVIEW

A THEORETICAL FRAMEWORK OF WORKING

CAPITAL MANAGEMENT
Management of working has
got a separate entity in every organization. Working capital is one of the
most important factors which determine the success of the institution both in
short and long term period. Each business needs funds for two purposes. For
its establishment and to carry out business efficiently. Funds are required to
create business facilities such as land and building, furniture and other
equipments etc
This type of investment in asset is permanent and is called
fixed capital. Funds are also needed for giving loans and advances, for
payment of wages and salaries and other expenses etc These types of
funds are known as working capital. It is also known as working capital. It is
also known by different names such as revolving capital or circulating capital
or short term capital etc

MEANING AND DEFINITION OF WORKING CAPITAL

The term working capital is commonly used for the
capital required for day-to-day working in a business concern. Such as for
purchasing raw materials, for meeting day-to-day expenditure on salaries,
wages, rent rates etc but there are much disagreement among various
financial authorities as to the extract meaning of the term working capital.
Definition
Accounting to Generstenberg Circulating capital means current assets
of a company that are changed in the ordinary course of business from one
to another, as for example, from cash to inventories, inventories to
receivables, receivables to cash
In other words of Shubin, working capital It is the amount of funds
necessary to cover the cost of operating the enterprise

CONCEPT OF WORKING CAPITAL

There are two concepts of working capital
i)
ii)

1.

Gross working capital

Net working capital

GROSS WORKING CAPITAL

According to one school of through (gross concept of working

capital ) supported by distinguished authorities like Baker, Mead, Malott and
field, The working capital refers to the firms total investment in current
assets. Current assets means assets which can be converted in to cash with
in an accounting year and within an accounting year and includes cash, short
term securities, debtors, bills receivable, stock etc The following definitions
will substantiate the concept:1. Working capital means current assets- Mead, Malott and field.
2. Accounting to J.S Mill the sum of the current assets is the working
capital of a business.

2.

NET WORKING CAPITAL

According to other school of thought (net concept) support

authorities like Lincoln, Stevens, Dories and Saliers, The working capital
refers to the difference between current assets and current liabilities. It is the
excess of the current assets over current liabilities. Current liabilities are
excepted refer to claims to outsiders which are expected to mature of
payment with in an accounting year and includes creditors for good, bills
payable, bank overdraft etc The concept may put in following
requirements:Net working capital = current assets current liabilities
Net working capital can be positive or negative. A positive network capital
arises current assets exceeds current liabilities and a negative working
capital occurs when current liabilities are in the excess of current assets.

OPERATING CYCLE OF WORKING CAPITAL

Working capital is required because of the time gap between the
sales and their actual realization in cash. This time gap is technically termed
as operating cycle of the business.
In the case of manufacturing company, the operating cycle is the length of
time necessary to complete the following cycles of event:i)
ii)
iii)
iv)
v)

Conversion
Conversion
Conversion
Conversion
Conversion

of
of
of
of
of

cash into raw materials.

raw materials in to work in process.
work in process into finished goods.
finished goods into accounts receivable and
accounts receivable into cash.

The operating cycle of a manufacturing business can be shown as in the

following chart.

Figure CASH

DEBTORS

RAW MATERIALS

SALES
WORK IN PROCESS

FINISHED GOODS

CLASSIFICATION OR KINDS OF WORKING CAPITAL

Working capital may be classified in two ways:
A. On the basis of concept
B. On the basis of time
Figure KINDS OF WORKING CAPITAL

ON THE BASIS OF
CONCEPT

GROSS
WORKING
CAPITAL

REGULAR
WORKING
CAPITAL

1.

ON THE BASIS OF
TIME

NET
WORKING
CAPITAL

PERMANENT OR
FIXED WORKING
CAPITAL

RESERVE
WORKING
CAPITAL

SEASONAL
WORKING CAPITAL

TEMPORARY OR
VARIABLE WORKING
CAPITAL

SPECIAL WORKING
CAPITAL

ON THE BASIS OF CONCEPT

On the basis of concepts, the working capital may be divided into

gross working capital and net working capital.
Gross working capital is represented by total current assets.
Net working capital is the excess of current assets over current liabilities. Net
working capital can be positive or negative.

2.

ON THE BASIS OF TIME

Working capital can also be classified into

(A) Fixed or permanent working capital and
(B) Variable working capital.

A - FIXED OR PERMANENT WORKING CAPITAL

It represents that part of capital which is permanently locked up in
the current assets to carry out the business smoothly. This investment in
current asset is if the permanent nature and will increase as the size of the
business expands. The permanent fixed working capital can again be
subdivided into (I) regular working capital, and (II) Reserve or cushion
working capital.
I.

Regular Working Capital

It is the minimum amount of liquid capital needed to keep up
the circulation of capital form cash to inventories to receivable and
again to cash. This would include sufficient minimum bank balance to
discount all bills, maintain adequate supply raw materials etc

II.

Reserve Working Capital

This excess over the needs or regular working capital that
should be kept reserve for contingencies that many arises at any time.
These contingencies include rising prices, business depression strikes,
special operation experiments with new products etc

B - VARIABLE WORKING CAPITAL

Variable working capital changes with the increase or decrease in the
volume of business. It may also be subdivided into (I) Seasonal and (II)
Special working capital.
I.

SEASONAL WORKING CAPITAL

The working capital to meet the seasonal liquidity of the business is

seasonal.

II.

SPECIAL WORKING CAPITAL

This the part of the variable working capital which is the required for
the financing the special operation such as extensive marketing
companies, experiments with products or method of production carrying
of special job etc

FACTORS DETERMINING THE WORKING CAPITAL

The working capital requirements of a company depend upon a
large number of factors such as nature and size of the business, the
character of their operations, the length of production cycles, the rate of
stock turnover and the state of economic situation. It is not possible to rank
them all because all such factors are of different importance and the
influence of individual factors changes for a firm over time. However, the
following are the important factors generally influencing the working capital
requirements:
I.

Nature or character of business

The working capital requirements of a firm basically depend

upon the nature of its business. Generally speaking it may be said that public
utility undertakings require small amount of working capital, trading and
financial firms require relatively very large amount, whereas manufacturing
undertakings require sizable working capital between the two extremes.
II.

Size of business

The working capital requirements of a concern are directly

influenced by the size of its business which may be measured in terms of
scale of operations. Greater the size of a business unit, generally larger will
be the requirement of working capital. However, in some cases even smaller
concern may need more working capital due to high overhead charges,
inefficient use of available resources and other economic disadvantages of
small size.

III.

Length of product cycle

In manufacturing business, the requirements of working capital

increase in direct proportion to length of manufacturing process. Longer the
process period of manufacture, larger is the amount of working capital
required.
IV.

Seasonal changes

In certain industries raw material is not available throughout the

year. They have to buy raw materials in bulk during the season to ensure an
uninterrupted flow and process them during the entire year. A huge amount
is thus blocked in the form of material inventories during such season, which
gives rise to more working capital requirements. Generally, during the busy
season a firm require larger amount of working capital than in the slack
season.
V.

Working capital cycle

In a manufacturing concern, the working capital cycle starts with

the purchase of raw material and ends with the realization of cash from the
sale of finished goods. This cycle involves purchase of raw materials and
stores, its conversion into stocks of finished goods through work-in-process
with progressive increment of labour and service costs, conversion of
finished goods into sales, debtors and receivables and ultimately realization
of cash and this cycle continues again and again.
VI.

Rate of stock turnover

There is a high degree of inverse co-relationship between the

quanta of working capital and the velocity with which the sales are affected.
A firm having a high degree of stock turnover will need lower amount of
working capital as compared to a firm having a low rate of stock turnover.
VII.

Credit policy

The credit policy of a concern in its dealing with debtors and

creditors influence considerably the requirements of working capital. A
concern that purchases its requirements on credit basis and sells its products
on cash requires lesser amount of working capital and vice-versa.
VIII.

Rate of growth of business

The working capital requirements of a concern increase with the

growth and expansion of its business activities. Although, it is difficult to
determine the relationship between the growth in the volume of business
and the growth in the working capital of a business, yet it may be concluded
that for normal rate of expansion in the volume of business, we may have
retained profits to provide for more working capital but in fast growing
concerns, we shall require larger amount of working capital.
IX.

Earning capacity and dividend policy

Some firms have more earning capacity than others due to quality
of their products, monopoly conditions etc. Such firms with high earning
capacity may generate cash profits from operations and contribute to their
working capital. The dividend policy of a concern also influences the working
capital requirement.
X.

Price level changes

Changes in price level also affect the working capital requirements.

Generally, the rising prices will require the firm to maintain larger amount of
working capital as more funds will be required to maintain the same current
assets. The effect of rising prices may be different for different firms. Some
firms may be affected much while some others may not be affected at all by
the rise in prices.
XI.

Production policy

The production could be kept either steady by accumulating

inventories during the slack periods with a view to meet high demand during
the peak season or the production could be curtailed during the slack season
and increased during the peak season. If the policy is to keep production
steady by accumulating inventories it will require higher working capital.
XII.

Other factors

Certain other factors such as operating efficiency, manufacturing

ability, irregularities of supply, import policy, asset structure, importance of
labour, banking facilities etc also influence the requirements of working
capital.

SOURCES OF WORKING CAPITAL

A large scale manufacturing concern may procure funds from
various sources to meet its working capital requirement from time to time for
the convenience of study, the source of working capital may be classified
under the two heads:A.
B.

Source of long term or regular working capital

Source of short term or seasonal working capital

The following chart gives a snapshot view of the various sources of working
capital.
Figure-

SOURCES OF WORKING CAPITAL

LONG TERM SOURCES

TERM SOURCES

SHORT

1. Issue of Shares
2.
Issue of Debentures
EXTERNAL
3.
Retained Earnings
1. Trade creditors
4. Sale of Fixed Assets
2. Credit papers

INTERNAL
1. Depreciation funds
2. Provision for taxation

5. Term Loans
3. Bank creditors

3. Accrued expenses

4. Public deposits
5. Customers credit
6. Managing
7. Govt. Assistance

A. SOURCE OF LONG-TERM OR REGULAR WORKING

CAPITAL
The long term working capital requirements include the initial working
capital and the regular working capital. Various source for providing long
term working capital requirements are summarized as follows:1. ISSUE OF SHARES
It is the most important source of long term regular working capital.
More ever, the company is obligation to return the capital.
2. SOURCE OF DEBENTURES
Regular working capital can also be procured by issue of debentures
or bond.
3. RETAINED PROFITS
Accumulated large profit is also considered to be a good source of
financing long-term working capital.
4. SALES OF FIXED ASSETS
If there is any idle asset in the firm, it can be sold out and proceeds
may be utilized for financing the working capital requirements.
5. TERMS LOANS

Such term loans can be borrowed from the special financial

institution such as industrial development bank of India, industrial
finance corporations, LIC etc

B. SOURCE OF SHORT - TERM WORKING CAPITAL

Short term requirements of working capital involve financing of
day-to-day business operations. The sources of short term working capital or
seasonal working capital may be classified into two heads (i) Internal and (ii)
External.
1. INTERNAL SOURCES
Under the category, the sources of working capital are tapped
within. The main internal sources are:
I.

Depreciation funds
Depreciation funds created out of profit of the
company provide a good source of working capital provided they
are not invested in or represented by an asset.

II.

Provision for taxation

There remains a time lag between working the
provision for and payment of taxation.

III.

Accrued expenses
A company sometimes postpones the payment of
certain expenditures due on the date of finalization of the accounts.

2. EXTERNAL SOURCES
External sources mean the source providing finances
for company working capital other than those of internal sources.
They may be enumerated as below:

Normal trade credit

Trade creditors provide short term financial to the

company by selling the goods, investors and equipment on the
basis of differed payment.
Credit papers

Under this category, bills payable promissory notes

etc are include. The acceptor of a bill of exchange gets time in
making the payment.
Bank credit

The greater part of the working capital is supplied by

commercial banks to their customers through direct advances in the
shape of loans, cash credits and through discounting the credit
papers.

Customers credit
Advances may also be obtained from the customers
against the contracts entered in to the by the enterprise.
Public deposits

Most of the companies in the recent years depend

on these sources to meet their working capital requirements.

Loans from managing director or directors

Sometimes directors of the company provide loans
to the company at very negligible rate of interest.

Government assistance
Central and state government of the country provide short
finances to industries or business by allowing them tax concessions,
sanctioning direct loans or grants to industries or a class of industries
to assist their production programs etc

TOOLS OF ANALYSIS
[1] - RATIO ANALYSIS

Ratio analysis is a technique of analysis and interpretation of

financial statement. It is the process of establishing and interpreting
various ratios for helping in making certain decision. It is only a mean
of better understanding o financial strengths and weakness of the
firm.
A - Advantages of ratio analysis
The following are the main advantages of ratio analysis.
1. Useful Financial Position Analysis
Accounting ratio reveals the financial
position of the concern. This helps the banks, insurance
companies and other financial institutions in lending and making
investment decision.
2. Useful In Simplifying Accounting Figures
Accounting ratio simplify summaries and
systematic the accounting figures in order to make them more
understandable and in lucid form.
3. Useful In Assessing The Operational Efficiency
Accounting ratio helps to have an idea of
the working of the concern. The efficiency of the firm becomes
evident when analysis is based on accounting ratios. They
diagnose the financial health by evaluating liquidity, solvency,
profitability etc this helps the management to asses financial
requirements and the capabilities of various business units.

4. Useful In Comparison Of Performance

Through according ratio comparison can be
made between one departments of a firm with another of the
same firm in order to evaluate the performance of various
departments in the firms.

B - Limitations of Ratio Analysis

The ratio analysis is the one of the important tools of financial

management. Though accounting ratios are simple to calculate and easy to
understand, they suffer from the following limitations.
1. The analyst for the user must have comprehensive but
practical knowledge and experience about the concerns
whose statements have been used for calculating these ratios.
2. The accuracy and correctness of ratio are totally depending on
the reliability of the data contained in financial statement of
the basis which ratios are calculated.
3. When ratios are used in the competitive study of two
concerns, there must be uniformity in the accounting plan
used by both concerns, similarly there must be consistency in
the preparation of financial statements and recording the
transactions from year to year within that concern.
4. The analyst must be able to examine the nature of the data
carefully. If accounting data lack uniformity mainly definitional
uniformity, then ratios calculated on the basis of them will be
misleading.
5. Ratios may make the competitive study complicated and
misleading on account of changes in price level.
6. Ratio analysis is one of the main techniques of analysis and
interpretation. Thus, while attempting to draw any conclusion
on the basis, other techniques should also be used.

CLASSIFICATION OF RATIOS
A - LIQUIDITY RATIOS
1 - CURRENT RATIO
Current ratio may be defined as the relationship between
current asset and current liabilities. This ratio is also known as working
capital ratio. Current ratio analysis of a short term liquidity or financial
position of a firm
CURRENT RATIO =

Current Asset
Current Liabilities

2 - QUICK OR LIQUID RATIO

This is ratio of liquid assets to liquid liabilities; it shows a firms
ability to meet current liabilities with its most liquid assets. 1:1 ratio is

considered ideal ratio for a concern because it is wise to keep the liquid asset
at least equal to liquid liabilities all the time, liquid assets are those assets
which are readily converted into cash and will include cash balance, bills
receivable, Sunday debtors etc
LIQUID RATIO =

Liquid Assets
Current Liabilities

3 - CASH TO CURRENT LIABILITY RATIO

This ratio relates cash with current liabilities. This another way
of looking at the effort of the concern to control cash balances.

CASH TO CURRENT LIABILITY RATIO =

Cash
Current Liabilities

B - ACTIVITY RATIOS
Activity ratios measure the efficiency or effectiveness with which
a firm manages its resources or assets. These ratios are also called turnover
ratios because they indicate the speed with which assets are converted or
turned over into sales.
1 - FIXED ASSETS TURNOVER RATIO
The investment of fixed assets is made for the ultimate purpose
of increasing sales; the ratio of fixed assets is measure of the achievement of
the sales. Sales depends on factors other than fixed assets.
Fixed assets turnover ratio = Net sale / fixed asset
2 - WORKING CAPITAL TURNOVER RATIO
Working capital of a concern is directly related to sales. Working
capital turnover ratio indicates the velocity of the utilization of net working
capital. This ratio indicates the number of times the working capital is turned
over in the course of a year. This ratio measures the efficiency with which the
working capital is being used by a firm.
Working capital turnover ratio = Net sales/ Net working capital

3 - CURRENT ASSETS TO FIXED ASSET RATIO

This may be defined as the relationship between the current assets
and fixed assets.
Current asset to fixed asset ratio = Current assets/Fixed assets
4 - DEBTORS TURNOVER RATIO
Credit is one of the important elements of sales promotion. The volume
of the sales can be increased by following a liberal credit policy. It indicates
the velocity of debt collection of a firm. It indicates the number of times
average debtors are turned over during a year.
Debtors turnover ratio = Net credit sales/ Average trade debtors

Average Collection Period

The average collection period represents the average number of days
for which a firm has to wait before its receivables are converted into
cash.
Average collection period = Number of working days/ Debtors turnover

ratio

C. SOLVENCY RATIOS
1 - PROPRIETORY RATIO OR EQUITY RATIO
This ratio establishes the relationship between shareholders funds to
total assets of the firm. The ratio of proprietors funds to total funds is an
important ratio for determining long term solvency of a firm. The
components of this ratio are shareholders fund and total assets.
Equity ratio = Shareholders fund/Total assets
2 - FIXED ASSETS TO NET WORTH RATIO
This ratio establishes the relationship between fixed assets and
shareholders funds.

Fixed asset to net worth ratio = Fixed assets/ Shareholders fund

3 - RATIO OF CURRENT ASSET TO PROPRIETORS FUNDS
The ratio is calculated by dividing the total of current assets by the
amount of shareholders funds.
Ratio
of
current
assets/Shareholders funds

assets

to

proprietors

fund

Current