Q 2. What do you understand by the term Working Capital?

Why is it required in a business and

how do you determine the requirement of Working Capital in a Business?

Working capital is one of the most difficult financial concepts for the small-business owner
to understand. In fact, the term means a lot of different things to a lot of different people. By
definition, working capital is the amount by which current assets exceed current liabilities.
However, if you simply run this calculation each period to try to analyze working capital, you
won't accomplish much in figuring out what your working capital needs are and how to meet
them.

A more useful tool for determining your working capital needs is the operating cycle. The
operating cycle analyzes the accounts receivable, inventory and accounts payable cycles in
terms of days. In other words, accounts receivable are analyzed by the average number of
days it takes to collect an account. Inventory is analyzed by the average number of days it
takes to turn over the sale of a product (from the point it comes in your door to the point it is
converted to cash or an account receivable). Accounts payable are analyzed by the average
number of days it takes to pay a supplier invoice.

Most businesses cannot finance the operating cycle (accounts receivable days + inventory
days) with accounts payable financing alone. Consequently, working capital financing is
needed. This shortfall is typically covered by the net profits generated internally or by
externally borrowed funds or by a combination of the two.

Most businesses need short-term working capital at some point in their operations. For
instance, retailers must find working capital to fund seasonal inventory buildup between
September and November for Christmas sales. But even a business that is not seasonal
occasionally experiences peak months when orders are unusually high. This creates a need
for working capital to fund the resulting inventory and accounts receivable buildup.

Some small businesses have enough cash reserves to fund seasonal working capital needs.
However, this is very rare for a new business. If your new venture experiences a need for
short-term working capital during its first few years of operation, you will have several
potential sources of funding. The important thing is to plan ahead. If you get caught off
guard, you might miss out on the one big order that could put your business over the hump.

Here are the five most common sources of short-term working capital financing:
 1. Equity. If your business is in its first year of operation and has not yet become
profitable, then you might have to rely on equity funds for short-term working capital
needs. These funds might be injected from your own personal resources or from a
family member, a friend or a third-party investor.

2. Trade creditors. If you have a particularly good relationship established with your
trade creditors, you might be able to solicit their help in providing short-term working
capital. If you have paid on time in the past, a trade creditor may be willing to extend
terms to enable you to meet a big order. For instance, if you receive a big order that
you can fulfill, ship out and collect in 60 days, you could obtain 60-day terms from
your supplier if 30-day terms are normally given. The trade creditor will want proof of
the order and may want to file a lien on it as security, but if it enables you to proceed,
that should not be a problem.

3. Factoring. Factoring is another resource for short-term working capital financing.

Once you have filled an order, a factoring company buys your account receivable and
then handles the collection. This type of financing is more expensive than conventional
bank financing but is often used by new businesses.

4. Line of credit. Lines of credit are not often given by banks to new businesses.
However, if your new business is well-capitalized by equity and you have good
collateral, your business might qualify for one. A line of credit allows you to borrow
funds for short-term needs when they arise. The funds are repaid once you collect the
accounts receivable that resulted from the short-term sales peak. Lines of credit
typically are made for one year at a time and are expected to be paid off for 30 to 60
consecutive days sometime during the year to ensure that the funds are used for short-
term needs only.

5. Short-term loan. While your new business may not qualify for a line of credit from a
bank, you might have success in obtaining a one-time short-term loan (less than a year)
to finance your temporary working capital needs. If you have established a good
banking relationship with a banker, he or she might be willing to provide a short-term
note for one order or for a seasonal inventory and/or accounts receivable buildup.

In addition to analyzing the average number of days it takes to make a product (inventory
days) and collect on an account (accounts receivable days) vs. the number of days financed
by accounts payable, the operating cycle analysis provides one other important analysis.
You can see that working capital has a direct impact on cash flow in a business. Since cash
flow is the name of the game for all business owners, a good understanding of working
capital is imperative to making any venture successful.

11 Determinants of Working Capital |

Financial Management
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Some of the most determinants of working capital are: 1. Nature of business 2.

Length of period of manufacture 3. Volume of business 4. The proportion of the
cost of raw materials to total cost 5. Use of Manual Labour or Mechanisation 6.
Need to keep large stocks of raw materials of finished goods 7. Turnover of
working capital 8. Terms of Credit 9. Seasonal Variations 10. Requirements of
Cash and 11. Other Factors.

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The requirements of working capital are not uniform in all enterprises, and
therefore, factors responsible for a particular size of working capital in one
company are different than in other enterprise.Therefore, a set pattern of factors
determining the optimum size of working capital is difficult to suggest.

1. Nature of business:
It is an important factor for determining the amount of working capital needed by
various companies. The trading or manufacturing concerns will require more
amount of working capital along-with their fixed investment of stock, raw
materials and finished products.
Public utilities and railway companies with huge fixed investment usually have the
lowest needs for current assets, partly because of cash, nature of their business
and partly due to their selling a service instead of a commodity. Similarly, basic
and key industries or those engaged in the manufacture of producer’s goods
usually have less proportion of working capital to fixed capital than industries
producing consumer goods.

2. Length of period of manufacture:

The average length of the period of manufacture, i.e., the time which elapses
between the commencement and end of the manufacturing process is an
important factor in determining the amount of the working capital.

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If it takes less time to make the finished product, the working capital required will
be less. To give an example, a baker requires one night time to bake his daily
quota of bread. His working capital is, therefore, much less than that of a ship-
building concern which takes three to five years to build a ship. Between these two
cases may fall other business concerns with varying periods of manufacture
requiring different amounts of working capital.

3. Volume of business:
Generally, the size of the company has a direct relation with the working capital
needs. Big concerns have to keep higher working capital for investment in current
assets and for paying current liabilities.

4. The proportion of the cost of raw materials to total cost:

Where the cost of raw materials to be used in manufacturing of a product is very
large in proportion to the total cost and its final value, working capital required
will also be more.
That is why, in a cotton textile mill or in a sugar mill, huge funds are required for
this purpose. A building contractor also needs huge working capital for this
reason. If the importance of materials is less, as for example in an oxygen
company, the needs of working capital will be naturally not more.

5. Use of Manual Labour or Mechanisation:

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In labour intensive industries, larger working capital will be required than in the
highly mechanized ones. The latter will have a large proportion of fixed capital. It
may be remembered, however, that to some extent the decision to use manual
labour or machinery lies with the management. Therefore, it is possible in most
cases to reduce the requirements of working capital and increase investments in
fixed assets and vice versa.

6. Need to keep large stocks of raw materials of finished goods:

The manufacturing concerns generally have to carry stocks of raw materials and
other stores and also finished goods. The larger the stocks (whether of raw
materials or finished goods) more will be the needs of working capital.

In certain lines of business, e.g., where the materials are bulky and have to be
purchased in large quantities, (as in cement manufacturing), stock piling of raw-
material is used.

Similarly, in public utilities, which must have adequate supplies of coal to assure
regular service, stock piling of coal is necessary. In seasonal industries finished
goods stocks have to be stored during off seasons. All these require large working
capital.

7. Turnover of working capital:

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Turnover means the speed with which the working capital is recovered by the sale
of goods. In certain businesses, sales are made quickly and the stocks are soon
exhausted and new purchases have to be made. In this manner, a small amount of
money invested in stocks will result in sales of much larger amount.

Considering the volume of sales, the amount of working capital requirements will
be rather small in such type of business. There are other businesses where sales
are made irregularly. For example, in case of jewellers, a costly jewellery may
remain locked up in the show-window for a long period before it catches the fancy
of a rich lady.

In such cases, large sums of money have to be kept invested in stocks. But a baker
or a news-hawker may be able to dispose of his stocks quickly, and may, therefore,
need much smaller amounts by way of working capital.

8. Terms of Credit:
A company purchasing all raw-materials for cash and selling on credit will be
requiring more amount of working capital. Contrary to this, if the enterprise is in
a position to buy on credit and sell it for cash, it will need less amount of working
capital. The length of the period of credit has a direct bearing on working capital.

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The essence of this is that the period which elapses between the purchase of
materials and sale of finished goods and receipts of sale proceeds, will determine
the requirements of working capital.

9. Seasonal Variations:
There are some industries which either produce goods or make sales only
seasonally. For example, the sugar industry produces practically all the sugar
between December and April and the woollen textile industry makes its sales
generally during winter.

In both these cases the needs of working capital will be very large, during few
months {i.e., season). The working capital requirements will gradually decrease as
and when the sales are made.

10. Requirements of Cash:

The need to have cash in hand to meet various requirements e.g., payment of
salaries, rents, rates etc., has an effect on the working capital. The more the cash
requirements the higher will be working capital needs of the company and vice
versa.

11. Other Factors:

In addition to the above mentioned considerations there are also a number of
other factors which affect the requirements of working capital. Some of them are
given below.

(i) Degree of co-ordination between production and distribution policies.

(ii) Specialisation in the field of distribution.

(iii) Developments of means of transportation and communications.

(iv) The hazards and contingencies inherent in the type of business.

Proper management of working capital is essential to a company’s fundamental

financial health and operational success as a business. A hallmark of good
business management is the ability to utilize working capital management to
maintain a solid balance between growth, profitability and liquidity.
A business uses working capital in its daily operations; working capital is the
difference between a business's current assets and current liabilities or debts.
Working capital serves as a metric for how efficiently a company is operating and
how financially stable it is in the short-term. The working capital ratio, which
divides current assets by current liabilities, indicates whether a company has
adequate cash flow to cover short-term debts and expenses.

The Importance of Working Capital

Working capital is a daily necessity for businesses, as they require a regular

amount of cash to make routine payments, cover unexpected costs, and purchase
basic materials used in the production of goods. Working capital is an easily
understandable concept, as it is linked to an individual’s cost of living and, thus,
can be understood in a more personal way. Individuals need to collect the money
that they are owed and maintain a certain amount on a daily basis to cover day-to-
day expenses, bills and other regular expenditures.

Working capital is a prevalent metric for the efficiency, liquidity and overall
health of a company. It is a reflection of the results of various company activities,
including revenue collection, debt management, inventory management and
payments to suppliers. This is because it includes inventory, accounts payable and
receivable, cash, portions of debt due within the period of a year and other short-
term accounts.
The needs for working capital vary from industry to industry, and they can even
vary among similar companies. This is due to several factors, including differences
in collection and payment policies, the timing of asset purchases, the likelihood of
a company writing off some of its past-due accounts receivable, and in some
instances, capital-raising efforts a company is undertaking.

The Importance of Working Capital Management

When a company does not have enough working capital to cover its obligations,
financial insolvency can result and lead to legal troubles, liquidation of assets and
potential bankruptcy. Thus, it is vital to all businesses to have adequate
management of working capital.

Working capital management is essentially an accounting strategy with a focus on

the maintenance of a sufficient balance between a company’s current assets and
liabilities. An effective working capital management system helps businesses not
only cover their financial obligations but also boost their earnings.

Managing working capital means managing inventories, cash, accounts payable

and accounts receivable. An efficient working capital management system often
uses key performance ratios, such as the working capital ratio, the inventory
turnover ratio and the collection ratio, to help identify areas that require focus in
order to maintain liquidity and profitability.

The advantages of having adequate working capital may be summarised:

1. Smooth Flow of Production:

To maintain a smooth flow of production, it is necessary that adequate working

capital is available for paying trade suppliers, hiring labour and incurring other
operating expenses.

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.

6. Regular Payment of Wages and Salaries:

The firm can make regular and timely payment of wages and salaries to its
employees. This increases the morale and efficiency of employees.

7. Security and Confidence:

It creates a sense of security and confidence in the mind of management or

officials of the firm.

8. Efficient Use of Fixed Assets:

Adequate amount of working capital enables the firm to use its fixed assets more
efficiently and extensively. If the fixed assets remain idle due to paucity of
working capital, depreciation of fixed assets and interest on borrowed capital
invested in fixed assets will have to be incurred unnecessarily.

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.