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 material, for meeting day-to-day expenditure on
salaries, wages, rents rates, advertising etc.
DEFINITION
Working capital refers to the circulating capital required to meet the day to day operations of a
business firm. Working capital refers to a firms investment in short term assets, such as cash
amounts receivables, inventories etc.
Working capital is defined as the excess of current assets over current liabilities and
provisions. But as per accounting terminology, it is difference between the inflow and outflow
of funds.
The term working capital is often referred to circulating capital which is frequently used to
denote those assets which are changed with relative speed from one form to another i.e., starting
from cash, changing to raw materials, converting into work-in-progress and finished products,
sale of finished products and ending with realization of cash from debtors.
The goal of working capital management is to manage the firms current assets
and liabilities in such a way that a satisfactory level of working capital is maintained.
This is so because if the firm cannot maintain a satisfactory level of working capital, it is
likely to become insolvent and may even be forced into bankruptcy. The current assets
should be large enough to cover its current liabilities in order to ensure a reasonable
margin of safety.
The interaction between current assets and current liabilities is, therefore, the main theme of the
theory of working management.
Working capital has been described as the life blood of any business which is apt because it
constitutes a cyclically flowing stream through the business
Concept of Working Capital Management
There are two concepts of working capital viz. quantitative and qualitative. Some people also
define the two concepts as gross concept and net concept. According to quantitative concept, the
amount of working capital refers to total of current assets. The qualitative concept gives an idea
regarding source of financing capital. According to qualitative concept the amount of working
capital refers to excess of current assets over current liabilities.
L.J. Guthmann defined working capital as the portion of a firms current assets which are
financed from longterm funds.
The excess of current assets over current liabilities is termed as Net working capital. In this
concept Net working capital represents the amount of current assets which would remain if all
current liabilities were paid. Both the concepts of working capital have their own points of
importance.
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If the objectives is to measure the size and extent to which current assets are being used, Gross
concept is useful; whereas in evaluating the liquidity position of an undertaking Net concept
becomes pertinent and preferable.
Current Assets
Current assets are those assets which can be converted into cash quickly and easily. These are
those types of assets which can be converted into cash as and when required. Examples of
current assets are cash in hand, cash at bank, debtors, working inventory and marketable
securities.
Current Liabilities
These are those types of liabilities which have to be paid in near future. The payment date is not
fixed but it can be mature any time. Long term debt will never be considered as current
liabilities, even if it has to be paid tomorrow. Examples of current liabilities are: Bills payable,
creditors etc.

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Circulation of Working Capital

At one given time both the current assets and current liabilities exist in the business. The current
assets and current liabilities are flowing round in a business like an electric current. However,
The working capital plays the same role in the business as the role of heart in human body.
Working capital funds are generated and these funds are circulated in the business. As and when
this circulation stops, the business becomes lifeless. It is because of this reason that he working
capital is known as the circulating capital as it circulates in the business just like blood in the
human body.

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Gross working capital refers to the firms investment in current assets. Current
assets are the assets which can be converted into cash within an accounting
year and include cash, short-term securities, debtors, (accounts receivable or
book debts) bills receivable and stock (inventory).

Gross work capital = total current assets

Net working capital refers to the difference between current assets and current
liabilities, Current liabilities are those claims of outsiders which are expected to
mature for payment within an accounting year and include creditors (accounts
payable), bills payable, and outstanding expenses. Net working capital can be
positive or negative. A positive net working capital will arise when current assets
exceed current liabilities are in excess of current assets.

Net working capital = current assets current liabilities

NEED FOR WORKING CAPITAL
The need for working capital (gross) or current assets cannot be
overemphasized. Given the objective of financial decision making to maximize the
shareholders wealth, it is necessary to generate sufficient profits. The extent to which
profits can be earned will naturally depend, among other thins, upon the magnitude of
the sales. A successful sales programmed is, in other words necessary for earning
profits by any business enterprise. However, sales do not convert into cash instantly;
there is invariably a time-lag between the sale of goods and the receipt of cash. There
is, therefore, a need for working capital in the form of current assets to deal with the
problem arising out of the lack of immediate realization of cash against goods sold.
Therefore, sufficient working capital is necessary to sustain sales activity.
Technically, this is referred to as the operating or cash cycle. The operating cycle
can be said to be at the heart of the need for work capital. The continuing flow from
cash to suppliers, to inventory, to accounts receivable and back into cash is what is
called the operating cycle.
In others words, the term cash cycle refers to the length of
time necessary to complete the following cycle of events.
1. Conversion of cash into inventory;
2. Conversion of inventory into receivables;
3. Conversion of receivables into cash.
Working Capital Management is a managerial accounting strategy whose main focus is
maintaining the proficient level current assets and current liabilities in respect to each

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other. The management makes sure that the companys cash structure is to pay off
operating expenses and short term liabilities.
By implementing an effective system of working capital management the companies
can improve their earnings.

There are various factors affecting the composition of Working Capital:

- Type of Industry to which entity belongs
- Competitiveness
- Availability of raw material used and nature of finished goods
- Stages of Growth and Expansion Working capital can be divided into two types
- Permanent Working Capital
- Temporary Working Capital
Both types of capital are necessary to facilitate the sales and production process through
operating cycle.
Working Capital = Current Assets Currents Liabilities

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PERNAMENT WORKING CAPITAL: Permanent of fixed working capital is the

minimum amount which is required to ensure effective utilization of fixed facilities and
for maintaining the circulation of current assets. There is always a minimum level of
current assets, which is continuously required by the enterprise to carry cut its normal
business operations. For example, every firm has to maintain a minimum level of raw
materials, work-in-process, finished goods and cash balance. This minimum level of
current assets is called permanent or fixed working capital as this part of capital is
permanently blocked in current assets. As the business grows the requirements of
permanent working capital also increase due to the increase in current assets.
The permanent working capital can further be classified as regular working capital and
reserve working capital required ensuring circulation of current assets from cash to
inventories, from inventories to receivables and from receivables to cash and so on.
i. Regular working Capital: This is the amount of working capital required for the
continuous operations of an enterprise. It refers to the excess of current
assets over current liabilities. Any organization has to maintain a
minimum stock of materials, finished goods and case to ensure its smooth
work and to meet its immediate obligations.
ii. Reserve Working Capital : Reserve working capital is the excess amount over
the requirement for regular working capital which may be provided for
contingencies that may arise at unstated period such as strikes, rise in prices,
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depression, etc.
Temporary or Variable Working Capital: Temporary or variable working capital is
the amount of working capital which is required to meet the seasonal demands and
some special exigencies. Variable working capital can be further classified as seasonal
working capital and special working capital.
i. Seasonal Working Capital: Seasonal working capital is required to meet the
seasonal needs of the enterprise such as a textile dealer would require large
amount of funds a few months before Diwali.
ii. Special Working Capital : Special working capital is that part of working capital
which is required to meet special exigencies such as launching of extensive
marketing campaigns for conducting research, etc.
Temporary working capital differs from permanent working capital in the sense
that it is required for short periods and cannot be permanently employed gainfully in the
business.

Distinction between permanent and temporary working capital

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Operating Cycle
The duration of time required to complete the following sequence of events, in case of
manufacturing firm, is called the operating cycle:
1. Conversion of cash into raw materials.
2. Conversion of raw materials into work-in-progress.
3. Conversion of work in process into finished goods.
4. Conversion of finished goods into debtors and bills receivables through sales.
5. Conversion of debtors and bills receivables into cash.
The length of cycle will depend on the nature of business. Non manufacturing concerns,
service concerns and financial concerns will not have raw material and work-in-process so their
cycle will be shorter. Financial Concerns have a shortest operating cycle.

1. Operating cycle of Manufacturing firm

2. Operating cycle of Non Manufacturing firm

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Importance or Advantages of Adequate Working Capital

Working capital is the life blood and nerve centre of a business. Just as circulation of blood is
essential in the human body for maintaining life, working capital is very essential to maintain the
smooth running of a business. No business can run successfully without an adequate amount of
working capital. The main advantages of maintaining adequate amount of working capital are as
follows:
1. Solvency of the business: Adequate working capital helps in maintaining solvency of the
business by providing uninterrupted flow of production.
2. Goodwill: Sufficient working capital enables a business concern to make prompt payments
and hence helps in creating and maintaining goodwill.
3. Easy loans: A concern having adequate working capital, high solvency and good credit
standing can arrange loans from banks and other on easy and favourable terms.
4. Cash Discounts: Adequate working capital also enables a concern to avail cash
discounts on the purchases and hence it reduces costs.
5. Regular supply of raw materials: Sufficient working capital ensures regular supply of raw
materials and continuous production.
6. Regular payment of salaries, wages and other day-to-day commitments: A company
which has ample working capital can make regular payment of salaries, wages and other day-today commitments which raises the morale of its employees, increases their efficiency, reduces
wastages and costs and enhances production and profits.

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7. Exploitation of favourable market conditions: Only concerns with adequate working capital
can exploit favourable market conditions such as purchasing its requirements in bulk when the
prices are lower and by holding its inventories for higher prices.
8. Ability to face Crisis: Adequate working capital enables a concern to face business crisis in
emergencies such as depression because during such periods, generally, there is much pressure
on working capital.
9. Quick and Regular return on Investments: Every Investor wants a quick and regular return
on his investments. Sufficiency of working capital enables a concern to pay quick and regular
dividends to its investors as there may not be much pressure to plough back profits. This gains
the confidence of its investors and creates a favourable market to raise additional funds i.e., the
future.
10. High morale: Adequacy of working capital creates an environment of security,
confidence, high morale and creates overall efficiency in a business.

Excess or Inadequate Working Capital

Every business concern should have adequate working capital to run its business operations. It
should have neither redundant or excess working capital nor inadequate or shortage of working
capital. Both excess as well as short working capital positions are bad for any business.
However, out of the two, it is the inadequacy of working capital which is more dangerous from
the point of view of the firm.

Disadvantages of Redundant or Excessive Working Capital

1. Excessive Working Capital means ideal funds which earn no profits for the business and hence
the business cannot earn a proper rate of return on its investments.
2. When there is a redundant working capital, it may lead to unnecessary purchasing and
accumulation of inventories causing more chances of theft, waste and losses.
3. Excessive working capital implies excessive debtors and defective credit policy which may
cause higher incidence of bad debts.
4. It may result into overall inefficiency in the organization.
5. When there is excessive working capital, relations with banks and other financial institutions
may not be maintained.
6. Due to low rate of return on investments, the value of shares may also fall.
7. The redundant working capital gives rise to speculative transactions.

The working capital needs of a business are influenced by numerous factors.

The important ones are discussed in brief as given below:

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POLICIES FOR FINANCEING CURRENT

ASSETS/Sources of working capital
A firm can adopt different policies vis--vis current assets. Three types of financing may
be distinguished:
1. Long-term financing : The sources of long-term financing include ordinary share
capital, preference share capital, debenture, long-term borrowings from financial
institutions and reserves and surplus (retained earnings).
2. Short-term financing : The short-term financing is obtained for a period less
than one year. It is arranged in advance from banks and other suppliers of short
term finance in the money market. Short-term finance includes working capital
funds from banks, public deposits, commercial paper, factoring of receivable etc.
3. Spontaneous financing : Spontaneous financing refers to the automatic sources
of short-term funds arising in the normal course of a business. Trade (suppliers)
credit and outstanding expenses are examples of spontaneous financing. There
is no explicit cost of spontaneous financing. A firm is expected to utilize these
sources of finances to the fullest extent. The real choice of financing current
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assets, once the spontaneous sources of financing have been fully utilized, is
between the long-term and short-term sources of finances.

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