3.

7 CONCEPT OF WORKING CAPITAL: The concept of working capital is basically divided into 2 categories
1. BALANCE SHEET OR TRADITIONAL CONCEPT:

It shows the positions of the firm at certain point of time. It is calculated in the basis of balance sheet prepare at a specific date. The Balance Sheet summarized the operations of a company from its inception to the date of the balance sheet report. Working Capital relates to the means the company has to operate and consist of different elements of the balance sheet such as Cash, Accounts Receivable, Loans, Financing and related items that can be used as working capital for operations. In this method there are two type of working capital: GROSS WORKING CAPITAL NET WORKING CAPITAL GROSS WORKING CAPITAL: It refers to the firms investments in current assets. The sum of the current assets is the working capital of the business. The sum of the current assets is a quantitative aspect of working capital. Which emphasizes more on quantity than its quality, but it fails to revail the true financial position of the firm because every increase in current liabilities will decrease the gross working capital. Gross working capital is the total of all current assets NET WORKING CAPITAL: It is the difference between current assets and current liabilities or the excess of total current assets over total current liabilities. It is also defined as that part of a firms current assets which is financed with long term funds. It may be either

positive or negative. When the current assets exceed the current liability, the working capital is positive and vice versa. Net working capital=Excess of current asset over current liabilities Net working capital=current assets-current liabilities

COMPONENT OF WORKING CAPITAL

PENDING

Working Capital Cycle What It Measures : The working capital cycle measures the amount of time that elapses between the moment when your business begins investing money in a product or service, and the moment the business receives payment for that product or service. This doesnt necessarily begin when you manufacture a productbusinesses often invest money in products when they hire people to produce goods, or when they buy raw materials. Why It Is Important A good working capital cycle balances incoming and outgoing payments to maximize working capital. Simply put, you need to know you can afford to research, produce, and sell your product. A short working capital cycle suggests a business has good cash flow. For example, a company that pays contractors in 7 days but takes 30 days to collect payments has 23 days of working capital to fundalso known as having a working capital cycle of 23 days. Amazon.com, in contrast, collects money before it pays for goods. This means the company has a negative working capital cycle and has more capital available to fund growth. For a business to grow, it needs access to cashand being able to free up cash from the working capital cycle is cheaper than other sources of finance, such as loans. How It Works in Practice The key to understanding a companys working capital cycle is to know where payments are collected and made, and to identify areas where the cycle is stretched and can potentially be reduced. The working capital cycle is a diagram rather than a mathematical calculation. The cycle shows all the cash coming in to the business, what it is used for, and how it leaves the business (i.e., what it is spent on). A simple working capital cycle diagram is shown in Figure 1. The arrows in the diagram show the movement of assets through the businessincluding cash, but also other assets such as raw materials and finished goods. Each item represents a

reservoir of assetsfor example, cash into the business is converted into labor. The working capital cycle will break down if there is not a supply of assets moving continually through the cycle (known as a liquidity crisis).

Cash in

Goods Sold

Payment to suppliers / Employees / cash

Goods produced

Figure 1. A simple working capital cycle diagram The working capital diagram should be customized to show the way capital moves around your business. More complex diagrams might include incoming assets such as cash payments, interest payments, loans,

and equity. Items that commonly absorb cash would be labor, inventory, and suppliers. The key thing to model is the time lag between each item on the diagram. For some businesses, there may be a very long delay between making the product and receiving cash from sales. Others may need to purchase raw materials a long time before the product can be manufactured. Once you have this information, it is possible to calculate your total working capital cycle, and potentially identify where time lags within the cycle can be reduced or eliminated. Tricks of the Trade For investors, the working capital cycle is most relevant when analyzing capitalintensive businesses where cash flow is used to buy inventory. Typically, the working capital cycle of retailers, consumer goods, and consumer goods manufacturers is critical to their success. The working capital cycle should be considered alongside the cash conversion cyclea measure of working capital efficiency that gives clues about the average number of days that working capital is invested in the operating cycle.

Principles of Working Capital Management:The following are the principles of working capital management: Principles of the risk variation Risk here refers to the inability of firm to maintain sufficient current assets to pay its obligations. If working capital is varied relative to sales, the amount of risk that a firm assumes is also varied and the opportunity for gain or loss is increased. In other words, there is a definite relationship between the degree of risk and the rate of return. As a firm assumes more risk, the opportunity for gain or loss increases. As the level of working capital relative to sales decreases, the degree of risk increases. When the degree of risk increases, the opportunity for gain and loss also increases. Thus, if the level of working capital goes up, amount of risk goes down, and vice-versa, the opportunity for gain is like-wise adversely affected. Principle of equity position According to this principle, the amount of working capital invested in each component should be adequately justified by a firms equity position. Every rupee invested in the working capital should contribute to the net worth of the firm. Principle of cost of capital This principle emphasizes that different sources of finance have different cost of capital. It should be remembered that the cost of capital moves inversely with risk. Thus, additional risk capital results in decline in the cost of capital. Principle of maturity of payment A company should make every effort to relate maturity of payments to its flow of internally generated funds. There should be the least disparity between the maturities of a firms short-term debt instruments and its flow of internally generated funds, because a greater risk is generated with greater disparity. A margin of safety should, however, be provided for any short-term debt payment.