DEFINITION OF WORKING CAPITAL
Working capital may be defined in two ways, either as the total of current assets or as the difference between the total of current assets and total of current liabilities.
Like, most other financial terms the concept of working capital is used in different connotations by different writers. Thus, there emerged the following two concepts of working capital.
i) Gross concept of working capital
ii) Net concept of working capital
Gross concept:
No special distinction is made between the terms total current assets and working capital by authors like Mehta, Archer, Bogen, Mead and Baker. According to them working capital is nothing but the total of current assets for the following reasons:
i) Profits are earned with the help of the assets which are partly fixed and partly current. To a certain degree, similarity can be observed in fixed and current assets in that both are partly borrowed and yield profit over and above the interest costs. Logic then demands that current assets should be taken to mean the working capital of the corporation.
ii) With every increase in funds, the gross working capital will increase while according to the net concept of working capital there will be no change in the funds available for the operating manager.
iii) The management is more concerned with the total current assets as they constitute the total funds available for operating purposes than with the sources from which the funds came, and that
iv) The net concept of working capital had relevance when the form of organisation was single entrepreneurship or partnership. In other words a close contact was involved between the ownership, management and control of the enterprise and consequently the ownership of current and fixed assets is not given so much importance as in the past.
Net concept:
Contrary to the aforesaid point of view, writers like Smith, Guthmann and Dongall. Howard and Gross, consider working capital as the mere difference between current assets and current liabilities. According to Keith. V. Smith, a broader view of working capital would also include current liabilities such as accounts payable, notes payable and other accruals. In his opinion, working capital management involves the managing of individual current liabilities and the managing of all inter-relationships that link current assets with current liabilities and other balance sheet accounts. The net concept is advocated for the following reasons:
i) in the long-run what matters is the surplus of current assets over current liabilities.
ii) it is this concept which helps creditors and investors to judge the financial soundness of the enterprise.
iii) what can always be relied upon to meet the contingencies is the excess of current assets over current liabilities, since it is not to be returned; and
iv) this definition helps to find out the correct financial position of companies having the same amount of current assets.
In general, the gross concept is referred to as the Economics concept, since assets are employed to derive a rate of return. What rate of return is generated by different assets is more important than the analysed difference between assets and liabilities. On the contrary, the net concept is said to be the point of view of an accountant. In this sense, working capital is viewed as a liquidation concept.
Therefore, The solvency of the firm is seen from the point of view of this difference Generally, lenders and creditors view this as the most pertinent approach to the problem of working capital.
DETERMINANTS OF WORKING CAPITAL
There are no set rules or formulas to determine the working capital requirements of a firm. The corporate management has to consider a number of factors to determine the level of working capital. The amount of working capital that a firm would need is affected not only by the factors associated with the firm itself but is also affected by economic, monetary and general business environment. Among the various factors the following are important ones.
Nature and Size of Business
The working capital needs of a firm are basically influenced by the nature of its business. Trading and financial firms generally have a low investment in fixed assets, but require a large investment in working capital. Retail stores, for example, must carry large stocks of a variety of merchandise to satisfy the varied demand of their customers. Some manufacturing businesses' like tobacco, and construction firms also have to invest substantially in working capital but only a nominal amount in fixed assets. In contrast, public utilities have a limited need for working capital and have to invest abundantly in fixed assets. Their working capital requirements are nominal because they have cash sales only and they supply services, not products. Thus, the amount of funds tied up with debtors or in stocks is either nil or very small. The working capital needs of most of the manufacturing concerns fall between the two extreme requirements of trading firms and public utilities.
The size of business also has an important impact on its working capital needs. Size may be measured in terms of the scale of operations. A firm with larger scale of operations will need more working capital than a small firm. The hazards and contingencies inherent in a particular type of business also have an influence in deciding the magnitude of working capital in terms of keeping liquid resources.
Manufacturing Cycle
The manufacturing cycle starts with the purchase of raw materials and is completed with the production of finished goods. If the manufacturing cycle involves a longer period the need for working capital will be more, because an extended manufacturing time span means a larger tie-up of funds in inventories. Any delay at any stage of manufacturing process will result in accumulation of work-in-process and will enhance the requirement of working capital. You may have observed that firms making heavy machinery or other such products, involving long manufacturing cycle, attempt to minimise their investment in inventories (and thereby in working capital) by seeking advance or periodic payments from customers.
Business Fluctuations
Seasonal and cyclical fluctuations in demand for a product affect the working capital requirement considerably, especially the temporary working capital requirements of the firm. An upward swing in the economy leads to increased sales, resulting in an increase in the firm's investment in inventory and receivables or book debts. On the other hand, a decline in the economy may register a fall in sales and, consequently, a fall in the levels of stocks and book debts.
Seasonal fluctuations may also create production problems. Increase in production level may be expensive during peak periods. A firm may follow a policy of steady production in all seasons to utilise its resources to the fullest extent. This will mean accumulation of inventories in off-season and their quick disposal in peak season. Therefore, financial arrangements for seasonal working capital requirement should be made in advance. The financial plan should be flexible enough to take care of any seasonal fluctuations.
Production Policy
If a firm follows steady production policy, even when the demand is seasonal, inventory will accumulate during off-season periods and there will be higher inventory costs and risks. If the costs and risks of maintaining a constant production schedule are high, the firm may adopt the policy of varying its production schedule in accordance with the changes in demand. Firms whose physical facilities can be utilised for manufacturing a variety of products can have the advantage of diversified activities. Such firms manufacture their main products during the season and other products during off-season. Thus, production policies may differ from firm to firm, depending upon the circumstances. Accordingly, the need for working capital will also vary.
Turnover of Circulating Capital
The speed with which the operating cycle completes its round (i.e., cash → raw materials → finished product → accounts receivables → cash) plays a decisive role in influencing the working capital needs. (Refer to Figure 1(.1 on operating cycle).
Credit Terms
The credit policy of the firm affects the size of working capital by influencing the level of book debts. Though the credit terms granted to customers to a great extent depend upon the norms and practices of the industry or trade to which the firm belongs; yet it may endeavor to shape its credit policy within such constraints. A long collection period will generally mean tying of larger funds in book debts. Slack collection procedures may even increase the chances of bad debts.
The working capital requirements of a firm are also affected by credit terms granted by its creditors. A firm enjoying liberal credit terms will need less working capital.
Growth and Expansion Activities
As a company grows, logically, larger amount of working capital will be needed, though it is difficult to state any firm rules regarding the relationship between growth in the volume of a firm's business and its working capital needs. The fact to recognize is that the need for increased working capital funds may precede the growth in business activities, rather than following it. The shift in composition of working capital in a company may be observed with changes in economic circumstances and corporate practices. Growing industries require more working capital than those that are static.
Operating Efficiency
Operating efficiency means optimum utilisation of resources. The firm can minimise its need for working capital by efficiently controlling its operating costs. With increased operating efficiency the use of working capital is improved and pace of cash cycle is accelerated. Better utilisation of resources improves profitability and helps in relieving the pressure on working capital.
Price Level Changes
Generally, rising price level requires a higher investment in working capital. With increasing prices the same levels of current assets need enhanced investment. However, firms which can immediately revise prices of their products upwards may not face a severe working capital problem in periods of rising levels. The effects of increasing price level may, however, be felt differently by different firms due to variations in individual prices. It is possible that some companies may not be affected by the rising prices, whereas others may be badly hit by it.
Other Factors
There are some other factors, which affect the determination of the need for working capital. A high net profit margin contributes towards the working capital pool. The net profit is a source of working capital to the extent it has been earned in cash. The cash inflow can be calculated by adjusting non-cash items such as depreciation, outstanding expenses, losses written off, etc, from the net profit.
The firm's appropriation policy, that is, the policy to retain or distribute profits also has a bearing on working capital. Payment of dividend consumes cash resources and thus reduces the firm ',s working capital to that extent. If the profits
In general, working capital needs also depend upon the means of transport and communication. If they are not well developed, the industries will have to keep huge stocks of raw materials, spares, finished goods, etc. at places of production, as well as at distribution outlets.
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