Working Capital 3rd Sem
Content
A measure of both a company's efficiency and its short-term financial health. The working capital ratio is calculated as:
This ratio indicates whether a company has enough short term assets to cover its short term debt.
If a company's current assets do not exceed its current liabilities, then it may run into trouble paying back creditors in the short term. The worst-case scenario is bankruptcy. Working capital also gives investors an idea of the company's underlying operational efficiency.
Need And Importance Of Working Capital
Working capital is the life blood and nerve center of business. Working capital is very essential to maintain smooth running of a business. No business can run successfully without an adequate amount of working capital. The main advantages or importance of working capital are as follows: 1. Strengthen The Solvency Working capital helps to operate the business smoothly without any financial problem for making the payment of short-term liabilities. Purchase of raw materials and payment of salary, wages and overhead can be made without any delay. Adequate working capital helps in maintaining solvency of the business by providing uninterrupted flow of production. 2. Enhance Goodwill Sufficient working capital enables a business concern to make prompt payments
and hence helps in creating and maintaining goodwill. Goodwill is enhanced because all current liabilities and operating expenses are paid on time. 3. Easy Obtaining Loan A firm having adequate working capital, high solvency and good credit rating can arrange loans from banks and financial institutions in easy and favorable terms. 4. Regular Supply Of Raw Material Quick payment of credit purchase of raw materials ensures the regular supply of raw materials fro suppliers. Suppliers are satisfied by the payment on time. It ensures regular supply of raw materials and continuous production. 5. Smooth Business Operation Working capital is really a life blood of any business organization which maintains the firm in well condition. Any day to day financial requirement can be met without any shortage of fund. All expenses and current liabilities are paid on time. 6. Ability To Face Crisis Adequate working capital enables a firm to face business crisis in emergencies such as depression.
Factors Affecting Working Capital Or Determinants Of Working Capital
Requirements Of working capital depend upon various factors such as nature of business, size of business, the flow of business activities. However, small organization relatively needs lesser working capital than the big business organization. Following are the factors which affect the working capital of a firm: 1. Size Of Business Working capital requirement of a firm is directly influenced by the size of its
business operation. Big business organizations require more working capital than the small business organization. Therefore, the size of organization is one of the major determinants of working capital. 2. Nature Of Business Working capital requirement depends upon the nature of business carried by the firm. Normally, manufacturing industries and trading organizations need more working capital than in the service business organizations. A service sector does not require any amount of stock of goods. In service enterprises, there are less credit transactions. But in the manufacturing or trading firm, credit sales and advance related transactions are in large amount. So, they need more working capital. 3. Storage Time Or Processing Period Time needed for keeping the stock in store is called storage period. The amount of working capital is influenced by the storage period. If storage period is high, a firm should keep more quantity of goods in store and hence requires more working capital. Similarly, if the processing time is more, then more stock of goods must be held in store as work-in-progress. 4. Credit Period Credit period allowed to customers is also one of the major factors which influence the requirement of working capital. Longer credit period requires more investment in debtors and hence more working capital is needed.But, the firm which allows less credit period to customers needs less working capital. 5. Seasonal Requirement In certain business, raw material is not available throughout the year. Such business organizations have to buy raw material in bulk during the season to ensure an uninterrupted flow and process them during the entire year. Thus, a huge amount is blocked in the form of raw material inventories which gives rise to more working capital requirements.
6. Potential Growth Or Expansion Of Business If the business is to be extended in future, more working capital is required. More amount of working capital is required to meet the expansion need of business. 7. Changes In Price Level Change in price level also affects the working capital requirements. Generally, the rise in price will require the firm to maintain large amount of working capital as more funds will be required to maintain the sale level of current assets. 8. Dividend Policy The dividend policy of the firm is an important determinant of working capital. The need for working capital can be met with the retained earning. If a firm retains more profit and distributes lower amount of dividend, it needs less working capital. 9. Access To Money Market If a firm has good access to capital market, it can raise loan from bank and financial institutions. It results in minimization of need of working capital. 10. Working Capital Cycle When the working capital cycle of a firm is long, it will require larger amount of working capital. But, if working capital cycle is short, it will need less working capital. 11. Operating Efficiency The operating efficiency of a firm also affects the firm's need of working capital. The operating efficiency of the firm results in optimum utilization of assets. The optimum utilization of assets in turn results in more fund release for working capital.
Working Capital Cycle/Operating Cycle A continuous process starting from payment of cash for purchasing raw material , production , stocking , selling until obtaining money from debtors.
It is a cycle involving—- conversion of cash into raw material > conversion of raw material into WIP > conversion of WIP into Finished goods> conversion of Finished goods into cash /debtors and > conversion of debtors into cash.
OC = R+W+F+D-C Ie. Duration of Operating Cycle = Raw mat. period+WIP period +Finished goods period +Debtors collection period –Creditors payment period
CALCULATION OF W. CAP . CYCLE i) Raw Mat. Stock Holding Period = R.Mat. Stock X 365 days Annual Purchases
+ ii) WIP duration Cost of Prodn. + iii) Finished Goods Stock Holding Period = Finished Goods Stock X 365 days Cost of Goods Sold + iv) Debtors Collection Period = Debtors Credit Sales X 365 days = WIP stock X 365 days
LESS : i) Creditors Payment Period = Creditors Credit Purchases X 365 days
This ratio indicates whether a company has enough short term assets to cover its short term debt.
If a company's current assets do not exceed its current liabilities, then it may run into trouble paying back creditors in the short term. The worst-case scenario is bankruptcy. Working capital also gives investors an idea of the company's underlying operational efficiency.
Need And Importance Of Working Capital
Working capital is the life blood and nerve center of business. Working capital is very essential to maintain smooth running of a business. No business can run successfully without an adequate amount of working capital. The main advantages or importance of working capital are as follows: 1. Strengthen The Solvency Working capital helps to operate the business smoothly without any financial problem for making the payment of short-term liabilities. Purchase of raw materials and payment of salary, wages and overhead can be made without any delay. Adequate working capital helps in maintaining solvency of the business by providing uninterrupted flow of production. 2. Enhance Goodwill Sufficient working capital enables a business concern to make prompt payments
and hence helps in creating and maintaining goodwill. Goodwill is enhanced because all current liabilities and operating expenses are paid on time. 3. Easy Obtaining Loan A firm having adequate working capital, high solvency and good credit rating can arrange loans from banks and financial institutions in easy and favorable terms. 4. Regular Supply Of Raw Material Quick payment of credit purchase of raw materials ensures the regular supply of raw materials fro suppliers. Suppliers are satisfied by the payment on time. It ensures regular supply of raw materials and continuous production. 5. Smooth Business Operation Working capital is really a life blood of any business organization which maintains the firm in well condition. Any day to day financial requirement can be met without any shortage of fund. All expenses and current liabilities are paid on time. 6. Ability To Face Crisis Adequate working capital enables a firm to face business crisis in emergencies such as depression.
Factors Affecting Working Capital Or Determinants Of Working Capital
Requirements Of working capital depend upon various factors such as nature of business, size of business, the flow of business activities. However, small organization relatively needs lesser working capital than the big business organization. Following are the factors which affect the working capital of a firm: 1. Size Of Business Working capital requirement of a firm is directly influenced by the size of its
business operation. Big business organizations require more working capital than the small business organization. Therefore, the size of organization is one of the major determinants of working capital. 2. Nature Of Business Working capital requirement depends upon the nature of business carried by the firm. Normally, manufacturing industries and trading organizations need more working capital than in the service business organizations. A service sector does not require any amount of stock of goods. In service enterprises, there are less credit transactions. But in the manufacturing or trading firm, credit sales and advance related transactions are in large amount. So, they need more working capital. 3. Storage Time Or Processing Period Time needed for keeping the stock in store is called storage period. The amount of working capital is influenced by the storage period. If storage period is high, a firm should keep more quantity of goods in store and hence requires more working capital. Similarly, if the processing time is more, then more stock of goods must be held in store as work-in-progress. 4. Credit Period Credit period allowed to customers is also one of the major factors which influence the requirement of working capital. Longer credit period requires more investment in debtors and hence more working capital is needed.But, the firm which allows less credit period to customers needs less working capital. 5. Seasonal Requirement In certain business, raw material is not available throughout the year. Such business organizations have to buy raw material in bulk during the season to ensure an uninterrupted flow and process them during the entire year. Thus, a huge amount is blocked in the form of raw material inventories which gives rise to more working capital requirements.
6. Potential Growth Or Expansion Of Business If the business is to be extended in future, more working capital is required. More amount of working capital is required to meet the expansion need of business. 7. Changes In Price Level Change in price level also affects the working capital requirements. Generally, the rise in price will require the firm to maintain large amount of working capital as more funds will be required to maintain the sale level of current assets. 8. Dividend Policy The dividend policy of the firm is an important determinant of working capital. The need for working capital can be met with the retained earning. If a firm retains more profit and distributes lower amount of dividend, it needs less working capital. 9. Access To Money Market If a firm has good access to capital market, it can raise loan from bank and financial institutions. It results in minimization of need of working capital. 10. Working Capital Cycle When the working capital cycle of a firm is long, it will require larger amount of working capital. But, if working capital cycle is short, it will need less working capital. 11. Operating Efficiency The operating efficiency of a firm also affects the firm's need of working capital. The operating efficiency of the firm results in optimum utilization of assets. The optimum utilization of assets in turn results in more fund release for working capital.
Working Capital Cycle/Operating Cycle A continuous process starting from payment of cash for purchasing raw material , production , stocking , selling until obtaining money from debtors.
It is a cycle involving—- conversion of cash into raw material > conversion of raw material into WIP > conversion of WIP into Finished goods> conversion of Finished goods into cash /debtors and > conversion of debtors into cash.
OC = R+W+F+D-C Ie. Duration of Operating Cycle = Raw mat. period+WIP period +Finished goods period +Debtors collection period –Creditors payment period
CALCULATION OF W. CAP . CYCLE i) Raw Mat. Stock Holding Period = R.Mat. Stock X 365 days Annual Purchases
+ ii) WIP duration Cost of Prodn. + iii) Finished Goods Stock Holding Period = Finished Goods Stock X 365 days Cost of Goods Sold + iv) Debtors Collection Period = Debtors Credit Sales X 365 days = WIP stock X 365 days
LESS : i) Creditors Payment Period = Creditors Credit Purchases X 365 days
