Working capital refers to the financial resources required to fund a company's day-to-day operations. It represents the difference between a company's current assets (such as cash, inventory, accounts receivable) and its current liabilities (such as accounts payable, short-term debt). Working capit...
Theories and Approaches
UNIT 1 CONCEPTUAL FRAMEWORK
Objectives
The objectives of this unit are to:
• Explain the various types of working capital and their behaviour.
• Examine the cyclical flow and characteristics of working capital.
• Discuss the significance and tools of planning for working capital.
• Find out the impact of inflation on working capital and finally.
• Analyse the trends in working capital in Indian companies.
Structure
1.1 Introduction
1.2 Definition of Working Capital
1.3 Constituents of Working Capital
1.4 Types of Working Capital
1.5 Cyclical Flow and Characteristics of Working Capital
1.6 Planning for Working Capital
1.7 Working Capital and Inflation
1.8 Trends in Working Capital
1.9 Summary
1.10 Key Words
1.11 Self Assessment Questions
1.12 Further Readings
1.1 INTRODUCTION
Financial management can be divided into two broad areas of responsibility as the
management of long-term capital and the management of short-term funds or
working capital. The management of working capital which constitutes a major
area of decision-making for financial managers is a continuous function which
involves the control of the every ebb and flow of financial resources circulating
in the enterprise in one form or another. It also refers to the management of
current assets and current liabilities. Efficient management of working capital is
an essential pre–requisite for the successful operation of a business enterprise
and improving its rate of return on the capital invested in short-term assets.
Virtually every business enterprise requires working capital to pay-off its short-
term obligations. Moreover, every firm needs working capital because it’s not
possible that production, sales, cash receipts and payments are all instantaneous
and synchronised. There elapses certain time for converting raw materials into
finished goods: finished goods into sales and finally realisation of sale proceeds.
Hence, funds are required to support all such activities in the firm. A number of
terms like working funds, circulating capital, temporary funds are used
synonymously for working capital. However, the expression, Working Capital, is
preferred by many due to its popularity and simplicity.
1.2 DEFINITION OF WORKING CAPITAL
,Concepts and Determination Like, most other financial terms the concept of working capital is used in
of Working Capital 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.
, and liabilities. On the contrary, the net concept is said to be the point of view of Theories and Approaches
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.
1.3 CONSTITUENTS OF WORKING CAPITAL
No matter how, we define working capital, we should know what constitutes
current assets and current liabilities. Let us refer to the Balance Sheet of Lupin
Laboratories Ltd. for this purpose.
Current Assets: The following are listed by the Company as current assets:
1) Inventories:
a) Raw materials and packing materials
b) Work-in-progress
c) Finished/Traded goods
d) Stores, Spares and fuel
2) Sundry Debtors:
a) Debts outstanding for a period exceeding six months
b) Other debts
3) Cash and Bank balances:
a) With Scheduled Banks
i) in Current accounts
ii) in Deposit accounts
b) With others
i) in Current accounts
4) Loans and advances:
a) Secured Advances
b) Unsecured (considered good)
i) Advances recoverable in cash or kind for value to be
received
ii) Deposits
iii) Balances with customs and excise authorities
Current liabilities: The following items are included under this category.
1) Current Liabilities:
a) Sundry creditors
b) Unclaimed dividend warrants
c) Unclaimed debenture interest warrants
2) Short term credit:
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