Working Capital – Definition and Factors Affecting Working Capital

Working capital is the amount of money that a company has tied up in funding its day-to-day operations. A company has to tie up money to fund its stocks, credit sales and other current assets, but this is offset by its ability to fund this from current liabilities liabilities such as purchases on credit.

In the Annual Survey of Industries (1961), working capital is defined to include “Stocks of materials, fuels, semi-finished goods including work-in-progress and finished goods and by-products; cash in hand and bank and the algebraic sum of sundry creditors as represented by (a) outstanding factory payments e.g. rent, wages, interest and dividend; b) purchase of goods and services; c) short-term loans and advances and sundry debtors comprising amounts due to the factory on account of sale of goods and services and advances towards tax payments”.

Modern industrial concerns produce an anticipation of demand. Payment has, therefore, to be made for the purchase of raw materials, the storage of finished and semi-finished goods, the work done by the staff and the workers. But, this sum cannot be god back immediately. Some time will pass before the goods are sold out and the amount spent on all these items is recovered. The working capital is needed for this purpose. It may be defined as the capital invested in the working or current assets like stock of raw materials, semi-finished and finished products, debtors, bills receivable, etc. Some writers use the term circulating capital or revolving capital for it. This is because the working capital is invested, recovered and re-invested repeatedly during the life-time of the concern. In other words, it keeps on revolving or circulating from cash to current assets and back. Apparently it would appear that the working capital requirements can be met with short-term funds. But it is forgotten that as long as the business of the concern continues, the working capital would be needed repeatedly. This means that at least a part of the working capital can be called ‘regular’ or ‘fixed’ working capital. The remaining part is known as the fluctuating or variable working capital. This is needed to meet the requirements of a raise in the volume of production during the peak periods of the year. It can, of course, be met with short-term capital.

Working capital = Current Assets – Current Liabilities

Current Assets are the assets, which one expects to be used, or sold, within a short time period usually one year or one operating cycle. Some examples include cash, receivables, inventory, prepaid expenses, etc. Current Liabilities are the liabilities, which one expects to be settled within one year or one operating cycle. Some examples include accounts payables, unearned revenue, etc.

According to Weston & Brigham – “Working capital refers to a firm’s investment in short  term assets, such as cash amounts receivables, inventories etc.”

Working capital is an indicator of the liquidity of the company. It is basically the ability of the company to meet up with the short-term (typically less than one year) obligations. However, quality of current assets should also be taken into account while checking the liquidity. Uncertain receivables and high inventory can often limit the capacity of working capital to judge liquidity. Also, too high an amount of working capital is a sign of inefficiency in the company. Working capital can be managed by managing the current assets such as inventories, receivables and cash and current liabilities such as accounts payable. Also the working capital requirement depends on the industry and modus operandi of the company.

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 following are the factors which determine a concerns requirements of working capital:

  1. The proportion of the cost of materials to total cost. In those industries where cost of materials is a large proportion of the total cost of the goods produced or where costly material will have to be used, requirements of working capital will be rather large sums are required for this purpose. But if the importance of materials is small, as for example, in an oxygen company, the requirements of working capital will naturally be small.
  2. Importance of  labor. This factor operates like the one mentioned above. If goods are manufactured with the help of labor, large sums of money will have to be kept invested as working capital. Industries where there is a great degree of mechanization, the working capital requirements are correspondingly small. It may be remembered, however, that to some extent the decision to use manual labor or machinery lies with the management. Therefore, it is possible in most cases to reduce the requirements of working capital and increase investment in fixed assets and vice versa.
  3. Length of period of manufacture. The time which elapses between the commencement and the end of the manufacturing process has an important bearing upon the requirements of working capital. If it takes long to manufacture the finished product, a large sum of money will have to be kept invested in the from of work-in progress at all stages. Hence, working capital will be required in large amounts. To give an example a baker requires a night’s time to bake his daily quota of bread. His working capital is, therefore, much less than that of a ship-building concern which takes three to five years to build a ship.
  4. Stocks. Manufacturing concerns generally have to carry stocks of raw materials and other stores and also finished goods. In certain cases, manufacture is carried out only against a definite order from a customer and as soon as production in completed the gods are delivered to him. In this case, there will be no finished stocks, and to this extent, the requirements, of working capital will be reduced. The larger the stocks, whether of raw materials or finished goods, the larger will be the requirement of working capital. To some extent, the size of stocks to be carried will depend upon the decisions of management. Besides, the stocks to be carried are generally proportionate to the volume of sales.
  5. Rapidity of turnover. Turnover represents the speed with which the working capital is recovered by the sale of goods. In certain businesses, sales are made quickly so that stocks are soon exhausted and new purchases have to be made. In this manner, a small sum of money invested in stocks will result in sales of a much larger amount. Considering the volume of sales the amount of working capital requirements will be rather small in such types of businesses. There are other business where sales are made infrequently. For instance, in case of jewelers, a piece of jewelery may stay in the show-window for a long time before it catches the fancy of a rich lady. In such cases large sums o money have to be kept invested in stocks. But a baker or a new-hawker may be able to dispose of his socks quickly, and may, therefore, need much smaller amounts by way of working capital.
  6. Terms of Credit. It goes without saying that if credit is allowed by suppliers, payment can be postponed for some time and can be made out of the sale proceeds of the goods produced. In such a case, the requirements of working capital will be reduced. The requirements will obviously be increased if credit has to be allowed to customer. The period of credit also determined the working capital requirements of a concern. If, for example, a retailer is allowed credit for a longer period than is allowed by him to his own customers, he would not need much working capital because he can pay the supplier after he has collected debts from his debtors.

At times, business needs to estimate the requirement of working capital in  advance for proper control and management. The factors discussed above  influence the quantum of working capital in the business. The assessment of  working capital requirement is made keeping these factors in view. Each constituent of working capital retains its form for a certain period and that holding period is determined by the factors discussed above. So for correct assessment of the working capital requirement, the duration at various stages of the  working capital cycle is estimated. Thereafter, proper value is assigned to the  respective current assets, depending on its level of completion.

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