Capital required for a business can be classified under two main categories via,
- Fixed Capital
- Working Capital
Every business needs funds for two purposes for its establishment and to carry out its day-to-day operations. Long terms funds are required to create production facilities through the purchase of fixed assets such as p&m, land, building, furniture, etc. Investments in these assets represent that part of the firm’s capital that is blocked on a permanent or fixed basis and is called fixed capital. Funds are also needed for short-term purposes for the purchase of raw material, payment of wages, and other day-to-day expenses, etc.
These funds are known as working capital. In simple words, working capital refers to that part of the firm’s capital that is required for financing short-term or current assets such as cash, marketable securities, debtors & inventories. Funds, thus, invested in current assets keep revolving fast and are being constantly converted in to cash and this cash flows out again in exchange for other current assets. Hence, it is also known as revolving or circulating capital or short term capital.
There are two concepts of working capital:
- Gross working capital
- Networking capital
The gross working capital is the capital invested in the total current assets of the enterprises current assets are those
Assets that can convert into cash within a short period normally one accounting year.
- Cash in hand and cash at bank
- Bills receivables
- Sundry debtors
- Short term loans and advances.
- Inventories of stock as:
- a. Raw material
- b. Work in process
- c. Stores and spares
- d. Finished goods
- Temporary investment of surplus funds.
- Prepaid expenses
- Accrued incomes.
- Marketable securities.
In a narrow sense, the term working capital refers to networking. Networking capital is the excess of current assets over current liability, or, say:
Net Working Capital = Current Assets – Current Liabilities
Networking capital can be positive or negative. When the current assets exceed the current liabilities are more than the current assets. Current liabilities are those liabilities, which are intended to be paid in the ordinary course of business within a short period of normally one accounting year out of the current assets or the income business.
Constituents of Current Liabilities
- Accrued or outstanding expenses.
- Short term loans, advances, and deposits.
- Dividends are payable.
- Bank overdraft.
- Provision for taxation, if it does not amt. to the app. of profit.
- Bills payable.
- Sundry creditors.
The gross working capital concept is a financial or going concern concept whereas net working capital is an accounting concept of working capital. Both concepts have their own merits.
The gross concept is sometimes referred to as the concept of working capital for the following reasons:
- It enables the enterprise to provide the correct amount of working capital at the correct time.
- Every management is more interested in the total current assets with which it has to operate than the source from where it is made available.
- It takes into consideration the fact every increase in the funds of the enterprise would increase its working capital.
- This concept is also useful in determining the rate of return on investments in working capital. The networking capital concept, however, is also important for the following reasons:
- It is a qualitative concept, which indicates the firm’s ability to meet its operating expenses and short-term liabilities.
- It indicates the margin of protection available to the short term creditors.
- It is an indicator of the financial soundness of enterprises.
- It suggests the need for financing a part of the working capital requirement out of the permanent sources of funds.
Working capital may be classified into ways:
- On the basis of the concept.
- On the basis of time.
On the basis of concept, working capital can be classified as gross working capital and net working capital. On the basis of time, working capital may be classified as:
- Permanent or fixed working capital.
- Temporary or variable working capital
Permanent or Fixed Working Capital
Permanent or fixed working capital is the minimum amount that is required to ensure effective utilization of fixed facilities and for maintaining the circulation of current assets. Every firm has to maintain a minimum level of raw material, work-in-process, finished goods, and cash balance. This minimum level of current assets is called permanent or fixed working capital as this part of working is permanently blocked in current assets. As the business grows the requirements of working capital also increases due to the increase in current assets.
Temporary or Variable Working Capital
Temporary or variable working capital is the amount of working capital that is required to meet the seasonal demands and some special exigencies. Variable working capital can further be classified as seasonal working capital and special working capital. The capital required to meet the seasonal need of the enterprise is called seasonal working capital. Special working capital is that part of working capital that is required to meet special exigencies such as the launching of extensive marketing for conducting research, etc.
Temporary working capital differs from permanent working capital in the sense that is required for short periods and cannot be permanently employed gainfully in the business.
And some special al is the amount of working capital which is required to meet the seasonal sets.
Importance of Advance of Adequate Working Capital
Solvency of the Business: Adequate working capital helps in maintaining the solvency of the business by providing uninterrupted production.
Goodwill: Sufficient amount of working capital enables a firm to make prompt payments and makes and maintain goodwill.
Easy Loans: Adequate working capital leads to high solvency and credit standing can arrange loans from banks and others on easy and favorable terms.
Cash Discounts: Adequate working capital also enables a concern to avail cash discounts on the purchases and hence reduces cost.
Regular Supply of Raw Material: Sufficient working capital ensures a regular supply of raw material and continuous production.
Regular Payment of Salaries, Wages, and Other Day to Day Commitments: It leads to the satisfaction of the employees and raises the morale of its employees, increases their efficiency, reduces wastage and costs, and enhances production and profits.
The exploitation of Favorable Market Conditions: If a firm is having adequate working capital then it can exploit the favorable market conditions such as purchasing its requirements in bulk when the prices are lower and holdings its inventories for higher prices.
Ability To Face Crises: A concern can face the situation during the depression.
Quick And Regular Return on Investments: Sufficient working capital enables a concern to pay quick and regular of dividends to its investors and gains confidence of the investors and can raise more funds in the future.
High Morale: Adequate working capital brings an environment of securities, confidence, high morale which results in overall efficiency in a business.
Excess or Inadequate Working Capital
Every business concern should have an adequate amount of working capital to run its business operations. It should have neither redundant nor excess working capital nor inadequate nor shortages of working capital. Both excess, as well as short working capital positions, are bad for any business. However, it is the inadequate working capital that is more dangerous from the point of view of the firm.
Disadvantages of Redundant or Excessive Working Capital
- Excessive working capital means ideal funds that earn no profit for the firm and the business cannot earn the required rate of return on its investments.
- Redundant working capital leads to unnecessary purchasing and accumulation of inventories.
- Excessive working capital implies excessive debtors and defective credit policy which causes a higher incidence of bad debts.
- It may reduce the overall efficiency of the business.
- If a firm is having excessive working capital then the relations with banks and other financial institutions may not be maintained.
- Due to the lower rate of return n investments, the values of shares may also fall.
- The redundant working capital gives rise to speculative transactions
Disadvantages of Inadequate Working Capital
Every business needs some amount of working capital. The need for working capital arises due to the time gap between production and the realization of cash from sales. There is an operating cycle involved in sales and realization of cash. There are time gaps in the purchase of raw material and production; production and sales; and realization of cash.
Thus working capital is needed for the following purposes:
- For the purpose of raw material, components, and spares.
- To pay wages and salaries
- To incur day-to-day expenses and overload costs such as office expenses.
- To meet the selling costs as packing, advertising, etc.
- To provide credit facilities to the customer.
- To maintain the inventories of the raw material, work-in-progress, stores, and spares, and finished stock.
For studying the need for working capital in a business, one has to study the business under varying circumstances such as a new concern requires a lot of funds to meet its initial requirements such as promotion and formation, etc. These expenses are called preliminary expenses and are capitalized. The amount needed for working capital depends upon the size of the company and the ambitions of its promoters. Greater the size of the business unit, generally larger will be the requirements of the working capital.
The requirement of the working capital goes on increasing with the growth and expensing of the business till it gains maturity. At maturity, the amount of working capital required is called normal working capital.
There are other factors that also influence the need for working capital in a business.