Business Study Management Study

Meaning, Definition and Nature of Working Capital

Working Capital
Written by punit

Cash required for conducting the business, i.e., purchase of raw material and conversion thereof into finished goods, on a regular basis is termed as ‘Working Capital’ (WC). The essential items of ‘Working Capital’ are:

1) Inventory (raw material, work-in-progress, and finished goods) level,

2) Debtors, and

3) Creditors.

They are considered as vital signals of a company’s productivity and financial power.

A company managing its ‘working capital’ in an efficient manner may not be required to borrow funds. The efficient management of working capital involves the balanced approach, i.e., as far as possible there should be neither shortage nor surplus of cash. The companies having the burden of surplus cash need to ensure that excess cash is invested suitably with a view to generating returns for their shareholders.

Definition of Working Capital

According to Shubin, “Working capital is the number of funds necessary to cover the cost of operating the enterprise”.

There are two components of working capital, viz. current assets and current liabilities. The excess of the company’s current assets over its current liabilities is the Working Capital. Management of working capital, thus, involves the management of its constituents, i.e., current assets and current liabilities and maintenance of m appropriate equilibrium between the two. Working Capital is also referred to as ‘Revolving Capital’, `Circulating Capital’, or ‘Short Term Capital‘.

Short term capital

Managing the ‘Working Capital’ of the company is of vital significance with the view to ensure that sufficient cash is held by it to conduct its daily business activities in an effective manner. It is crucial for a company to keep its ‘Cash Conversion Cycle’ (CCC) at a lower level. The CCC measures how fast the company can convert its cash-in-hand into even more cash-in-hand. CCC operates like this — the cash is first converted into inventory and Accounts Payable (AP), through sales and Accounts Receivable (AR) and then again converted into cash.

Generally, lower the CCC, better for the company. In order to reduce the CCC following steps may be taken by a company:

1) Reduction in the credit period given to its customers,

2) Enhancement in its own credit period with the suppliers,

3) Maintenance of an appropriate level of inventory which results in reduced raw material cost, and

4) Efficient cash management which results in a reduction in cash-holding cost. By taking the above steps mentioned, the working capital requirements may be brought down considerably.

Nature of Working Capital

The nature/characteristics of working capital are outlined in the following points:

1) Short-Term Needs:

Working capital is required to procure raw materials, which after going through a short process (WC Cycle), is converted into cash. The short period involved in the working capital differentiates it from ‘Fixed Capital’, wherein funds remain locked for the long-period. The period for which working capital is required depends upon the duration of the production cycle (conversion of raw material into finished goods, sale of finished goods and receipt of sale proceeds).

2) Circular Movement:

Working capital cycle (working capital — raw material — work in progress — finished goods — sales — sale proceeds — cash receipt — working capital) is the continuous and recurring process. The cash is used to acquire current assets converted into finished goods and sold out, which is followed by receipt of cash as sale proceeds. The cycle of WC begins with cash and ends on cash. As it moves in a circular manner, working capital is also termed as ‘Circulating Capital’.

3) Element of Permanency:

Although the working capital requirement is for a short duration, it is demanded on an ongoing basis to ensure the sustainability of the production activity of the company. As long as production in a company goes on, there would be a continuous demand for working capital. The working capital which is required for a permanent basis is termed as ‘Permanent or Regular Working Capital’.

4) Element of Fluctuation:

Although the working capital requirement of the company is permanent in nature, there is fluctuation in its demand. This fluctuation is wider in comparison with that of the fixed capital. Working capital requirement is variable and is in the direct proportion to the level of production. With the changes in purchase policy, sales policy, price level, etc., the working capital requirement also changes. The part of working capital which changes with production, sales, price, etc., is termed as `Variable Working Capital’.

5) Liquidity:

Comparatively working capital is more liquid than the fixed capital. In the case of necessity, working capital is convertible into cash with ease and without loss of time. Emergent cash requirement may be choosing the following options: i) Insisting on the prompt recovery of bills receivables, ii) Expeditious sale of goods and iii) Speeding up the conversion of raw materials into finished goods. Due to this benefit of being highly liquid, companies with huge working capital are considered to be safe and sound.

6) Less Risky:

Money locked up in the fixed capital is not easily recoverable, if required, as it is meant for the long-term. There is also the threat of plant and machinery becoming obsolete, with the passage of time and due to frequent technological advancements. Investment in fixed capital is therefore burdened with comparatively high risk. Investment in working capital, on the other hand, is less risky, because it is of short duration. However, it is exposed to ‘Physical Risk’ to some extent. `Financial or Economic Risks’ associated with working capital are much less, which is due to less severity in the variations of product prices. Further, the working capital is converted into cash and cash into working capital and this cycle goes on. Due to this cyclical nature of working capital, it is not exposed to the risk generated out of technological advancement.

7) Special Accounting System not Needed:

Long-term assets obtained through fixed capital are subject to some system for evaluation of its depreciation every year. Short-term assets procured through the working capital, on the other hand, last only for a year. As such, there is no need for adopting a special accounting system for them.

About the author

punit

Professional Blogger, Youtuber, Entrepreneur And Digital Marketer, Founder of Eazzyone

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