After reading this article you will learn about:- 1. Meaning of Working Capital 2. Classification of Working Capital 3. Factors.
Meaning of Working Capital:
Working capital is that part of capital which is required to meet the day to day needs in running the business. It is required for the purchase of raw material, meeting the day to day expenses such as salaries, rent, stationary etc. Some capital is also required to keep the stock of partly finished products, some cash is also required for emergency work.
Working capital generally involves the use of short-term funds in business and is regularly converted to cash. Materials are changed into finished products, products are sold out to realise cash and the cash is utilised in purchasing the material etc. Thus, this working capital is also known as revolving or circulating capital.
At any time, working capital can be calculated by deducting current liabilities from working assets of the concern as shown in the following equation:
Working assets – Current liabilities = Working capital.
Working capital is required to meet the following important items:
i. Purchase of raw material and supplies and their storage costs.
ii. Payment of wages.
iii. Maintenance costs.
iv. Advertisement and selling expenses.
v. Transportation costs.
Expenditure on production during time lag between sale of products and receipt of their payment, and also during production cycle,
Classification of Working Capital:
Working capital can be classified in following two heads:
1. Regular or Permanent or Fixed Working Capital:
Working capital invested in starting the circulation of current assets and keeping it moving is permanently locked up. For example, every manufacturing concern has to maintain a minimum stock of raw materials for works in progress, finished products, loose tools and equipment’s etc. It also requires money for the payment of wages throughout the year.
2. Seasonal Variable or Special Working Capital:
Requirement of working capital varies with the seasonal changes in many industries. Additional working capital may also be required on account of certain abnormal conditions. For example, for strikes, lockout and to face cut-throat competitions, additional capital is required. Similarly, special advertisement campaigns or execution of special orders of the government will have to be financed by additional working capital.
Factors Affecting Working Capital:
It is very difficult to determine the amount of working capital required, as there is no formula for calculating it. Working capital requirement depends upon several factors.
Following are some of the factors which should be considered while determining the working capital:
i. Length of period of manufacture.
ii. Turnover of working capital.
iii. Term of purchase and sales.
iv. Nature and volume of business.
v. Business cycle (seasonal variations in business).
vi. Converting working assets into cash.
1. Length of Period of Manufacture:
Volume of output and the average length of the period of manufacture is important in determining how much working capital a company will need. A factory manufacturing a product requiring a long period of manufacture, will need large amount of money for the large amount of raw material, salary for labour and other incidental expenses and has to wait for a long period till the finished product is ready for sale.
Thus large amount of capital is tied up in the process of manufacture. Ship-building is an example of it, as manufacture of a ship requires 3 to 4 years hence the raw material, wages to the labour and other expenses for such a long time have to be borne by the manufacturers. In the meantime, there is risk of getting the prices down.
2. Turnover of Working Capital:
‘Turnover’ is the ratio of annual gross sales to average working assets. Thus, this figure shows how many times the amount invested in working assets have been traded.
The ratio is more when demand is more and products are sold quickly e.g., a retail store deals with a product which has great demand and which can be sold almost as quickly as it is stocked, will have large gross sales and investment in stock will be small. If, on the other hand, store which deals with the products having an irregular and slow demand, the amount of working capital invested in stock will necessarily be heavy.
3. Terms of Purchase and Sales:
A firm purchasing its requirement in cash will need large working capital than that purchasing on credit (as in the latter, cash payment can be made from the money received from cash). Similarly a firm selling the product on cash will require less working capital than that of selling the product on credit.
4. Nature of the Business:
Requirement of working capital depends upon the nature of the business. There are certain business which require large amount of fixed capital and need a lesser amount of working capital like railways etc., while there are some businesses like trading companies which require little in fixed capital and large amount of working capital.
5. Business Cycles:
In most of the businesses, there are variations in prices. Manufacturers, psychologically, like to take advantage of it and stop the sale of their products during the low rates and sell during high rates, while they purchase the raw material during the low rates. In both the cases, large amount of money is required for working capital.
6. Converting Working Assets into Cash:
A concern having a good amount of quick or liquid working assets requires less working capital. Quick assets mean the bills receivable that mature within few days and the merchandise which is already sold or readily saleable for cash.
The current assets which require sometime to convert into cash cannot be considered as quick assets. Hence a working capital required in a concern depends upon the quick or liquid working assets. A concern having a little quick assets requires large amount of working capital and vice- versa.