Page 21 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Working Capital Management

Notes Working capital is of major importance to internal and external analysis because of its close
relationship with the current day-to-day operations of a business. Every business needs funds
for two purposes.
1. Long-term funds are required to create production facilities through purchase of fixed
assets such as plants, machineries, lands, buildings, etc.

2. Short-term funds are required for the purchase of raw materials, payment of wages, and
other day-to-day expenses. It is otherwise known as revolving or circulating capital.
A business firm must maintain an adequate level of working capital in order to run its business
smoothly. It is worthy to note that both excessive and inadequate working capital positions are
harmful. Working capital is just like the heart of business. If it becomes weak, the business can
hardly prosper and survive. No business can run successfully without an adequate amount of
working capital.

2.1 Types of Working Capital

The concept of Working Capital includes current assets and current liabilities both. There are
two concepts of working capital. They are Gross and Net Working Capital.

2.1.1 Gross Working Capital

Gross Working Capital refers to the firm’s investment in Current Assets. Current assets are the
assets, which can be converted into cash within an accounting year or operating cycle. It includes
cash, short-term securities, debtors (account receivables or book debts), bills receivables and
stock (inventory).
The concept of Gross Working Capital focuses attention on two aspects of current assets’
management. They are:
1. Way of optimizing investment in Current Assets.
2. Way of financing current assets.
1. Optimizing Investment in Current Assets: Investment in Current Assets should be just
adequate i.e., neither in excess nor deficit because excess investment increases liquidity
but reduces profitability as idle investment earns nothing and inadequate amount of
working capital can threaten the solvency of the firm because of its inability to meet its
obligation. It is taken into consideration that the Working Capital needs of the firm may
be fluctuating with changing business activities which may cause excess or shortage of
Working Capital frequently and prompt management can control the imbalances.

2. Way of Financing Current Assets: This aspect points to the need of arranging funds to
finance Country Assets. It says whenever a need for working Capital arises; financing
arrangement should be made quickly. The financial manager should have the knowledge
of sources of the working capital funds as wheel as investment avenues where idle funds
can be temporarily invested.

2.1.2 Net Working Capital

Net Working Capital refers to the difference between Current Assets and Current Liabilities are
those claims of outsiders, which are expected to mature for payment within an accounting year.
It includes creditors or accounts payables, bills payables and outstanding expenses.
Net Working Capital can be positive or negative. A positive net working capital will arise when
current assets exceed current liabilities and vice versa.

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