Page 8 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Unit 1: Introduction to Working Capital Management

3. What can always be relied upon to meet the contingencies, is the excess of current assets Notes
over the current liabilities since this amount is not to be returned; and
4. This definition helps to find out the correct financial position of companies having the
same amount of current assets.
Institute of Chartered Accountants of India, while suggesting a vertical form of balance sheet,
also endorsed the former view of working capital when it described net current assets as the
difference between current assets and current liabilities.
The conventional definition of working capital in terms of the difference between the current
assets and the current liabilities is somewhat confusing. Working capital is really what a part of
long-term finance is locked in and used for supporting current activities. Consequently, the
larger the amount of working capital so derived, greater the proportion of long-term capital
sources siphoned off to short-term activities. It is about tight working capital situation, the logic
of the above definition would perhaps indicate diversion to bring in cash, under the conventional
method, working capital would evidently remain unchanged. Liquidation of debtors and
inventory into cash would also keep the level of working capital unchanged. A relatively large
amount of working capital according to this definition may produce a false sense of security at
a time when cash resources may be negligible, or when these may be provided increasingly by
long-term fund sources in the absence of adequate profits. Again, under the conventional method,
cash enters into the computation of working capital. But it may have been more appropriate to
exclude cash from such calculations because one compares cash requirements with current assets
less current liabilities. The implication of this in conventional working capital computations is
that during the financial period current assets get converted into cash which, after paying off the
current liabilities, can be used to meet other operational expenses. The paradox, however, is that
such current assets as are relied upon to yield cash must themselves to be supported by
long-term funds until are converted into cash.

Task Analyse the paradox in computing the working capital.

At least, three points seem to emerge from the above. First, the balance sheet definition of
working capital is perhaps not so meaningful, except as an indication of the firm’s current
solvency in repaying its creditors. Secondly, when firms speak of shortage of working capital,
they in fact possible imply scarcity of cash resources. Thirdly, in fund flow analysis an increase
in working capital, as conventionally defined, represents employment or application of funds.

1.1.2 Operating Cycle Concept

A company’s operating cycle typically consists of three primary activities; purchasing resources,
producing the product, and distributing (selling) the product. These activities create funds flows
that are both unsynchronized because cash disbursements usually take place before cash receipts.

Example: Payments for resource purchases takes place before the collection of receivables.
They are uncertain because future sales and costs, which generate the respective receipts and
disbursements, cannot be forecasted with complete accuracy. If the firm is to maintain a cash
balance to pay the bills as they come due. In addition, the company must invest in inventories to
fill customer orders promptly. And, finally, the company invests in accounts receivable to
extend credit to its customers.

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