Page 144 - DMGT409Basic Financial Management

Unit 8: Working Capital Management

supported this concept and viewed that the net working capital helps creditors and investors to Notes

judge the financial soundness of a fi rm.
Net Working Capital Concept represents the amount of the current assets, which would remain
after all the current liabilities were paid. It may be either positive or negative. It will be positive,
if current assets exceed the current liabilities and negative, if the current liabilities are in excess of
current assets. Another alternative definition is that net working capital refers to that portion of

firm’s current assets, which financed with long-term funds.
Net Working Capital Concept indicates or measures the liquidity and also suggests the extent to

which working capital needs may be financed by the permanent source of funds. To quote Roy
Chowdary, “Net Working Capital indicates the liquidity of the business whilst gross working
capital denotes the quantum of working capital with which business has to operate”.
Net working capital = Current Assets – Current Liabilities

Signifi cance

Net Working Capital Concept focuses attention on the two aspects of current assets management,
they are: (i) Maintaining liquidity position, and (ii) To decide upon the extent of long-term capital
in financing current assets.

1. Maintaining Liquidity Position: For maintaining liquidity position there is a need to
maintain current assets sufficiently in excess of current liabilities. In other words, excess

current assets helps in meeting its financial obligation within the operating cycle of the
firm. Generally for every one rupee of current asset there will be one rupee of current

liability. As discussed above, negative and excess working capitals both are bad to the
fi rm.
2. To decide upon the Extent of Long-term Capital in Financing Current Assets: Net Working
Capital (NWC) means the portion of current assets that should be fi nanced by long-term
funds. This concept helps to decide the extent of long-term funds required in fi nance
current assets.

Example: If there are ` 1, 00,000 current assets and ` 75,000 current liabilities, the extent
of current assets should be decided by the NWC base. The NWC is the difference between current
assets and current liabilities. In the above example NWC is ` 25,000. This is the amount that is

supposed to be financed by long-term funds.
Hence, NWC helps management to decide the extent to which current assets should be

financed with equity capital and borrowed funds.
8.2 Operating Cycle and Cash Cycle

The continuing flow from cash to suppliers, to inventory, to accounts receivables and back into

cash is what is called the operating cycle. The operating cycle involves the following procedure:
1. Conversion of cash into raw materials.
2. Conversion of raw materials into work-in-process.
3. Conversion of work-in-process into fi nished goods.

4. Conversion of finished goods into sales [debtors and cash].

If firm sells good on cash basis with (d) operating cycle then returns to the operating cycle

(a). But if, firm sells goods on credit basis then there will be another cycle that is,

5. Conversion of debtors into cash.

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