Working Capital Concept

The objective of running any Company is to earn profits. A Company will require funds to acquire Fixed Assets like Land, Building, Plant & Machinery, Equipment, Tools, etc and also to run business viz, for its day to day operations (working). Capital or Funds required for a Company can therefore be bifurcated as Fixed Capital & Working Capital.

Funds required for day to day working would be to finance production and sales. For production, funds are needed for purchase of Raw Materials / Stores / Fuel, for payment of Labour, Power Charges, etc, for storing Finished Goods, and for financing the sales, by way of sundry debtors / receivables.

Concept of Working Capital:

Working Capital is often defined as the excess of Current Assets over Current Liabilities.

Current Assets are those, that in the ordinary course of business can be or will be converted into cash within one year (during operating cycle of the industry).

Current Liabilities are those liabilities intended, at their inception, to be paid in the ordinary course of business within a reasonably short time (normally one year) out of current assets or the income of the business.

The above definition of Working Capital, however, takes into account only the funds available to the Company from long term sources like capital and long-term borrowings.

It does not represent the total funds required by the Company towards Working Capital, to sustain its level of operations. The excess of CA(Current Assets) over CL(Current Liabilities) is therefore, known in working parlance, as Net Working Capital (NWC) or Liquid Surplus (LS) and represents that portion of the Working Capital, which has been provided from the long-term sources.

Permanent and Temporary Working Capital

Considering time as the basis of classification, there are two types of working capital viz, ‘Permanent’ and ‘Temporary’.

Permanent working capital represents the assets required on continuing basis over the entire year, whereas temporary working capital represents additional assets required at different items during
the operation of the year.

A firm will finance its seasonal and current fluctuations in business operations through short term debt financing. For example, in peak seasons more raw materials to be purchased, more manufacturing expenses to be incurred, more funds will be locked in debtors balances etc.

In such times excess requirement of working capital would be financed from short-term financing sources.

The permanent component current assets which are required throughout the year will generally be financed from long-term debt and equity. Tandon Committee has referred to this type of working capital as ‘Core Current Assets’.

Core Current Assets are those required by the firm to ensure the continuity of
operations which represents the minimum levels of various items of current assets viz., stock of raw materials, stock of work-in-process, stock of finished goods, debtors balances, cash and bank etc.

This minimum level of current assets will be financed by the long-term sources and any fluctuations over the minimum level of current assets will be financed by the short-term financing. Sometimes core current assets are also referred to as ‘hard core working capital’.

The management of working capital is concerned with maximizing the return to
shareholders within the accepted risk constraints carried by the participants in
the company.

Just as excessive long-term debt puts a company at risk, so an inordinate quantity of short-term debt also increases the risk to a company by straining its solvency. The suppliers of permanent working capital look for long term return on funds invested whereas the suppliers of temporary working capital will look for immediate return and the cost of such financing will also be costlier than the cost of permanent funds used for working capital.

Gross Working Capital

Gross Working Capital is equal to total current assets only. It is identified with
current assets alone. It is the value of non-fixed assets of an enterprise and includes inventories (raw materials, work-in-progress, finished goods, spares and consumable stores), receivables, short-term investments, advances to suppliers, loans, tender deposits, sundry deposits with excise and customs,cash and back balances, prepaid expenses, incomes receivable, etc.

Gross Working Capital indicated the quantum of working capital available to
meet current liabilities.

Thus, Gross Working Capital = Current Assets

Net Working Capital

Net Working Capital is the excess of current assets over current liabilities, i.e current assets less current liabilities.

This concept of working capital is widely accepted. This approach, however, does not reflect the exact position of working capital due to the following factors:

  • Valuation of inventories include write-offs.
  • Debtors include the profit element
  • Debts outstanding for more than a year likewise debtors which are doubtful or not provided for are included as asset are also placed under the head ‘current assets’
  • Non-moving and slow-moving items of inventories are also included in inventories, and
  • Write-offs and the profits do not involve cash outflow

To assess the real strength of working capital position, it is necessary to exclude the non-moving and obsolete items from inventories. Working Capital thus arrived at is termed as ‘Tangible Working Capital.’

Working Capital Cycle

Alternatively known as ‘Operating Cycle Concept’ of working capital.

This concept is based on the continuity of flow of funds through business operations. This flow of value is caused by different operational activities during a given period of time. the operational activities of an organization may comprise of:

  • Purchase of raw materials
  • Conversion of raw materials into finished products
  • Sale of finished products and
  • Realization of accounts receivable.

Material cost is partly covered by trade credit from suppliers and successive
operational activities also cash flow. If the flow continues without any interruption, operational activities of the company will also continue smoothly.

Movement of cash through the above processes is called ‘circular flow of cash’. The period required to complete this flow is called ‘the operating period’ or ‘the operating cycle’.

To estimate the working capital required, the number of operating cycles in a year is to be calculated. This is calculated by dividing the number of days in a year by the length of the cycle.

Total operating expenses of a year divided by the number of operating cycles in that year is the amount of working capital required.

Assessment of Working Capital

Funds required to carry the required levels of current assets, to enable the Company to carry on its operations at the expected levels uninterruptedly, are the Working Capital Requirements. Therefore Working Capital Requirement (WCR) is proportional to:

  1. The volume of activity (i.e. level of operation )
  2. The type of business carried on viz. manufacturing process, production programme.

Though there are various methods for assessing the quantum of WCR for an industry, the following three are commonly known and used.

  1. Operating Cycle Method (for W/C limits upto Rs.25000)
  2. Usual or Traditional Method (for W/C limit upto Rs.10 lacs)
  3. Using Tandon & Chore Committee Norms (for W/C limit above Rs.10 lacs)

Operating Cycle Method:
Any manufacturing activity is characterized by a cycle of operations consisting of purchase of raw materials for cash, converting these into FGs and realising cash by sale of these finished goods.

The cycle consists of:

  1. Time taken to acquire RMs & Ave. period for which they are in stores.
  2. Conversion process time.
  3. Ave. period for which finished goods are in stores.
  4. Ave. collection period of receivable (Sundry Debtors) operating cycle is also called cash to cash cycle & indicates how cash is converted into RM, SIP, FG & Bill receivables and finally cash.

If length of operating cycle is, say 120 days. Then it means 365 / 120 = 3 cycles of operations in a year. This means each rupee of WCR employed in the unit is turned over 3 times in a year. This is also known as Working Capital Turnover Ratio(WCR).

WCR =Operating Expenses/No. of Cycles per annum

Factors, which influence WCR, are:

  1. Level of operating Expense &
  2. Length of operating Cycle.

Usual (Traditional) Method of Assessment of WCR:

The operating cycle concept serves to identify the areas requiring improvement for the purpose of control and performance review. But bankers require a more detailed analysis to assess the various components of WCR viz. finance for stocks, bills, etc.

Hence usual method is different.
Bankers provide working capital finance for holding an acceptable level of Current Assets, viz. RM, SIP, FG, and SDrs for achieving a pre-determined level of production and sales.
Quantification of these funds, required to be blocked, in each of these items of CA at any time is as follows:

  1. R.M. requirement is generally expressed as so many months requirement (consumption).
  2. S.I.P. a rough & ready formula for computing the requirement of funds is to find the Cost of Production for the period of processing. viz.( RM consumed / month + Expenses / month) * period of processing in months.
  3. F.G. the requirement of funds against FG is expressed as so many months cost of production.
  4. Sundry Debtors: WCR against Sundry Debtors will be computed on the basis of Cost of Production (where as the Permissible Bank Finance will be on the basis of the sale value)

WCR is normally expressed as so many months of Cost of Production (CoP).
Working Capital of any industry can thus be summerised as:

Working capital calculation

The purpose of assessing the Working Capital Requirement of the company is to determine how the total requirement of funds will be met.

The two resources are:

1) Long term Borrowing and Capital
2) Short term Bank Borrowing.

Method using Tandon / Chore Committee Norms:
The Reserve Bank of India constituted study groups in 1974 and 1979 viz. Tandon Committee and Chore Committee to frame suitable guidelines for Working Capital Finance.

The recommendations of Tandon / Chore Committee relate to:

  • Norms for Inventory and Receivables
  • Approach to Lending
  • Follow-up, Supervision & Control of Advances

The Tandon Committee prescribed definitive norms as to the reasonable level of inventory and the receivables the unit should carry and the extent to which the total Current Assets are supported by long-term funds.

The lending norms comprise of three methods as under:
1st method: The quantum of the banks short-term advances will be restricted to 75% of the Working Capital gap; remaining 25% is to be met from NWC.

2nd method: NWC should be atleast be equal to 25% of the total value of acceptable current assets. The remaining 75% should first be financed by other CL and then the banker may finance the balance of the requirement.

3rd method: Borrower should provide for entire core CA and 25% of the CA over the core CA. RBI has not implemented this method.

All the units with Fund Based Working Capital limits of Rs.50 lacs and over should be straightaway placed under 2nd method of lending.

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