Monday, October 05, 2015

Working Capital: Meaning, Types and Need of Working Capital

Meaning and definition of Working Capital
The capital required for a business is of two types. These are fixed capital and working capital. Fixed capital is required for the purchase of fixed assets like building, land, machinery, furniture etc. Fixed capital is invested for long period, therefore it is known as long-term capital. Similarly, the capital, which is needed for investing in current assets, is called working capital. The capital which is needed for the regular operation of business is called working capital. Working capital is also called circulating capital or revolving capital or short-term capital.

In the words of John. J Harpton “Working capital may be defined as all the shot term assets used in daily operation”.

According to “Hoagland”, “Working Capital is descriptive of that capital which is not fixed. But, the more common use of Working Capital is to consider it as the difference between the book value of the current assets and the current liabilities.

From the above definitions, Working Capital means the excess of Current Assets over Current Liabilities. Working Capital is the amount of net Current Assets. It is the investments made by a business organisation in short term Current Assets like Cash, Debtors, Bills receivable etc.

Concepts of Working Capital

There are two concepts of working capital:
a)      Gross working capital
b)      Net working capital

Gross working capital refers to investment in all current assets -raw materials, work-in-progress, finished goods, book debts, bank balance and cash balance. The gross concept of working capital is significant in the context of measuring working capital needed, measuring the size of the business, continued and smooth flow of operations of the business and the like.

Net working capital refers to the excess of current assets over current liabilities. That is, value of current assets minus value of current liabilities (current liabilities include trade creditors, bills payable, outstanding expenses such as wages, salaries, dividend payable and tax payable, bank overdraft, etc.) The net concept of working capital is significant in the context of financing of working capital, the short term liquidity aspects of the business, and the like.

Classification of Working Capital
Some portion of working capital is fixed natured and some portion fluctuates for some time. In the view point working capital classified in to 2 classes,
a)      Fixed or permanent working capital
b)      Variable or temporary working capital
Fixed or permanent working capital: The fund, which is required to produce a certain amount of goods or services at a certain period of time, is called Fixed working capital. The minimum amount of cash money, A/R, which are kept to operate the business is called Fixed working capital.
Variable working capital: When extra working capital is required then a addition to fixed working capital due to seasonal causes or increased production or sales, this working capital is variable working capital. So, the working capital which fluctuates with keeping the relation between production & Sales is variable working capital.

Need and Importance of Working Capital
Working Capital means excess of current assets over current liabilities. Such Working Capital is required to smooth conduct of business activities. It is as important as blood to body. An organisation’s profitability depends on the quantum of Working Capital available to it. Adequate Working Capital is a source of energy to any business organisation. It is the life blood of an organisation. The following points will highlight the need of adequate working capital:
a) Enables a company to meet its obligations: Working capital helps to operate the business smoothly without any financial problem for making the payment of short-term liabilities. Purchase of raw materials and payment of salary, wages and overhead can be made without any delay. Adequate working capital helps in maintaining solvency of the business by providing uninterrupted flow of production.
b) Enhance Goodwill:  Sufficient working capital enables a business concern to make prompt payments and hence helps in creating and maintaining goodwill. Goodwill is enhanced because all current liabilities and operating expenses are paid on time.
c) Facilitates obtaining Credit from banks without any difficulty: A firm having adequate working capital, high solvency and good credit rating can arrange loans from banks and financial institutions in easy and favorable terms.
d) Regular Supply of Raw Material: Quick payment of credit purchase of raw materials ensures the regular supply of raw materials fro suppliers. Suppliers are satisfied by the payment on time. It ensures regular supply of raw materials and continuous production. Prompt payments to its creditors also enable a company to take advantage of cash and quantity discounts offered by them.
e) Smooth Business Operation: Working capital is really a life blood of any business organization which maintains the firm in well condition. Any day to day financial requirement can be met without any shortage of fund. All expenses and current liabilities are paid on time.
f) Ability to Face Crisis: Adequate working capital enables a firm to face business crisis in emergencies such as depression.
g) It improves the prospects of prosperity and progress of a company.

Thus, adequate Working Capital is an important factor for prosperity and smooth running of a business organisation. It is rightly called as the “backbone” of the financial structure of a business organisation.