Working Capital - Notes - M.com

Working capital shows the efficiency of the company to cover its short-term obligations. Working capital gives information to investors about the efficiency of the operations of the business. It is very important to know that how much working capital should be financed?

Concept of Working Capital

In working capital, assets having life of one year and obligations relating to current year are managed in such a way that helps in running the business efficiently.

In order to understand working capital, the two types of working capital are examined:

Ø Gross working capital (G.W.C)

In G.W.C, the company is interested in making investments only in those assets having life of one year. Assets having life of one year are those that are to be considered as CA (Current Assets) which are used by the business in meeting operating expenses or in meeting current obligations. It includes cash, debtors (account receivables), bills receivables and stock (inventory or merchandise).

Cash equivalents are those assets which can be converted into cash very quickly, normally within 6 months. Examples of Cash Equivalents are marketable securities, etc.

Ø Net working capital (N.W.C)

Net working capital is obtained by deducting current liabilities from the current assets. The company must meet current obligations from the current resources of the business, otherwise, the current obligations are more than current resources of the business and it is not good sign for daily conducting of the business. Examples of current liabilities are:

  ü  Creditors or Accounts Payable

  ü  Bills payable

  ü  Outstanding Expenses

Net working capital is positive when current assets are more than current liabilities and it is good sign for the business because now the current resources can meet successfully the current obligations and operational expenses. Negative net working capital is possible only when current obligations are more than current resources of the business. Negative working capital is not good sign for the company because the company can not successfully meet the daily operating expenses.

Sources of W.C (Working Capital)

Financing Working Capital or Working Capital Credit plays an important role in the sources of Working Capital. Working Capital is the use of current assets in the daily operations of the business. 

Two main types of working capital must be considered by the business while selecting the sources of finance for working capital.

·   Fixed Working Capital

·   Variable Working Capital

·   Fixed Working Capital

Fixed working capital is financed through long-term sources. These source are shares, loans having maturity more than one year, etc.

·   Variable Working Capital

Variable working capital includes those sources having maturity within one year. These sources are money lenders, bank loans, etc.

(Anik, 2013)

Working Capital Financing Approaches

Approaches to working capital include:

§ Aggressive Approach

§ Conservative Approach

§ Moderate Approach

§ Aggressive Approach

Under this approach, the company get short-term financing and takes higher risk in order to get greater return. The higher risk is due to fluctuation of interest rates and greater return is due to lower cost financing.

§  Conservative Approach

In this approach the company gets long-term financing. The company is risk aversion due to higher cost of long-term financing. As the company is taking less risk and due to higher cost of financing, so the company cannot get the maximum value creation.

§ Moderate Approach

Under this approach, the company tries to maintain the balance between risk and return. The company has a moderate value of net working capital. Relatively amount of risk is off set with the relatively moderate amount of the expected return.

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