Working capital is that amount of funds which is required to carry out the day-to-day operations of an enterprise. It may also be regarded as that portion of total capital which is employed in its short-term operations. These operations include primarily such items like raw material, semi-processed goods, finished goods, sundry debtors, consumable stores, short-term investments, etc.
Concept of Working Capital
(1) Gross Working Capital – The concept of gross working capital means the total value of current assets. In other words, gross working capital refers to the total amount available for financing of current assets. As per this concept:
Gross Working Capital = Total Current Assets
However, it does not reveal the true financial position of an enterprise. For instance, borrowing will increase current asset which results the same increase in gross working capital. But, current liabilities will also increase at the same time. Therefore, the net working capital will remain the same which is not appropriate. This concept of working capital is usually supported by many entrepreneurs because it raises their assets and may be useful to borrow funds from external sources.
(2) Net Working Capital – According to this concept, working capital means net working capital which is the excess of current assets over current liabilities. Importantly, net working capital will increase only when there is increase in current assets without corresponding increase in current liabilities.
Net Working Capital = Current Assets – Current Liabilities
Working capital normally refers to net working capital. The banks and financial institutions also adopt the net working capital concept as it helps to assess the requirements of the borrower.
Importance of Working Capital
Working capital serves as blood circulation in an enterprise. When a business is started, working capital is required for purchasing raw materials. The raw material is then converted into finished goods by incurring some additional costs on it. Then, goods are sold in the market. Total sales do not covert into cash instantly because there is invariably some credit sales. Thus, there exists a time lag between sales of goods and receipt of cash.
The time period which is required to convert raw materials into finished goods and then, finished goods into cash is called operating cycle. During this period, expenses are incurred to continue the business operations. For the purpose of incurring expenses, working capital is required.
Need for working capital depends upon the period of operating cycle. Greater the period, more working capital will be required. Period of operating cycle depends upon the nature of business. Period of operating cycle in a manufacturing concern is greater than the period of operating cycle in a trading concern.
Types of Working Capital
Working capital in an enterprise is needed because of operating cycle. The need for working capital does not come to an end after the cycle is completed. The operating cycle is continuous process, thus, there is a need for continuous supply of working capital. However, the amount of working capital is not constant throughout the year, it is fluctuating. The total working capital composed of two parts:
(1) Fixed working capital – To carry out day-to-day business operations, a certain minimum level of raw-materials, semi-finished goods, finished goods and cash must be maintained on level is a continuous basis. The amount needed to maintain current assets at this minimum called fixed or permanent or regular working capital. The amount of fixed working capital has to meet from long-term sources of finance i.e. capital, debentures, long-term loans, etc.
(2) Variable or Temporary Working Capital – Due to seasonal changes, level of business activities may be higher than normal during some months of a year. Therefore, additional working capital will be required in these months to meet additional expenditure. Thus, an amount required over and above the fixed working capital is called variable working capital. Once the season is over, demand for variable working capital is over. Need for variable working capital is met from short-term sources of finance.