Definition of Working Capital Management
Working capital Management refers to the cash a business requires for day-to-day operations,or more specifically, for financing the conversion of raw materials into finished goods,which the company sells for payments. Among the most important items of working capital are levels of inventory,debtors and creditors. These items are looked at for signs of a company’s efficiency and financial strength.
According to shubin __”Working capital the amount of funds necessary to cover the cost of operating the enterprise”.
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”.
Importance of Working Capital Management
Working capital management requires great care due to potential interactions between its components. For example, extending the credit period offered to customers can lead to additional sales. However, the company’s cash position will fall due to the longer wait for customers to pay, potentially leading to the need for a bank overdraft. Interest on the overdraft may even exceed the profit arising from the additional sales, particularly if there is also an increase in the incidence of bad debts.
Working capital management is central to the effective management of a business because:
- current assets comprise the majority of the total assets of some companies
- shareholder wealth is more closely related to cash generation than accounting profits
- failure to control working capital, and hence to manage liquidity, is a major cause of corporate collapse.
Characteristics of Working Capital
- Short-Term Needs: Working capital is being utilized in acquiring current assets which will be converted to cash for a short period only.
- Circular Movement: Working capital is being converted to cash constantly which will just be turned as a working capital all over again.
- Element of Permanency: Although it is just a kind of short term capital, working capital is needed by a business forever and always.
- Element of Fluctuation: Working still fluctuates every now and then even it is something permanent.
- Liquidity: It is very liquid for it can be converted as cash any time without losing anything.
- Less Risky: Investments in current assets such as working capital comes with less risk for it is just for short term.
- Special Accounting System No Needed: Since working capital is a short term asset that will last for a year only, there will be no need for adoption of a special accounting system.
Nature of Working Capital
- It is used for purchase of raw materials, payment of wages and expenses.
- It changes form constantly to keep the wheels of business moving.
- Working capital enhances liquidity, solvency, creditworthiness and reputation of the enterprise.
- It generates the elements of cost namely: Materials, wages and expenses.
- It enables the enterprise to avail the cash discount facilities offered by its suppliers.
Concept of working capital
There are two concepts of working capital:
1. Gross Working Capital
The concept of gross working capital refers to the total value of current assets. In other words, gross working capital is the total amount available for financing of current assets. However, it does not reveal the true financial position of an enterprise. How? A borrowing will increase current assets and, thus, will increase gross working capital but, at the same time, it will increase current liabilities also.
As a result, the net working capital will remain the same. This concept is usually supported by the business community as it raises their assets (current) and is in their advantage to borrow the funds from external sources such as banks and the financial institutions.
Gross Working Capital = Total Current Assets
2. Net Working Capital
The net working capital is an accounting concept which represents the excess of current assets over current liabilities. Current assets consist of items such as cash, bank balance, stock, debtors, bills receivables, etc. and current liabilities include items such as bills payables, creditors, etc. Excess of current assets over current liabilities, thus, indicates the liquid position of an enterprise.The ratio of 2:1 between current assets and current liabilities is considered as optimum or sound. What this ratio implies is that the firm/ enterprise have sufficient liquidity to meet operating expenses and current liabilities. It is important to mention that net working capital will not increase with every increase in gross working capital. Importantly, net working capital will increase only when there is increase in current assets without corresponding increase in current liabilities.