Every Company makes investment in fixed and current assets. Fixed assets like e.g., plant and machinery, land and building, vehicles, etc, remains in the business for more than one year. On the other hand, Current assets like inventories, debtors, bills receivables, etc. get converted into cash or cash equivalents within one year. Some part of these, current assets are usually financed through short-term sources, i.e., current liabilities. The rest is financed through long-term sources and is called Net Working Capital.
Net Working Capital (NWC) = Current Assets (CA) – Current Liabilities (CL)
Thus, net working capital may be defined as the excess of current assets over current liabilities.
WC Management is a process of managing short-term assets and liabilities. It makes sure that a firm has sufficient liquidity to run its operations smoothly.
Components of WC:
As clear from above, WC includes both current assets & current liabilities:
- Current Assets are short-term assets either in form of cash or a cash equivalent which can be converted to cash within 12 months.
- Typical current assets include:
- cash equivalents,
- short-term investments (marketable securities),
- accounts receivable,
- stock inventory,
- Current Liabilities include payment obligations which are due for payment within 1 year.
- Current Liabilities include:
- Bills Payable
- Bank Overdraft
- Unpaid Expenses
- Dividend Payable
- Income Tax Payable
- Short-term Credit
Working Capital Cycle
Most of the amount invested in current assets is continuously recovered through realisations of debtors and cash sale of goods, and is re-invested in current assets. It keeps on revolving from cash to current assets and back again to cash. For this reason, it is also known as circulating capital.
Factors Influencing WC:
- Nature of Business
- Scale of Operations/ Size of Business
- Production Cycle
- Credit Policy
- Availability of Credit
- Operating Efficiency
- Availability of raw materials
- Growth Prospects
- Business Cycle
- Changes in Technology
- Seasonal factors
- Taxation Policy
- Level of Competition
Kinds of Working Capital:
- Gross WC is the sum of all of a company’s current assets (assets that are convertible to cash within a year or less).
- It includes assets such as cash, accounts receivable, inventory, short-term investments and marketable securities.
- Gross working capital or current assets, less current liabilities equate to Net WC.
- A part of WC is of a permanent nature because depending on the volume of business certain amount of cash, debtors and stock-in-trade shall always be maintained by every firm.
- This part is known as permanent or fixed WC.
- It must always be financed through long-term sources.
- The remaining part of the WC requirement varies from period to period on account of fluctuations in the volume of business and is called fluctuating or variable WC.
- This part is usually financed through short-term sources like bank overdraft, trade creditors, bills payable, etc.
Importance of WC
Working capital is a prevalent metric for the efficiency, liquidity and overall health of a company.
- Sufficient WC enables a business concern to make prompt payments and hence helps in creating and maintaining goodwill.
- Adequate WC management helps a firm to survive through a crisis or ramp up production in case of an unexpectedly large order.
- It helps to operate the business smoothly by making payment of short-term liabilities. This allows purchase of raw materials and payment of salary, wages and overhead can be made without any delay, which in turn, improves solvency of the business by providing uninterrupted flow of production.
- Quick payment of credit purchase of raw materials ensures the regular supply of raw materials fro suppliers and improves the credit rating of the firm.
- Adequate WC, high solvency and good credit rating also helps to arrange loans from banks and financial institutions in easy and favourable terms.
- Optimal WC helps in improving operating efficiency of the firm.