Working Capital Meaning, Definition and Nature

Nature of Working Capital

Meaning of Working Capital

Cash required for conducting the business, i.e., purchase of raw material and conversion thereof into finished goods, daily is termed as ‘Working Capital’ (WC). The essential items of “Working Capital” are:

  1. Inventory (work-in-progress, raw material, and finished goods) level,
  2. Debtors, and
  3. Creditors.

These factors are important in determining a company’s productivity and financial viability. A company that efficiently manages its working capital might not need to borrow funds. Efficient management of working capital involves a balanced approach, ie. as far as possible there should be neither shortage of cash nor its surplus. Companies burdened with surplus cash must ensure appropriate investment to generate returns for their shareholders.

Definition of Working Capital

According to Gerestenberg, “Circulating capital means current assets of a company that are changed in the ordinary course of business from one form to another, as, from cash to inventories, inventories to receivables, receivables into cash”.

As per Shubin, “Working capital is 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”.

The Significance of Managing Working Capital

Working capital comprises two components: current assets and current liabilities. Excess of a company’s current assets over its current liabilities is the Working Capital. Management of working capital, thus, involves management of its constituents, i.e., current assets and current liabilities and maintenance of an appropriate equilibrium between the two. “Revolving Capital,” “Circulating Capital,” and “Short Term Capital” are alternative terms for working capital.

Effectively managing a company’s working capital is important to ensure it has enough cash for seamless daily business operations. Maintaining a low ‘Cash Conversion Cycle’ (CCC) is important for a company. The CCC quantifies how quickly a company can transform available cash into additional funds. The CCC functions by initially converting cash into inventory and Accounts Payable (AP) through sales and Accounts Receivable (AR), and subsequently transforming it back into cash. Generally, the lower the CCC, the better for the company. A company can take the following steps to reduce CCC.

1) Enhancement in its credit period with the suppliers,

2) Reduction in the credit period given to its customers,

3) Efficient cash management, which results in a reduction in cash-holding costs.

4) Maintenance of an appropriate level of inventory, which results in reduced raw material costs, and

Implementing the above measures can greatly reduce the working capital requirement.

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Nature of Working Capital

The nature of working capital is as follows:

  1. Short-Term Needs
  2. Circular Movement
  3. Element of Permanency
  4. Element of Fluctuation
  5. Liquidity
  6. Less Risky
  7. A Special Accounting System is not Needed

The following paragraphs outline the nature of working capital.

1) Short-Term Needs

The acquisition of raw materials relies on ‘Working Capital,’ and this Working Capital, after a short process (Working Capital Cycle), becomes cash. The short period involved in the working capital differentiates it from ‘Fixed Capital’, wherein funds remain locked for a fairly long period. The period for which working capital is required depends upon the duration of the production cycle (conversion of raw material into finished goods, sale of finished goods and receipt of sale proceeds).

2) Circular Movement

The Working Capital Cycle (working capital material in progress – finished goods-sales-sale proceeds cash receipt working capital) is a continuous and recurring process. The cash is used to acquire current assets, transform them into finished goods, and subsequently sell these goods, leading to cash receipts from the sales. The cycle of WC begins with cash and ends with cash. The term “working capital,” often referred to as “circulating capital,” denotes funds that circularly circulate within a business.

3) Element of Permanency

Although the working capital requirement is for a short duration, it is demanded on an ongoing basis to ensure the sustainability of a company’s production activity. As long as production in a company goes on, there will be a continuous demand for working capital. ‘Permanent’ or ‘Regular Working Capital’ signifies working capital required permanently.

4) Element of Fluctuation

Although the working capital requirement of a company is permanent, there is a fluctuation in its demand. This fluctuation exhibits a broader range when compared to that of the Fixed Capital. Working capital requirement is variable and is in direct proportion to the level of production. With the changes in sales policy, purchase policy, price level, etc., the working capital requirement also changes. The part of working capital, which changes with production, sales, price, etc., is termed ‘Variable Working Capital’.

5) Liquidity

Comparatively operating capital is much more liquid than fixed capital. In the case of necessity, working capital can be smoothly and promptly converted into cash. Emergent cash requirements may be choosing the following options:

i) Emphasizing quick recovery of bills receivables,

ii) Expeditious sale of goods,

iii) Speeding up the conversion of raw materials to finished goods enhances efficiency. The strong liquidity of companies with substantial working capital adds to their reputation for security and stability.

6) Less Risky

Money locked up in fixed capital is not easily recoverable, if required, as it is meant for long-term duration. The risk of plant and machinery becoming outdated is present as technology continually advances. Investing in fixed capital carries a relatively high level of risk. On the other hand, investing in working capital is less risky due to its short-term nature.

However, there is exposure to a certain level of “Physical Risk.” Financial or Economic Risks associated with working capital are much less, which is due to less severity in the variations of product prices. Furthermore, working capital undergoes conversion into cash, followed by its re-transformation into working capital, maintaining this cycle. Due to this cyclical nature of working capital, it is not exposed to the risk generated by technological advancement.

7) A Special Accounting System is not Needed

Long-term assets obtained through fixed capital are subject to some system for evaluation of its depreciation, every year. On the other hand, short-term assets acquired through working capital have a lifespan of just one year. As such there is no need for adopting a special accounting system for them.

Nature of Working Capital

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