Working Capital
Working capital is the capital available for conducting the day-to-day operations of an organisation, represented by its current assets. It refers to the amount of Current Assets that exceeds Current Liabilities (i.e. CA – CL). Working capital is the money used to produce goods and attract sales. In short working capital refers to short term assets such as stock, debtors and cash minus short term creditors. Working Capital is also known as revolving or Circulating Capital or Short-Term Capital.
- Working Capital = Current Assets
- Net Working Capital = Current Assets − Current Liabilities
- Net Operating Working Capital = Current Assets – Non Interest-bearing Current Liabilities
- Equity Working Capital = Current Assets − Current Liabilities − Long-term Debt
Working capital is an investment which affects cash flows. For example, when stocks are purchased, cash is paid for them. Debtors represented the cost of selling goods or services to customers including the costs of the materials and labour incurred. Investing in working capital has a cost which can be expressed as either as: The cost of funding it or the lost investment opportunities because cash tied up and unavailable for other
Working Capital Cycle: Cash → Raw-Materials → Work-in-Process → Finished Goods → Cash
Working capital management
Working capital management is the device of finance. It ensures a company has sufficient cash flow in order to meet its short-term debt obligations and operating expenses. Working Capital Management means the deployment of current assets and current liabilities efficiently so as to maximize short-term liquidity. Implementing an effective working capital management system is an excellent way for many companies to improve their earnings. Working capital management entails short term decisions - generally, relating to the next one-year period - which is "reversible".
Two Steps involved in the Working Capital Management
- Forecasting the Amount of Working Capital
- Determining the Sources of Working Capital
Importance of Working Capital Management
- Working Capital is the Life Blood of the Business
- Fixed Assets (Long Term Assets) can be purchased on Lease/Hire Purchase but Current Assets cannot be
- Liquidity V/s Profitability
Objectives of Working Capital Management
- Deciding Optimum Level of Investment in various WC Assets
- Decide Optimal Mix of Short Term and Long Term Capital
- Decide appropriate means of Short Term Financing
Process/Steps Involved in Working Capital Management
- Forecasting the Amount of Working Capital
- Determining the Sources of Working Capital
Different Aspects of Working Capital Management
- Management of Inventory
- Management of Receivables/Debtors
- Management of Cash
- Management of Payables/Creditors
Types of Working Capital
- Gross working capital - Total or gross working capital is that working capital which is used for all the current assets. Total value of current assets will equal to gross working capital.
- Net Working Capital - Net working capital is the excess of current assets over current liabilities.
- Net Working Capital = Total Current Assets – Total Current Liabilities
- This amount shows that if we deduct total current liabilities from total current assets, then balance amount can be used for repayment of long-term debts at any time.
- Permanent Working Capital - Permanent working capital is that amount of capital which must be in cash or current assets for continuing the activities of business.
- Temporary Working Capital - Sometime, it may possible that we have to pay fixed liabilities, at that time we need working capital which is more than permanent working capital, then this excess amount will be temporary working capital. In normal working of business, we don’t need such capital.
Calculating the cash operating cycle
For a manufacturing business the cash operating cycle will be measured by:
- Cash operating cycle= raw materials holding period + WIP holding period + finished goods holding period + debtors’ collecting period- creditors’ payment period. For a wholesale or retail business, there will be no raw materials or WIP holding periods and the cycle is:
- Cash operating cycle = stock holding period + debtors’ collecting period – creditors’ payment period. The cash operating cycle is measurable in days as: Stock turn over period + Debtor days – Creditor days.
Example 1
|
Particulars |
GHC |
|
Credit sale |
1,200,000 |
|
Credit
purchases |
650,000 |
|
Average stock |
80,000 |
|
Average
debtors |
200,000 |
|
Average
creditors |
54,000 |
Calculate the length of cash operating cycle for the following:
- Stock turnover
- Creditors
- Debtors
- State the length of cash operating cycle Tuber Ltd
Solution
1. Average length of time goods remain in stock
Formula:
Average stock ÷ Credit purchases × 365 days
Calculation:
= 80,000 ÷ 650,000 × 365
= 45 days
2. Average time taken to pay suppliers
Formula:
Average creditors ÷ Credit purchases × 365 days
Calculation:
= 54,000 ÷ 650,000 × 365
= 30 days
3. Average time taken to collect cash from credit sales
Formula:
Average debtors ÷ Credit sales × 365 days
Calculation:
= 200,000 ÷ 1,200,000 × 365
= 61 days
4. Working Capital / Cash Operating Cycle
Formula:
Stock turnover + Debtors – Creditors
Calculation:
= 45 + 61 – 30
= 76 days
Final Answer: Length of cash operating cycle of Tuber Ltd = 76 days
Example 2
Extracts from the profit and loss account for the year and the balance sheet at the end of the year for Tuber Ltd show the following:
|
Particulars |
GHC |
|
Credit Sales |
250,000 |
|
Credit
Purchases |
140,000 |
|
Debtors |
31,250 |
|
Creditors |
21,000 |
|
Stock |
92,000 |
Note: All sales and purchases are on credit.
Calculate the length of cash operating cycle for the following:
- Creditors
- Debtors
- Stock turnover
- State the length of cash operating cycle for the company
Solution
1. Creditors
Average payment period
Formula:
Creditors ÷ Credit Purchases × 365
Calculation:
= 21,000 ÷ 140,000 × 365
= 55 days
2. Debtors
Average collection period
Formula:
Debtors ÷ Credit Sales × 365
Calculation:
= 31,250 ÷ 250,000 × 365
= 46 days
3. Stock Turnover
Formula:
Stock ÷ Credit Sales × 365
Calculation:
= 92,000 ÷ 250,000 × 365
= 134 days
4. Length of Cash Operating Cycle
Formula:
Stock turnover + Debtors − Creditors
Calculation:
= 134 + 46 − 55
= 125 days
Final Answer: Length of cash operating cycle = 125 days
Interpretation: The longer the cycle, the greater the level of resources tied up in working capital.
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