The capital required to meet day to day financial requirements is known as working capital.
There are two concepts of Working Capital:
- Gross Working Capital: Gross working capital is the sum total of all current assets.
- Net Working Capital: Net working capital is the difference between the current assets and current liabilities.
Alternatively, net working capital is that portion of current assets which is financed from long term capital or fixed liabilities.
Working Capital can be of two types:
- Permanent Working Capital:
A certain minimum amount of working capital which is required in the business at all times is known as permanent working capital.
- Temporary Working Capital:
Part of working capital for which the requirements change with with seasonal changes in production and sales is known as temporary working capital.
Need for Working Capital can be explained with the help of operating cycle or cash cycle. Operating cycle has three phases:
- It begins with the investment of cash to purchase stock.
- Sale of stock on credit leads to creation of receivables.
- On collection, accounts receivables are converted into cash.
As the firm passes through these three stages, the form of working capital changes from cash to inventory, inventory to receivables and receivables to cash.
In case of a manufacturing firm the inventory of raw material is converted to semi-finished goods and then to finished goods which are ready for sale.
To ensure smooth functioning of operating cycle, appropriate investment of working capital is necessary in the form of cash, inventory and receivables.
DETERMINANTS OF WORKING CAPITAL
The following factors influence the working capital requirements of a firm:
- Nature of Business
- Size of Business
- Nature of Business Cycle
- Method of Production
- Operating efficiency
- Production Policy
- Availability of Raw Material
- Fluctuation in prices
- Credit Policy of the firm towards the customers
- Credit Policy of the suppliers of the firm
- Future growth and expansion
- Cash profits of the firm
- Dividend Policy of the firm
- Depreciation policy of the firm
- Tax liability of the firm
- Relations with the bank