What is Role of Working Capital in Business

Working capital is the life blood and nerve centre of a business. Jus as circulation of blood is essential in the human body for maintaining life. Working capital is very essential to maintain the smooth running of a business. No business can run successfully without an adequate amount of working capital. However, it must also be noted that working capital is a means to run the business smoothly and profitably, and not an end. Thus, concept of working capital has its own importance in a going concern. A going concern, usually, has a positive balance of working capital, i.e., the excess of current assets over current liabilities, but sometimes the uses of working capital may be more than the sources resulting into negative value of the working capital. This negative balance is generally offset soon by gains in the following periods. A study of changes in the uses and sources of working capital is necessary to evaluate the efficiency with which the working capital is employed in a business. This involves the need of working capital analysis.

Analysis of working capital can be conducted through devices 

    Ratio Analysis
    Fund Flow Analysis
    Budgeting

Ratio Analysis

 A ratio analysis is a simple arithmetical expression of the relationship of one number to another. The technique of ratio analysis can be employed for measuring short term liquidity or working capital position of a firm.

Fund Flow Analysis

Funds flow analysis is a technical device designated to study the sources from which additional funds were derived and the use to which these sources were put. It is an effective management tool to study changes in the financial position of a business enterprise between beginning and ending financial statements dates. The fund flow analysis consist of

    Preparing schedule of changes in working capital

    Statement of sources and application of funds

Working capital Budget

A budget is a financial and quantitative expression of business plans and policies to be pursued in the future period of time. Working capital budget, as a part of total budgeting process of a business, is prepared estimating future long term and short term working capital needs and sources to finance. 

The quantitative concept of Working Capital

The quantitative concept of Working Capital is known as gross working capital while that under qualitative concept is known as net working capital. Working capital can be classified in various ways. The important classifications are as given below:

Conceptual classification – There are two concept of working capital viz., quantitative and qualitative. The quantitative concept takes into account as the current assets while the qualitative concept takes into account the excess of current assets over current liabilities. Deficit of working capital exists where the amount of current liabilities exceeds the amount of current assets. The above can be summarised as follows:

                        (i) Gross Working Capital = Total Current Assets

                        (ii) Net Working Capital = Excess of Current Assets over Current Liabilities

                        (iii) Working Capital Deficit = Excess of Current Liabilities over Current Assets.

Classification on the basis of financial reports – The information of working capital can be collected from Balance Sheet or Profit and Loss Account; as such the working capital may be classified as follows:

• Cash Working Capital – This is calculated from the information contained in profit and loss account. This concept of working capital has assumed a great significance in recent years as it shows the adequacy of cash flow in business. It is based on ‘Operating Cycle Concept’s which is explained later in this chapter.
• Balance Sheet Working Capital – The data for Balance Sheet Working Capital is collected from the balance sheet. On this basis the Working Capital can also be divided in three more types, viz., gross Working Capital, net Working Capital and Working Capital deficit.

Classification on the Basis of Variability – Gross Working Capital can be divided in two categories viz., (i) permanent or fixed working capital, and (ii) Temporary, Seasonal or variable working capital. Such type of classification is very important for hedging decisions.

• Temporary Working Capital – Temporary Working Capital is also called as fluctuating or seasonal working capital. This represents additional investment needed during prosperity and favourable seasons. It increases with the growth of the business. ”Temporary working capital is the additional assets required to meet the variations in sales above the permanent level.” This can be calculated as follows:

                         Temporary Working Capital = Total Current Assets – permanent Current Assets

•  Permanent Working Capital – It is a part of total current assets which is not changed due to variation in sales. There is always a minimum level of cash, inventories, and accounts receivables which is always maintained in the business even if sales are reduced to a minimum. Amount of such investment is called as permanent working capital. “Permanent Working Capital is the amount of working capital that persists over time regardless of fluctuations in sales.” This is also called as regular working capital. 

Necessitating enhanced working capital

The term “production” or “manufacturing cycle” refer to the time involved in the manufacture of goods. It covers the time span between the procurement of raw materials and the completion of the manufacturing process leading to the production of finished goods. Funds will have to be necessarily tied up during the process of manufacturing, necessitating enhanced working capital. In other words, there is some gap before raw material becomes finished goods. To sustain such activities the need for working capital is obvious. The longer the time – span the larger will be the funds tied up and, therefore, the larger the working capital needed and vice versa. There are enterprises which due to nature of the business will have a shorter operating cycle. A distillery, which has an ageing process, has generally to make a relatively heavy investment in inventory. The other extreme is provided by a bakery. The bakeries sell their products at shorter intervals and have a high inventory turnover. The investment in inventory and, consequently, working capital is not very large

Even within the same group of industries, the operating cycle may be different due to technological considerations. For economy in working capital, that process should be selected which has a shorter manufacturing process. Having selected a  particular process of manufacture, steps should be taken to ensure that the cycle is completed in the expected time. This underlines the need for effective organization and co-ordination at all levels of the enterprise. Appropriate policies concerning terms of credit for raw materials and other supplies can help in reducing working capital requirements. Often companies manufacturing heavy machinery and equipment minimize the investment from inventory or working capital by requiring advance payment from customers as work proceeds against orders. Thus, a part of the financial burden relating to the manufacturing cycle time is passed on to other.