Working Capital Management

Unit 5
Financial Management
MBA 2nd Semester
Department of Business
Administration, University of
Lucknow, Lucknow

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Working Capital Management
Working capital management is a business
strategy to ensure that operating activities of
business are smooth and efficient. Working
capital management involves a relationship
between current assets and current liabilities
enabling the company to maintain adequate
working capital in order to meet the current
obligations of business.
Two Concepts of Working Capital:
Gross Working Capital = Total Current Assets
Net Working Capital =Current Assets – Current
Liabilities
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Current Assets and Current Liabilities
Current assets mean those short term assets which in the normal course of business
are converted into cash within a year. Examples of current assets are:
1. Inventories of raw material, work-in-progress and finished goods
2. Debtors, bill receivable
3. Short term investment or marketable securities
4. Pre-paid expenses
5. Short term advances
6. Accrued incomes
7. Cash in hand and bank balances
Current liabilities are those short term liabilities which in the normal course of
business are payable within a year. Examples of current liabilities are:
1. Creditors, bill payables
2. Outstanding expenses
3. Short term loans
4. Bank overdrafts
5. Provision for tax
6. Proposed dividends etc.
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Different Sources of Working Capital
A business firm uses two types of sources to finance its working
capital requirements:
A. Long Term Sources
B. Short Term Sources
Long Term Sources of Working Capital Financing:
Every business is required to maintain a minimum balance of
cash and other current assets at all times irrespective of business
level of operations. The part of working capital which is
continuously maintained by any business at all times to carry on
its business is called the permanent working capital. This type of
working is advised to be financed partly through long term
sources as given under:
1. Issue of equity and preference share capital
2. Retained earnings
3. Issue of debentures and long term bonds
4. Long term loans from financial institutions
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Short Term Sources of Working Capital Financing:
Generally, it is the short term working capital which used
to finance the short term payment obligations. This
working capital is termed as temporary working capital
needed to support seasonal fluctuations in the operations.
The examples of short term sources are given as under:
1. Bank credit, overdraft etc.
2. Public deposits
3. Trade credits
4. Sales revenues
5. Outstanding expenses
6. Provision for depreciation, taxes etc
7. Advances from customers
8. Employees’ security money etc.
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Importance of Working Capital Management
1. Efficient and smooth business operations
2. Optimizing profits in current assets investment
3. Helpful in continuous production and supply
4. Improved liquidity and solvency of business
5. Enhancement in business credibility
6. Efficient use of fixed assets
7. Meeting of contingencies
8. Timely payment of interest and dividend
9. Better cash flow management
10. Consistent with wealth maximization objective
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Consequences of Inadequate and Surplus of Working Capital
Working capital management seeks to find the optimum
level to ensure liquidity and maximize profitability. The
working capital of an organization is the result of deducting
its current liabilities. If managers do not keep an
organization's working capital within certain levels, it can
have serious consequences to the organization's financial
health.
The Inadequacy of working capital results in the following:
1. Interrupted production and supply
2. Low employees morale
3. Low efficiency and profitability
4. Low market reputation
5. Defaults in payment of interest and other dues
6. Lack of synchronization in cash flows
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Consequences of Excess Working Capital
On the other hand surplus working capital is also not good
for the organization. Excess working capital in a business
organization results in the following consequences:
1. Wastage and quality deterioration of inventory
2. Increased cost of funds invested in working capital
3. Unnecessary expenses leading to inefficiency and losses
4. Misuse of resources
5. Increased bad debts and defaults
6. Increased imbalance in cash flows
7. Continuous fall in efficiency and profitability

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Concept of Optimum Level of Working Capital
Optimum level of working capital is that level of
working capital where the business organization is
capable to pay all its short term dues.
In addition to this, the company should carry an
additional working capital in order to meet its
emergency situation of business such as delay in
supply of raw material, sudden excess demand of
production and supply, payment of advance to
suppliers, employees etc.
Optimum level of working capital is the situation
wherein the cost of liquidity and the cost of
illiquidity both are balanced at an intersection point
as both of these costs are inversely related.
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Important Principles of WC Management
Principles of working capital management are the
general guidelines which if are carefully followed
would lead to effective and efficient management of
working capital in a given organization. These
principles are:
1. Principle of Equity Position of Current Assets
2. Principle of Cost of Capital
3. Principle of Maturity of Payment
4. Principle of Risk Variation

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 Principles of WC Management (Cont..)
Principle of equity position: As per this principle all the current assets in the
organization should measured optimally so that each part of current asset can
contribute to the net worth of the firm. The position of current assets can be
well judged by the two ratios: a) current assets to total asset and; b) current
asset to total sales.
Principle of Cost of Capital and Risk: Different sources of working capital
finance have different cost of capital. There is an inverse relationship between
the risk and cost of capital, which means more the risk less will be the cost and
vice versa. So there should be balance between the two, cost and risk. For
example loan is less costly and more risky whereas reserve is more costly and
less risky.
Principle of Maturity of Payment: This principle states that funds for
working capital should be raised from different sources keeping in mind their
maturity aspect so that the firm can repay them on the time of their maturity of
payment.
Principle of risk variation: there is direct relationship between risk and
return. More liquidity facilitates transaction and reduces the risk of failure of
operation but high funds means more cost of capital and less return and vice
versa.

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Factors affecting Working Capital Requirement
1. Length of operating and manufacturing cycle
2. Nature of business
3. Scale of operation
4. Business cycle fluctuation
5. Seasonal factors
6. Production techniques
7. Sales and credit policy
8. Credit availability
9. Operating efficiency
10. Easy availability of raw material
11. Level of competition
12. Level of inflation
13. Growth prospects of business
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Operating and Manufacturing Cycle

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Nature of Business

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Scale of Business Operation

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Business Cycle Fluctuations

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Seasonal Factors

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Production Techniques

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Sales and Credit Policy

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Concluding Remarks
1. Working capital management establishes a relationship between
current assets and current liabilities.
2. The objective of working capital management is to ensure
smooth functioning of business operation and timely meeting
short term obligations.
3. In order to fulfill working capital management objectives,
finance manager is required to ensure the availability of
optimum working in business.
4. Optimum working capital is that position which is none of
shortage or excess of working capital.
5. Only at optimum working capital business ensures efficiency
and profitability in working capital management.
6. The four principles of working capital management are helpful
in fulfilling the objectives.
7. there are a number of consideration that influence working
requirement in an organization.

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