Capital required for a business can be classified under two main heads:
- Fixed Capital
- Working Capital
Fixed capital / Long term funds is required to meet long term obligations namely purchase of fixed assets such as plant & machinery, land, building, furniture etc. Any business requires funds to meet short-term purposes such as purchase of raw materials, payment of wages and other day-to-day expenses. These funds are called Working capital. In short, working capital is the funds required to meet day-to-day operations of a business firm. And hence study of Working capital is considered to be very significant. An inefficient management of working capital leads to not only loss of profits but also to the closure of the business firm.
There are two concepts of Working capital namely,
- Gross Working Capital (GWC)
- Net Working Capital
Generally working capital refers to the gross working capital and represents funds invested in total current assets of the firm.
GWC=CA
Where CA = Current Assets
Net Working Capital is often referred to as circulating capital and represents the excess of current assets over current liabilities. Current liabilities are short-term obligations which are to be paid in the ordinary course of the business within a short period of one accounting year.
NWC=CA-CL c. Sales tax, excise
Where Current Assets-Current Liabilities
Net working capital is positive when current assets exceed current liabilities. It is negative when current liabilities exceed current assets.
- Cash Management: Cash is one of the important components of current assets. It is needed for performing all the activities of a firm, i.e. from acquisition of raw materials to marketing of finished goods. Therefore it is essential for a firm to maintain an adequate cash balance. One of the important functions of a finance manager is to match the inflows and outflows of cash so as to maintain adequate cash.
- Receivables Management: The term receivable is defined as any claim for money owed to the firm from customers arising from sale of goods or services in normal course of business. The term account receivable represents sundry debtors of a firm. It is one of the significant components of working capital next to cash and inventories.
The total volume of accounts receivable depends on its credit sale and debt collection policy—these two significantly influence the requirement of working capital. Liberal credit policy increases the volume of sales but at the same time it also increases the investment in receivables. Therefore, examination of costs and benefits associated with credit policy is one of the important tasks of a finance manager.
- Inventory Management: Inventory constitutes a major part of total working capital. Efficient management of inventory results in maximization of earnings of the shareholders. Efficient inventory management consists of managing two conflicting objectives:
- minimization of investment in inventory on the one hand; and
- maintenance of the smooth flow of raw materials for production and sales on the other.
Therefore the objective of a finance manager is to calculate the level of inventory where these conflicting interests are reconciled. Like cash, a firm holds inventory for transaction, precautionary and speculative motives.
- Accounts Payable Management: Payables or creditors are one of the important components of working capital. Payables provide a spontaneous source of financing of working capital. Payable management is very closely related with the cash management. Effective payable management leads to steady supply of materials to a firm as well as enhances its reputation.
It is generally considered as a relatively cheap source of finance as suppliers rarely charge any interest on the amount owed. However, trade creditors will have a cost as a result of loss of enjoying cash discount on cash purchases.