Working Capital – Meaning, Nature and Uses

Working Capital – Meaning, Nature and Uses

MEANING OF WORKING CAPITAL – There have been diverging views among scholars on the definition of working capital. Western and Bingham defined it as a firm’s investment in short-term assets such as cash, short-term securities, accounts receivables and inventories”. Firth (1970) give his definition of working capital as a company’s investment in the short-term assets”. 15 working capital constitutes these assets hold for current use within a business, less the amount due to those awaiting settlement in the short-term for value supplied in whatever form. It is customary to divide working capital into two categories, that is;  

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a)     Gross working capital

b)    Net working capital

Gross working capital is the sum total of all current assts, while the net working capital is the difference between current assets and current liabilities”. The gross working capital presents the financial problem of how to manage the individual components of current assets. The net working capital has financial significance for two reasons. The first reasons is that the amount for net working capital represents the volume of current assets which are being financed by long-term resources. Through, current assets and liabilities are turned over within short period of time, the net balance of current assets is that proportion which is permanently owned by the company. The second reason is that creditors have particular interest in the net working capital position because they regard them as the ultimate source of funds for repayment of the loans.

Lee (1976) takes a clearly different view from the above definition of working capital. He see working capital in terms of net resources available in the short-term. He argues that in a business context, working capital should be regarded as the sum of the non-cash, cash and current resources of the firms.

He identifies non-cash resources as comprising stocks and work in progress as well as debtors minus creditors and other short-term liabilities excluding overdraft, according to him, overdraft should be excluded because it is revolving liability of non current nature.

Aguolu P, in his lecture hand-out on financial management summarized working capital thus:. “working capital is the difference between current assets and current liabilities. It sometimes called circulating capital”.

 COMPOSITION OF WORKING CAPITAL

According to L. E. Howard, the constituent part normally make up the figure of working capital otherwise called the net current assets will be items of current assets and current liabilities. The current items include the following:-

  1. Stock (including raw materials, working in progress and finished goods)    
  2. Payments (ie payments in account of expenses to be incurred)
  3. Investment, readily realizable in nature and temporary investment.
  4. Trade debtors
  5. Bills receivable
  6. Balance at bank and
  7. Any outstanding liabilities currently payable.

 FACTORS AFFECTING THE COMPOSITION OF WORKING CAPITAL

A number of factors influence the composition of working capital requirement of the firms and they include:

A)      NATURE OF THE BUSINESS

The working capital needs of a firm are dependent on the nature of its business. For example, trading and financial firms have less investments in fixed assets but require a large sum of cash to be invested in working capital. Again, where services are rendered on cash bases, inventories will be at the minimum and debtors almost non-existent.

B)      SIZE OF THE BUSINESS

The size of the firm also has an impact on its working capital requirements. Size may be measured in terms of the scale of operation. A firm with large scale of operation will need more working capital than a small firms. In other words, large firms carry heavy inventories of raw materials, work-in-progress and their debtors are likewise quite substantial than small firms.

C)      INTERNAL POLICIES

Internal policies that affect the composition perspectives. First, the production policy may affect the capital needs of the firm. If a strategy of constant production is maintained, it will cause inventories to accumulate during the of-reasons period the firm will be exposed to greater inventory costs and risks. Where the cost and risks of maintaining a constant production schedule are high, the firm may adopt the policy of varying its production schedules in a accordance with the charging demand, secondly, the credit policy of the firm may affect the working capital by influencing the book debts. The credit terms to be granted to the customers may depend upon the industry policy, but a firm has the flexibility of shaping its credit policy within the constrains of the industry norms and practices.

D)      AVAILABILITY OF CREDIT FACILITIES

Credit terms granted by a firm’s creditors and banks influences the working capital needs of a firm. A firm will need less working capital if liberal credit terms are available to it. Similarly, a firm which can get bank credit easily on favaourable conditions will operate with more working capital than a firm without such facility.

E)      OPERATING EFFICIENCY

The operating efficiency of the firm relates to the optimum utilization of resources at minimum costs. The firm will be effectively contributing to its working capital if it is reducing the operating costs. The use o working capital is improved and the cash cycle is increased with operating efficiency. Better utilization of resources improves profitability and helps in releasing the pressure on working capital.

 CURRENT ASSETS

Current assets represents fund that are invested in the short-term operating of the firm. They are items that will normally be converted into cash without one year. These items are usually listed in order of liquidity. In the balance sheet presentation, cash being the most liquid of all assets is at the end of the list. Stocks whether in the form of raw materials, work-in-progress or finished goods are the least liquid and they are recorded at the beginning.

Stocks present many difficult management problems in additions to that of their liquidity. The raw materials, have to be processed through the manufacturing operation and therefore is a long period of time between acquisition and eventually sale.

There is a partial exception to this process if the firm deals in the commodity market and treats its purchases of raw materials as part of an investment in commodity/commodities. The management must be prepared to accept the risks involved in the liquidity of stocks if the firm is to make profit. Stocks in all forms require handling and storage. Some suffer spoilage and restage ever time. In addition, market prices can change rapidly, it may well be faced with stocks that are failing in value even as they are being manufactured into finished goods.

 CURRENT LIABILITIES

According to accounting research bulletin No 45, current liabilities are defined from both solving and operational perspective. The solvency is reflected in the statement that the term current liabilities are used principally to designate obligations whose liquidations is reasonably expected to require the use of existing resources properly classified as current assets or creation of another current liabilities. The operational point of view is reflected thus: as a balance sheet category and the classification is intended to include specifications for times which fall into the operating cycle, such as payable incurred in the acquisition of materials and supplies to be used in production of goods or in providing services to be offered to sale”.

According to Smith “Current liabilities are obligations that require the use of current assets for their payments, and the are liabilities that will be paid within an operating cycle. Payment can be made by expending current assets or by incurring another current liability.

 MANAGEMENT OF WORKING CAPITAL

Working capital management, according to Aguolou may be defined as managerial decisions on the amount of capital to the invested in various current assets and how this investment is to be financed. Any transaction of a business enterprise that affects the current assets or the current liabilities would affect the working capital management. Working capital has a life of less than one year. The terms is used normally to indicate the amount of surplus funds enabling it to most demands requiring immediate settlement.   

Most businesses, for instance, need money for the payment of wages. The working capital indicates the liquidity position of the firm and suggests the extent to which working capital needs may be financed by permanent sources of funds. A week liquidity position posses a threat to the solvency of the company and makes it unsafe and unsound. Excessive liquidity is also bad in that it decreases the firms rate of return.

TYPES OF WORKING CAPITAL

Working capital is categorized into permanent and fluctuating (or temporary) working capital. There is always a minimum level of current assets which is continuously required by the firm to carry on its business operations. This is referred to as permanent or fixed working capital. It is permanent in the same way as the firm’s fixed assets are:

The need for working over and above, this will fluctuate according to the change in production and sales. (see figures 1 and 2 below) since production and sales grow over time, the graph slopes upwards.

CHARACTERISTICS OF WORKING CAPITAL

The characteristics of working capital are as follows:-

1)      Short – life – working capital

This is characterized by assets with life span that is generally less than one year. Thus short-life leads to high volatility in the level of investment required to finance working capital.

2)      Nearness to cash working capital   

Finished goods when sold are converted into accounts receivable which on collection are transformed into cash.

 3)     Lack of synchronization

The level of investment in working capital is affected by the sales volume, production policies and collection policies. For typical firms, production sales and collection are synchronized. There characteristic have an important bearing on the level of investment in current assets and how the current assets are financed.

 SOURCES OF WORKING CAPITAL

          Some transactions cause an increase in working capital thus they are regarded as sources of working capital. The increase results from either increase in current asset value or reduction in liabilities.

A)      NET GAIN FROM SALES

This source supplies fund in day-to-day operations for meeting current costs of labour, raw materials and various overhead costs and expenses of insurance, property taxes, advertising, supervision and general administration. (In the long – run operations, we only consider the net addition to working capital from sales). This source can be stated as net sales cash expenditure. = working capital inflow, or net profit + depreciation expenses = working capital inflow.

 B)      SALE OF CURRENT ASSETS ABOVE BOOK VALUE

The most obvious source of net-working capital from the sales of current assets is the sale of inventories above their books costs. The mark-up above inventory costs is the gross profit in the operating statement marketable securities are sold at a profit, working capital will be increased.

C)      RETIRING CURRENT DEBTS AT BELOW BOOK VALUE

In some current debts are paid off for less than the contracted amount. A trade creditor experiencing cash shortage, for instance, many accept in full payment, an amount less than the face value of the original debt. Cash discount also increases working capital through book profit.

D)      SALES OF FIXED ASSETS

Sales tangible or intangible fixed a assets and to working capital the exact amount realized.

Note: profit and loss are not relevant here.

 E)      CAPITAL BORROWING AND ISSUANCE OF CAPITAL STOCK 

          This entails securing working capital by means of debt contracts with maturities in excess one year. The immediate purpose and result of the borrowing is to increase working capital.

F)      EXCHANGING CURRENT FOR CAPITAL DEBT

          Getting a short-term creditor to accept a long-term notes or bond in place of cash has the same effect of increasing working capital as a new capital borrowing.      

USES OF WORKING CAPITAL

According to Frank Wood, “it cannot be stressed too strongly that the working capital should be adequate to finance the running of the business with out undue strain. A shortage of working capital can mean that creditors cannot be paid on time, thus losing valuable cash discounts, that creditors may take legal action to enforce the payment of debts which may cause the firm to close down if it is unable to take part in certain profitable activities that may occur, for instance a bulk purchase of goods at a very low price may have to be missed. Some other transactions cause working capital to decrease. The limiting effect of the loss in working capital depends on how the funds are used.     

The following are the uses of working capital funds

1.       MEETING NET LOSSES FROM SALES:

When cash expenditures required to generate sales are greater than the cash generated by the sales a less in net working capital occurs. In other words working capital is reduced when cut-of-packet expenditures are greater than sales income sometime this is inevitable and it does not spell business failure. If it is planned and controlled. But not business can stand up long under repeated shortage of cash from operations.         

 2.       DECLARATION OF DIVIDENDS

The declaration of dividends causes a dividend payable account in the current liabilities hat reduces working capital by the amount of dividend payable, thus hampering future short-run operation.

3.            RETIRING CURRENT LIABILITIES ABOVE BOOK VALUE

Working capital may be lost when the firm pays its debt above he book value. An example is where the firm finds tat its income taxes actually paid are higher than the amount reserved for taxes in current liabilities.

4.            PURCHASING FIXED ASSETS

This cause loss of working capital equal to  the full purchase prize of the asset (tangible or intangible). It may have serious short-run reprehensions on future short – run profits and external credit.

5.            RETIRING CAPITAL DEBTS AND OUTSTANDING STOCK

Retiring capital debts reduces working capital by the full amount of the payment just as in the case of the fixed assets purchased. Retiring outstanding stock is more server than retiring capital debts. Besides, using up working capital for short term credit, the net capital of the business is reduced and the long run credit standing of the business as well as the short is improved permanently.

6.            EXCHANGE CAPITAL FOR CURRENT DEBTS

Giving creditors short – term notes and bill in exchange for long – term contracts has the same effect as bringing down capital debts from capital structure to current liabilities when they mature. Working capital is reduced by increasing current debts and shortening the long – term debt structure.           

—This article is not complete———–This article is not complete————
This article was extracted from a Project Research Work/Material Topic

EFFECTIVE WORKING CAPITAL MANAGEMENT IN PAINT INDUSTRIES (A CASE STUDY OF MARSHAL PAINT AND CHEMICAL LIMITED ENUGU – ENUGU STATE)

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Working Capital – Meaning, Nature and Uses

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