Working capital nature

1. I Nature & elements of working capital
Introduction:
Working capital is another part of the capital which is needed for meeting day-to-day
requirement of the business concern. Normally, it consists of recurring in nature. It can be
easily converted into cash. Hence it is also known as short-term capital. For example –
payment to creditors, salary paid to workers, purchase of raw materials etc.
Definition of working capital
Working capital means current assets. The sum of the current asset is the working capital of a
business.
According to the Weston and Brigham, “Working capital refers to a firm’s investment in
short-term assets, cash, short-term securities accounts receivables and inventors.”
Bonneville defined that, “Any acquisition of funds which increases the current assets,
increase working capital also for they are one and the same.”
According to the definition of Genestenberg, “Circulating capital means current assets of a
company that are changed in the ordinary course of business from one to another.”
Nature of Working Capital:
The nature of working capital is as discussed below:
i. It is used for purchase of raw materials, payment of wages and expenses.
ii. It changes form constantly to keep the wheels of business moving.
iii. Working capital enhances liquidity, solvency, creditworthiness and reputation of the
enterprise.
iv. It generates the elements of cost namely: Materials, wages and expenses.
v. It enables the enterprise to avail the cash discount facilities offered by its suppliers.
vi. It helps improve the morale of business executives and their efficiency reaches at the
highest climax.

2. vii. It facilitates expansion programmes of the enterprise and helps in maintaining operational
efficiency of fixed assets.
The elements of working capital
Meaning: Working capital is the capital available for conducting the day-to-day operations of
an organisation; normally the excess of current assets over current liabilities.
Elements of working capital
Working capital management is the management of all aspects of both current assets and
current liabilities, to minimise the risk of insolvency while maximising the return on assets.
Current Assets: Current assets are all the assets of a company that are expected to be sold or
used as a result of standard business operations over the next year. Current assets include
cash, cash equivalents, accounts receivable, stock inventory, marketable securities, pre-paid
liabilities, and other liquid assets.
Current Liability: A current liability is an obligation that must be repaid within the current
period or the next year whatever is longer. In other words, it’s a short-term loan or long-term
debt that will become due in the next 12 months and require payment of current assets.
Description of nature of working capital
Investing in working capital has a cost, which can be expressed either as:

3. • The cost of funding it, or
• The opportunity cost of lost investment opportunities because cash is tied up and
unavailable for other uses.
Working capital and cash flows: Working capital is an investment which affects cash flows.
• When inventory is purchased, cash is paid to acquire it.
• Receivables represent the cost of selling goods or services to customers, including the costs
of the materials and the labour incurred.
• The cash tied up in working capital is reduced to the extent that inventory is financed by
trade payables. If suppliers give a firm a credit period, the firm’s cash flows are improved and
working capital is reduced.
The objectives of working capital management in terms of liquidity and profitability
The main objective of
working capital management
is to get the balance of
current assets and current
liabilities right.
This can also be seen as the
trade-off between cash flow versus profits. Current assets are a major financial position
statement item and especially significant to smaller firms. Mismanagement of working capital
is therefore a common cause of business failure, e.g.:
• Inability to meet bills as they fall due
• Demands on cash during periods of growth being too great (overtrading)
• overstocking.

4. Working capital management is a key factor in an organisation's long-term success. The
trade-off between liquidity and profitability and its role in determining a business’s overall
investment in working capital is fundamental to your understanding of working capital
management for the examination.
Conflict between the elements of main elements of working capital
Profitability v liquidity
The decision regarding the level of overall investment in working capital is a cost/benefit
trade-off – liquidity versus profitability, or cash flow versus profits.
Cash flow versus profit
It is worth while stressing the difference between cash flow and profits. Cash flow is as
important as profit. Unprofitable companies can survive if they have liquidity. Profitable
companies can fail if they run out of cash to pay their liabilities (wages, amounts due to
suppliers, overdraft interest, etc.).
Some examples of transactions that have this ‘trade-off’ effect on cash flows and on profits
are as follows:
(a) Purchase of non-current assets for cash. The cash will be paid in full to the supplier when
the asset is delivered; however the cost will be charged to profits gradually over the life of the
asset in the form of depreciation.
(b) Sale of goods on credit. Profits will be credited in full once the sale has been confirmed;
however the cash may not be received for some considerable period afterwards.
(c) With some payments such as tax there may be a significant timing difference between the
impact on reported profit and the cash flow.
Clearly, cash balances and cash flows need to be monitored just as closely as trading profits.
The need for adequate cash flow information is vital to enable management to fulfil this
responsibility.

5. Liquidity versus profitability
Liquidity in the context of working capital management means having enough cash or ready
access to cash to meet all payment obligations when these fall due. The main sources of
liquidity are usually:
• Cash in the bank
• Short-term investments that can be cashed in easily and quickly
• Cash inflows from normal trading operations (cash sales and payments by receivables for
credit sales)
• An overdraft facility or other ready source of extra borrowing.
The basis of the trade-off is where a company is able to improve its profitability but at the
expense of tying up cash. For example:
• Receiving a bulk purchase discount (improved profitability) for buying more inventory than
is currently required (reduced liquidity)
• Offering credit to customers (attracts more customers so improves profitability but reduces
liquidity)
Sometimes, the opposite situation can be seen where a company can improve its liquidity
position but at the expense of profitability. For example, offering an early settlement discount
to customers.
Role of Working Capital in Financial Management:
1. Expansion of investment portfolio
Funds released through sound working capital management practices act as a cheap source of
finance that can be used for expansion of existing projects or for investment in new spheres
of investment.
2. Increased profitability

6. Increasing profitability is one of the main objectives of engaging in working capital
management. One of the ways of increasing profitability through adequate working capital
management is in saving of financial cost that would have otherwise been incurred but for
managing short-term assets and liabilities.
3. Ensure the availability of sufficient resources
Through stock management which is a component of working capital management, a
business is able to ensure that resources are sufficient at all times. Optimal stock level, for
instance, is determined using some models outside the scope of this article.
4. Solidifies the going concern status of a company
In business, it is very common to find a profitable company goes out of business if it fails to
meet up with the short-term financial needs of the business. Businesses need to satisfy its
short term and medium term obligations in order to be in business and still remain
competitive.
5. Improves overall efficiency of a company
The overall operational excellence of a company would be greatly improved by an effective
working capital management system. Where this system is in place, finances are managed in
such a way that it poses no hindrance or obstacle to any aspect of the entity.
6. Helps a company avoid overtrading
Overtrading is one of the fastest ways to business failure. One main characteristic of
overtrading is mismatching assets and finances. The business goes beyond set financial goals
and objectives, and in the long run, it meets with ruin. Some trends signalling overtrading
will include uncontrolled, out of proportion business expansion.
7. Maintain good relation with suppliers and other creditors

7. Where a business engages in the proper management of its working capital and other
financial indices, Trade creditors and other non-trade creditors are poised to continue doing
business with it. Their knowledge of the existence of this system goes a long way to boost
their confidence in the business and their dealings.
8. Avoid underutilization of resources
While we condemn overtrading and tag it as a negative impact on the functionality of the
business, we must also reiterate that under trading can cost a business a fortune in an
unearned profit. Through proper management of working capital, a company can ensure that
there are no idle resources.
9. Provides better insight into the true financial state of a company
Through working capitals ratios, analysts and financial experts can gain a better
understanding of a business. The working capital management affords the business the
opportunity of taking a closer look at all of its financial indices.
10. Allocation of resources
Management of working capital is essential in the allocation of resources. It assists the
business management incorrectly allocating the right resources to appropriate quarters.
Applying the ratios revealed upon the utilization of the management system, as well as all
other necessary analysis, areas with surplus resources and the shortage of resources are
identified and followed swiftly with appropriate even distribution of resources to all.