Chapter 6 - Working Capital

CHAPTER 4
WORKING CAPITAL
1. What is mean by Fixed Capital and Working Capital? Explain the
concepts of gross and net working capital.
Capital required for a business may be a classified under two main categories
1) Fixed Capital
2) Working Capital
1) Fixed Capital: Capital required for purchase of fixed assets like land,
building, plant, machinery, office equipment and furniture is called Fixed
capital. These assets are purchased for constant use in production. They are
not intended for resale. These fixed assets are used on a permanent basis for
producing goods and services. Hence fixed capital requirements are financed
by means of share capital and long-term borrowings. The amount of fixed
capital required will depend upon the size of the organization and the nature
of the business.
2) Working Capital: Capital required for purchase of raw materials and for the
meeting the day-to-day expenditure on salaries, wages, rents, advertising
etc., is called Working Capital. In other words, working capital refers to that
part of a firms capital which is employed for the short-term operations.
Gross Working Capital: In a broad sense, the term working capital refers to
the gross working capital. This represents the amount of funds invested in
current assets. Under the gross concept, working capital is equal to total current
assets.
Net Working Capital: In a narrow sense, working capital refers to the net
working capital.Net working capital is the excess of current assets over current
liabilities .Of the two, the concept of net working capital is the most widely
accepted.
2. Difference between Permanent Working Capital and Variable Working
Capital.
Permanent Working Capital: Permanent or fixed working capital is the
minimum amount required to ensure effective utilization of fixed assets and support
the normal operations of the business. There is always a minimum level of current
assets which is continuously required by the enterprise to carryout its normal
business operations. For example, every firm has to maintain a minimum level of
raw materials, work in progress, finished goods and cash balance. This minimum
level of current assets is called permanent working capital as this part of capital is
permanently blocked in current assets. Permanent working capital will remain
permanent in business. Hence, it is financed by long-term sources. As the business
grows, permanent working capital will increase due to the increase in current
assets.
Temporary or Variable Working Capital: It is the amount of Working
capital required for short periods. It is intended to meet seasonal demands and
some special exigencies. Variable working capital cannot be permanently employed
gainfully in the business. Therefore, only short-term sources are employed to
finance variable working capital.
3. Explain the need for or object of working capital
Modern business enterprises produce goods in anticipation of demand. Goods
produced are not sold immediately. Cash for sales is also not realized immediately.
From the time of purchase of raw materials, to the time of realization of cash for
sales made, an operating cycle is involved. The following stages are usually found in
the operating cycle of a manufacturing firm.
1.
2.
3.
4.
5.
Conversion
Conversion
Conversion
Conversion
Conversion
of
of
of
of
of
cash into raw materials.

raw materials into work-in-progress.
work-in-progress into finished goods.
finished goods into debtors through sales.
debtors into cash.
Debtors
Cash
Sales
Finished goods
There are
time
gaps between purchase
Raw
Materials
Work of
in raw materials and production;
production and sales; and sales and progress
realization of cash. Thus, the need for
working capital arises due to the time gap between purchase of raw materials
and realization of cash from sales.
Working capital is needed for the following purposes.
1. To purchase raw materials, spares and component parts.
2. To pay wages and salaries.
3. To incur day-to-day expenses.
4. To meet selling costs such as packing, advertising.
5. To provide credit facilities to customers.
6. To maintain inventories of raw material, work-in-progress and
finished stock.
4. Discuss the importance (advantages) of working capital for a
manufacturing concern.
Working capital is the life blood and nerve centre of a business. No

business can be run successfully without adequate amount of working
capital. The advantages of maintaining adequate working capital are as
follows:
1. Continuous Production: Adequate working capital ensures
regular supply of raw materials and continuous production.
2. Solvency and Goodwill: Adequate working capital enables
prompt payment to creditors. This helps in creating and maintaining
goodwill.
3. Easy Loans: A concern having sufficient working capital enjoys
high liquidity and good credit standing. Hence it can secure loans
from banks and others on easy and favourable terms.
4. Cash Discounts: Adequate working capital enables a concern to
avail cash discounts on the purchases, leading to a reduction in
costs.
5. Regular Payment of Expenses: A company which has ample
working capital can make regular payment of salaries, wages and
other day-to-day commitments. Such prompt payment raises the
morale of employees and increases their efficiency .As a result,
costs are minimized and profit increases.
6. Exploitation of Market Conditions: A concern with adequate
working capital can exploit favourable market conditions. It can buy
its requirements of raw materials in bulk when the market price is
lower. Similarly, it can hold stock of finished goods to realize better
prices.
7. Ability to face Crisis: Adequate working capital enables a concern
to face business crisis such as depression because during such
periods there is much pressure on working capital.
8. High Return on Investments: Adequacy of working capital
facilitates continuous production and effective utilization of fixed
assets. Because of this, the concern is able to generate more profits
and ensure higher return on investments.
5. Explain the dangers of a) Excess Working Capital b) Inadequate
Working Capital.
Every business concern should have adequate working capital for its
smooth functioning. It should have neither excess working capital nor
shortage of working capital. Both redundant as well as inadequate working
capital positions are bad for any business. However, out of the two,
inadequacy of working capital is more dangerous for a firm.
Disadvantages of Excessive Working Capital
1. Excessive working capital means idle funds which earn no profits for the
business. Hence, the business cannot earn a proper rate of return on its
investments.
2. Due to low rate of return on investments, the value of shares may also
fall.
3. Redundant working capital may lead to unnecessary purchasing and
accumulation of inventories. As a result, chances of theft, waste and
losses will increase.
4. Excessive working capital is an indication of excessive debtors and
defective credit policy. Consequently, there may be delay in collection and
higher incidence of bad debts.
5. Excessive working capital makes management complacent. It leads to
overall inefficiency in the organization.
Disadvantages of Inadequate Working Capital

1. A concern which has inadequate working capital cannot pay its
short-term liabilities in time. As a result, it loses its reputation and
faces tight credit terms.
2. It cannot buy its requirements in bulk and take advantage of cash
discounts.
3. The concern will experience difficulties in meeting its day-to-day
expenses. This will lead to inefficiency, increase in costs and
reduction in profits.
4. It becomes difficult to exploit favourable market conditions and
undertake profitable projects due to lack of working capital.
5. Due to paucity (scarcity) of working capital, fixed assets are not
effectively utilized. Thus, the rate of return on investment falls.

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CHAPTER 4

cash into raw materials.

Working capital is the life blood and nerve centre of a business. No

Disadvantages of Inadequate Working Capital

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