i.Concepts: There are two concepts of working capital; namely, Gross concept and net concept.
Gross Working Capital: According to this concept, working capital represents the total of all current assets. In other words, this concept views working capital and aggregate of current assets as two interchangeable terms. Working capital so defined is also referred to as ‘current capital’ or ‘circulating capital’.
This concept has the following advantages :
Gross Working Capital: According to this concept, working capital represents the total of all current assets. In other words, this concept views working capital and aggregate of current assets as two interchangeable terms. Working capital so defined is also referred to as ‘current capital’ or ‘circulating capital’.
This concept has the following advantages :
- Management is profoundly concerned with total current assets as they indicate the total funds available for operating purposes.
- It enables a firm to plan the use of funds for maximizing the returns to the enterprises.
Net Working Capital : The net working capital (NWC) is commonly defined as the difference between current assets and current liabilities. NWC is positive when current assets exceed current liabilities and it is negative when current liabilities are greater that current assets. From the point of view of working capital management, this is very important concept, as, to meet the contingencies in business, it is the excess of current assets over current liabilities which can be relied upon.
The concept of NWC is used to assess the liquidity position of the firm. The liquidity of a business firm is measured by its ability to satisfy short-term obligations as they become due. The greater the amount of NWC, the greater is the liquidity of the firm. Efficient working capital management seeks to ensure that an enterprise has sufficient NWC in order to be able to meet the claims of the creditors and other day-to-day needs of business. The amount of NWC that can be considered ‘sufficient’ vary from firm to firm and depends on a number of factors that we will discuss later.
The gross and net concepts of working capital are two important facets of working capital management. Both the concepts have operational significance for the management. The gross concept emphasizes the quantitative aspect while the net concept focuses on the qualitative aspect.
ii. Need for WC : The aim of the firm is to maximize the wealth of share-holders.For this purpose, firms should earn profits from its business operations. The extent to which profits can be earned will naturally depend upon the magnitude of the sales, among other things. To sustain, a successful sales activity sufficient working capital is necessary.
You are aware that a firm will be able to meet the customer’s demand for its product only if it has finished goods in stock, that is, firms must have adequate inventory to guard against the possibility of not being able to meet a demand for their products. Adequate inventory, therefore, provides a cushion against being out of stock. In several instances, sales of firms do not convert into cash instantly;there is a time-lag between the sale of goods and the receipt of cash. This is particularly the case for sale of goods by a manufacturing firm to the wholesaler and also by wholesaler to retailer, as they often sell goods on credit, in a desire to increase their business activity. Thus, to remain competitive necessitates the holding of accounts receivables.
A manufacturing firm needs to maintain additional liquidity to meet the expenditure on several items, like raw material, fuel, power, wages, salaries etc. in the process of manufacturing the goods. Even if a business concern does not manufacture goods on its own, rather it purchases it from manufacturer or wholesaler, working capital in the form of cash is required to meet its routine requirement to finance the transactions which a firm carries out in its ordinary course of business. This is called transactions motive of requiring cash balances.
Besides transactions motive the firms need working capital in the form of cash in hand or bank for three other purposes, precautionary motive, speculative motive and compensation motive. Precautionary motive refers to the need of keeping cash balances in reserve for random and unforeseen circumstances e.g. strike,failure of important customers, cancellation of order etc.Speculative motive refers to the desire of a firm to take advantage of opportunities which present themselves at unexpected moments and which are typically outside the normal course of business. For example, an opportunity to purchase raw materials at a reduced price on payment of immediate cash; a chance to speculate on interest rate movements by buying securities when interest rates are expected to decline etc. While the precautionary motive is defensive in nature in that, firms must make provisions to tide over expected contingencies, the speculative motive represents a positive and aggressive approach.
Compensation motive to hold cash balances is for compensating the banks for providing certain services to business firms like clearance of cheque, supply of credit information, transfer of funds etc. You may be knowing that for some services, like making bank drafts, banks cheque, a commission or fee, is there but do you know that for several other services, banks seek indirect compensation?Let us tell you how banks do this. Usually, clients are required to maintain a minimum balance of cash at the bank. Since this balance cannot be utilized by the firms for transactions purposes, the banks themselves can use the amount to earn a return. To be compensated for their services indirectly in this form, they require the clients to always keep a bank balance sufficient to earn a return equal to the cost of services. Such balances are compensating balances.
The concept of NWC is used to assess the liquidity position of the firm. The liquidity of a business firm is measured by its ability to satisfy short-term obligations as they become due. The greater the amount of NWC, the greater is the liquidity of the firm. Efficient working capital management seeks to ensure that an enterprise has sufficient NWC in order to be able to meet the claims of the creditors and other day-to-day needs of business. The amount of NWC that can be considered ‘sufficient’ vary from firm to firm and depends on a number of factors that we will discuss later.
The gross and net concepts of working capital are two important facets of working capital management. Both the concepts have operational significance for the management. The gross concept emphasizes the quantitative aspect while the net concept focuses on the qualitative aspect.
ii. Need for WC : The aim of the firm is to maximize the wealth of share-holders.For this purpose, firms should earn profits from its business operations. The extent to which profits can be earned will naturally depend upon the magnitude of the sales, among other things. To sustain, a successful sales activity sufficient working capital is necessary.
You are aware that a firm will be able to meet the customer’s demand for its product only if it has finished goods in stock, that is, firms must have adequate inventory to guard against the possibility of not being able to meet a demand for their products. Adequate inventory, therefore, provides a cushion against being out of stock. In several instances, sales of firms do not convert into cash instantly;there is a time-lag between the sale of goods and the receipt of cash. This is particularly the case for sale of goods by a manufacturing firm to the wholesaler and also by wholesaler to retailer, as they often sell goods on credit, in a desire to increase their business activity. Thus, to remain competitive necessitates the holding of accounts receivables.
A manufacturing firm needs to maintain additional liquidity to meet the expenditure on several items, like raw material, fuel, power, wages, salaries etc. in the process of manufacturing the goods. Even if a business concern does not manufacture goods on its own, rather it purchases it from manufacturer or wholesaler, working capital in the form of cash is required to meet its routine requirement to finance the transactions which a firm carries out in its ordinary course of business. This is called transactions motive of requiring cash balances.
Besides transactions motive the firms need working capital in the form of cash in hand or bank for three other purposes, precautionary motive, speculative motive and compensation motive. Precautionary motive refers to the need of keeping cash balances in reserve for random and unforeseen circumstances e.g. strike,failure of important customers, cancellation of order etc.Speculative motive refers to the desire of a firm to take advantage of opportunities which present themselves at unexpected moments and which are typically outside the normal course of business. For example, an opportunity to purchase raw materials at a reduced price on payment of immediate cash; a chance to speculate on interest rate movements by buying securities when interest rates are expected to decline etc. While the precautionary motive is defensive in nature in that, firms must make provisions to tide over expected contingencies, the speculative motive represents a positive and aggressive approach.
Compensation motive to hold cash balances is for compensating the banks for providing certain services to business firms like clearance of cheque, supply of credit information, transfer of funds etc. You may be knowing that for some services, like making bank drafts, banks cheque, a commission or fee, is there but do you know that for several other services, banks seek indirect compensation?Let us tell you how banks do this. Usually, clients are required to maintain a minimum balance of cash at the bank. Since this balance cannot be utilized by the firms for transactions purposes, the banks themselves can use the amount to earn a return. To be compensated for their services indirectly in this form, they require the clients to always keep a bank balance sufficient to earn a return equal to the cost of services. Such balances are compensating balances.
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