Define working capital and its significance for a firm

Define working capital and its significance for a firm  

MANAGEMENT ACCOUNTING

JUNE 2014

08. a) Define working capital and its significance for a firm.                                            5

Answer: Working capital is a financial metric which represents operating liquidity available to a business, organization or other entity, including governmental entity. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. Gross working capital equals to current assets.

 The working capital is calculated as: 

Working Capital = Current Assets – Current  Liabilities

To operate the functions of a firm working capital is very important. A firm is a unit of an industry to produce the finished goods for earning profit. The importance of working capital for a firm is as below:

01.  For smooth production;

02.  Sufficient stock;

03.  Smooth sales;

04.  Bearing regular expenses;

05.  Establish as a solvent firm;

06.  Earning profits;

07.  Creation of goodwill;

08.  Wealth maximization;

09.  Protection of fixed Capital;

10.  Increase credit rating.

01. For smooth Production: for the smooth production of a firm healthy working capital is very important.

02. Sufficient stock: To stock sufficient raw materials working capital is very important for a firm.

03. Smooth sales: To sell produced goods working capital of a firm is required.

04. Bearing regular expenses: Various types of expenses not even related to production bears by a firm important to have healthy working capital.

05. Establish as a solvent firm: To establish as a solvent firm working capital is an important parameter to have.

06. Earning profit: For the optimum level of production and sales promotion working capital of a firm is very necessary.

07. Creation of goodwill: Goodwill of a firm is the asset of it. To create goodwill of the firm working capital plays an important role.

08. Wealth maximization: For the accelerate production goods and services a firm can earn profit increase day by day to enhance its wealth.

09.  Protection of fixed capital: For the well protection of the fixed capital of a firm consistence of working capital is highly required.

10. Increase credit rating: Credit from a bank of financial institutions credit rating is very important. Healthy working capital of a firm increases the credit rating.

The aforesaid explanations denote that working capital is very important for a firm.

08. b) Explain the factors affecting working capital requirements.                                    5

Answer: The main factors affecting working capital are as below:

01. Nature of Business: The requirement of working capital depends on the nature of business. The nature of business is usually of two types: Manufacturing Business and Trading Business. In the case of manufacturing business it takes a lot of time in converting raw material into finished goods. Therefore, capital remains invested for a long time in raw material, semi-finished goods and the stocking of the finished goods.

02. Scale of Operations: There is a direct link between the working capital and the scale of operations. In other words, more working capital is required in case of big organizations while less working capital is needed in case of small organizations.

03. Business Cycle: The need for the working capital is affected by various stages of the business cycle. During the boom period, the demand of a product increases and sales also increase. Therefore, more working capital is needed. On the contrary, during the period of depression, the demand declines and it affects both the production and sales of goods. Therefore, in such a situation less working capital is required.

04. Seasonal Factors: Some goods are demanded throughout the year while others have seasonal demand. Goods which have uniform demand the whole year their production and sale are continuous. Consequently, such enterprises need little working capital.

05. Production Cycle: Production cycle means the time involved in converting raw material into finished product. Thus, more working capital will be needed. On the contrary, where period of production cycle is little, less working capital will be needed.

06. Credit Allowed: Those enterprises which sell goods on cash payment basis need little working capital but those who provide credit facilities to the customers need more working capital.

07.Credit Avails: If raw material and other inputs are easily available on credit, less working capital is needed. On the contrary, if these things are not available on credit then to make cash payment quickly large amount of working capital will be needed.

08. Operating Efficiency: Operating efficiency means efficiently completing the various business operations. Operating efficiency of every organization happens to be different.

09. Availability of Raw Materials: Availability of raw material also influences the amount of working capital. If the enterprise makes use of such raw material which is available easily throughout the year, then less working capital will be required, because there will be no need to stock it in large quantity. Reversely happened when the raw materials are not available anytime and anywhere. 

10. Growth Prospects: Growth means the development of the scale of business operations (production, sales, etc.). The organizations which have sufficient possibilities of growth require more working capital, while the case is different in respect of companies with less growth prospects.

11. Level of Competition: High level of competition increases the need for more working capital. In order to face competition, more stock is required for quick delivery and credit facility for a long period has to be made available.

12. Inflation: Inflation means rise in prices. In such a situation more capital is required than before in order to maintain the previous scale of production and sales. Therefore, with the increasing rate of inflation, there is a corresponding increase in the working capital.