Concept of Working Capital

We may now summarise the causes of fluctuations of net working capital as under:-

Working Capital :

Increases

(i) when fresh capital is brought in

(ii) when long term loans are borrowed and retained in business

(iii) when fixed assets are sold and retained in business

(iv) when profits are earned and retained in business

Decreases

(i) when capital is repaid or reduced

(ii) when loans are repaid

(iii) when long term loans are repaid

(iv) when fixed assets are bought either for cash or on credit

(v) when dividends and taxes are paid

(vi) when net losses are sustained.

The increase or decrease of tangible net worth takes place

Increase :

(i) when fresh capital is brought in

(ii) when profits are earned and retained in business.

Decrease:

(i) when capital is repaid or educed,

(ii) when losses are incurred.

The evaluation of any increase or decrease in working capital and the tangible net worth of any company is an important aspect of financial analysis as it gives an inside view of its working and indicates whether the credit strength increases or decreases, and its rate of growth.

(a) transfer of current funds to block.

(b) redemption of mortgage loans, debentures, etc, without marshalling sufficient long term resources.

(c) payment of unearned dividends.

(d) operating losses

(e) diversion of funds to subsidiaries.

We shall illustrate the strength or weakness of working capital position by a practical example.

ABC Ltd. was an old textile mill which has seen very good days in the past. In the nineteen seventies consequent to bad management practice it suffered losses which aggregated to about Rs.100 lacs in 1977. Since then under a new management the mill commenced earning steady profits which were all retained in business so that the accumulated losses were gradually reduced to Rs.0.35 lacs in 2014. The balance sheets of the company for the year 2013 and 2014 are given herebelow for comparative study:-

The above balance sheets cast in the vertical form will show the following structural position

The following inferences are possible :-

(i) The working capital debt at Rs.60.78 lacs in 2013 has been reduced to Rs.45.38 lacs. Profits have been earned and retained in business.

(ii) Reserves have increased from Rs.36.36 lacs to Rs.45.81 lacs which also support the above inference.

(iii) It may therefore generally be presumed that the financial position in 2014 was far better than in 2013 inspite of the subsisting working capital debt and the trend was definitely progressive.

In spite of the progressive trend the mill had to stop working soon after in 1985. The reasons are typical and would be found in most of the textile mills which have from time to time stopped working, namely absence of adequate working capital. It may be perused from the above structural position, the working of the mill was being mostly financed by the holding of large current liabilities, and mostly from sundry creditors by delaying or withholding the payment of supplier's bills. This mode of financing the working of the mill cannot be undertaken without generating certain internal pressures militating against the smooth working of the mill.

The Mill had a cash credit arrangement for Rs.one crore with a certain bank on the charge of its stocks. Consequent to some adverse economic factors the offtake of piecegoods fell and there was accumulation of finished stocks in the Mill. Availment in the cash credit account almost came to the hilt. Creditors who have supplied cotton had to be paid, wages had to be met and old creditors' claims had to be settled. Sales had fallen down, and inspite of the mill having the latest machinery, well stocked godowns, an efficient labour force, it has to shut down, because its capacity to marshall liquid resources had come to the vanishing point. This illustrates the point that a large working capital debt is a position full of potential danger to be confronted in a balance sheet. It is possible that by a hand to mouth existence the agony of the enterprise may be prolonged, but the position is dangerous like that of a tight rope walker liable to topple over and fall when even a small whiff of air is likely to make him lose his balance.

For the banker, ascertainment of the quantum of working capital in any balance sheet, the velocity of its circulation, its increase and decrease by progression should be subjects of very careful study.

Commercial Banks were expected to be predominantly purveyors of working capital to enterprises and providing of term loans was vested with All India and State level financial institutions.

The viability of an enterprise used to be assessed primarily by the term loan lenders and once again assessed by the Commercial Banks for working capital and there used to be lack of co-ordination resulting in setting up of two committees headed by Buchar and Bhide.

Ground rules for better co-ordination between All India/State level financial institutions and commercial banks were laid down. Over a period, by way of better co-ordination, commercial banks are involved in the primary appraisal stage itself so that all issues are sorted out at the very beginning and the quantum of term loan, the possible working capital requirement, the margin money thereof, extent of participation by the borrower etc are reasonably determined.

Providing credit facilities, whether term loan or working capital or both presupposes a detailed credit appraisal. For convenience of our discussion, credit appraisal can be broadly classified into :

1. Assessment of the Borrower.

2. Appraisal of the project.

3. Assessment of the credit requirement,

4. Reasonable forecast of the short-term, medium term and long-term viability of the enterprise.