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Concept of Working Capital
1. Introduction to Working Capital
Working capital is the net liquid resources of a business. It indicates the excess of Current Assets over Current Liabilities.
Liquidity Surplus: The surplus of liquid assets over current liabilities. This is vital for meeting maturing financial commitments and ensuring operational smoothness.
2. Structural Position of Assets
How is Tangible Net Worth spread across different asset categories? Let's analyze a vertical Balance Sheet position:
| Asset Classification | Amount (Lacs) | Sub-total | Total |
|---|---|---|---|
| Fixed Assets (Non-liquid) | 10.00 | ||
| Less: Deferred Liability | 6.00 | 2.00 | 8.00 |
| Current Assets | 4.00 | ||
| Less: Current Liability | 2.00 | ||
| Miscellaneous Assets (Slow moving) | 1.00 | ||
| TANGIBLE NET WORTH | 11.00 |
The Core Insight: The Rs. 2.00 lacs difference represents the company's own money used to finance operations without relying on credit. This ensures the company can meet any contingency.
3. Sources of WC
- Initial Shareholder Capital
- Retained Profits (Internal Accruals)
- Sale of Fixed Assets
- Long-term Mortgages/Debentures
4. Requirement Factors
Requirement is determined by several considerations:
5. Advantages of Adequate Working Capital
Ensures the concern's ability to command credit, improves credit standing, and adequately finances operations to meet current liabilities smoothly.
6. Components of Working Capital
| 1. Bank Borrowings (on demand) | |
| 2. Sundry Creditors | |
| 3. Provisions (Tax, Div, Contingencies) |
| 1. Cash & Bank Balances | |
| 2. Inventory (Raw/WIP/Finished) | |
| 3. Sundry Debtors / Marketable Sec. |
7. Evolution Scenarios: SSI Ltd.
Follow the financial evolution of SSI Ltd. through 9 key stages to see how Working Capital (WC) and Tangible Net Worth (TNW) shifts.
Phase A: Setup & Equipment Scenarios 1-2
1. Inception (Rs. 10,000 Capital)
Capital Rs. 10k is in Bank.
2. Asset Purchase (Rs. 5,000 Equip)
Cash converted to Block.
Phase B: Inventory & Credit Purchases Scenarios 3-4
3. Cash to Raw Material (Rs. 3,000)
Shape of current assets changes. No change in net position.
4. Credit Purchase & Expenses (Rs. 500)
RM +1,000 (Credit), Expenses 500 (Cash).
Phase C: Profits, Debt & Diversion Scenarios 5-8
Rs. 1,000 profit earned.
WC/TNW +1,000
Asset block +3,000.
WC reduces to 2,500
Rs. 200 loss sustained.
WC drops to 2,300
Loan to allied (2,500).
WC becomes NEGATIVE
Phase D: Capital Restoration Scenario 9
9. Fresh Capital Injection (Rs. 2,000)
The best way to restore health. TNW increases and WC returns to positive (Rs. 1,800).
8. Rules of Fluctuation
Positive Factors
- Fresh capital influx.
- Long-term borrowing retained as current assets.
- Internal profit generation.
- Divestment of fixed assets into cash.
Erosion Factors
- Repayment of capital/long-term debt.
- Diversion of current funds to block/subsidiaries.
- Payment of taxes or dividends.
- Operating losses sustained.
9. Practical Case Case Study: The Textile Collapse
Despite earning profits and growing reserves, the mill shut down in 1985. The structural analysis reveals the hidden danger of negative working capital funded by creditors.
| Analysis Point | 2013 (Lacs) | 2014 (Lacs) |
|---|---|---|
| WC Debt (Negative Surplus) | (60.78) | (45.38) |
| Tangible Net Worth | 95.86 | 105.46 |
10. Future Focus: Credit Appraisal
Modern banking shifts from hand-to-mouth lending to comprehensive Credit Appraisal. This involves assessing the borrower, project viability, and forecasting medium-to-long term success.