Accounting for working capital

Accounting for working capital

Introduction
Business organizations require adequate capital to establish business and operate their activities. The total capital of business can be classified as fixed capital and working capital. Fixed capital is required for the purchase of fixed assets like building, land, machinery, furniture etc. fixed capital is invested for a long period, therefore, it is known as long-term capital. Similarly, the capital which is needed for investing in current assets is called working capital.

Meaning and concept of working capital
The capital which is needed for the regular operation of business working capital. Working capital is also called circulating capital or revolving or short-term capital. Working capital is used for regular business activities like for the purchase of raw materials, for the payment of wages, used for regular business activities like for the purchase of raw materials, for the payment of wages, payment of rent payment of other expense. Working capital is kept in the form of cash, debtors, raw materials inventory, stock of finished goods, bills receivable etc.

According to genstenberg, "circulating capital means current assets of a company that are changed in the ordinary course of business from one form to another, a form example, from cash to inventories, inventories to receivable, receivable to cash. " in the words of Weston and Brigham, working capital is a firm's investment in short-term securities, account receivable and inventories."

Generally, there are two concepts of working capital i.e. gross concept and net concept.

a.    Gross concept
According to gross concept, working capital refers to all the current assets and represents the amount of funds invested in current assets. Thus, gross working capital is the capital invested in current assets. Current assets are those assets which can be converted into cash within the sort-term period.
Gross working capital= total current assets
In this way, gross working capital refers to the firms' investment in current assets. Gross working capital represented total of current assets which includes cash in hand, bank balance, investor, prepaid expense, bills receivable etc.
b.    Net concept
According to net concept, working capital is the excess of current asses over current liabilities. In other words, the difference between currents and current liabilities is called net working capital.
Net working capital= current assets – current liabilities
In this way, net working capital is the difference current assets and current liabilities.

Classification of working capital
Working capital can be classification into the following two types:

Permanent of fixed working capital
Permanent working capital represented the current asses required on containing basis over the entire year. A fixed amount of current assets are required to operate the business. Every business organization must maintain minimum current assets to ensure effective utilization of fixed facilities and for maintaining the circulating of current assets. Thus, minimum level of current assets is called permanent or fixed working capital. Permanent working capital balance and minimum stock, minimum cash and bank balance and minimum other current and bank balance and minimum other current assets.
 Generally, permanent working capital is financed by long-term sources of funds.

Temporary or variable working capital
Temporary working capital represented additional current assets required during the operation of the operation of the year. It is the extra working capital needed to support the changing production and sales activities of the firm. Any excess amount of working capital over the seasonal demands and contingencies. Temporary working capital is fluctuating-sometimes increasing and sometimes decreasing. Generally, temporary working capital is financed from short-term sources of funds.
Need and importance of working capital
Working capital is the life blood and nerve centre of a business. Working capital is very essential to maintain smooth running of a business. No business can run successfully without an adequate amount of working capital. The main advantages of maintaining adequate working capital are as follows:

Strengthen the solvency: working capital helps to operate the business smoothly without any financial problem for making the payment of short-term liabilities. Purchase of raw material and payment of salary, wages and overhead can be made without any delay. Adequate working capital helps in maintaining solvency of the business by providing uninterrupted flow of production.

Enhance goodwill: sufficient working capital enables a business concern to make prompt payments and hence helps in creating and maintaining goodwill. Goodwill is enhanced because all current liabilities and operating expenses are paid on time.
Easy obtaining of loan: a firm having adequate working capital, high solvency and good credit rating can rating can arrange loans from banks and financial institutes an easy and favorable terms.
Regular supply of raw material: quick payment of credit purchase of raw materials ensues the regular supply of raw materials from suppliers. Supplies are satisfied by the payment on time. It ensue regular supply of raw materials and continues production.
Smooth business operation: working capital is really a life blood of any business organization which maintains the firm in well condition. Any day to day financial requirement can be met without any shortage of fund. All expense and current liabilities are paid on time.
Ability to face crisis: adequate working capital enables to firm a face business crisis in emergencies such as depression.

Factors affecting/determinants working capital
Requirements of working capital depend upon various factors such as nature of business, size of business, the flow of business activities. However, small organization relatively needs lesser working capital than the big business organization. Followings ars the major factors whih affect the working capital requirement of a firm.

Size of business: working capital requirement of a firm is directly influenced by the size of its business operation. Big business organization requires relatively more capital than the small business organization. The size of organization is one of the major determinants of working capital.

Nature of business: working capital requirement depends upon the nature of business carried by the firm. Normally, manufacturing industries and trading organization needs more capital than in the service business organization. A service sector does not require any amount of stock of goods. In service enterprise, there are less credit transitions. But, in the manufacturing or trading firm, credit sales and advance related transactions are in large amount. So, in the large amount. So, they need more working capital.

Storage time or processing period: time needed for keeping the stock in store is called storage period. The amount or working capital is influenced by the storage period. If storage period is high, a firm should keep more quality of good in store and hence requires more working capital. Similarly, if the processing time is more, then more stock of goods must be held is store s work-in-progress.

Credit period: credit period allowed to customers is also one of the major factors which influence the requirement of working capital. Longer credit period required more investment in debtors and hence more working capital is needed. But, the firm which allows less credit period to customers' needs less working capital.

Seasonal requirement: in certain business, raw material is not available throughout the year. Such types of business organization have to buy raw material in bulk during the season to ensure an uninterrupted flow and process them during the entire year. Thus, a huge amount is blocked in the form of raw material inventories which gives rise to more working capital requirements.

Potential growth or expansion of business: if the business is to be extended in future, more working capital required. More amount of working capital is needed to meet the expansion need of business.
Changes in price level: changes in price level also affect the working capital requirements. Generally, the rise in price will require the firm to maintain the large amount of working capital as more funds will be required to maintain the same level of current assets.

Dividend policy: the dividend policy of the firm is an important determined of working capital. The need for working capital can be met with the retained earnings. If a firm retains more profit and distributed lower amount of dividend, it needs less working of current assets.


Access to money market: if a firm has good access to capital market, it can raise loan from bank and financial institutions. It results in minimization of need of working capital.

Working capital cycle: when the working capital cycle of a firm is long, it will require large amount of working capital. But if working capital cycle is short, it will need less working capital.

Operating efficiency: the operating efficiency of a firm's need of working capital. The operating affiance of the firm results in optimum utilization of assets. The optimum utilization of assets in turn results in more fund release for working capital.

Disadvantages of insufficient working capital
The amount of working capital should be sufficient. Inadequate amount of working capital may create of a lot of financial problem is business. Sometimes inadequate working capital may be the major causes for closing down the business organization. Due to shortage of working capital, raw material cannot be purchase of time and payment of labor and other expenses cannot be made on time. The disadvantages suffered by a firm with insufficient working capital are as follows:

a.    The firm is unable to take advantages of new opportunities or adapt to changes.
b.    Trade discounts are lost. A firm with sufficient working capital is able to finance large stock and can therefore place large orders.
c.    Cash discounts are lost. Some firms will try to persuade their debtors to pay entry by offering cash discount.
d.    The advantages of being able to offer a credit line to customers are forgone.
e.    Financial reputation is short due to non-payment of trade creditors on time.
f.    Creditors may apply to the court for winding up if the firm fails to pay their obligations of time.

Determination of working capital
Determination of working capital requirement is one of the major short-term planning which plays very vital role for operating the business successfully. The determination of working capital is to be done very effectively otherwise there may be over or under estimation of working capital. The amount of working capital should be sufficient. Following two methods can be determining the amount of working capital.
1.    Projected balance method
2.    Operating cycle method

1.    Projected balance sheet method
It is the conventional methods of calculating the working capital. Total current assets and current liabilities are taken into account to calculate working capital. All the data given in the balance sheet regarding current assets and current liabilities are taken into consideration for estimating the working capital.

2.    Operating cycle method
Time which is needed to convert raw material into finished goods, finished into sales and account receivable into cash is called operation cycle. Under operating cycle method, time needed for different types of current assets and time lag needed for payment of purchase and expense are cindered to compute requirement of working capital. The items of current assets and current liabilities are calculated as follows:

1.    Raw material inventory= annual output x material cost per unit x inventory holding period / total periods
2.    Work-in-progress inventory= annual output x manufacturing cost per unit x inventory holding period/ total periods
3.    Finished goods inventory= annual output x total cost per unit x inventory holding period / total periods
4.    Account receivable (debtors)= annual credit sales unit x total cost per unit x credit period allowed to debtors / total periods
5.    Prepaid expense= annual expenses x advance period/ total periods
6.    Creditors (account payable)= annual output x raw material cost per unit x credit period granted by suppliers/ total periods
7.    Outstanding wages= annual output x overhead per unit x time lag/ total periods
8.    Outstanding overhead= annual output x overhead per unit x time log/ total periods
9.    Outstanding expenses= annual expense x time log/ total periods