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Meaning of working capital
Working capital means the amount available for day-to-day operations or activities of the business. It is also known as revolving capital to meet the day-to-day requirements of the business. It is also an indicator of a company’s ability to meet its short-term obligation.
The process of managing activities and procedures that relate to working capital is called working capital management.
This management helps the company to maintain stability in the company’s cash flow in a short-term period.
The formula for working capital=current assets -current liabilities.
The items that are covered in current assets are
B. Raw materials
C. Work in progress
E. Cash and bank balance etc
The items that are covered in current liabilities are
A. Commercial banks
C. Advances etc
Types of working capital
1. Gross working capital
2.Net working capital
Gross working capital:
The assets that are converted or turned into cash within one accounting year are known as gross working capital.
Gross working capital = Total amount of current assets.
Net working capital:
It is the difference between current assets and current liabilities. It represents the company’s liquidity position. It is for the long term.
Sources of working capital
1. Permanent source
2. Temporary source
A permanent source of working capital is to provide long-term financial stability. Some of the long-term sources are:
c. Public deposit
d. Retain profits
e. Loans from financial institutions.
A temporary source of working capital is for short-term plans. some sources are Advances
b. Commercial banks
c. Trade credits
d. Commercial paper
Working capital management is mainly dependent on three factors. They are
3. Structure of the business
If the working capital is less than the requirement then the company assets are insufficient to meet its short-term obligation which may lead to disturbances in the business. Also if the company maintains more than the required amount of working capital then the company can’t invest more in its fixed assets.
The management of working capital policies is connected with some conditions such as
A. Connected with profitability, liquidity, and firm risk.
B. Connected with current assets
C. Connected with current liabilities.
The objective of working capital
A. To know the operating cycle period of the company.
B. To know the current assets investment policy of the company
C. To know the increase and decrease in current assets
To know the turnover in working capital there is also a formula i,e.
Working capital turnover ratio=sales/net current assets.
Similarly to know the liquidity of a company there are some ratios such as:
A. Current ratio =current assets/current liabilities It measures the liquidity of a company.
The conventional rule of the current ratio is 2:1
B. Quick ratio=Current assets-inventory /current liabilities
It is the proportion of quick assets to quick current liabilities of the company.
The conventional ratio of the quick ratio is 1:1
C . Total assets turnover ratio=sales/total assets
It measures the efficiency of a company’s assets in generating revenue.
D. Inventory turnover ratio =Net sales/inventory.
It determines the number of times inventory is purchased and sold in a financial year.
Approaches to working capital
There are three types of approaches to working capital. They are
1. Matching approach
In this approach, long-term financing is used to fund fixed assets and permanent current assets.
2. Conservative approach
In this approach, long-term financing can be placed in tradable securities to save liquidity and also some portion in funding permanent assets.
3. Aggressive approach
In this approach, short-term financing is utilized to place some portion of the company’s long-term current liabilities.
What is permanent working capital?
Working capital that is permanently or fixedly tied up in current assets in order to run the firm efficiently is referred to as permanent working capital. Permanent working capital is the minimal quantity of current assets required to run the business successfully throughout the year.
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