characteristics of working capital: Working Capital: Meaning, Types and Importance Accounting


Thus, the cash which is generated from operation depends on some policy of the firm viz., taxation, depreciation, dividend etc. Under the Income-Tax Act, firms are liable to pay income-tax on the assessable net profit as per rates prescribed for the same by Finance Act from time to time. As such, once the net profit of a firm has been ascertained, it makes provisions out of the said profit for payment of Income-tax. Another method of procuring the finance to meet the requirement of short-term or seasonal working capital is public deposits.


LIFO accounting means inventory acquired at last would be used up or sold first. Credit SalesCredit Sales is a transaction type in which the customers/buyers are allowed to pay up for the bought item later on instead of paying at the exact time of purchase. It gives them the required time to collect money & make the payment. Working capital refers to the difference between your organization’s present belongings and current liabilities. We teach several aspects of business operations and how a business can do a lot more than what it is doing today. It may be an indication of excessively liberal credit policy and slack collection from customers resulting in higher incidence of bad debts.

Regular supply of raw materials

As its volume of production rises with the passage of time so also does the quantum of the permanent working capital. The permanent working capital is upward sloping for a growing firm. The temporary working capital will change due to changes in production caused by seasonal operations. Thus, net working capital indicates the financing needs of a firm, both through long-term and short-term financing sources.

These elements are money coming in, money going out, and the management of inventory. A concern having adequate working capital also enables to avail cash discounts on the purchases of material by paying in cash; it reduces the cost of production and increases in the profits also. According to this method, the period for each stage of the operating cycle is estimated and then requirement of working capital is calculated on the basis of cost of different items.

On the other hand, if the ratio is above a this might indicate poor administration of the capital. The company may have an excessive amount of inventory sitting on its shelves or an excessive amount of income sitting within the financial institution and not being invested into the further development of the enterprise. Current assets typically embody cash held in current and financial savings accounts, inventory, accounts receivable, pre-paid bills and quick-term investments. In accounting phrases, it’s the difference between present property and present liabilities . A healthy business could have ample capacity to repay its current liabilities with present property.


Inventory is a company’s primary asset that it converts into sales revenues. The rate at which a company sells and replenishes its inventory is a measure of its success. Investors also consider the inventory turnover rate to be an indication of the strength of sales and how efficient the company is in its purchasing and manufacturing. Low inventory means that the company is in danger of losing out on sales, but excessively high inventory levels could be a sign of wasteful use of working capital. Adequate working capital creates an environment of security, confidence, and high morale and creates overall efficiency in a business.

The estimated requirement of Working Capital for the budget period can be determined on the basis of the data contained in the Balance Sheet of the earlier or previous period. While inadequate Working Capital creates a lot of problems, an amount in excess of the requisite Working Capital which is not utilized properly and remains idle, can also increase the cost. Therefore, in order to avoid both these difficulties, a Working Capital Requirement Forecast is prepared after scrutinizing and analysing every aspect of business activity. While formulating policy, proper provision must be made for the requirement of working capital so that production will not be interrupted. Percentage of safety stock level is very high so that a large amount of working capital is blocked in inventory. For example, when salaries and wages are paid in cash, a part of cash is consumed and does not create any current asset through transformation directly.

Bills & Recharges

Another important element of working management is inventory management. These are the amounts the business has to pay for credit purchases made by it. A crafted payables management policy goes a long way in ensuring timely payment and cordial business relations with vendors and creditors. Cash Conversion CycleThe Cash Conversion Cycle is a ratio analysis measure to evaluate the number of days or time a company converts its inventory and other inputs into cash. It considers the days inventory outstanding, days sales outstanding and days payable outstanding for computation. In accounting, the time period “current” refers to assets you could convert into money or liabilities which might be due in lower than 12 months.

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The operating cycle method considers production and other business operations, and forecasts the changes that may be necessary in the pursuit of the future activities. However, during peak seasons (e.g., Diwali), retail stores need higher levels of merchandise. Therefore, extra inventory has to be maintained to support sales during peak sales period. Similarly, receivables also increase and must be financed during the period of high sales.

Inventory is another significant part of current assets and, without a doubt, forms an integral component of working capital management. Good Inventory Management is essential since it is responsible for proper control over inventory from the raw material stage to the finished goods stage. You will pay all you short term money owed, working bills, and salaries with additional to re-spend money on your corporation. On the other hand, a unfavorable working capital, in which you’ve extra quick liabilities than money assets, especially as a yearly trend, can be a huge red flag to buyers. Using long-term financing for short-term assets is expensive and costly since the funds will remain idle after the expiry of assets’ lives.

Seasonal Working Capital

A similar financial metric called the quick ratio measures a ratio of current assets to current liabilities. In addition to using different accounts in its formula, it reports the relationship as a percentage as opposed to a dollar amount. To calculate working capital, subtract a company’s current liabilities from its current assets.

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35.1, in a newly set up undertaking begins with conversion of cash into raw materials which are, in turn, transformed into work-in-process and then in finished goods. With the sale of merchandise finished goods turn into accounts receivable, presuming the goods are normally sold on credit terms. Working capital comprises current assets which are distinct from other assets. In the first instance, current assets consist of those assets which are of short duration. For example, cash is held idle for a week or so, accounts receivables may not have a life span of more than three months and inventories may be held for one to three months. Gross working capital refers to total investment in current assets.

Under this policy, permanent assets and a part of temporary current assets are financed with long-term financing. Therefore, if the firm has no temporary current assets at any period, it stores liquidity by investing surplus funds into marketable securities. A firm wants to be safe by resorting to this technique since it is less risky. Shows that the fixed assets and permanent current assets are financed with long-term sources and when the level of permanent current assets increases, long- term finance also increases.

Similar to Working capital (

Commercial paper represents unsecured promissory notes issued by firms to raise short term funds. It is an important money market instrument in advanced countries like U.S.A. In India, the RBI introduced commercial paper in the Indian money market on the recommendations of the working group on Money Market . But only large companies enjoying high credit rating and sound financial health can issue commercial paper to raise short term funds. Trading and financial firms have less investment in fixed assets, but require higher working capital as most of their investment is concentrated in stock or inventory. In other words the ability of the company to guarantee a large volume of sales with a small current asset base is a measure of the Company’s operating efficiency.

Somecharacteristics of working capitals, the value of current assets is less than the current liabilities, it shows negative working capital. If such type of situation arise, the firm is going to meet the financial crisis very shortly. The concept of gross capital is a financial concept whereas that of net concept is an accounting concept.

  • Variable capital requirement can, however, be financed out of short-term loans from the banks or inviting public deposits.
  • In nutshell, temporary working capital is an extra working capital required to support the changing production and sales activities.
  • The manufacturing cycle is longer than what it should be due to non-synchronization of different inputs, non-availability of some key factors etc.
  • It refers to the short term financial arrangement made by the business units to meet uncertain changes or to meet uncertainties.
  • For example, trading and financial firms require a large amount of investment in working capital but a significantly smaller amount of investment in fixed assets.

But they are all the more necessary today when production has become capitalistic. Even agriculture employs all sorts of machines like tractors, threshers, harvester-combines, etc., All these are obtained with capital. Another equally necessary function that capital performs is the supply of tools, implements and appliances.

Hence it deals with both, assets and liabilities—in the sense of managing working capital it is the excess of current assets over current liabilities. In this article we will discuss about the various aspects of working capital. The current ratio indicates how well a firm is able to meet its short-term obligations, and it’s a measure of liquidity.


But when Cash is received from Debtors, Debtors are converted into Cash, Debtors here are not consumed but transformed or rather converted. The period of conversion in this case is also reckoned to be one operating cycle of the business instead of one year. Besides the above factors there are some factors which have direct bearing on working capital requirements of a firm. Thus, from the above discussion it becomes clear that the level of working capital requirements depends upon a host of factors which are partly internal and partly external. It is known to us that proper utilization of resources, no doubt, improves the profitability of the firm and reduces the pressure on working capital.

This is possible by striving to maintain a correct ratio between working capital and fixed capital. If the raw material supply is not smooth for any reason, companies tend to store more raw materials than needed, increasing the requirement for working capital. In contrast, a firm experiencing growth situation will require permanent working capital on an increasing scale and therefore, permanent working capital line will no longer remain stable, as may be noted from Figure 35.3. Similarly, in periods of dull business conditions when most of the produce remains held in stock due to fall in demand, the company would require additional cash to tide over the crisis.

It is equal to the total sum of current assets only and it may represent both owned capital as well as loan capital used for financing the current assets. The cash position of the firm, however, may be higher or lower at the end of the period than at the beginning. For the cash balance to rise, the cash inflow from cash sales and the collection of receivables must be greater than cash outflow for labour, materials and other costs. Capital assets are primarily the assets of a business that can be found on the current or long-term portion of the balance sheet. These assets can include cash, cash equivalents, marketable securities, infrastructure, building, storage facilities. Hence, capital may also be defined as man-made instrument of production.

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