Working capital | Meaning | Needs | Balance Sheet Concept

What is working capital?

Working capital is the amount used to meet the day to day operation activities of a business. In the broad sense, the term working capital is used to denote the total value of current assets.

Needs for working capital

An effective operation of a business is based on the proper management of working capital. Initially, the business unit should forecast the adequate working capital. In this context, working capital forecasting is getting more importance than the management of working capital. Generally, each business unit requires adequate amount of capital. The reason is that capital is required for the establishment of a business units and its proper functioning.

Fixed assets such as Land and Building, fixtures, furniture, machinery, plant and other fixed assets are required for the establishment of a business. A portion of capital is used to acquire the fixed assets. Such capital is called fixed capital. After the establishment, the business unit should function properly.

  • Functioning means carrying the activities like trading, service or manufacturing.
  • Trading means buying and selling of goods without making any alteration in the goods.
  • Service means rendering of intangible things like electricity, parcel service, courier service, telephone, lorry service and the like. Manufacturing means conversion of raw materials into finished goods which is meant for sale.

Therefore, the business unit requires capital for its proper functioning i.e. meeting the expenses of day to day activities. Such capital is called working capital. The other names of working capital are Circulating Capital and Revolving Capital.

Balance sheet concept of working capital

The working capital can be classified into two types under the balance sheet concept. They are

  1. Gross Working Capital;
  2. Net Working Capital

1. Gross Working Capital:

Gross working capital means an amount of funds invested in the various forms of current assets in total. Current assets are those assets which are bought in the ordinary course of business and converted into cash within a short period which is normally one accounting year.

2. Net working capital:

Net working capital is the excess of current assets over current liabilities. Again, the net working capital is divided into two types. They are

  • Positive net working capital and
  • Negative net working capital.

The positive net working capital exists, whenever the current assets exceeds current liabilities. The negative net working capital exists whenever the current liabilities exceeds the current assets. Current liability means a liability payable within one accounting year in the ordinary course of business or payable out of the current assets within a short period normally one year or payable out of the revenue income of the business.

Why is Gross working capital preferable?

Both gross working capital and net working capital concepts are used for financial management purposes. But, gross working capital concept is preferable to net working capital concept due to the following reasons.

l. It helps the business concern to provide adequate amount of working capital at the time of requirements.

2. Every business concern is interested to know the gross value of current assets since its effective operation lies on the value of current assets rather than the source of short term finance.

3. Every increase in current assets leads to increase in the gross working capital.

4. It is highly useful in determining the rate of return on investments in working capital.

Why is Net working capital preferable?

Sometimes, net working capital concept is preferable to gross working capital concept due to the following reasons.

1. It indicates the ability of the concern to meet its operating expenses and short term liabilities.

2. It discloses the financial soundness of the business concern.

3. It shows the margin of protection available to the short term creditors i.e. the excess of current assets over current liabilities.

4. It suggests the need for using a part of working capital requirements out of long term or permanent source of funds.

Net or Gross?

In nutshell, either gross working capital concept or net working capital concept is applicable to a business concern. The net working capital concept is suitable to sole-trade concern and partnership firm. But, gross working capital is highly suitable to private limited company and public limited company form of business organization where there is a distinction between ownership, management and control. Generally, working capital refers to net working capital.