MGT201 Module 8 Topics 145-162 Preparation

Topic 145-Working Capital and Its need in business

In simple words, Working Capital is that part of total capital which is used in the operations of a business. For example, the amount that is invested in a business initially is put into the Fixed Asset. It means that a larger part of our capital is invested in our fixed assets (I.e., land, building, equipment, machinery, vehicles etc.).

But once we have invested some of our capital in these fixed assets then we also required Additional Capital to generate profit from these fixed assets. And this Additional Capital is required for the purchase of inventory, for blocking our money in the accounts receivables that is debtors, whenever we make credit sales to make prepayments, to have sufficient amount of cash in our hand.

So, when we look at all these assets we collectively termed them as Current Assets. By definition, Current Assets are those assets which are normally kept in the business for a period less than one year. And it does not mean that if any of the current assets is kept in a business longer than one year, it will not be a current asset but by definition we call those assets which generally have a life of one year as Current Assets.

And likewise, opposite to current assets we have got some liabilities, these are those liabilities which are to be paid within one year time period so, we call them Current Liabilities. So, Working Capital in its nature is basically about Current Assets and Current Liabilities.

Gross WC (Working Capital):

Gross Working Capital is one in which we only consider the Current Assets meaning that if we add our all Current assets then we can name that figure as Gross

Net WC (Working Capital):

These items of Current Assets are to be actually financed mostly by Current Liability. So, if we take a difference of our Current Assets and Current Liabilities then it is called Net Working Capital.

Net Working Capital = Current Assets – Current Liabilities

Requirement or Importance of Working Capital:

So, this is the definition of Working Capital and simply its importance that if as a business organization we do not have enough Working Capital then we will not be able to operate and run our business.

It means that our Fixed Assets (plant, machinery, vehicles, equipment, land, building etc.) are useless even till if we do not have inventory of Raw material through which we produce finished goods and sale in the market or if we do not have enough money for the payment of electricity bills to run these machinery. So, this is the requirement of Working Capital.

Why we need Working Capital?

As we have said that Working Capital comprises of Current Assets so let’s have a look at what are the major main Current assets which are mainly there in almost every business organization.

Inventory:

We need Working Capital to operate the business because without Working Capital, our machines will not run; they will not produce anything which can be sold. So, we need to have inventory means we should have stock in trade. In manufacturing business where we convert raw material into finished goods so, we have got Inventory of Raw Material. And that Inventory is required in the business; if we are doing a trading business that we call Merchandizing business then there Inventory is that Finished product which we purchase and sell them.

But in any case in our business, which is not a service-oriented business we need Financing and Working Capital for Inventory.

Accounts Receivables:

We also need Working Capital for Accounts Receivables.

Why we need Working Capital for Accounts Receivables?

When we do credit sales or borrowing then our product on which our cost has incurred and then sell it to someone without collecting or receiving cash from our customer. So, our capital or money or financing will be blocked with the customer till we don’t receive our cash or payment of credit sales.

We need Working Capital to block that amount and which is obviously necessary because without credit sales we cannot generate income and hence we cannot generate profit.

Prepayments:

We also have to make several Payments in advance and if we do not make these payments then we cannot operate our business. There are some mandatory Prepayments so, we need to have Capital and which is the Working Capital that is to be used for Prepayments.

Cash:

We also need Working Capital to have a sufficient amount of Cash in hand.