Concepts of Working Capital

Principle & Practice of Management

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Concepts of Working Capital

Working Capital

Working capitals refers to short-term funds to meet operating expenses. To quote Ramamoorthy, “It refers to the funds, which a company must possess to finance its day-to-day operations”. It is concerned with the management of the firm’s current assets and current liabilities. It relates to the with the problems that arise in attempting to manage the current assets, current liabilities and their inter-relationship that exists between them. If a firm cannot maintain a satisfactory level of working capital, it is likely to become insolvent and may even be forced into bankruptcy.
The concept of working capitals has been a matter of great controversy, among the financial wizards and they view it differently. There is no universally accepted definition of working capital. Broadly, there are two concepts of working capitals commonly found in the existing literature of finance such as:
1. Gross Working Capitals (Quantitative Concept), and
2. Net Working Capitals (Qualitative Concept).
Both these concepts of working capital have operational significance. The two concepts are not to be regarded as mutually exclusive. Each has its relevance in specific situations from the management point of view.
Each concept of working capital has its own significance – the ‘gross concept’ emphasising the ‘use’ and the ‘net concept’ the ‘source’ – an integration of both these concepts is necessary in order to understand working capital management in the context of risk, return and uncertainty.

Gross Working Capital Concept

According to this concept, the total current assets are termed as the gross circulating capital. Total current assets include; cash, marketable securities, accounts receivables, inventory, prepaid expense, advance payment of tax; etc. This concept also called as ‘quantitative or broader approach’. To quote Weston and Brigham, “Gross Working Capital refers to firm’s investments in short-term assets such as cash, short-term securities, accounts receivables and inventories”. The concept helps in making optimum investment in current assets and their financing. According to Walker, “Use of this concept is helpful in providing for the current amount of working capitals at the right time so that the firm is able to realise the greatest return on investment”. The supporters of this concept like Mead, Field, and Baker and Malott, argue that the management is very much concerned with the total current assets as they constitute the total funds available for operating process.

Net Working Capital Concept

As per this concept, the excess of current assets over current liabilities represents net working capital. Similar view is expressed by Guthmann and Dougall, Gerstenberg, Goel, Park and Gladson, Kennedy and McMullen, and Myer in their distinguished works. ‘Accounts Hand Book’ has also fully supported this view. The famous economists like, Sailer, Lincoln, and Stevens, fully supported this concept and viewed that the net working capital helps creditors and investors to judge the financial soundness of a firm.
Net Working Capitals Concept represents the amount of the current assets, which would remain after all the current liabilities were paid. It may be either positive or negative. It will be positive, if current assets exceed the current liabilities and negative, if the current liabilities are in excess of current assets. Another alternative definition is that net working capital refers to that portion of firm’s current assets, which financed with long-term funds.
Net Working Capital Concept indicates or measures the liquidity and also suggests the extent to which working capital needs may be financed by the permanent source of funds. To quote Roy Chowdary, “Net Working Capital indicates the liquidity of the business whilst gross working capital denotes the quantum of working capital with which business has to operate”.