UNIT 1 CONCEPTUAL FRAMEWORK

Theories and Approaches

Objectives
The objectives of this unit are to:

Explain the various types of working capital and their behaviour.

Examine the cyclical flow and characteristics of working capital.
Discuss the significance and tools of planning for working capital.
Find out the impact of inflation on working capital and finally.
Analyse the trends in working capital in Indian companies.

Structure
1.1
1.2
1.3
1.4
1.5
1.6
1.7
1.8
1.9
1.10
1.11
1.12

Introduction
Definition of Working Capital
Constituents of Working Capital
Types of Working Capital
Cyclical Flow and Characteristics of Working Capital
Planning for Working Capital
Working Capital and Inflation
Trends in Working Capital
Summary
Key Words
Self Assessment Questions
Further Readings

1.1 INTRODUCTION
Financial management can be divided into two broad areas of responsibility as the
management of long-term capital and the management of short-term funds or
working capital. The management of working capital which constitutes a major
area of decision-making for financial managers is a continuous function which
involves the control of the every ebb and flow of financial resources circulating
in the enterprise in one form or another. It also refers to the management of
current assets and current liabilities. Efficient management of working capital is
an essential prerequisite for the successful operation of a business enterprise
and improving its rate of return on the capital invested in short-term assets.
Virtually every business enterprise requires working capital to pay-off its shortterm obligations. Moreover, every firm needs working capital because its not
possible that production, sales, cash receipts and payments are all instantaneous
and synchronised. There elapses certain time for converting raw materials into
finished goods: finished goods into sales and finally realisation of sale proceeds.
Hence, funds are required to support all such activities in the firm. A number of
terms like working funds, circulating capital, temporary funds are used
synonymously for working capital. However, the expression, Working Capital, is
preferred by many due to its popularity and simplicity.

1.2 DEFINITION OF WORKING CAPITAL

Working capital may be defined in two ways, either as the total of current assets or
as the difference between the total of current assets and total of current liabilities.

Concepts and Determination

of Working Capital

Like, most other financial terms the concept of working capital is used in
different connotations by different writers. Thus, there emerged the following two
concepts of working capital.
i)

Gross concept of working capital

ii) Net concept of working capital

Gross concept:
No special distinction is made between the terms total current assets and working
capital by authors like Mehta, Archer, Bogen, Mead and Baker. According to
them working capital is nothing but the total of current assets for the following
reasons:
i)

Profits are earned with the help of the assets which are partly fixed and
partly current. To a certain degree, similarity can be observed in fixed and
current assets in that both are partly borrowed and yield profit over and
above the interest costs. Logic then demands that current assets should be
taken to mean the working capital of the corporation.

ii) With every increase in funds, the gross working capital will increase while
according to the net concept of working capital there will be no change in
the funds available for the operating manager.
iii) The management is more concerned with the total current assets as they
constitute the total funds available for operating purposes than with the
sources from which the funds came, and that
iv) The net concept of working capital had relevance when the form of
organisation was single entrepreneurship or partnership. In other words a
close contact was involved between the ownership, management and control
of the enterprise and consequently the ownership of current and fixed assets
is not given so much importance as in the past.
Net concept:
Contrary to the aforesaid point of view, writers like Smith, Guthmann and
Dongall. Howard and Gross, consider working capital as the mere difference
between current assets and current liabilities. According to Keith. V. Smith, a
broader view of working capital would also include current liabilities such as
accounts payable, notes payable and other accruals. In his opinion, working
capital management involves the managing of individual current liabilities and the
managing of all inter-relationships that link current assets with current liabilities
and other balance sheet accounts. The net concept is advocated for the following
reasons:
i)

in the long-run what matters is the surplus of current assets over current
liabilities.

ii) it is this concept which helps creditors and investors to judge the financial
soundness of the enterprise.
iii) what can always be relied upon to meet the contingencies is the excess of
current assets over current liabilities, since it is not to be returned; and
iv) this definition helps to find out the correct financial position of companies
having the same amount of current assets.

In general, the gross concept is referred to as the Economics concept, since

assets are employed to derive a rate of return. What rate of return is generated
by different assets is more important than the analysed difference between assets

and liabilities. On the contrary, the net concept is said to be the point of view of
an accountant. In this sense, working capital is viewed as a liquidation concept.

Theories and Approaches

Therefore, The solvency of the firm is seen from the point of view of this
difference Generally, lenders and creditors view this as the most pertinent
approach to the problem of working capital.

1.3 CONSTITUENTS OF WORKING CAPITAL

No matter how, we define working capital, we should know what constitutes
current assets and current liabilities. Let us refer to the Balance Sheet of Lupin
Laboratories Ltd. for this purpose.
Current Assets: The following are listed by the Company as current assets:
1)

2)

3)

Inventories:
a)

Raw materials and packing materials

b)

Work-in-progress

c)

Finished/Traded goods

d)

Stores, Spares and fuel

Sundry Debtors:
a)

Debts outstanding for a period exceeding six months

b)

Other debts

Cash and Bank balances:

a)

b)

With Scheduled Banks

i)

in Current accounts

ii)

in Deposit accounts

With others
i)

4)

in Current accounts

Loans and advances:

a)

Secured Advances

b)

Unsecured (considered good)

i)

Advances recoverable in cash or kind for value to be

ii)

Deposits

iii)

Balances with customs and excise authorities

received

Current liabilities: The following items are included under this category.
1)

2)

Current Liabilities:
a)

Sundry creditors

b)

Unclaimed dividend warrants

c)

Unclaimed debenture interest warrants

Short term credit:

a)

Short term loans

b)

Cash credit from banks

c)

Other short term payables

Concepts and Determination

of Working Capital

3)

Provisions:
a)

For Taxation

b)

Proposed Dividend
i)

on preference shares

ii)

on equity shares

Besides, items like prepaid expenses, certain advance payments are also included
in the list of current assets. Similarly, bills payable, income received in advance
for the services to be rendered are treated as current liabilities. Nevertheless,
there is difference of opinion as to what is current. In the strict sense of the
term, it is related to the, operating cycle, of the firm and current assets are
treated as those that can be converted into cash within the operating cycle. The
period of the operating cycle may be more or less compared to the accounting
period of the firm. In case of some firms the operating cycle period may be
small and in an accounting period there can be more than one cycle. In order to
avoid this confusion, a more general treatment is given to the, currentness, of
assets and liabilities and the accounting period (generally one-year) is taken as
the basis for distinguishing current and non-current assets.

1.4 TYPES OF WORKING CAPITAL

Sometimes, working capital is divided into two varieties as:
i)

Permanent working capital

ii)

Variable working capital

Permanent Working Capital: Though working capital has a limited life and
usually not exceeding a year, in actual practice some part of the investment in
that is always permanent. Since firms have relatively longer life and production
does not stop at the end of a particular accounting period some investment is
always locked up in the form of raw materials, work-in-progress, finished stocks,
book debts and cash. The investment in these components of working capital is
simply carried forward to the next year. This minimum level of investment in
current assets that is required to continue the business without interruption is
referred to as permanent working capital. While suggesting a methodology for
financing working capital requirements by commercial banks, the Tandon
committee has also recognised the need to maintain a minimum level of
investment in current assets. It referred them as, hard core current assets. The
Committee wanted the borrowers to meet this portion of investment out of their
own sources and not to depend on commercial banks.
Variable Working Capital: This is also known as the circulating or transitory
working capital. This is the amount of investment required to take care of the
fluctuations in the business activity. While permanent working capital is meant to
take care of the minimum investment in various current assets, variable working
capital is expected to care for the peaks in the business activity. While
investment in permanent portion can be predicted with some probability,
investment in variable portion of working capital cannot be predicted easily as
sudden changes in the business activity causes variations in this portion of
working capital.

1.4.1 Working Capital Behaviour

One of the implications of the division of working capital into two types is to
understand its behaviour over a period of time. Investment in working capital is
related to sales volume. A variation in sales volume over time would consequently

Theories and Approaches

bring about a change in the investment of working capital. This is said to vary
depending upon the type of working capital. These variations with respect to
different types of firms are presumed to vary as indicated in Fig. 1.1
Figure 1.1 exemplifies the behaviour of different types of working capital in
diverse firms affected by seasonal and cyclical variations in production or sales.
In case of non-growth non-seasonal and non-cyclical firms, all the working capital
can be considered permanent as shown in (A). Similarly, growing firms require
more working capital over a period of time, but fluctuations are not assumed to
occur. As such, in this case also, no variable portion of working capital is
present. In the third case (growing seasonal and non-cyclical firms), there are
two types of working capital. On the contrary, in case of growing, seasonal and
cyclical firms, all the working capital is assumed to be of varying type.
Fig. 1.1: Behaviour of Working Capital

wo

rk

in

(B) Growing, non-seasonal

and non-cyclical firms

Pe
Ca rma
pit ne
al nt

Working Capital (Rs.)

(A) Non-growth, non-seasonal

non-cyclical firms

Permanent
W.C

(C) Growing, seasonal and

non-cyclical firms

(D) Growing, seasonal and

cyclical firms

Variable
W.C.

Perma

.C
nent W

Variable W.C.
Time (years)
Activity 1.1
Mention the points of differentiation between
i) Gross concept and Net concept
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................

Concepts and Determination

of Working Capital

ii) Permanent working capital & Variable working capital

.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................

1.5

CYCLICAL FLOW AND CHARACTERISTICS OF

WORKING CAPITAL

For every business enterprise there will be a natural cycle of activity. Due to the
interaction of the various forces affecting the working capital, it transforms and
moves from one to the other. The role of the financial manager then, is to ensure
that the flow proceeds through different working capital stages at an effective
rate and at the appropriate time. However, the successive movements in this
cycle will be different from one enterprise to another, based on the nature of the
enterprises. For example:
i)

If the enterprise is a manufacturing concern, the cycle will run something

like: Cash(buying)Raw Materials(production)Finished Goods(sales
on credit) Accounts Receivable(Collections)Cash.

ii)

If the enterprise is purely a Retailing Company and one, which has no

manufacturing problem the cycle is shortened as:
Cash(buying)Merchandise(Sales)Accounts
Receivables(Collections) Cash.

iii) If the enterprise is a purely financing enterprise, the cycle is still shorter and
it can be shown as:
Cash(sanction of loans)Debtors(collections)Cash.
But in real business situations, the cyclical flow of working capital is not simple
and smooth going, as one may be tempted to conclude from these simple flows.
This cyclical process is repeated again and again and so do the values keep on
changing as they move through the cash to cash path. In other words the cash
flows arising from cash sales and collections from debtors will either exceed or
be lower than cash outflows represented by the amounts spent on materials,
labour and other expenses. An excess cash outflow over cash inflow is a clear
indication of the enterprise having suffered a loss. Thus it is apparent, that the
amount of working capital required and its level at any particular time will be
governed directly by the frequency with which this cash cycle can be sustained
and repeated. The faster the cycle the lesser will be the investment needed in
working capital.
Form the aforesaid discussion, one can easily identify three important
characteristics of working capital, namely, short life span, swift transformation and
interrelated asset forms and synchronization of activity levels.
1. Short-life Span
Components of working capital are short-lived. Typically their life span does not
exceed one year. In practice, however, some assets that violate this criterion are
still classified as current assets.
2. Swift Transformation and Inter-related Asset Forms
6

In addition to their short span of life, each component of the current assets is
swiftly transformed into the other asset. Thus cash is utilised to replenish

inventories. Inventories are diminished when sales occur that augment accounts
receivable and collection of accounts receivable increases cash balances. Thus a
natural corollary of this quick transformation is the frequent and repetitive
decisions that affect the level of working capital and the close interaction that
exists among the members of the family of working capital. The latter entails the
assumption that efficient management of one asset cannot be undertaken without
simultaneous consideration of other assets.

Theories and Approaches

3. Assets Forms and Synchronization of Activity Levels

A third characteristic of working capital components is that their life span
depends upon the extent to which the basic activities like production, distribution
and collection are non-instantaneous and unsynchronized. If these three activities
are only instantaneous and synchronized, the management of working capital
would obviously be a trivial problem. If production and sales are synchronized
there would be no need to have inventories. Similarly, when all customers pay
cash, management of accounts receivable would become unnecessary.

1.6 PLANNING FOR WORKING CAPITAL

Planning provides a logical starting point for many of the decisions. It is very
much true for working capital decision also. Unless, we plan for procurement and
effective use we will not be in a position to get best out of working capital. In a
way, effective planning leads to appropriate allocation of the money among
different components of working capital. Drawing a distinction of the kind of
Peter F. Drucker, between efficiency (doing things right) and effectiveness
(during right things). Planning clearly embraces the latter. It is for this reason
planning for working capital is considered highly appropriate and inclusive of the
present discussion on conceptual framework.
While planning should logically begin at the top of the organisational hierarchy,
responsibility for planning exists at all levels within the organisation. While
working capital planning is a part of financial planning the responsibility permeats
among different managers within the organisation responsible for managing
different components of working capital. At the level of planning for individual
components of working capital persons like materials manager, credit manager
and cash manager are involved. However, the overall responsibility for coordinating the planning of working capital typically rests with the top
management.

1.6.1 Tools of Planning for Working Capital

It should be interesting to know how to identify the relevant tools for completing
the planning exercise. Treating the planning for working capital as part of
financial planning. We can note down the following tools of analysis with respect
to time- frame.
a) Short term planning Cash Budgeting
b) Medium term planning Determination of appropriate levels of working
capital items
c) Long term planning Projected pay outs and returns to shareholders in
terms of CVP and funds flow analysis.
Cash budget: In the short term cash budgeting is considered a handy device for
planning working capital. The use of cash budget technique as a means of
determining the size of the cash flows is considered superior to the use of
proforma balance sheets or judging by the past experience. A cash budget is a

Concepts and Determination

of Working Capital

comparision of estimated cash inflows and outflows for a particular period such
as a day, a week, a month, a quarter or year. Typically Cash budget is designed
to cover oneyear period and the period covered is sub-divided into intervals. It
can be prepared in various ways like the one based on cash receipts and
disbursements method, or the adjusted net income method, or the working capital
differential method.
The budgeting process begins with the beginning balance to which are added
expected receipts. This amount is reached by multiplying expected cash receipts
by the probability distribution that the management budgetary will prevail during
the budgetary period. If outlays exceed the beginning balance plus anticipated
receipts the difference must be financed from external sources. If an excess
exist, management must make a decision regarding its disposal either in terms of
investing in short-term securities, repaying the existing debts or returning the
funds to the share-holders.
The preparation of the cash budget helps management in many ways.
Management will be able to ward off the disadvantages of excessive liquidity,
since there will be information on how and when such cash results in. Similarly it
will be able to contact different sources of finance to tide over a situation of
cash shortage and can avoid rushing to obtain finance at whatever cost. It allows
the management to relate the maturity of the loan to the need and determine the
best source of funds, since the information furnished by the budget reflects the
amounts and time for which funds are needed. Further, cash Budget establishes a
sound basis for controlling the cash position.
Of the several methods of preparing the cash budget, Receipts and Payments
method is popular among many undertakings. Moreso the preparation of cash
budgets in the organisations was an integral part of the budgetary process, since
the whole of the budgetary structure was divided into revenue budgets,
expenditure budgets and cash budgets. Cash budget was prepared by the
organisations by borrowing figures from various other budgets which they
prepared such as the:
i) Production budgets.
ii) Sales budget.
iii) Cost of production estimates with its necessary subdivisions for example.
a) materials purchase estimates:
b) labour and personnel estimates:
c) plant maintenance estimates: etc.
iv) Manpower budget.
v) Township and welfare estimates
vi) Profit and loss estimates.
vii) Capital expenditure budget.
Thus, cash budget is prepared as a means of identifying the past cash flows and
determine the future course of action. Cash budgets, generally are prepared by
all enterprises on yearly basis having monthly breakups.
Medium term planning : In the medium term determining appropriate level of
working capital is considered a focal point. In unit 3 of this course on
Determination of working Capital, we have discussed in detail the following
three approaches to determine optimum investment in working capital.

1)

Industry Norm Approach

2)

Economic Modelling Approach

3)

Strategic Choice Approach

Theories and Approaches

Therefore, students are advised to refer to that particular unit and hence
discussion on them is not repeated here.
CVP Analysis: As a measure of long term planning, macro- level techniques like
C-V-P and funds flow are considered helpful in making an effective planning.
These are helpful not only for working capital planning but also for the entire
financial planning. At the level of working capital planning, we are required to
establish relationships between costs, volume and profits. Though the regular
break-even point is used to determine that level of sales or production which
equals total costs, in the area of working capital, we can be cautious about the
costs and revenues akin to working capital items such as inventory, receivables
and cash. Firms often face a dilemma of whether to place an order to keep a
particular level of inventory or not and whether a customer be provided credit or
not. These matters can be effectively dealt with orientation towards the C-V-P
relationships.
In this context, a distinction may be made between cash break even point and
profit break-even point, which represents liquidity and profitability respectively.
Cash break-even point, which is defined as that level of sales per period for
which sales revenue just equals the cash outlays associated with the product or
business. This kind of an analysis helps in focusing on the areas of cash deficit
and cash surplus leading to better liquidity management. When we appreciate the
fact that working capital is a liquidation concept, the utility of CVP concept in
making better exercise in planning for working capital needs no special emphasis.
Funds Flow: Funds flow is yet another tool used in the long run to analyse the
financial position of a company. Though the term funds can be understood to
include all financial resources, preparation of funds flow statements on working
capital basis are more common in finance. The preparation of such flow
statements gives an idea as to the movement of funds in the organisation. The
particulars relating to the funds generated from operations and changes in net
working capital position are highly relevant in this analysis. A firms capacity to
pay off its current debts depends mainly on its ability to secure funds from
operations. The prime objective of funds flow statement (prepared on the basis of
working capital movements) is to show the ebb and flow of funds through
working capital and to shed light on factors contributing to the movements. As a
matter of fact the internal movement of wealth (to a large extent) usually takes
place among working capital items. An analysis of these movements therefore
would provide an understanding of the efficiency of working capital management.
Whereas the schedule of working capital is designed to measure, the flow of
funds through working capital. For that matter, one has to ascertain changes in
current assets and current liabilities during the two balance sheet dates and
record variations in working capital. This would help in identifying the net
changes. i.e., increases and decreases in working capital position.

1.7 WORKING CAPITAL AND INFLATION

Inflation, which is commonly indicated by the rise in prices of goods and services,
is so rampant in the world that no economy is far off from its deleterious
effects. Inflation has been experienced by almost all the countries in the world
irrespective of their political system and the stage of industrialisation. The fact is
that, over the last two decades, annual rates of inflation in excess of two to
three percent have become common all over the world.

Concepts and Determination

of Working Capital

In India, the rate of inflation was more grievous than in many other countries,
and the wholesale prices rose by almost 32 percent during 1956-61, by slightly
less than 30 percent during 1961-66, and 25 percent during the Annual Plan
periods (1966-69). Besides fluctuations the annual rate of rise in the wholesale
price was exceptionally high and in 1974-75, almost alarming. Inflation rate based
on Wholesale Price Index (WPI) averaged around 9 per cent during 1970-71 to
1990-91. Again it touched the highest level of the decade in 1991-92 at 16.7
percent, when the economic activity was at its lowest ebb. Consequent upon the
reforms, there has been some recovery in the economy and the rate of inflation
has come down to even 2 percent during 1998-99, threatening the regime of
deflation. Nevertheless, there is no consistency in the performance of the
economy. Again the rate of inflation is moving towards an average of 4-5
percent. Alongside these indices there are some hidden inflationary potentials
which are not apparent. Prominent among these are generous subsidies, changing
international prices of crude oil and petroleum products and the administered
prices for certain other products. The combined impact of these factors is
definitely seen on the inflation. The impact of inflation on working capital be
understood in the following manner.

1.7.1 Size of Working Capital

Inflation causes a spurt in the prices of input factories like raw materials, labour,
fuel and power, even though there is no increase in the quantum of such input
factors used. Secondly inflationary conditions by providing motivation for higher
profits induce the manufacturers to increase their volume of operations. High
profits and high prices create further demand thus, leading to further investments
in inventories, receivables and cash. The cycle, thus continues for a long time,
entailing on the finance manager to arrange for larger working funds after each
successive increase in the volume of operations. Thirdly, companies also tend to
accumulate inventories during inflation to reap the speculative profits. This kind of
blocking up of funds, in turn necessitates enterprise to maintain larger working
capital funds. Finally the existing financial reporting practices of firms on the
basis of historical costs as per the companies Act and Income Tax Act are also
responsible, for the reduction in the size of working capital finance. During the
period of inflation, since historical costs set against the current prices and
inventories are valued at current prices, higher profits would be reported. The
reporting of inflated profits creates two aberrations. The company has to pay
higher taxes on the inflated profit figure though much of it is unrealised and if
the company also declares the remaining profits as dividends, it leads to
distribution of dividends out of capital and eventually reduces the funds available
to the company for operations in inflationary years owing to escalation in cost of
inputs, increase in the volume of operations, accumulation of speculative inventory
and the adoption of historical cost accounting system.

1.7.2

Availability of Working Capital

Besides the problem of increased demand for funds there would be a reduction
in the availability of such funds associated with higher costs during inflation.
There would be no problem if the working capital funds were available to an
unlimited extent at a reasonable cost, regardless of the economic condition
prevailing in the economy. In reality, the situation is completely the opposite as
both internal and external sources of funds for financing working capital become
scarce.
As pointed out earlier, during inflation the availability of internal sources gets
reduced because of the maintenance of records on historical cost basis. On the
other hand, the position with regard to external sources of funds is equally
10

disheartening. The rapid increase in inflation has given rise to the formulation of
tight money policy by the Reserve Bank of India with a view to restricting the
flow of credit in the economy. Consequently, the extension of credit facilities
from banks have become extremely limited. Further, the diversion of bank funds
to priority sectors, after nationalisation has made it more difficult to raise funds
from banks.

Theories and Approaches

Till recently, companies depended heavily on public deposits for meeting their
working capital requirements. Their availability however was reduced due to the
restrictions imposed by the RBI on the companies for the mobilisation of deposits
from public, particularly since 1978. Further the advent of Government companies
into the capital market for accepting public deposits made it more difficult to
attract funds from the public.
Coming to the trade credit, one must note that it may not be available for long
periods, and the suppliers of goods tighten the credit facilities during inflationary
period. The issue of long term loans may also be slackened, as the investors
would be less attracted by investments offering a fixed return like debentures and
preference shares. This is so because in terms of purchasing power the principal
amount of investment as well as the interest would dwindle. Thus, these
restrictions and limitations on the availability of working capital from internal and
external sources makes it difficult for the finance manager to raise funds during
inflation.

1.7.3 Components of Working Capital

It may be interesting at this stage of the analysis to consider the impact of
inflation on the components of working capital, namely, inventory receivables and
cash.
Inventory
Not many understand fully the impact of inflation on the management of
inventory. Inflation affects the decisions in respect of inventory in many ways,
namely;
i)

It leads to over-investment in inventory.

ii)

It results in shortages.

iii) It affects valuation of inventories; and

iv) It renders the traditional inventory control techniques ineffective.
During the periods of inflation when the prices rise rapidly, companies will have
an incentive to invest more heavily in inventory than is indicated by the minimum
cost calculation. If the management believes the price of an item will increase by
10 per cent in the next month, substantially more of that item may be ordered
than normal, of course, due to increase in inventory the company may get
speculative gain, but this speculative gain may be off-set by the increase in taxes
due to higher profit figures, reported in times of inflation and higher carrying
costs.
Another difficulty that the company is required to face is the material shortages
in the periods of inflation. It is not known whether inflationary escalations result
in shortages or shortages occur because of instability caused by inflation.
Whatever be the real source of the problem, companies should be conscious of
the price trends and accordingly re-evaluate their internal purchasing and
organisational systems.
11

Concepts and Determination

of Working Capital

Very few firms realise the impact of inflation on the valuation of inventory and
the extent to which it contributes to unrealised profits. In other words, inflation
affects the valuation of inventories, affecting thereby the amount of profits
reported in the financial statements.
Not only inflation affects the inventory, but inflation itself is also increased due to
the inefficient management of inventory. Delivering the keynote address at a
National Convention on the subject of, Curbing Inflation through Effective
Materials Management, Shri P.J.Fernandes put forward the following five
propositions to show the impact of inflation on the materials management.
a) The stocks which are held by the enterprises have a direct and immediate
relationship to general price levels.
b) The price level in any country is to a great extent determined by the cost of
production. The cost of production is to a great extent determined by the
cost of inputs. Hence, if the cost of inputs goes up, the cost of production as
well as the price level also goes up.
c) An effective system of materials management must necessarily result in an
increase in production.
d) The materials manager can have a total and absolute impact on production
outside his unit, and
e) It is the materials management, which can reduce the crushing burden of
credit expansion, and the money supply, which again will have a direct and
absolute impact on inflationary tendency.
Finally, it may be considered with the help of the following illustration how
inflation renders the traditional inventory control techniques ineffective.
Assumptions
1)

Annual consumption

Rs. 1,00,000

2)

Economic Ordering Quantity

Rs. 3,125

3)

No of orders per year

4)

Ordering cost

Rs. 20 per order

5)

Carrying cost

Rs. 25 per cent

6)

Lead time constant

32

7)
Price rise
month.

5 per cent per

The ordering and carrying costs would be as follows:

a)

Ordering costs = 32 20 = Rs 640

b)

3125
25
Carrying costs = = Rs 390.63
2
100

c)

Total costs = Rs. 640 + 390.63 = Rs 1030.63

If 32 orders are placed in a year, the distribution of the same in each month and
the material cost month-wise would be as given below.

12

Theories and Approaches

Total Material Cost

No. of months
.
1st Month

No. of orders

Material cost

3125 2 1.00 =

6,250.00

2nd Month

3125 3 1.05 =

9,843.75

3rd Month

3125 3 1.10 = 10,312.50

4th Month

3125 2 1.15 =

5th Month

3125 3 1.20 = 11,250.00

6 Month

3125 3 1.25 = 11,718.75

7th Month

3125 3 1.30 = 12,187.50

8th Month

3125 2 1.35 =

9th Month

3125 3 1.40 = 13,125.00

10 Month

3125 3 1.45 = 13,593.75

11th Month

3125 3 1.50 = 14,062.50

12th Month

3125 2 1.55 =

th

th

32

7,187.50

8,437.50

9,687.50

1,27,656.25

Based on the EOQ formula, if one places orders as shown in the example, the
total material cost comes to Rs. 1,27,656.25 (i.e., Material Cost + Ordering Costs
+ Inventory Carrying Costs). In contrast, If the firm in question does not apply
the EOQ technique and simply resorts to buying at the single stretch or lot
buying, the total material cost would be only Rs. 1,12,520/- as worked out below:
1)

Quantity needed for the year = Rs. 1,00,000

2)

No of orders = 1(one lot)

3)

Ordering Costs = 1 20 = Rs. 20

4)

Carrying Costs = 1,00,000/2 25/100 = 12,500

5)

Material Cost = Rs. 1,00,000

6)

Total Cost = 1,00,000 + 20 + 12,500 = Rs.1,12,520

Thus, it would appear that the conventional inventory control technique of EOQ is
not really valid under the assumed conditions.
Receivables
The effect of inflation on the receivables is felt through the size of investment in
receivables. The amount of investment in receivables varies depending upon the
credit and collection policies of the organisation. Evidently, during the periods of
inflation the higher the amount involved in the receivables the greater would be
the loss to the company, since the debtor would be paying cheaper rupees.
Likewise, the length of the time too makes the firm lose much in the transaction.
For instance, if the firm in the beginning made a credit sale of about Rs. 1,00,000
with an allowed credit period of three months, assuming a 20 percent inflation in
the economy, the amount the company receives in real terms after the allowed
credit period becomes only Rs. 95,000. Here, even considering the same time lag
between delivery and realisation, as between debtors and creditors, sundry
debtors would create bigger problem than the sundry creditors, because the
declining value of sundry debtors would affect adversely the anticipated
13

Concepts and Determination

of Working Capital

profitability of the enterprise. Thus, the effect of inflation varies in accordance

with the quantum of receivables and the time allowed to repay them.
Cash
Management of cash takes on an added importance during the periods of
inflation. With money losing value in real terms almost daily, idle cash depreciates
rapidly. A company that holds Rs.1, 00,000 in cash during 20 percent annual rate
of inflation finds that the moneys real value is only Rs. 80,000 in terms of
current purchasing power. Even more important, idle cash is not earning any
return. During inflationary periods, it is important that cash is treated as an asset
required to earn a reasonable return. The loss on the excess cash may be off-set
or partly mitigated, if it is invested to produce an income in the form of interest
earned. Obviously, if the rate of interest exceeds the rise in the price level, the
firm realises a gain equivalent to the excess, or sustains a loss if it is vice versa.
Further, the loss of the purchasing power of excess cash is of particular concern,
if the company sells debts or fixed income securities with the intention of
subsequently investing the proceeds in fixed assets.

1.8 TRENDS IN WORKING CAPITAL

In order that we gain a better idea of the working capital, it is also necessary to
go into the working capital in Indian companies, besides having an idea of the
conceptual framework. For the purpose of analysing trends in working capital,
data is culled from the publications of RBI on Finances of public limited
companies. The data of RBI covers roughly about one-third of the nongovernment, non-financial companies in terms of paid-up capital. Table 1.1 depicts
the period covered from 1992-93 to 2001-02. The trends are analysed for this
period of nine years with a gap of one year (98-99). In view of the variations in
the sample number of companies during the period under consideration, trends are
analysed to a great extent in terms of percentages than in absolutes.

1.8.1 Size of Working Capital

Working capital, if taken, as the total of current assets increased from Rs. 67,558
crores in 1992-93 to Rs. 1,96,426 crores in 2001-02. (as worked out in table 1.3).
In terms of percentages, working capital worked out to about 53 percent of the
total net assets of the Indian companies. Nevertheless, there is a decline in the
percentage to 43 percent in 2001-02 almost 10 percentage points.
The implication of the study of size is that the ratio of current assets to total
assets provides a measure of relative liquidity of the firms asset structure. The
higher the ratio the lower would be the profitability and risk. In the sense that
higher investment in current assets not only locks up the funds that can be
gainfully employed elsewhere, but also necessitates the firm to incur additional
costs in the maintenance of such high volume of current assets.
An attempt is made to capture the position among diverse industries. An
examination of this position has revealed that current assets as per cent of total
net assets stood high in the industries such as trading, construction, tobacco,
sugar, cotton, textiles, engineering and rubber (See Table-1.1) It appears that all
traditional industries had higher amounts invested in working capital. A welcome
feature of these trends is that diversified companies (with a wide variety of
product groups) had investment in working capital upto around 42.6 percent only.

14

Further, the relation between current assets and current liabilities (as depicted
through current ratio) is sending a signal of poor liquidity. Accepting that a 2:1
relation between current assets and current liabilities as comfortable in exhibiting
adequate liquidity, the public limited companies have never been closer to this

standard. It was varying between the lowest of 1.23:1 and the highest of 1.52:1
during the period, 1992-98. In case of individual industries too none of them could
achieve this mark except shipping industry. (See Table 1.2).

Theories and Approaches

1.8.2 Constituents of Working Capital

In order to know the significance of each of the items of working capital, it is
better to decompose the total. Such an attempt is made both for current assets
and current liabilities. Among the current assets, loans and advances dominated
the total position. Almost half of the current assets are in the form of debtors
and advances (see Table-1.3). It is heartening to note that the dominant position
of inventories once has come down significantly from around 60 percent to only
just 32 percent now. Receivables always blamed more than half of the current
assets. Debtors can be considered more liquid than inventories. In that sense this
development can be considered a healthy feature of the Indian corporate sector.
Among the current liabilities sundry creditors and other current liabilities have
occupied a prime place (see Table- 1.4), constituting around almost 60 percent.
Bank borrowings for working capital purposes have come down following the
credit discipline exercised by the Reserve Bank, during nineties, but showing up
during 2001-02. These trends give an idea of the behaviour of working capital in
Indian companies.

1.9 SUMMARY
This unit has aimed at providing a conceptual understanding of the issues involved
in working capital. Thus, it started with the discussion on definition and ended
with the trends in working capital in Indian companies. There is a clear
difference in the understanding of the concept of working capital among
accountants and economists. This unit has attempted to highlight this aspect.
Similarly, what constitutes working capital is discussed to enhance the
understanding of the readers. Though there is a broad consensus, there are a
few differences in identifying the constituents, particularly in the area of
investments and advance payments. Attempt has also been made to highlight the
significant characteristics of working capital. Working capital planning is
considered yet another issue, which engages the attention of corporate managers.
The discussion is further strengthened to incorporate matters on inflation and
trends. At the end, a synoptic view is presented of the working capital trends, as
compiled from the data of RBI.

1.10 KEY WORDS

Working capital: Working capital is defined as the total of current assets or as
the difference between current assets and current liabilities.
Current assets: The total of inventories, debtors, loans and advanced, cash and
marketable securities.
Current liabilities: The sum of sundry creditors, unclaimed dividends short term
loans, bank credit and various types of provisions.
Permanent working capital: Minimum level of investment in current assets
required for production.
Variable working capital: Working capital which takes care of the fluctuations
in business activity.
Cash budget: A projection of estimated cash inflows and outflows.
CVP analysis: A measure of long term planning to study the relationship among
cost, volume and profit.

15

Concepts and Determination

of Working Capital

Funds flow

: A tool to underline changes in the movement of funds.

Inflation: A phenomenon of rising prices.

1.11 SELF ASSESSMENT QUESTIONS

1) Distinguish between gross working capital and net working capital?
2) Why is working capital considered a liquidation concept?
3) Discuss the various types of working capital and trace out the behaviour of
working capital with respect to time?
4) What is the impact of inflation on working capital?
5) How do you plan for the working capital of an organisation? Choose your
own company as an example?
6) Refer to the balance sheets of a company for a few years and analyse the
trends is working capital. What do they mean to the enterprise studied?
Table 1.1 : Current Assets as percentage of total net assets among different industry
groups in public limited companies in India
Sl. Industry

1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 99-00 00-01 01-02

1)

Tea

38.1

34.6

41.2

38.8

36.2

39.5

38.6

36.5

35.6

2)

Sugar

62.6

58.9

60.4

56.3

56.2

54.8

55.4

56.8

57.6

3)

Tobacco

68.5

66.3

66.7

67.6

61.8

60.0

4)

Cotton Textiles

51.7

53.5

53.5

53.2

51.8

50.7

42.1

41.6

41.8

Silk Rayon

50.1

48.4

49.3

35.9

30.8

28.9

5)

Textiles
6)

Engineering

62.2

58.3

58.4

57.3

52.5

49.2

7)

Chemicals

45.0

44.3

42.8

41.5

37.3

36.1

45.5

45.4

46.1

8)

Rubber

57.3

56.5

55.6

60.0

58.0

56.8

46.8

47.9

46.3

9)

Paper

47.3

43.8

44.7

43.4

34.5

37.6

34.3

35.3

32.7

10) Construction

74.5

71.6

71.7

50.9

66.5

37.1

66.3

64.5

65.5

11) Electricity

23.6

16.1

19.6

23.8

29.4

23.9

61.5

58.7

57.4

12) Trading

79.2

77.7

79.5

80.9

79.1

80.1

82.5

83.5

81.6

13) Shipping

28.6

30.6

38.8

36.9

37.0

36.6

50.4

47.3

45.4

14) Diversified Co.

47.5

45.0

44.3

48.9

43.7

40.8

36.8

43.1

42.6

Source: RBI Bulletins, October 1997, October 1999 and October 2003.
Table 1.2 : Current ratio among different industry groups in public limited companies in India
Sl. Industry

1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 99-00 00-01 01-02

1)

Tea

1.56

1.60

1.96

1.5

1.4

1.7

1.6

1.4

1.4

2)

Sugar

1.16

1.32

1.35

1.2

1.1

1.1

1.2

1.1

1.0

3)

Tobacco

1.22

1.34

1.30

1.3

1.3

1.3

4)

Cotton Textiles

1.26

1.33

1.35

1.4

1.4

1.3

1.2

1.2

1.0

5)

Silk Rayon

1.43

1.64

1.72

1.6

1.0

0.8

1.44

1.3

1.3

1.2

Textiles

16

6)

Engineering

1.35

1.36

7)

Chemicals

1.41

1.43

1.54

1.5

1.5

1.3

1.3

1.3

1.2

8)

Rubber

1.36

1.38

1.54

1.6

1.4

1.4

1.3

1.3

1.2

9)

Paper

1.17

1.34

1.52

1.3

1.3

1.2

1.1

1.1

0.8

10) Construction

1.09

1.04

1.09

1.1

1.5

0.9

1.3

1.3

1.1

11) Electricity

1.00

0.98

1.18

1.3

1.1

1.4

1.4

1.3

1.3

12) Trading

1.21

1.29

1.28

1.4

1.5

1.4

1.4

1.4

1.4

13) Shipping

1.28

1.64

2.29

2.1

2.1

1.9

1.4

1.2

1.2

14) Diversified

1.84

1.73

1.82

1.4

1.3

1.2

1.0

1.1

1.2

Companies

Theories and Approaches

Source: RBI Bulletins, October,1997; October 1999 and October 2003.

Tabla-1.3 : Constituents of current Assets (in percent )in public limited companies.
Sl. Particulars

1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 99-00 00-01 01-02

1.

Inventories

39.8

33.3

32.5

34.5

32.2

32.0

33.8

33.7

31.8

2.

Receivables

50.9

47.5

52.9

53.2

56.3

55.2

53.4

53.7

54.3

3.

Quoted Investments 2.6

11.8

7.4

4.9

4.8

3.5

4.9

5.5

5.5

4.

Advance of
Income tax

0.1

0.1

0.2

0.1

0.1

0.1

0.4

0.4

5.

Cash & Bank

Balances

6.6

7.3

6.9

7.3

6.6

9.2

7.5

6.7

8.4

Total

100.00

100.00

100.00

100.00

100.00

Current Assets

(67558)

(82134) (115541) (136469) (148353) (155716) (179159) (189080) (196426)

100.00 100.00 100.00 100.00

Source: RBI Bulletins, October, 1997, October 1999 & October 2003.

Note: Figurers in the brackets indicate absolute amounts in crores.

Table 1.4 : Constituents of current liabilities (in per cent) in public limited companies
Particulars

1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 99-00 00-01

A. Short term
borrowings
from Banks

01-02

33.2

28.3

29.5

29.7

29.8

29.3

32.0

37.5

40.0

B.

Unsecured loans
from Companies
and others

6.5

8.4

9.4

8.9

13.4

15.6

C.

Trade dues and

other Current
liabilities

59.7

62.7

60.6

60.7

55.9

54.0

63.1

55.2

53.2

1.Sundry creditors

38.5

39.2

34.2

37.6

35.2

20.2

37.5

33.8

31.7

2.Others

21.2

23.5

26.4

23.1

20.7

31.8

25.6

21.4

21.5

0.6

0.6

0.5

0.7

1.0

1.0

4.9

5.4

9.8

Total Current Liabilities 100.0

100.0

100.0

100.0

100.0

100.0 100.0 100.0

100.0

(48089)

(54307)

(67618)

D.

Provisions

(96646) (111653) (126555) (133005)(164273) (180165)

Source: RBI Bulletins, October 1997; October.1999 and October 2003.

Note: Figures in the brackets indicate absolute amounts in crore.

1.12 FURTHER READINGS

1) V.K. Bhalla, 2003, Working Capital Management, Amol Publications Pvt.
Ltd., New Delhi-110002.
2) Rao, K.V., 1990, Management of Working Capital, Deep & Deep,New Delhi.
3) Ramamoorthy, V.E., 1976, Working Capital Management,. IFMR, Madras.
4) Dileep R. Mehta., 1974, Working Capital Management, Englewood Cliffs,
Prentice Hall.
5) Park and Gladson, 1963, Working Capital, Macmillan, New York.

17