DIMENSIONS OF WORKING CAPITAL MANAGEMENT

There exists two concepts of working capital, namely gross concept and net
concept. According to gross concept, working capital refers to current assets, viz. cash,
marketable securities, inventories of raw material, work-in-process, finished goods and
receivables. According to net concept, working capital refers to the difference between
current assets and current liabilities. Working capital can be classified into fixed or
permanent and variable or fluctuating parts. The minimum level of investment in current
assets regularly employed in business is called fixed or permanent working capital and
the extra working capital needed to support the changing business activities is called
variable or fluctuating working capital. Working capital management is concerned with
all aspects of managing current assets and current liabilities.
(i) Managing Investment in current assets: Determination of appropriate level of
investment in current assets is the first and foremost responsibility of working capital
manager. Although the amount of investment in any current asset ordinarily varies from
day-to-day, the average amount or level over a period of time can be used in determining
the fluctuating and permanent investment in current assets. This distinction is of great
importance in devising appropriate financing strategies. Besides the level of investment,
the type of current assets to be held are equally important decision variables. There is a
very large number of alternative levels of investment in each type of current asset.
Therefore, in principle, current asset investment is a problem of evaluating a large
number of mutually exclusive investment opportunities.
(ii) Financing of working capital: Another important dimension of working capital
management is determining the mix of finance for working capital which may be a
combination of spontaneous, short-term and long term sources. Spontaneous sources of
financing consist of trade credit and other accounts payable that arise spontaneously in
the firms day-to-day operations, such as purchase of raw materials and supplies. In
addition to trade credit, wages and salaries payable, accrued interest and accrued taxes
also provide the firm with valuable sources of spontaneous financing. Thus the credit
which arises in conjunction with the day-to-day operations of the firm provide
spontaneous source of financing of working capital. Bills payable, short term bank loans,
inter corporate loans, commercial paper are the most common examples of short term
sources of working capital finance. Term loans, debentures, equity and retained earnings
constitute long-term sources of working capital finance.
(iii) Inter-relatedness : Inter-relatedness is the most distinguishing characteristic of
working capital decisions. The desired level of inventory over a period and sales could
not be made without considering the implications for accounts receivable. Moreover
increased sales and collections for the firm is likely to mean that lower average cash
balances will be needed or that a new cash management system would be desirable.
If sales increase, an increase in inventory will be financed spontaneously with trade
credit. The amount of trade credit financing will depend on decisions regarding
payments. Inventory decisions are thus linked to trade credit decisions. Thus working
capital managers have to pay attention to the inter related nature of current assets and

current liabilities and take into account major interactions that influence the working
capital investment and financing decisions.
(iv) Volatility and Reversibility: Another significant feature of the working capital
management is that the amount of money invested in current assets can change rapidly,
and so does the financing required. The level of investment in current assets is influenced
by a variety of factors, which may be as erratic as labor unrest or flooding of the plant.
Seasonal and cyclical fluctuations in demand are a common cause of rapid changes in
investment in current assets and the financing required. Related to volatility is the
reversibility feature of current assets and current liabilities, which means that the cash
flow related to these could be readily reversed.

RISK RETURN TRADE OFF IN WORKING CAPITAL MANAGEMENT

Working capital decisions of the finance manager must be geared to maximization
of shareholders wealth. Accordingly, risk return trade-off characterizes each of the
working capital decision. There are two types of risks inherent in working capital
management namely, liquidity risk and opportunity loss risk. Liquidity risk is the nonavailability of cash to pay a liability that falls due. It can cause not only a loss of
reputation but also make the work condition unfavourable for getting the best terms on
transaction with the trade creditors. The other risk involved in working capital
management is the risk of opportunity loss i.e risk of having too little inventory to
maintain production and sales, or the risk of not granting adequate credit for realizing the
achievable level of sales. In other words, it is the risk of not being able to produce more
or sell more or both and therefore not being able to earn the potential profit, because there
were not enough funds to support higher inventory and book debts. Thus it is only
theoretical that the current assets could all take zero values. Indeed, it is neither
practicable nor advisable. In practice, all current assets take positive values, because
firms seek to reduce working capital risks. However, greater the funds locked up or
deployed in current assets, the higher is the cost of fund employed, and therefore lesser
the profit.
The risk return trade off in managing the firms liquidity by investing in
marketable securities, does have a favourable effect on firms liquidity, but it also has an
unfavourable effect on the firms rate of return earned on invested funds. The risk return
trade off involved in holding more cash and marketable securities, therefore, is one of
added liquidity versus reduced profitability. In the use of current versus long term debt
for financing working capital needs also the firm faces a risk-return trade off. Other
things remaining the same, the greater its reliance upon short term debt or current
liabilities in financing its current asset investments the lower will be its liquidity. On the
other hand, the use of current liabilities offers some very real advantages to the user in
that they can be less costly than long-term financing as they provide the firm with a
flexible means o financing its fluctuating needs for current assets. Thus a firm can reduce
its risk of illiquidity through the use of long term debt at the expense of a reduction of its

return on invested funds. The risk return trade off involves an increased risk of illiquidity
versus increased profitability.
Theoratically, NPV rules developed for the firms investment decisions would
apply to investment in current assets. But in practice, in view of certain unique
characteristics of current assets, two useful modifications of NPV are followed as
decision criteria in working capital decisions. They are Average Net Profit per period and
Total cost. We can use net profit per period as a criterion for choosing among alternative
reversible investments. The investment with the highest value of net profit per period is
also the investment with the highest net present value, regardless of when the investment
is reversed. Investments with positive NPVs will have positive net profits, investments
with zero NPVs will have zero net profits and investments with negative NPVs will have
negative profit. Thus, net profit per period instead of NPV can be used as a decision
criterion for working capital management.
Many current asset decisions, particularly inventory decisions can be made on the
basis of minimizing cost. There also instead of minimizing the net present value of costs,
one may minimize the total annual cost where the annual capital cost of the investment is
the discount rate times the amount invested. In sum, the current assets may be treated as
reversible and investment policies may be selected that maximize net profit or minimize
total cost per period. The choice between the profit or cost criterion will of course depend
on the particular problem being analysed.

HEDGING PRINCIPLE
A principle which can be used as a guide to firms working capital financing
decisions is the hedging principle or matching principle. Simply speaking, the hedging
principle involves matching the cash flow generating characteristics of an asset with the
maturity of the source of financing used to finance its acquisition. For example, a
seasonal expansion in inventories, according to the hedging principle should be financed
with a short term loan or current liability. The rationale underlying the rule is straight
forward. Funds are needed for a limited period of time, and when that time has passed,
the cash needed to repay the loan will be generated by the sale of extra inventory items.
Obtaining the needed funds from a long term source (longer than one year) would mean
that the firm would still have the funds after the inventories (they helped finance) have
been sold. In this case the firm would have excess liquidity which they either hold in cash
or invest in low yielding marketable securities until the seasonal increase in inventories
occurs again and the funds are needed. This would result in an over all lowering of firm
profits.
To put it very succinctly, the hedging principle states that the firms assets not
financed by spontaneous sources should be financed in accordance with the rule:
permanent assets (including permanent working capital needs) financed with long term
sources and temporary assets (viz. fluctuating working capital need) with short term

sources of finance to ward of the liquidity risk. In practice, several modifications of the
strict hedging principle such as conservative financing strategy and the aggressive
financing strategy are followed by the firms at different times. The hedging principle
provides an important guide regarding the appropriate use of short term credit for
working capital financing.
In conservative financing strategy, the firm follows a more cautious plan, whereby
long-term sources of financing exceed permanent assets in trough period such that excess
cash is available (which must be invested in marketable securities). Note that the firm
actually has excess liquidity during the low ebb of its asset cycle and thus faces a lower
risk of being caught short of cash than a firm that follows the pure hedging approach.
However, the firm also increases its investment in relatively low-yielding assets such that
its return on investment is diminished.
In aggressive financing strategy, the firm continually finances a part of its
permanent asset needs with short term funds and thus follows a more aggressive strategy
in managing its working capital. It can be seen that even when its investment in asst
needs is lowest the firm must still rely on short term financing. Such a firm would be
subjected to increased risks of a cash short fall in that it must depend on a continual
rollover or replacement of its short term debt with more short term debt. The benefit
derived from following such a policy relates to the possible savings resulting from the use
of lower cost short-term debt as opposed to long-term debt.

RATIOS
Working capital management is concerned with maintaining an
adequate amount of working capital by proper balance of current assets vis-vis non current assets in the asset structure and a reasonable mix of shot
term and long term sources in the financial structure of the firm. Ratio
analysis can be used by management as a tool to verify the level and
composition of working capital held by management in the business as against
its operations, the extent of liquidity present in its asset structure as well
as financial structure and the efficiency with which working capital is being
used in the business. In the other words, management can employ ratios to
analyze three facets of working capital management namely efficiency,
liquidity and its structural health.

RATIOS TO ANLAYSE THE EFFICIENCY OF WORKING CAPITAL

The efficiency with which working capital is being used by the
management can be analyzed in terms of the overall working capital and/or
its constituent parts viz. cash, inventory, receivables. Efficiency ratios
indicate the efficiency with which working capital and its constituent parts
(cash, inventory, receivables) are being utilized. Overall working capital and
its elements are generally expressed as number of times they are converted
into sales/ cost of goods sold or number of days they are being held. In this
category the ratios are: working capital turnover, inventory turnover,
receivables turnover, cash turnover, payables turnover. Inventory turnover
ratio is further classified as raw material turnover ratio, work-in-process
turnover ratio and finished goods inventory turnover ratio. Liquidity ratios
indicate the extent to which a firm will be able to meet its shot term
obligations. These ratios include current ratio, acid test ratio and cash
ratio. The set of ratios : current assets to total assets, cash to current
asset, receivables to current assets, inventory to current asset and current
liabilities to total liabilities helps to evaluate structural shifts and changes
that have taken place over time and are indicative of structural health of
working capital in the business. Working capital and its various elements
should form a reasonable balance in the asset structure as well as financial
structure.

EFFICIENCY OF OVERALL WORKING CAPITAL

The efficient use of overall working capital in the firm can be gauged
with the help of working capital turnover ratio.

Working capital turnover ratio =

Net Sales
--------------------------------Average Net Working Capital

This ratio indicates the rate of working capital utilization in the firm. A
higher ratio of a firm when compared with that of an industry average
indicates that the amount of working capital in this firm is less than that
required by its operations i.e., sales. So the firm may have to go for
additional working capital that can be supplied to it by its owners through
reinvestment of earnings or can be obtained by selling additional shares or
debentures. Likewise if this ratio is lower than the industry average, it
indicates that the investment in net working capital is more than what is
required. This calls for either withdrawing excess amount or increasing the
sales in the market so that the relationship between the amount of working
capital financed by long term sources and sales is reasonable.
Net working capital turnover ratio can also be analyzed over a period
of five to seven years. An increasing ratio indicates that working capital has
been used more intensively over a period of time. A decreasing ratio is
indicative of relative inefficiency in the use of working capital. A variant of
this ratio is current asset turnover ratio which is cost of goods sold to
average current asset. Generally a higher ratio is considered an indicator of
better efficiency and a lower one the opposite.
EFFICIENCY OF WORKING CAPITAL ELEMENTS
Inventory constitutes an important part of the total working capital.
In actual practice, many firms face serious problems due to slow moving, out
dated inventory. But if too much amount is invested in this for too long, it
poses a serious threat to the profitability as well as solvency of the concern.
Inventory turnover ratio reflects the efficiency with which inventory is
being managed in the concern.

Inventory turnover ratio =

Cost of Goods Sold

--------------------Average Inventory

It shows how rapidly the inventory is being turned into receivables/cash

through sales. Generally a higher turnover is considered good and a low
turnover bad. A low turnover implies an excessive level of inventory than
warranted by production or sales operations. This may also indicate the
presence of slow moving or obsolete inventory.

RECEIVABLES EFFICIENCY RATIO

With the increasing competition in the business, management
sometimes offers liberal credit terms to its customers, thereby maximizing
sales and total profits. Thus the number of times the management is able to
turn the receivables into sales indicates the efficiency with which the
receivables are being managed. This is given by the receivables turnover
ratio.

Receivables turnover ratio =

Total Sales
--------------------Average Receivables

A low turnover ratio is an indicator of the firms increased reliance on credit

sales in its marketing efforts. If this is not backed up by timely and
efficient collection of receivables, it may jeopardize the very solvency of
the firm.

CASH EFFICIENCY
Cash is considered an idle asset as it does not earn any return.
Therefore, a balance has to be struck between too much and too less an
amount of cash that a concern should have. In fact, it should be just
adequate to the needs of the concern. Efficient management of cash
requires that there should be proper relationship between cash needs of the

concern to the average balance of cash held by it during the year. This is
expressed by cash turnover ratio.

Cash turnover ratio =

Cash operating expenses during the year

--------------------------------------------Average cash balance during the year

However no conclusions can be drawn if this ratio deviates from the selected
standards of comparisons.

PAYABLES EFFICIENCY
Accounts payable constitute an important source to provide
spontaneous working capital finance for the firm. To what extent
management is able to use it properly is an important area worth probing.
Payables turnover ratio expresses the number of times account payables are
converted into purchases by management during the year.

Payables turnover ratio =

Annual purchases
-------------------Average payables

Normally, a higher turnover ratio is preferred. This means that with a

smaller amount of payables, management could purchase more material
during the year.

Inventory comprises raw material, work-in-process, finished goods and

spare parts etc. All the components should form a reasonable part of the
total inventory. Therefore all components should be related individually to
the total inventory to find out the proportion of each of them. Inventory
turnover ratio is further classified as raw material turnover ratio, work-inprocess turnover ratio and finished goods inventory turnover ratio.

Raw material inventory =

turnover

Raw materials consumed during the year

------------------------------------------Average raw material inventory

This ratio indicates the rate of utilization of raw material. A higher turnover
ratio over a period of time indicates its increasing utilization. But too high a
ratio may indicate that proportionately less raw materials were held in order
to carry out the production which may be quite risky.

Work-in-process inventory =
turnover

Cost of goods manufactured

-------------------------------Average W.I.P inventory

This ratio establishes a relationship between the value of goods produced

and the value of average work-in-process. A higher turnover ratio indicates,
lower inventory accumulation and lesser tied-up working capital. A falling
turnover means either management has become lax in controlling the
productive processes or some external factors have retarded the production
movement at its final run-up.

Finished goods inventory =

turnover

Cost of goods sold

------------------------------------Average finished goods inventory

If the finished goods are turned over faster, the amount of locked up funds
would be less; otherwise, it will be more. Finished goods inventory turnover
ratio attempts to capture this aspect.

RATIOS TO ANALYSE LIQUIDITY OF WORKING CAPITAL ELEMENTS

The liquidity of working capital is an important aspect to be analysed
by the management for maintaining proper liquid resources to meet both
operational requirements as well as financing commitment of repayment of
borrowed funds.

CURRENT or WORKING CAPITAL RATIO

Current ratio =

Current assets
------------------Current liabilities

This ratio indicates the extent to which short term creditors are safe in
terms of liquidity of the current assets. Thus, higher the value of the
current ratio, more liquid the firm is and more ability it has to pay its bills. A
low value of current ratio means that the firm may find it difficult to pay
the bills. However, a current ratio of 2:1 is considered generally
satisfactory. It indicates that in the worst situation even if the value of
current assets go down by half, management would still be able to repay the
debts and meet its obligations. Thus it represents the cushion that creditors
have to protect themselves against any adverse liquid position. A relatively
very high ratio indicates slackness of management practices as reflected in
excessive holding of current assets. On the other hand, a low ratio indicates
an inadequate margin of safety between the current resources and short
term obligations.

ACID TEST or QUICK RATIO

Acid Test ratio =

Current assets - inventory

------------------------------Current liabilities

This ratio gives clues about the liquidity of working capital. Quick asset is
defined as current assets minus inventory. Among the various elements of
working capital, inventory is relatively less liquid and hence deducted from
total current assets to give the value of quick assets in the firm. Quick
liabilities are the same as current liabilities. An acid test ratio of 1:1 is
considered satisfactory.

CASH or ABSOLUTE LIQUIDITY RATIO

Cash Ratio =

Cash and Marketable securities

------------------------------------Current liabilities

This ratio is the most rigorous test of the liquidity position of the business
unit. This ratio is a stricter one to measure the liquidity position as only cash
and marketable securities have been taken into account. Thus cash ratio
measures the absolute liquidity of the business.

RATIOS TO ANALYSE THE STRUCTURE OF WORKING CAPITAL

The structural health of the working capital in the business is
generally studied by analyzing the shifts and changes between its various
elements i.e., cash, receivables, inventories, and other items of current
asset. Decomposition analysis can help management to detect the
occurrences and extent of such structural shifts and changes in firms
resource allocation over a period of time. If after scanning the data any
unusual phenomenon is detected, management can further investigate that in
depth. Under decomposition analysis the value of individual items can be seen
in relation to total value of the current assets and the value of the current
assets in relation to total assets. Likewise the proportion of short term
liabilities can be gauged with respect to total liabilities. The following ratios
are generally used to analyze the structure of the working capital in the
business.
a)
b)
c)
d)
e)

Current assets to total assets ratio

Cash to current asset ratio
Receivables to current asset ratio
Inventory to current asset ratio
Current liabilities to total liabilities ratio

These ratios if analyzed together indicate the areas of strength and

weaknesses in the sphere of working capital management.

FUND FLOW / CASH FLOW ANALYSIS

Funds flow is used to refer to changes in or movement of current assets and
current liabilities. Working capital means total current assets less current liabilities.
Working capital implies amount of resources invested in current assets from sources of
finance other than current liabilities. This net amount is also the amount available for use
in the business in the form of fund. During an accounting period, working capital or
funds flow from one element of balance sheet to another and according to net working
capital approach , working capital is the amount which is available to the firm as a
liquid resource. A statement that uses net working capital as a measure of liquidity
position is referred to as fund flow statement, and its analysis as fund flow analysis.
Cash and cash equivalent basis is another way in which liquidity position of the
firm is conceived. Marketable securities are considered as cash equivalent under this
approach. The change in the amount of cash and its equivalents during the accounting
period reflects liquidity position. This implies that many of the items which do not
change NWC position but affect cash position of the firm are analyzed. The statement
prepared on cash basis is called cash flow statement and its analysis is referred to as cash
flow analysis.
In order to undertake fund flow analysis, it requires an understanding of the
following:
1. The concept of sources and uses of funds.
2. The effect of changes in various balance sheet items on the NWC position of the
firm i.e., how various accounts affect working capital position.
3. The rearrangement and consolidation of information taken from balance sheet as
indicated above and relevant information from profit and loss account in the form
of Fund flow statement.
The first step in the analysis fund flows is to classify the business transactions into
sources and uses of funds. Normally, an increase in liabilities or a decrease in assets of
the firm is considered as sources of funds. On the other hand, an increase in assets or a
decrease in liabilities, is considered as use of funds. An increase in working capital means
its amount at the end of the period is greater than its amount at the beginning of the
period, and it denotes the deployment of funds by the amount of the increase and hence it
is considered a use of funds. On the other hand, a decrease in net working capital balance
during the accounting period denotes the availability of funds with the business, hence it
is a source of funds.
An analysis of the fluctuations of current assets and current liabilities i.e., working
capital tells us how the working capital has increased or decreased. We want to know
where the increased working capital is applied if it has increased, and from where funds
have been released if it has decreased. The profit and loss account gives some indication
of the results of the operations and its impact on the funds position. We try to integrate
the impact of operations reported in the profit and loss account and balance sheet by

preparing a statement of changes in financial position. It describes the sources from

which funds were received and the uses to which funds were put. This statement of
changes in financial position is usually referred to as fund flow statement or statement of
sources and application of funds. It traces the flow of funds through the organization.
The statement of funds flow is usually bifurcated into two logical divisions: sources
of funds or inflows during the periods and uses of funds or applications of funds during
the period. The division showing sources of funds summarizes all those transactions
which had the net effect of decreasing the working capital. Uses of funds on the other
hand deal with all those transactions which had the effect of increasing the working
capital. To summarize, an increase in net working capital is possible due to increase in
non-current liabilities and owners equity or decrease in non-current assets. While
decrease in net working capital results from an increase in non-current assets or decrease
in non-current liabilities and / or owners equity. Working capital does not get affected: if
transactions affect only current items i.e., current assets and current liabilities or if
transactions affect only non-current assets. The flow of funds statement gives a summary
of the impacts of managerial decisions. As such it reflects the policies of financing,
investment, acquisition and retirement of fixed assets, distribution of profits and the
success of operations.
SOURCES OF FUNDS
Working capital is required to finance that portion of current assets which is not
financed by current liabilities. The investments represented by current assets are
converted into cash during the operating cycle. This implies that our need for financing is
for one such cycle. Under normal circumstances every unit of investment in working
capital is converted into cash at the end of the cycle at an added value, to the extent of
profits.
Internal Sources : Every profitable sale brings with it funds in excess of what was
expended on the goods sold. In other words, profits generated by the business contribute
towards additional working capital. Whenever we measure profits, we match the revenue
against all expenses relating to the revenue, whether it involves use of funds in the
current period or not. Thus the profits measured do not reflect the actual amount of funds
available. In order to assess the actual funds generated from current operations we should
add back to the profits all those items of expenses not involving use of funds during the
current period. One major example of such an item is depreciation. Thus we could
summarize the important possible sources of funds as: Funds generated from operations,
i.e., profit plus depreciation and other amortizations and sale of non-current assets, any
surplus working capital.
Funds from Operations : Funds from operations represent the sale proceeds of goods and
services by the company. Part of these funds is utilized for meeting the cost of inputs
such as material, personnel and other operating costs. Apart from these we have also to
meet the interest commitments and costs expiration of the machinery and equipment.
However, expiration of costs of the machinery and equipment (depreciation) is one item
which does not require use of funds in the current period. Thus the funds provided from

the operations are in fact the revenues earned from operations (as also non-operating
incomes) less all immediate costs of goods sold requiring use of funds. In other words, it
is net income or profit after taxes plus all the non-cash expenses, such as depreciation and
amortisation.
External Sources : External sources of funds are resources raised form outside the
organization to augment funds availability for any of the uses. Normally there are two
ways of doing this: by contributing or raising additional capital and by increased long
term borrowing. Short-term creditors are not included as a source of funds since we have
already defined funds as current assets less current liabilities. Thus working capital
represents long term investment in current assets and hence short term borrowing will not
increase working capital. The sources of funds, as usually presented in the fund flow
statement are given below:
Sources of Funds
Operations:
Net Profit after taxes
Add: Depreciation
Other amortizations
Funds provided by operations
New issue of share capital
New issue of debentures/bonds
Additional long-term borrowing
Sale proceeds of fixed assets
Sale of long term investments

-------------------------------------------------------------------------------------------------------------------------

USES (APPLICATIONS) OF FUNDS

A business would require additional capital for two purposes:
1. Financing additional fixed assets and 2. Financing additional working capital.
Investment in fixed assets is required to expand capacity or to improve the current
operation. Usually, addition to investments are judged on the basis of its ability to reduce
the present costs or to increase the present output. Additional working capital is required
to finance increased holding of inventory, increased credit to customers and increased
cash holding requirements. Obviously, current creditors would finance part of this
requirement for working capital. Whenever additional investment is to be made in noncurrent assets, we have to use the funds (working capital) available with us unless
separate arrangement is made for their financing. Likewise, when non-current assets are
sold they provide funds or results in sources of funds. We could summarize the usual
applications of funds as follows:
1.
2.
3.
4.

Acquisition of new non-current assets (fixed assets)

Repayment of non-current debt (loans)
Payment of dividends
Increase in the balance of working capital (current assets current liabilities)

If the trading or business operations are unsuccessful, they may use funds rather than
provide funds. The uses of funds, as they are usually presented in the fund flow
statement, are given below:
Uses of Funds
Dividends
Non-operating losses not passed through P & L account
Redemption of redeemable preference share capital
Repayment of debentures/bonds
Repayment of long term loans
Purchase of fixed assets
Purchase of long-term-investment
Increase in working capital

-------------------------------------------------------------------------------------------------

FACTORS AFFECTING FUND REQUIREMENTS

Fund requirements vary with the nature and type of business. Working capital
requirements are directly influenced by sales volume. Fund requirements for the business
may be seasonal. An important aspect which may condition fund requirement is the
velocity of circulation of current assets. In other words the length of the operating cycle
will influence the need for funds. Shorter the duration of operating cycle faster is the
conversion of money invested in current assets into cash and hence lesser the need for net
working capital. Net working capital requirement is also influenced by the terms
available from the suppliers. The credit terms extended by the suppliers will determine
the amount of additional funds required. We can summarise the need for working capital
by saying that the ability of the firm to circulate the cash->raw material inventory ->
work-in process -> finished goods inventory -> receivables -> cash is the most vital and
important factor in determining the amount of working capital. However the exact
amount needed to be invested in all these will be determined by the period and quantum
of holding of each of these elements.
ANALYSING CHANGES IN WORKING CAPITAL
In understanding the financial statements of a company, one of the first steps
involved is the study of the changes in current financial position of the company and the
reasons for the changes. We can attempt at studying these changes and their causes by
using the data contained in the summarized comparative balance sheet and profit & loss
account of a company. A statement of changes in working capital helps us in locating
where these changes took place. In the first instance we try to show the increase
(decrease) in individual items and try to classify them in terms of increase and decrease
in working capital. Since working capital is measured by subtracting current liabilities
from current assets, any increase in current assets and decrease in current liabilities shows
an increase in working capital. Similarly, a decrease in current assets and an increase in
current liabilities represent a decrease in working capital.

BALANCE SHEET
Balance sheet is the most significant financial statement. It indicates the financial
condition or the state of affairs of a business at a particular moment of time. In the
language of accounting, balance sheet communicates information about assets, liabilities
and owners equity for a business firm as on a specific date. It provides a snapshot of the
financial position of the firm at the close of the firms accounting period.
ASSETS
Assets, representing economic resources are the valuable possessions owned by the firm.
Assets are the future benefits. They represent: (a) stored purchasing power (e.g. cash), (b)
money claims (e.g. receivables, stock) and (c) tangible and intangible items that can be
sold or used in the business to generate earnings. Tangible items include land, building,
plant, equipment or stocks of materials and finished goods and all such items which have
physical substance. Intangible items do not have any physical existence, but they have
value to a firm. They include patents, copy rights, trade name or goodwill.
Assets may be classified as: (1) current assets and (2) fixed (long-term) assets.
CURRENT ASSETS
Current assets, sometimes called liquid assets, are those resources of a firm which are
either held in the form of cash or are expected to be converted in cash within the
accounting period or the operating cycle of the business. Current assets include cash,
tradable (marketable) securities, book debts (accounts receivables) and stock of raw
material, work-in-process and finished goods.
CASH
Cash is the most liquid current asset. It is the current purchasing power in the hands of a
firm and can be used for the purposes of acquiring resources or paying obligations. Cash
includes actual money in hand and cash deposits in bank account.
MARKETABLE SECURITIES
Marketable securities are temporary, or short-term investments in shares, debentures,
bonds and other securities. These securities are readily marketable and can be converted
into cash within the accounting period. The inter-corporate lending is another popular
short-term investment in India.
ACCOUNTS RECEIVABLE
Accounts receivable are the amounts due from debtors (customers) to whom goods or
services have been sold on credit. These amounts are generally realizable in cash within
the accounting period. All accounts receivable (also called book debts) may not be
realized by the firm. Debts which will never be collected are called bad debts.
BILLS RECEIVABLES
Bills receivables represent the promises made in writing by the debtors to pay definite
sums of money after some specified period of time. Bills are written by the firm and
become effective when accepted by the debtors. A firm may discount its bills receivables

with a bank and realize cash immediately. The amount of discount is the banks
commission.
STOCK (or INVENTORY)
Stock or inventory includes raw materials, work-in-process and finished goods in case of
manufacturing firms. A merchandise business may not have raw material and work-inprocess inventories as it has no manufacturing activity.
PREPAID EXPENSES AND ACCRUED INCOMES
Prepaid expenses and accrued incomes are also included incurrent assets. Prepaid
expenses are the expenses of future period paid in advance. Examples of prepaid
expenses are prepaid insurance, prepaid rent or taxes paid in advance. They are current
assets because their benefits will be received within the accounting period. Accrued
incomes are the benefits which the firm has earned, but they have not been received in
cash yet. They include items such as accrued dividend, accrued commission, or accrued
interest.
LOANS AND ADVANCES
Loans and Advances are also included in current assets in India. They include dues from
employees or associates, advances for current supplies and advances against acquisition
of capital assets.
FIXED ASSETS
Fixed or long-term assets are held for periods longer than the accounting period. They are
held for use in business, and not for the purpose of sale. Fixed assets would include longterm investment and all non-current assets.
Tangible fixed assets
Tangible fixed assets include land, building, machinery, equipment, furniture etc. These
are normally recorded at cost. Costs of tangible fixed assets are allocated over their useful
lives. The amount so allocated each year is called depreciation. Costs of tangible fixed
assets are reduced every year by the amount of depreciation. Depreciating an asset is a
process of allocating cost and does not involve any cash outlay.
Intangible fixed assets
Intangible fixed assets represent the firms rights and include patents, copyrights,
franchises, trade-marks, trade names and goodwill. Patents are the exclusive rights
granted by the government enabling the holder to control the use of an invention. Copy
rights are the exclusive rights to reproduce and sell literary, musical and artistic works.
Franchises are the contracts giving exclusive rights to perform certain functions or to sell
certain services or products. Trade marks and trade names are the exclusive rights granted
by the government to use certain names, symbols, labels, designs etc. Goodwill
represents the excessive earning power of a firm due to special advantages that it
possesses. Costs of intangible fixed assets are amortized over their useful lives.

Gross block
Gross block represents the original cost of total fixed assets. When accumulated
depreciation is subtracted from the gross block, the difference is called the net block.
Long-term investments
Long-term investments represent the firms in shares, debentures and bonds of other
firms or government bodies for profits and control. These investments are held for a
period of time greater than the accounting period.
Other non-current assets
Other non-current assets include assets that cannot be included in any of the above
categories. Usually they represent deferred charges. Prepayments for services or benefits
for a period longer than the accounting period are referred to as deferred charges and
include advertising, preliminary expenses etc.
LIABILITIES
Liabilities are debts payable in the future by the firm to its creditors. They represent
economic obligations to pay cash or to provide goods or services in some future period.
Generally, liabilities are created by borrowing money or purchasing goods or services on
credit. Examples of liabilities are creditors, bills payable, wages and salaries payable,
interest payable, taxes payable, bonds, debentures, borrowing from banks and financial
institutions, public deposits etc.
Liabilities are of two types: (1) current liabilities and (2) long-term (fixed) liabilities.
CURRENT LIABILITES
Current liabilities are debts payable within an accounting period. Current assets are
converted into cash to pay current liabilities. Sometimes new current liabilities may be
incurred to liquidate the existing ones. The typical examples of current liabilities are
creditors, bills payable, bank overdraft, tax payable, outstanding expenses and incomes
received in advance.
Sundry creditors or accounts payable
Sundry creditors or accounts payable represent the current liability towards suppliers
from whom the firm has purchased the raw materials on credit.
Bills payable
Bills payable are the promises made in writing by the firm to make payment of a
specified sum to creditors at some specific date. Bills are written by creditors over the
firm and become bills payable once they are accepted by the firm. Bills payable have a
life of less than a year.
Bank borrowings
Bank borrowings form a substantial part of current liabilities. Commercial banks advance
short-term credit to firms for financing their current assets.

Provisions
Provisions are other types of current liabilities. They include provision for taxes and
dividends. Generally, the amount of tax is estimated and shown as provision for taxes or
tax liability. Similarly, provision for paying dividends to shareholders may be created and
shown as current liability.
Expenses payable or outstanding expenses
Expenses payable or outstanding expenses are also current liabilities. The firm may owe
payments to its employees and others at the end of the accounting period for the services
received in the current year. These payments are payable within a very short period.
Examples of outstanding expenses are wages payable, rent payable, or commission
payable.
Income received in advance
Income received in advance is yet another example of current liability. A firm can
sometimes receive income for goods or services to be supplied in future. As goods or
services have to be provided within the accounting period, such receipts are shown as
current liabilities.
Instalments of long-term loans
Instalments of long-term loans are payable periodically. That portion of the long term
loan which is payable in the current year will form part of current liabilities.
Deposits from public
Deposits from public may be raised by a firm for financing its current assets. These may
therefore be classified under current liabilities.
LONG-TERM LIABILITIES
Long-term liabilities are the obligations or debts payable in a period of time greater than
the accounting period. Long-term liabilities usually represent borrowing for a long period
of time. They include debentures, bonds and secured long term loans from banks and
financial institutions.
Debentures or bonds
Debentures or bonds are issued by a firm to the public to raise debt. A debenture or a
bond is a general obligation of the firm to pay interest and return the principal sum as per
the agreement. Loan raised through issue of debentures or bonds may be secured or
unsecured.
Secured loans
Secured loans are the long-term borrowings with fixed assets pledged as security. Term
loans from financial institutions and commercial banks are secured against the assets of
the firm.

EQUITY
The financial interests of the owners are called owners equity. The owners interest is
residual in nature, reflecting the excess of the firms assets over its liabilities. As
liabilities are the claims of outside parties, equity represents owners claim against the
business entity as of the balance sheet date. But the nature of the owners claim is not the
same as that of the creditors. Creditors claims are defined and have to be met within the
specified period. The claim of the owners change and the amount payable to them can be
determined only when the firm is liquidated. Since assets are recorded at cost, there can
be considerable difference between the owners book claim and the real claim.
Initially, owners equity arises on account of the funds invested by them. But it changes
due to the earnings of the firm and their distribution. The firms earnings (or losses) do
not effect the creditors claims. Owners equity will increase when the firm makes
earnings and retains whole or part. If losses are incurred by the firm, owners claim will
be reduced.
Share capital
In case of a company, owners are called shareholders (or stockholders). Therefore,
owners equity is referred to as shareholders equity of shareholders funds. Shareholders
equity has two parts (i) paid-up share capital and (ii) reserves and surplus (retained
earnings) representing undistributed profits. Paid-up share capital is the amount of funds
directly contributed by the shareholders. If the shareholders are actually required to pay
more than the stated or par value per share, the amount is separately shown as share
premium.
Reserves and surplus
The second part of the owners equity is referred to as retained earnings or reserves and
surplus. The difference between the total earnings to date and the total amount of
dividends to date is reserves and surplus. It represents total undistributed earnings. (The
term deficit is used to represent excess of total dividends over total earnings or losses
incurred by the firm). Undistributed profits (reserve) may be earmarked for some specific
purpose, such as replacement or debenture redemption. Reserves that are not earmarked
are called free reserves.
Net worth
The term net worth is used for the sum of share capital and reserves and surplus, i.e., the
owners equity.
Relationship Between Assets, Liabilities and Owners Equity
Assets are resources of the firm that are acquired from funds provided by outsiders,
known as liabilities and funds provided by owners, known as owners equity. In other
words, assets represent the outsiders and owners investments. The relationship is:
Total Assets (TA) = Total Liabilities (TL) + Owners Equity (OE)

Or
TA TL = OE i.e., owners equity is the firms remaining resources
(assets) after the obligations of outsiders (liabilities) have been taken care of. Thus
changes in assets and liabilities will cause a change in owners equity. Change in owners
equity in the case of companies, will be reflected in retained earnings or reserves and
surplus. The paid-up share capital will not normally decrease in the life time of a
company; but it can increase whenever funds are raised by issuing new shares.
Total Assets (TA) = Net fixed assets (NFA) + Current assets (CA)
Total Liabilities (TL) = Long-term liabilities (LTL) + Current liabilities (CL)
i.e., NFA + CA = LTL + CL + OE
i.e., NFA + (CA CL) = LTL + OE
i.e., NFA + NCA = LTL + OE, NCA net current assets
Net working capital gap
The difference between current assets (CA) and current liabilities (CL) is called net
working capital (NWC) or net current assets (NCA). NWC or NCA is that portion of
current assets that is not financed from current liabilities; therefore, it must necessarily be
financed from long-term funds. Bank credit is an important component of current
liabilities that finances current assets. But it is a current liability that does not arise
directly from the firms operations. Accounts payable and bills payable and various types
of accruals arise spontaneously out of the firms operations and are therefore called
spontaneous current liabilities (SCL). The difference between current assets and
spontaneous current liabilities (that is, current liabilities less bank credit) may be referred
to as net working capital gap (NWCG), or operating capital (OC). NWCG must of
necessity be financed by bank borrowing (BB) and long-term funds.
NFA + CA ( SCL + BB ) = LTL + OE
NFA + NWCG BB = LTL + OE
NFA + NWCG = BB + LTL + OE
Where BB is bank borrowing for financing current assets not covered by spontaneous
current liabilities (SCL).
Capital employed
It may be defined as a net fixed assets plus net current assets
CE = NFA + NCA
Since NFA + NCA = LTL + OE, it implies that capital employed equals long-term funds:
CE = LTL + OE
The alternative definition of capital employed is total interest bearing debt or loan funds
(i.e., long-term debt plus bank borrowing) plus owners equity or shareholders funds (net
worth). From asset side, it means net fixed assets plus net working capital gap:
CE = NFA + NWCG
Since bank borrowing does not arise directly from the operations of the firm, and that it
has to be raised externally at a cost, it is more logical to use the second definition of
capital employed for analytical purposes.