Working Capital Policy
Financial management revision article series
Definition of working capital - Gross and Net
The total value of current assets is termed gross working capital.
The value of current assets - current liabilities is termed net working capital
The important current assets are cash, inventories and debtors.
Operating cycle analysis
Investment criteria for current assets
Investment in assets must result in cash flow that returns the original investment with the desired profit.
Working capital cycle:This refers to the length of time between the firm's paying cash for materials, (creditors) (entering into the production process/stock), and the inflow of cash from debtors (sales). When costs are incurred on labour, overheads and raw materials, work-in-progress (WIP) is generated.
In the production cycle, WIP is converted into finished goods. The finished goods when sold on credit, gets converted into sundry debtors. The debtors are realised after the credit period. This cash is then again used to pay for raw materials, etc. Thus there is a complete cycle from cash to cash.
Short-term funds are required to meet the requirement of money during this period. The time period is dependent upon the length of time within which the original cash gets converted into cash again. This cycle is also known as "Operating Cycle" and can be depicted as follows:
WORKING CAPITAL CYCLE
DEBTORS ------------> CASH -------------------> RAW MATERIALS (Creditors),LABOUR, OVERHEADS
FINISHED GOODS <-----------------WORK-IN-PROGRESS (WIP)
Prasanna Chandra, Financial Management, 5th Ed., Tata McGraw Hill, 2001
Brealey and Myers, Corporate Finance, Fifth Edition, Prentice Hall India, 2001