Introduction

Working capital management ensures that a company has sufficient short-term assets to cover its day-to-day operations and short-term liabilities. Efficient working capital management improves liquidity, profitability, and operational efficiency, helping businesses avoid cash flow problems.

This guide covers:
✔ Significance and types of working capital
✔ Operating cycle and estimation of working capital requirements
✔ Financing and sources of working capital
✔ Factoring services and bank finance norms
✔ Key committee reports on working capital finance
✔ Dimensions of working capital management

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1. Significance and Types of Working Capital

What is Working Capital?

Working Capital (WC) represents the funds required to cover a business’s short-term expenses.

Formula:

$$\text{Working Capital}=\text{Current Assets}-\text{Current Liabilities}$$

Significance of Working Capital:

✔ Ensures smooth operations by maintaining liquidity.
✔ Improves financial health and reduces short-term borrowing.
✔ Enhances profitability by optimizing inventory and receivables.
✔ Minimizes financial risk by preventing liquidity crises.

Types of Working Capital:

1. Gross Working Capital (GWC): Total current assets.
2. Net Working Capital (NWC): Difference between current assets and current liabilities.
3. Permanent Working Capital: Minimum WC required to sustain operations.
4. Temporary (Fluctuating) Working Capital: WC that changes with seasonal demand.

Example:

A retail business may require higher working capital during the holiday season due to increased inventory and sales.

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2. Operating Cycle and Working Capital Estimation

Operating Cycle (OC)

The Operating Cycle measures how long a company takes to convert raw materials into cash from sales.

Formula:

$$\text{OC}=\text{Inventory Period}+\text{Receivables Period}-\text{Payables Period}$$

✔ Shorter OC → Better cash flow.
✔ Longer OC → Higher working capital needs.

Steps to Estimate Working Capital Requirements:

1. Estimate operating cycle components (inventory, receivables, payables).
2. Calculate cash conversion period (time to turn assets into cash).
3. Determine seasonal variations in working capital needs.

Example:
A manufacturing company with:
✔ Inventory Period = 60 days
✔ Receivables Period = 45 days
✔ Payables Period = 30 days

$$\text{OC}=60+45-30=75\text{ days}$$

This means the company takes 75 days to convert its raw materials into cash inflows.

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3. Financing of Working Capital and Bank Finance Norms

Companies finance working capital through:
✔ Short-term bank loans.
✔ Trade credit from suppliers.
✔ Factoring and invoice discounting.

Bank Finance Norms for Working Capital

Banks provide working capital loans based on:
✔ Turnover Method (Tandon Committee): 25% of working capital should be financed by the company.
✔ MPBF (Maximum Permissible Bank Finance): Sets limits on bank funding.
✔ CMA Data Analysis (Credit Monitoring Arrangement): Used to evaluate working capital needs.

Example:

A company with a working capital gap of ₹10 crores may receive ₹7.5 crores in bank financing under MPBF norms.

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4. Sources of Working Capital

Companies fund working capital through:

Short-Term Sources:

✔ Trade Credit: Suppliers offer credit periods for payments.
✔ Bank Overdrafts: Businesses withdraw more than the account balance.
✔ Factoring: Selling receivables to third parties for quick cash.

Long-Term Sources:

✔ Equity Financing: Raising capital through shares.
✔ Long-term Loans: Used for financing permanent working capital.

Example:

A business may use supplier credit (30 days) + bank overdraft to manage short-term liquidity.

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5. Factoring Services in Working Capital Management

Factoring involves selling accounts receivable to a financial institution (factor) for immediate cash.

Types of Factoring:

✔ Recourse Factoring: The seller bears the risk of unpaid invoices.
✔ Non-Recourse Factoring: The factor assumes default risk.

Benefits of Factoring:

✔ Improves cash flow without increasing debt.
✔ Reduces bad debt risks (for non-recourse factoring).
✔ Lowers collection costs and administrative burden.

Example:
A manufacturing firm sells ₹1 crore in invoices to a factoring company at 90% advance, receiving ₹90 lakhs immediately.

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6. Committee Reports on Bank Finance

Key Committees on Working Capital Finance:

✔ Tandon Committee (1975):

• Recommended businesses should fund 25% of working capital needs.
• Introduced MPBF concept to limit excessive borrowing.

✔ Chore Committee (1979):

• Strengthened credit monitoring by banks.
• Encouraged firms to reduce dependency on bank finance.

✔ Nayak Committee (1992):

• Recommended 20% working capital finance for SMEs based on projected turnover.

✔ Kannan Committee (1997):

• Suggested flexible working capital finance based on industry needs.

Example:

A small business applying for a working capital loan may be assessed based on Nayak Committee norms, ensuring it receives at least 20% of its projected turnover as bank finance.

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7. Dimensions of Working Capital Management

Managing working capital effectively requires balancing liquidity and profitability.

Key Aspects of Working Capital Management:

✔ Inventory Management: Avoid overstocking or shortages.
✔ Receivables Management: Reduce credit period and improve collections.
✔ Payables Management: Optimize payment schedules without losing supplier trust.
✔ Cash Management: Maintain sufficient liquidity while investing excess cash.

Example:

A company using Just-in-Time (JIT) inventory management reduces storage costs and improves cash flow.

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Conclusion

Efficient working capital management ensures businesses maintain liquidity, reduce financial risk, and optimize profitability.

Key Takeaways:

✔ Working capital is essential for smooth business operations.
✔ Operating cycle analysis helps determine working capital needs.
✔ Bank finance norms and committee reports guide working capital funding.
✔ Factoring services improve cash flow without increasing debt.
✔ Proper inventory, receivables, and payables management enhance efficiency.

What’s Next?

How does your company manage working capital? Share your insights below!