Need For Working Capital

For the efficient operation of the business, working capital is required along with the fixed capital. Working capital is needed for the purchase of raw material and for the payment of various day to day expenses. There will be hardly any business which does not require working capital. The need for working capital is different businesses. Financial management aims at maximising the wealth of shareholders. To achieve this objective, it is necessary to earn adequate profits. The profit depends largely on sales but sales do not result in cash immediately.

To increase sales goods are to be sold on credit, the collection of which takes place after time terms. Thus, there exists a gap between the sale of goods and realisation of cash. During this period expenses are to be incurred to continue business operations. For this purpose, working capital is required. The need for working capital can be explained with the help of operating cycle or cash cycle. Operating cycle means that time period which is required to convert raw material into cash. In a manufacturing enterprise raw material is purchased with cash, then raw material is converted into work-in progress, which in turn gets converted into finished goods; both receivable through sales and lastly cash is received from debtors and bills receivable.

In the operating cycle, following events are included:

  1. Conversation of cash into raw material.

  2. Conversation of raw material into work-in-progress.

  3. Conversation of work in progress into finished goods.

  4. Conversation of finished goods into Debtors and Bills Receivable.

  5. Conversation of Debtors and Bills receivable through sales into cash.