270 Corporate Finance
Net working capital is also called liquid surplus. To sum up, working capital is the funds required to carry
the required levels of current assets to enable the company to carry on its operations at the expected level
without any disruption. Working capital is a function of the level of activity (i.e., sales), and the type of busi-
ness. Working capital for a trading company will be generally more that that for a manufacturing company.
Net working capital = Current assets – Current liabilities.The deficit (CA – CL) is to be financed by bank borrowings and long-term funds.Current assets = Current liabilities + Margin from long term sources
+ Working capital limit from banks.In the given equation, current assets are more than current liabilities. Is this always true? When current
liabilities are more than current assets—i.e., working capital is negative—one can infer that short-term
funds have been diverted to long-term uses, or the value of current assets have shrunk (may be due to
obsolescence of stocks, book debts turning bad, etc.). Obviously this is not a satisfactory situation and the
company is said to be facing liquidity crunch. We have discussed financial ratios earlier. The current ratio
and the quick ratio are measures of liquidity. How high should the liquidity be? Is a large liquid surplus a
desirable situation? We will answer these questions as we go along. Before that, let us take a quick look at
the components of the working capital.
Components of Working Capital
The components of working capital are:
- Cash
- Inventory
- Accounts receivable
- Marketable securities
- Loan from bank
Cash
It is the most liquid component of the working capital. Holding cash enhances liquidity. But this is not cost
free. Cash can be invested in business to earn a return. There is an opportunity cost involved—the cost of not
investing in available alternatives of the company. But why do companies hold cash? Cash balances are
necessary to meet day to day expenses like raw materials, wages, salaries, etc., to meet (random fluctuation)
contingencies or take advantage of business opportunities that may arise. Accordingly, these motives are
classified as: Transaction Motive, Precautionary Motive, and Speculative Motive.
Marketable securities are temporary investments that the company intends to liquidate when cash is
required. They are a substitute for holding idle cash balance, say, after a sale of long-term security, as there
is a lag between raising and deployment of funds. Marketable securities can also be held to ‘ride’ the seasonal-
ity of operations—that is, hold during lean periods, sell off during high demand phase to free up cash for
normal business.