Theoretical View on Working Capital

After explaining Working Capital in simplified way above, I would also like to touch upon the academic important view on Working Capital. Can we question why should one invest in Working Capital? The answer lies in objective of maintaining the Working Capital. When you increase Current Assets in the business, it off course provides comfort in maintaining the business (the more and varied Stocks you have, the more customers will drop in because they get wider choice and surety of getting the item at your Shop, isn’t it?). However, increasing the Current Assets involve cost. It does not come free. You have to either invest more from your own pocket in the business OR borrow from banks OR negotiate with your Vendors for more credit terms (in terms of volume as well period) for supply of Stocks. When you invest in the business from your own pocket, you expect profit (at a rate at least more than the interest rate offered by banks on fixed deports (FD) i.e. if bank offer 10% p.a. on FD for 1 year, you expect return from business more much more than 10% p.a. otherwise what’s the benefit of taking such big risk on your money!). Any guarantee for earning profit (more than 10% p.a. on your investment)? If no, than better to invest money in Bank FDs or other avenues than to invest in increasing Current Assets in business.

When the Vendor gives you one month credit, he will sell the goods to you at x% more than the selling price he will agree if you purchase in cash. Why? Because Vendor is indirectly giving you money (in the form of goods) for one month which he bought by borrowing from his banker at say 10% p.a. After all he has to recover interest what he needs to pay to his banker. So, if USD 100 is the cost of goods if purchase in cash, then on one month credit basis term, the Vendor will sell the same goods to you at USD 100.83 (USD 100 plus USD (100 X 10%)/12). Therefore, the more money you invest (by own source, borrowing, credit terms), the more money you will need to return to your financiers and your profitability will come down.

The objective of Working Capital management is to maintain or better say balance the liquidity and profitability depending on the your attitude towards risk in the business under constraints imposed by the environment (condition of creditors, bankers etc.)