Working Capital Management Short Answer Type Questions

Question 1.
Explain the different principles of Working Capital.
Answer:
The different principles of working capital are:
(i) Principle of Risk Variation: Risk refers to the inability of a firm to maintain sufficient current assets to pay for its obligations. There is a definite relationship between the degree of risk and the rate of return. As a firm assumes more risk, the opportunity for gain or loss increases.

As the level of working capital relative to sales decreases, the degree of risk increases. When the degree of risk increases, the opportunity for gain and loss also increases. Thus, if the level of working capital goes up, the amount of risk goes down, the opportunity for gain or loss is likewise adversely affected. Depending upon their attitudes, the managements change the size of their working capital.

(ii) Principle of Cost of Capital: This principle emphasises the different sources of finance, for each source has a different cost of capital. It should be remembered that the cost of capital moves inversely with risk. Thus, additional risk capital results in the decline in the cost of capital.

(iii) Principle of Equity Position: According to this principle, the amount of working capital invested in each component should be adequately justified by a firm’s equity position. Every rupee invested in the working capital should contribute to the new worth of the firm.

(iv) Principle of Maturity of Payment: A company should make every effort to relate maturities of payment to its flow of internally generated funds. There should be the least disparity between the maturities of a firm’s short-term debt instruments and its flow of internally generated funds because a greater risk is generated with greater disparity. A margin of safety should, however, be provided for short-term debt payments.

Question 2.
Explain the characteristics of working capital.
Answer:
The features of working capital are:
1) Short term Needs: Working capital is used to acquire current assets which get converted into cash in a short period. In this respect it differs from fixed capital which represents funds locked in long term assets. The duration of the working capital depends on the length of production process, the time that elapses in the sale and the waiting period of the cash receipt.

2) Circular Movement: Working capital is constantly converted into cash which again turns into working capital. This process of conversion goes on continuously. The cash is used to purchase current assets and when the goods are produced and sold out; those current assets are transformed into cash. Thus it moves in a circular away. That is why working capital is also described as circulating capital.

3) An Element of Permanency: Though working capital is a short term capital it is necessary to continue the productive activity of the enterprise. Hence so long as production continues, the enterprise will constantly remain in need of working capital. The working capital that is required permanently is called permanent or regular working capital.

4) An Element of Fluctuation: Though the requirement of working capital is felt permanently, its requirement fluctuates more widely than that of fixed capital. The requirement of working capital varies directly with the level of production. It varies with, the variation of the purchase and sale policy; price level and the level of demand also. The portion of working capital that changes with production, sale, price etc. is called variable working capital.

5) Liquidity: Working capital is more liquid than fixed capital. If need arises, working capital can be converted into cash within a short period and without much loss. A company in need of cash can get it through the conversion of its working capital by insisting on quick recovery of its bills receivable and by expediting sales of its product. It is due to this trait of working capital that the companies with a larger amount of working capital feel more secure.

6) Less Risky: Funds invested in fixed assets get locked up for a long period of time and cannot be recovered easily. There is also a danger of fixed assets like machinery getting obsolete due to technological innovations. Hence investment in fixed capital is comparatively more risky. As against this, investment in current assets is less risky as it is a short term investment. Working capital involves more of physical risk only, and that too is limited. Working capital involves financial or economic risk to a much less extent because the variations of product , prices are less severe generally.

7) Special Accounting System not needed: Since fixed capital is invested in long term assets, it becomes necessary to adopt various systems of estimating depreciation. On the other hand working capital is invested in short term assets which last for one year only. Hence it is not necessary to adopt special accounting system for them.

Question 3.
Explain various types of working capital.
Answer:
The various types of working capital are as follows:
1. Permanent working capital: It is the minimum amount of current assets which is needed to conduct a business even during the off season of the year. It is maintained to carry out operations at any time. It varies from year to year and organisation to organisation, depending upon the growth of fund required to produce the goods, necessary to satisfy demand at a particular point.

2. Temporary working capital: It represents the additional assets which is required from time to time during a year as per market fluctuations. It is also called as variable or seasonal working capital. It is required during the more active business seasons of the year.

3. Gross working capital: It refers to the amount of funds invest in current assets. It provides the correct amount of working capital at right time.

4. Net working capital: The net working capital is the difference between current liabilities. It enables the firm to determine how much amount is left for operational requirements.

Question 4.
Explain the Importance of adequate working capital. OR Describe the need of working capital in a firm.
Answer:
Adequate working capital is important for an organisation because of the following reasons:

To protect a business from the adverse effects of reduction in the value of current assets.
To permit a sufficient level of inventories for continuous production.
To enable the management to overcome depression period
To pay current liabilities on time promptly and avail discounts on payment.
Acts as a cushion in emergencies like strikes, flood etc.
Have favourable credit terms with customers.
Helpful in providing funds for expansion.
Working capital if possible can be invested in non-current assets.
Necessary funds can be accumulated for meeting future expenses.
It enables the company to operate its business more efficiently
To overcome excessive non operating losses.
To meet higher inventories and fixed assets requirements.

Question 5.
What are the disadvantages of excess working capital in the company.
Answer:
Excess working capital is a threat to a company. The following are disadvantages of excess working capital:

Leads to low profitability even though sufficient cash is available.
Outstanding and losses may be faced.
One of the root causes over overcapitalisation
It leads to greater production level but not having a matching demand in market.
High level of inventories and its maintenance and storage cost increases.
It may lead to carelessness about costs and therefore inefficiency of operations.
Creates an imbalance between liquidity and profitability
Unwise dividend policies.

Excessive working capital is not a good indicator for future growth and profitability for the organisation. The management should avoid such a condition and maintain a level of adequate working capital in the organisation.

Question 6.
What are the disadvantages of inadequate working capital in the company?
Answer:
Inadequate working capital is also not a favourable position for an organisation. There are several disadvantages of it.
These are as follows:

May not be able to take bulk orders.
It leads to adverse effects on solvency of the firm
Cash discount facilities cannot be availed properly or efficiently.
Leads to low liquidity which ultimately leads to decrease in profitability.
The organisation will not be able to pay dividends because of non availability of funds.
The credit worthiness of the company is adversely effected due to insufficient funds and untimely payment to creditors.
The upgradation of machines and even its repairs cannot be done properly due to lack of funds with the company.
Leads to borrowing at higher rates many times.
May not be able to take up profitable business opportunities.
Cash sales of the company mostly stagnate or even reduce and it may restrict its activities.

Question 7.
Explain the methods of estimating working capital requirements.
Answer:
There are two methods usually followed in determining working capital requirements:
(i) Conventional Method or Cash Cycle Method:
According to the conventional method, cash inflows and outflows are matched with each other. Greater emphasis is laid on liquidity and greater importance is attached to current ratio, liquidity ratio etc. which pertain to the liquidity of a business.

(ii) Operating Cycle Method:
The term operating cycle or cash cycle refers to the time duration required to convert the cash to raw materials, raw materials to work-in-progress, work in progress to finished goods, finished goods to debtors and debtors back to cash. We should know the operating cycle of an enterprise. There are four major components of the operating cycle of a manufacturing company.
(a) The cycle starts with free capital in the form of cash and credit, followed by investment in materials, manpower and the services

(b) Production phase

(d) Cash or accounts receivable collection period, which results in, and ends at the point of dis-investment of the free capital originally committed. New free capital then becomes available for productive reinvestment. When new liquid capital becomes available for recommitment to productive activity, a new operating cycle begins.

Question 8.
What are the different motives of holding cash? OR What are the objectives of cash management?
Answer:
a. Transactionary motive:
A firm requires cash to meet the transactions in the ordinary course of the business like making payments towards dividends taxes, purchases wages etc. As there is no synchronisation between the cash inflows and the cash outflows the firms has to keep aside a certain portion of the amount to meet its day to day transactions.

b. Precautionary motive:
Cash under this motive is held as a precautionary measure. Firms are exposed to unforeseen events or contingencies like calamities, competition, strike, lockouts, consumer behaviour, changing government policies. As such so to meet these additional formalities firms have to set aside a certain portion of the amount to meet these unforeseen events.

c. Speculative motive:
The speculative motive relates to holding cash for investing in profitable investments as and when they arise. As such investments does not occur on a regular basis so the firm can keep a certain portion of the amount aside to reap the benefits of taking up the profitable investments as and when they occur. Ex. Prices of raw materials may fall temporarily so the firm may utilise the portion kept aside for speculative purpose and purchase the materials when they are available at lesser prices.

Question 9.
How to prepare Cash Budget? Explain.
Answer:
The cash budget is prepared after operating budgets and the capital expenditure budgets are prepared.
(i) The cash budget starts with the beginning cash balance to which is added the cash inflows to get cash available.

(ii) Cash outflows for the period are then subtracted to calculate the cash balance before financing.

(iii) If this balance is below the company’s required balance, the financing section shows the borrowings needed.

(iv) The financing section also includes debt repayments, including interest payments.

(v) The cash balance before financing is adjusted by the financing activity to calculate the ending cash balance.

(vi) The ending cash balance is the cash balance in the budgeted or pro forma balance sheet.

(vii) The format of this budget is:
Beginning cash balance
+ cash receipts
= cash available
? cash disbursements
= excess/deficiency of cash
+/- financing
= Ending cash balance

Question 10.
What are the factors influencing size of receivables?
Answer:
A number of factors influence the size of receivables, following are some of the factors:
1) Volume of credit sales: A firm has to be very competitive to ensure that it faces the competition in the market. It has to attract customers which is possible by offering credit sales to the customers. Hence, the volume of credit sales is one of the factor that influences the size of the receivables. More the credit sales more will be the accounts receivables.

2) New products: A firm to promote its new products will have to offer attractive terms like discounts, Sale on credit basis etc. If the firm is selling its new products on credit basis it will result in accounts receivables or debtors. Hence, promotion of the new product is one of the factor affecting the account receivable.

3) Location: If the firm is operating from a distant place from the market area, location becomes a demerit. So the firm to promote its product and attract the customers offers the products on credit basis which will in turn result in debtors.

4) Credit policy: If the firm is rigid on selling goods on credit basis the size of the accounts receivable is almost nil. But if the firm is liberal in offering its goods on credit basis then the size of the accounts receivable will be more.

5) Credit worthiness of the customers: The paying habits of the customers affects the size of the accounts receivables, if the customers delay the payments it will adversely affect the size of the accounts receivables.

6) Credit collection efforts: The firm should give due concern in collecting the credit given to the customers. The firm has to send periodical reminders reminding the customers to pay the money due to the firm. If the firm is liberal in collecting the credit, the customers also will delay their payments. This will effect the size of the accounts receivables.

Question 11.
Explain various Inventory Management Techniques.
Answer:
Inventory management refers to managing the stores to ensure that there is neither over stocking nor under stocking of materials. An efficient system of inventory management will determine what to purchase, from where to purchase, how much to purchase, and where to store. Following are, the tools of inventory management.
a. Fixation of levels: It is a tool through by which materials are maintained in the store houses by fixing different levels namely Maximum level, Re-order level, Minimum level and Danger level. Levels are fixed taking into consideration the factors like cost and nature of raw materials, lead time, storage spare etc.

b. ABC analysis: Materials are controlled giving importance to its value. Materials are graded as A, B & C wherein materials with ‘A’ grade are costlier in value but less in number where as materials with ‘C” grade are cheaper in value and more in number. Grade ‘B’ materials are moderate in value and moderate number of such items are maintained.

c. VED analysis: Materials are categorised as vital, essential and desirable components. Much importance is given to the materials categorised as vital than to the desirable components.

d. FSN analysis: Under this type, materials are grouped according to their movements. Fast moving items are stored in large quantities to meet the requirements. Slow moving items are moderately stored. Non moving items are rarely required therefore the quantity stored is very less.

e. Economic order quantity: Economic order quantity is the size of the lot to be purchased which is economically viable. EOQ is a point at which the ordering cost and the carrying cost are minimum.

f. Perpetual inventory system: A record is kept on a continuous basis as and when the materials are received and issued and hence, it is called perpetual inventory system.