Difference between working capital and capital employed?

Answer 1

Capital Employed

Total resources are also known as total capital employed and sometimes as gross capital employed or total assets before depreciation. Thus total capital consists of all assets fixed and current. In other words, the total of the assets side of the balance sheet is considered as total assets employed.

While calculating capital employed on the basis of assets, following points must be noted.

* Any asset which is not in use should be excluded.

* Intangible assets like goodwill, patents, trademarks etc should be excluded. If they have some potential sales value, they should be included.

* Investments which are not concerned with business, should be excluded

* Fictitious assets are to be excluded

Working Capital

Working capital is defined as the excess of current assets over current liabilities. Current assets are those assets which will be converted into cash within the current accounting period or within the next year as a result of the ordinary operations of the business. They are cash or near cash resources. These include:

* Cash and Bank balances

* Receivables

* Inventory

· Raw materials, stores and spares

· Work-in-progress

· Finished goods

* Prepaid expenses

* Short-term advances

* Temporary investment

The value represented by these assets circulates among several items. Cash is used to buy raw materials, to pay wages and to meet other manufacturing expenses. Finished goods are produced. These are held as inventories. When these are sold, accounts receivables are created. The collection of accounts receivables brings cash into the firm. The cycle starts again.

Current liabilities are the debts of the firms that have to be paid during the current accounting period or within a year. These include:

* Creditors for goods purchased

* Outstanding expenses i.e., expenses due but not paid

* Short-term borrowings

* Advances received against sales

* Taxes and dividends payable

* Other liabilities maturing within a year

Working capital is also known as circulating capital, fluctuating capital and revolving capital. The magnitude and composition keep on changing continuously in the course of business.

Permanent and Temporary Working Capital

Considering time as the basis of classification, there are two types of working capital viz, 'Permanent' and 'Temporary'. Permanent working capital represents the assets required on continuing basis over the entire year, whereas temporary working capital represents additional assets required at different items during the operation of the year. A firm will finance its seasonal and current fluctuations in business operations through short term debt financing. For example, in peak seasons more raw materials to be purchased, more manufacturing expenses to be incurred, more funds will be locked in debtors balances etc. In such times excess requirement of working capital would be financed from short-term financing sources.

The permanent component current assets which are required throughout the year will generally be financed from long-term debt and equity. Tandon Committee has referred to this type of working capital as 'Core Current Assets'. Core Current Assets are those required by the firm to ensure the continuity of operations which represents the minimum levels of various items of current assets viz., stock of raw materials, stock of work-in-process, stock of finished goods, debtors balances, cash and bank etc. This minimum level of current assets will be financed by the long-term sources and any fluctuations over the minimum level of current assets will be financed by the short-term financing. Sometimes core current assets are also referred to as 'hard core working capital'.

The management of working capital is concerned with maximizing the return to shareholders within the accepted risk constraints carried by the participants in the company. Just as excessive long-term debt puts a company at risk, so an inordinate quantity of short-term debt also increases the risk to a company by straining its solvency. The suppliers of permanent working capital look for long- term return on funds invested whereas the suppliers of temporary working capital will look for immediate return and the cost of such financing will also be costlier than the cost of permanent funds used for working capital.

Gross Working Capital

Gross Working Capital is equal to total current assets only. It is identified with current assets alone. It is the value of non-fixed assets of an enterprise and includes inventories (raw materials, work-in-progress, finished goods, spares and consumable stores), receivables, short-term investments, advances to suppliers, loans, tender deposits, sundry deposits with excise and customs, cash and back balances, prepaid expenses, incomes receivable, etc.

Gross Working Capital indicated the quantum of working capital available to meet current liabilities.

Thus, Gross Working Capital = Current Assets

Net Working Capital

Net Working Capital is the excess of current assets over current liabilities, i.e. current assets less current liabilities.

This concept of working capital is widely accepted. This approach, however, does not reflect the exact position of working capital due to the following factors:

* Valuation of inventories include write-offs

* Debtors include the profit element

* Debts outstanding for more than a year likewise debtors which are doubtful or not provided for are included as asset are also placed under the head 'current assets'

* Non-moving and slow-moving items of inventories are also included in inventories, and

* Write-offs and the profits do not involve cash outflow

To assess the real strength of working capital position, it is necessary to exclude the non-moving and obsolete items from inventories. Working Capital thus arrived at is termed as 'Tangible Working Capital.'