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DIMENSIONS OF WORKING CAPITAL MANAGEMENT
There exists two concepts of worin! c"pit"#$ n"%e#& !ross concept "n' netconcept( Accor'in! to !ross concept$ worin! c"pit"# refers to c)rrent "ssets$ *i+( c"sh$
%"ret",#e sec)rities$ in*entories of r"w %"teri"#$ wor-in-process$ finishe' !oo's "n'
recei*",#es( Accor'in! to net concept$ worin! c"pit"# refers to the 'ifference ,etweenc)rrent "ssets "n' c)rrent #i",i#ities( Worin! c"pit"# c"n ,e c#"ssifie' into fixe' or
per%"nent "n' *"ri",#e or f#)ct)"tin! p"rts( The %ini%)% #e*e# of in*est%ent in c)rrent
"ssets re!)#"r#& e%p#o&e' in ,)siness is c"##e' fixe' or per%"nent worin! c"pit"# "n'the extr" worin! c"pit"# nee'e' to s)pport the ch"n!in! ,)siness "cti*ities is c"##e'
*"ri",#e or f#)ct)"tin! worin! c"pit"#( Worin! c"pit"# %"n"!e%ent is concerne' with
"## "spects of %"n"!in! c)rrent "ssets "n' c)rrent #i",i#ities(
.i/ M"n"!in! In*est%ent in c)rrent "ssets0 Deter%in"tion of "ppropri"te #e*e# of
in*est%ent in c)rrent "ssets is the first "n' fore%ost responsi,i#it& of worin! c"pit"#
%"n"!er( A#tho)!h the "%o)nt of in*est%ent in "n& c)rrent "sset or'in"ri#& *"ries fro%
'"&-to-'"&$ the "*er"!e "%o)nt or #e*e# o*er " perio' of ti%e c"n ,e )se' in 'eter%inin!the f#)ct)"tin! "n' per%"nent in*est%ent in c)rrent "ssets( This 'istinction is of !re"t
i%port"nce in 'e*isin! "ppropri"te fin"ncin! str"te!ies( 1esi'es the #e*e# of in*est%ent$the t&pe of c)rrent "ssets to ,e he#' "re e2)"##& i%port"nt 'ecision *"ri",#es( There is "
*er& #"r!e n)%,er of "#tern"ti*e #e*e#s of in*est%ent in e"ch t&pe of c)rrent "sset(
Therefore$ in princip#e$ c)rrent "sset in*est%ent is " pro,#e% of e*"#)"tin! " #"r!en)%,er of %)t)"##& exc#)si*e in*est%ent opport)nities(
.ii/ Fin"ncin! of worin! c"pit"#0 Another i%port"nt 'i%ension of worin! c"pit"#
%"n"!e%ent is 'eter%inin! the %ix of fin"nce for worin! c"pit"# which %"& ,e "co%,in"tion of spont"neo)s$ short-ter% "n' #on! ter% so)rces( Spont"neo)s so)rces of
fin"ncin! consist of tr"'e cre'it "n' other "cco)nts p"&",#e th"t "rise spont"neo)s#& inthe fir%3s '"&-to-'"& oper"tions$ s)ch "s p)rch"se of r"w %"teri"#s "n' s)pp#ies( In"''ition to tr"'e cre'it$ w"!es "n' s"#"ries p"&",#e$ "ccr)e' interest "n' "ccr)e' t"xes
"#so pro*i'e the fir% with *"#)",#e so)rces of spont"neo)s fin"ncin!( Th)s the cre'it
which "rises in con4)nction with the '"&-to-'"& oper"tions of the fir% pro*i'espont"neo)s so)rce of fin"ncin! of worin! c"pit"#( 1i##s p"&",#e$ short ter% ,"n #o"ns$
inter corpor"te #o"ns$ co%%erci"# p"per "re the %ost co%%on ex"%p#es of short ter%
so)rces of worin! c"pit"# fin"nce( Ter% #o"ns$ 'e,ent)res$ e2)it& "n' ret"ine' e"rnin!sconstit)te #on!-ter% so)rces of worin! c"pit"# fin"nce(
.iii/ Inter-re#"te'ness 0 Inter-re#"te'ness is the %ost 'istin!)ishin! ch"r"cteristic of
worin! c"pit"# 'ecisions( The 'esire' #e*e# of in*entor& o*er " perio' "n' s"#es co)#'not ,e %"'e witho)t consi'erin! the i%p#ic"tions for "cco)nts recei*",#e( Moreo*er
incre"se' s"#es "n' co##ections for the fir% is #ie#& to %e"n th"t #ower "*er"!e c"sh
,"#"nces wi## ,e nee'e' or th"t " new c"sh %"n"!e%ent s&ste% wo)#' ,e 'esir",#e(If s"#es incre"se$ "n incre"se in in*entor& wi## ,e fin"nce' spont"neo)s#& with tr"'e
cre'it( The "%o)nt of tr"'e cre'it fin"ncin! wi## 'epen' on 'ecisions re!"r'in!
p"&%ents( In*entor& 'ecisions "re th)s #ine' to tr"'e cre'it 'ecisions( Th)s worin!c"pit"# %"n"!ers h"*e to p"& "ttention to the inter re#"te' n"t)re of c)rrent "ssets "n'
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c)rrent #i",i#ities "n' t"e into "cco)nt %"4or inter"ctions th"t inf#)ence the worin!
c"pit"# in*est%ent "n' fin"ncin! 'ecisions(
.i*/ 5o#"ti#it& "n' Re*ersi,i#it&0 Another si!nific"nt fe"t)re of the worin! c"pit"#
%"n"!e%ent is th"t the "%o)nt of %one& in*este' in c)rrent "ssets c"n ch"n!e r"pi'#&$
"n' so 'oes the fin"ncin! re2)ire'( The #e*e# of in*est%ent in c)rrent "ssets is inf#)ence',& " *"riet& of f"ctors$ which %"& ,e "s err"tic "s #",or )nrest or f#oo'in! of the p#"nt(
Se"son"# "n' c&c#ic"# f#)ct)"tions in 'e%"n' "re " co%%on c")se of r"pi' ch"n!es in
in*est%ent in c)rrent "ssets "n' the fin"ncin! re2)ire'( Re#"te' to *o#"ti#it& is there*ersi,i#it& fe"t)re of c)rrent "ssets "n' c)rrent #i",i#ities$ which %e"ns th"t the c"sh
f#ow re#"te' to these co)#' ,e re"'i#& re*erse'(
RISK RET6RN TRADE OFF IN WORKING CAPITAL MANAGEMENT
Worin! c"pit"# 'ecisions of the fin"nce %"n"!er %)st ,e !e"re' to %"xi%i+"tion
of sh"reho#'ers we"#th( Accor'in!#&$ ris ret)rn tr"'e-off ch"r"cteri+es e"ch of theworin! c"pit"# 'ecision( There "re two t&pes of riss inherent in worin! c"pit"#
%"n"!e%ent n"%e#&$ #i2)i'it& ris "n' opport)nit& #oss ris( Li2)i'it& ris is the non-"*"i#",i#it& of c"sh to p"& " #i",i#it& th"t f"##s ')e( It c"n c")se not on#& " #oss of
rep)t"tion ,)t "#so %"e the wor con'ition )nf"*o)r",#e for !ettin! the ,est ter%s on
tr"ns"ction with the tr"'e cre'itors( The other ris in*o#*e' in worin! c"pit"#%"n"!e%ent is the ris of opport)nit& #oss i(e ris of h"*in! too #itt#e in*entor& to
%"int"in pro')ction "n' s"#es$ or the ris of not !r"ntin! "'e2)"te cre'it for re"#i+in! the
"chie*",#e #e*e# of s"#es( In other wor's$ it is the ris of not ,ein! ",#e to pro')ce %ore
or se## %ore or ,oth "n' therefore not ,ein! ",#e to e"rn the potenti"# profit$ ,ec")se therewere not eno)!h f)n's to s)pport hi!her in*entor& "n' ,oo 'e,ts( Th)s it is on#&
theoretic"# th"t the c)rrent "ssets co)#' "## t"e +ero *"#)es( In'ee'$ it is neitherpr"ctic",#e nor "'*is",#e( In pr"ctice$ "## c)rrent "ssets t"e positi*e *"#)es$ ,ec")sefir%s see to re')ce worin! c"pit"# riss( 7owe*er$ !re"ter the f)n's #oce' )p or
'ep#o&e' in c)rrent "ssets$ the hi!her is the cost of f)n' e%p#o&e'$ "n' therefore #esser
the profit(
The ris ret)rn tr"'e off in %"n"!in! the fir%3s #i2)i'it& ,& in*estin! in
%"ret",#e sec)rities$ 'oes h"*e " f"*o)r",#e effect on fir%3s #i2)i'it&$ ,)t it "#so h"s "n)nf"*o)r",#e effect on the fir%3s r"te of ret)rn e"rne' on in*este' f)n's( The ris ret)rn
tr"'e off in*o#*e' in ho#'in! %ore c"sh "n' %"ret",#e sec)rities$ therefore$ is one of
"''e' #i2)i'it& *ers)s re')ce' profit",i#it&( In the )se of c)rrent *ers)s #on! ter% 'e,t
for fin"ncin! worin! c"pit"# nee's "#so the fir% f"ces " ris-ret)rn tr"'e off( Otherthin!s re%"inin! the s"%e$ the !re"ter its re#i"nce )pon short ter% 'e,t or c)rrent
#i",i#ities in fin"ncin! its c)rrent "sset in*est%ents the #ower wi## ,e its #i2)i'it&( On the
other h"n'$ the )se of c)rrent #i",i#ities offers so%e *er& re"# "'*"nt"!es to the )ser inth"t the& c"n ,e #ess cost#& th"n #on!-ter% fin"ncin! "s the& pro*i'e the fir% with "
f#exi,#e %e"ns o fin"ncin! its f#)ct)"tin! nee's for c)rrent "ssets( Th)s " fir% c"n re')ce
its ris of i##i2)i'it& thro)!h the )se of #on! ter% 'e,t "t the expense of " re')ction of its
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ret)rn on in*este' f)n's( The ris ret)rn tr"'e off in*o#*es "n incre"se' ris of i##i2)i'it&
*ers)s incre"se' profit",i#it&(
Theor"tic"##&$ NP5 r)#es 'e*e#ope' for the fir%3s in*est%ent 'ecisions wo)#'
"pp#& to in*est%ent in c)rrent "ssets( 1)t in pr"ctice$ in *iew of cert"in )ni2)ech"r"cteristics of c)rrent "ssets$ two )sef)# %o'ific"tions of NP5 "re fo##owe' "s
'ecision criteri" in worin! c"pit"# 'ecisions( The& "re A*er"!e Net Profit per perio' "n'
Tot"# cost( We c"n )se net profit per perio' "s " criterion for choosin! "%on! "#tern"ti*ere*ersi,#e in*est%ents( The in*est%ent with the hi!hest *"#)e of net profit per perio' is
"#so the in*est%ent with the hi!hest net present *"#)e$ re!"r'#ess of when the in*est%ent
is re*erse'( In*est%ents with positi*e NP5s wi## h"*e positi*e net profits$ in*est%ents
with +ero NP5s wi## h"*e +ero net profits "n' in*est%ents with ne!"ti*e NP5s wi## h"*ene!"ti*e profit( Th)s$ net profit per perio' inste"' of NP5 c"n ,e )se' "s " 'ecision
criterion for worin! c"pit"# %"n"!e%ent(
M"n& c)rrent "sset 'ecisions$ p"rtic)#"r#& in*entor& 'ecisions c"n ,e %"'e on the,"sis of %ini%i+in! cost( There "#so inste"' of %ini%i+in! the net present *"#)e of costs$
one %"& %ini%i+e the tot"# "nn)"# cost where the "nn)"# c"pit"# cost of the in*est%ent isthe 'isco)nt r"te ti%es the "%o)nt in*este'( In s)%$ the c)rrent "ssets %"& ,e tre"te' "s
re*ersi,#e "n' in*est%ent po#icies %"& ,e se#ecte' th"t %"xi%i+e net profit or %ini%i+e
tot"# cost per perio'( The choice ,etween the profit or cost criterion wi## of co)rse 'epen'on the p"rtic)#"r pro,#e% ,ein! "n"#&se'(
7EDGING PRINCIPLE
A princip#e which c"n ,e )se' "s " !)i'e to fir%3s worin! c"pit"# fin"ncin!'ecisions is the he'!in! princip#e or %"tchin! princip#e( Si%p#& spe"in!$ the he'!in!princip#e in*o#*es %"tchin! the c"sh f#ow !ener"tin! ch"r"cteristics of "n "sset with the
%"t)rit& of the so)rce of fin"ncin! )se' to fin"nce its "c2)isition( For ex"%p#e$ "
se"son"# exp"nsion in in*entories$ "ccor'in! to the he'!in! princip#e sho)#' ,e fin"nce'with " short ter% #o"n or c)rrent #i",i#it&( The r"tion"#e )n'er#&in! the r)#e is str"i!ht
forw"r'( F)n's "re nee'e' for " #i%ite' perio' of ti%e$ "n' when th"t ti%e h"s p"sse'$
the c"sh nee'e' to rep"& the #o"n wi## ,e !ener"te' ,& the s"#e of extr" in*entor& ite%s(O,t"inin! the nee'e' f)n's fro% " #on! ter% so)rce .#on!er th"n one &e"r/ wo)#' %e"n
th"t the fir% wo)#' sti## h"*e the f)n's "fter the in*entories .the& he#pe' fin"nce/ h"*e
,een so#'( In this c"se the fir% wo)#' h"*e excess #i2)i'it& which the& either ho#' in c"sh
or in*est in #ow &ie#'in! %"ret",#e sec)rities )nti# the se"son"# incre"se in in*entoriesocc)rs "!"in "n' the f)n's "re nee'e'( This wo)#' res)#t in "n o*er "## #owerin! of fir%
profits(
To p)t it *er& s)ccinct#&$ the he'!in! princip#e st"tes th"t the fir%3s "ssets not
fin"nce' ,& spont"neo)s so)rces sho)#' ,e fin"nce' in "ccor'"nce with the r)#e0
per%"nent "ssets .inc#)'in! per%"nent worin! c"pit"# nee's/ fin"nce' with #on! ter%so)rces "n' te%por"r& "ssets .*i+( f#)ct)"tin! worin! c"pit"# nee'/ with short ter%
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so)rces of fin"nce to w"r' of the #i2)i'it& ris( In pr"ctice$ se*er"# %o'ific"tions of the
strict he'!in! princip#e s)ch "s conser*"ti*e fin"ncin! str"te!& "n' the "!!ressi*e
fin"ncin! str"te!& "re fo##owe' ,& the fir%s "t 'ifferent ti%es( The he'!in! princip#epro*i'es "n i%port"nt !)i'e re!"r'in! the "ppropri"te )se of short ter% cre'it for
worin! c"pit"# fin"ncin!(
In conser*"ti*e fin"ncin! str"te!&$ the fir% fo##ows " %ore c")tio)s p#"n$ where,&
#on!-ter% so)rces of fin"ncin! excee' per%"nent "ssets in tro)!h perio' s)ch th"t excess
c"sh is "*"i#",#e .which %)st ,e in*este' in %"ret",#e sec)rities/( Note th"t the fir%"ct)"##& h"s excess #i2)i'it& ')rin! the #ow e,, of its "sset c&c#e "n' th)s f"ces " #ower
ris of ,ein! c")!ht short of c"sh th"n " fir% th"t fo##ows the p)re he'!in! "ppro"ch(
7owe*er$ the fir% "#so incre"ses its in*est%ent in re#"ti*e#& #ow-&ie#'in! "ssets s)ch th"t
its ret)rn on in*est%ent is 'i%inishe'(
In "!!ressi*e fin"ncin! str"te!&$ the fir% contin)"##& fin"nces " p"rt of its
per%"nent "sset nee's with short ter% f)n's "n' th)s fo##ows " %ore "!!ressi*e str"te!&
in %"n"!in! its worin! c"pit"#( It c"n ,e seen th"t e*en when its in*est%ent in "sstnee's is #owest the fir% %)st sti## re#& on short ter% fin"ncin!( S)ch " fir% wo)#' ,e
s),4ecte' to incre"se' riss of " c"sh short f"## in th"t it %)st 'epen' on " contin)"#ro##o*er or rep#"ce%ent of its short ter% 'e,t with %ore short ter% 'e,t( The ,enefit
'eri*e' fro% fo##owin! s)ch " po#ic& re#"tes to the possi,#e s"*in!s res)#tin! fro% the )se
of #ower cost short-ter% 'e,t "s oppose' to #on!-ter% 'e,t(
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RATIOS
Working capital management is concerned with maintaining an
adequate amount of working capital by proper balance of current assets vis
!vis non current assets in the asset structure and a reasonable mi" of shotterm and long term sources in the financial structure of the firm# Ratio
analysis can be used by management as a tool to verify the level and
composition of working capital held by management in the business as against
its operations$ the e"tent of liquidity present in its asset structure as well
as financial structure and the efficiency with which working capital is being
used in the business# In the other words$ management can employ ratios to
analy%e three facets of working capital management namely efficiency$
liquidity and its structural health#
RATIOS TO A&'A(S) T*) )++I,I)&,( O+ WOR-I&. ,A/ITA'
The efficiency with which working capital is being used by the
management can be analy%ed in terms of the overall working capital and0or
its constituent parts vi%# cash$ inventory$ receivables# )fficiency ratios
indicate the efficiency with which working capital and its constituent parts
1cash$ inventory$ receivables2 are being utili%ed# Overall working capital and
its elements are generally e"pressed as number of times they are convertedinto sales0 cost of goods sold or number of days they are being held# In this
category the ratios are3 working capital turnover$ inventory turnover$
receivables turnover$ cash turnover$ payables turnover# Inventory turnover
ratio is further classified as raw material turnover ratio$ workinprocess
turnover ratio and finished goods inventory turnover ratio# 'iquidity ratios
indicate the e"tent to which a firm will be able to meet its shot term
obligations# These ratios include current ratio$ acid test ratio and cash
ratio# The set of ratios 3 current assets to total assets$ cash to current
asset$ receivables to current assets$ inventory to current asset and current
liabilities to total liabilities helps to evaluate structural shifts and changes
that have taken place over time and are indicative of structural health of
working capital in the business# Working capital and its various elements
should form a reasonable balance in the asset structure as well as financial
structure#
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)++I,I)&,( O+ O4)RA'' WOR-I&. ,A/ITA'
The efficient use of overall working capital in the firm can be gauged
with the help of working capital turnover ratio#
&et Sales
Working capital turnover ratio 5
Average &et Working ,apital
This ratio indicates the rate of working capital utili%ation in the firm# A
higher ratio of a firm when compared with that of an industry average
indicates that the amount of working capital in this firm is less than that
required by its operations i#e#$ sales# So the firm may have to go for
additional working capital that can be supplied to it by its owners throughreinvestment of earnings or can be obtained by selling additional shares or
debentures# 'ikewise if this ratio is lower than the industry average$ it
indicates that the investment in net working capital is more than what is
required# This calls for either withdrawing e"cess amount or increasing the
sales in the market so that the relationship between the amount of working
capital financed by long term sources and sales is reasonable#
&et working capital turnover ratio can also be analy%ed over a period
of five to seven years# An increasing ratio indicates that working capital has
been used more intensively over a period of time# A decreasing ratio is
indicative of relative inefficiency in the use of working capital# A variant of
this ratio is current asset turnover ratio which is cost of goods sold to
average current asset# .enerally a higher ratio is considered an indicator of
better efficiency and a lower one the opposite(
)++I,I)&,( O+ WOR-I&. ,A/ITA' )')6)&TS
Inventory constitutes an important part of the total working capital#In actual practice$ many firms face serious problems due to slow moving$ out
dated inventory# 7ut if too much amount is invested in this for too long$ it
poses a serious threat to the profitability as well as solvency of the concern#
Inventory turnover ratio reflects the efficiency with which inventory is
being managed in the concern#
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,ost of .oods Sold
Inventory turnover ratio 5
Average Inventory
It shows how rapidly the inventory is being turned into receivables0cashthrough sales# .enerally a higher turnover is considered good and a low
turnover bad# A low turnover implies an e"cessive level of inventory than
warranted by production or sales operations# This may also indicate the
presence of slow moving or obsolete inventory#
R),)I4A7')S )++I,I)&,( RATIO
With the increasing competition in the business$ managementsometimes offers liberal credit terms to its customers$ thereby ma"imi%ing
sales and total profits# Thus the number of times the management is able to
turn the receivables into sales indicates the efficiency with which the
receivables are being managed# This is given by the receivables turnover
ratio#
Total Sales
Receivables turnover ratio 5
Average Receivables
A low turnover ratio is an indicator of the firm8s increased reliance on credit
sales in its marketing efforts# If this is not backed up by timely and
efficient collection of receivables$ it may 9eopardi%e the very solvency of
the firm#
,AS* )++I,I)&,(
,ash is considered an idle asset as it does not earn any return#
Therefore$ a balance has to be struck between too much and too less an
amount of cash that a concern should have# In fact$ it should be 9ust
adequate to the needs of the concern# )fficient management of cash
requires that there should be proper relationship between cash needs of the
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concern to the average balance of cash held by it during the year# This is
e"pressed by cash turnover ratio#
,ash operating e"penses during the year
,ash turnover ratio 5 Average cash balance during the year
*owever no conclusions can be drawn if this ratio deviates from the selected
standards of comparisons#
/A(A7')S )++I,I)&,(
Accounts payable constitute an important source to providespontaneous working capital finance for the firm# To what e"tent
management is able to use it properly is an important area worth probing#
/ayables turnover ratio e"presses the number of times account payables are
converted into purchases by management during the year#
Annual purchases
/ayables turnover ratio 5
Average payables
&ormally$ a higher turnover ratio is preferred# This means that with a
smaller amount of payables$ management could purchase more material
during the year#
Inventory comprises raw material$ workinprocess$ finished goods and
spare parts etc# All the components should form a reasonable part of the
total inventory# Therefore all components should be related individually to
the total inventory to find out the proportion of each of them# Inventory
turnover ratio is further classified as raw material turnover ratio$ workin
process turnover ratio and finished goods inventory turnover ratio#
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Raw materials consumed during the year
Raw material inventory 5
turnover Average raw material inventory
This ratio indicates the rate of utili%ation of raw material# A higher turnoverratio over a period of time indicates its increasing utili%ation# 7ut too high a
ratio may indicate that proportionately less raw materials were held in order
to carry out the production which may be quite risky#
,ost of goods manufactured
Workinprocess inventory 5
turnover Average W#I#/ inventory
This ratio establishes a relationship between the value of goods produced
and the value of average workinprocess# A higher turnover ratio indicates$
lower inventory accumulation and lesser tiedup working capital# A falling
turnover means either management has become la" in controlling the
productive processes or some e"ternal factors have retarded the production
movement at its final runup#
,ost of goods sold
+inished goods inventory 5
turnover Average finished goods inventory
If the finished goods are turned over faster$ the amount of locked up funds
would be less: otherwise$ it will be more# +inished goods inventory turnover
ratio attempts to capture this aspect#
RATIOS TO A&A'(S) 'I;
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,
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,AS* or A7SO'
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F6ND FLOW 8 CAS7 FLOW ANAL9SIS
F)n's f#ow is )se' to refer to ch"n!es in or %o*e%ent of c)rrent "ssets "n'c)rrent #i",i#ities( Worin! c"pit"# %e"ns tot"# c)rrent "ssets #ess c)rrent #i",i#ities(
Worin! c"pit"# i%p#ies "%o)nt of reso)rces in*este' in c)rrent "ssets fro% so)rces of
fin"nce other th"n c)rrent #i",i#ities( This net "%o)nt is "#so the "%o)nt "*"i#",#e for )sein the ,)siness in the for% of f)n'( D)rin! "n "cco)ntin! perio'$ worin! c"pit"# or
f)n's f#ow fro% one e#e%ent of ,"#"nce sheet to "nother "n' "ccor'in! to net worin!
c"pit"# "ppro"ch $ worin! c"pit"# is the "%o)nt which is "*"i#",#e to the fir% "s "#i2)i' reso)rce( A st"te%ent th"t )ses net worin! c"pit"# "s " %e"s)re of #i2)i'it&
position is referre' to "s f)n' f#ow st"te%ent$ "n' its "n"#&sis "s f)n' f#ow "n"#&sis(
C"sh "n' c"sh e2)i*"#ent ,"sis is "nother w"& in which #i2)i'it& position of the
fir% is concei*e'( M"ret",#e sec)rities "re consi'ere' "s c"sh e2)i*"#ent )n'er this
"ppro"ch( The ch"n!e in the "%o)nt of c"sh "n' its e2)i*"#ents ')rin! the "cco)ntin!
perio' ref#ects #i2)i'it& position( This i%p#ies th"t %"n& of the ite%s which 'o not
ch"n!e NWC position ,)t "ffect c"sh position of the fir% "re "n"#&+e'( The st"te%entprep"re' on c"sh ,"sis is c"##e' c"sh f#ow st"te%ent "n' its "n"#&sis is referre' to "s c"sh
f#ow "n"#&sis(
In or'er to )n'ert"e f)n' f#ow "n"#&sis$ it re2)ires "n )n'erst"n'in! of the
fo##owin!0
?# The concept of so)rces "n' )ses of f)n's(
># The effect of ch"n!es in *"rio)s ,"#"nce sheet ite%s on the NWC position of thefir% i(e($ how *"rio)s "cco)nts "ffect worin! c"pit"# position(
@# The re"rr"n!e%ent "n' conso#i'"tion of infor%"tion t"en fro% ,"#"nce sheet "sin'ic"te' ",o*e "n' re#e*"nt infor%"tion fro% profit "n' #oss "cco)nt in the for%of F)n' f#ow st"te%ent(
The first step in the "n"#&sis f)n' f#ows is to c#"ssif& the ,)siness tr"ns"ctions intoso)rces "n' )ses of f)n's( Nor%"##&$ "n incre"se in #i",i#ities or " 'ecre"se in "ssets of
the fir% is consi'ere' "s so)rces of f)n's( On the other h"n'$ "n incre"se in "ssets or "
'ecre"se in #i",i#ities$ is consi'ere' "s )se of f)n's( An incre"se in worin! c"pit"# %e"nsits "%o)nt "t the en' of the perio' is !re"ter th"n its "%o)nt "t the ,e!innin! of the
perio'$ "n' it 'enotes the 'ep#o&%ent of f)n's ,& the "%o)nt of the incre"se "n' hence it
is consi'ere' " )se of f)n's( On the other h"n'$ " 'ecre"se in net worin! c"pit"# ,"#"nce')rin! the "cco)ntin! perio' 'enotes the "*"i#",i#it& of f)n's with the ,)siness$ hence it
is " so)rce of f)n's(
An "n"#&sis of the f#)ct)"tions of c)rrent "ssets "n' c)rrent #i",i#ities i(e($ worin!c"pit"# te##s )s how the worin! c"pit"# h"s incre"se' or 'ecre"se'( We w"nt to now
where the incre"se' worin! c"pit"# is "pp#ie' if it h"s incre"se'$ "n' fro% where f)n's
h"*e ,een re#e"se' if it h"s 'ecre"se'( The profit "n' #oss "cco)nt !i*es so%e in'ic"tionof the res)#ts of the oper"tions "n' its i%p"ct on the f)n's position( We tr& to inte!r"te
the i%p"ct of oper"tions reporte' in the profit "n' #oss "cco)nt "n' ,"#"nce sheet ,&
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prep"rin! " st"te%ent of ch"n!es in fin"nci"# position( It 'escri,es the so)rces fro%
which f)n's were recei*e' "n' the )ses to which f)n's were p)t( This st"te%ent of
ch"n!es in fin"nci"# position is )s)"##& referre' to "s f)n' f#ow st"te%ent or st"te%ent ofso)rces "n' "pp#ic"tion of f)n's( It tr"ces the f#ow of f)n's thro)!h the or!"ni+"tion(
The st"te%ent of f)n's f#ow is )s)"##& ,if)rc"te' into two #o!ic"# 'i*isions0 so)rcesof f)n's or inf#ows ')rin! the perio's "n' )ses of f)n's or "pp#ic"tions of f)n's ')rin!
the perio'( The 'i*ision showin! so)rces of f)n's s)%%"ri+es "## those tr"ns"ctions
which h"' the net effect of 'ecre"sin! the worin! c"pit"#( 6ses of f)n's on the otherh"n' 'e"# with "## those tr"ns"ctions which h"' the effect of incre"sin! the worin!
c"pit"#( To s)%%"ri+e$ "n incre"se in net worin! c"pit"# is possi,#e ')e to incre"se in
non-c)rrent #i",i#ities "n' owners3 e2)it& or 'ecre"se in non-c)rrent "ssets( Whi#e
'ecre"se in net worin! c"pit"# res)#ts fro% "n incre"se in non-c)rrent "ssets or 'ecre"sein non-c)rrent #i",i#ities "n' 8 or owners3 e2)it&( Worin! c"pit"# 'oes not !et "ffecte'0 if
tr"ns"ctions "ffect on#& c)rrent ite%s i(e($ c)rrent "ssets "n' c)rrent #i",i#ities or if
tr"ns"ctions "ffect on#& non-c)rrent "ssets( The f#ow of f)n's st"te%ent !i*es " s)%%"r&
of the i%p"cts of %"n"!eri"# 'ecisions( As s)ch it ref#ects the po#icies of fin"ncin!$in*est%ent$ "c2)isition "n' retire%ent of fixe' "ssets$ 'istri,)tion of profits "n' the
s)ccess of oper"tions(
SOURCES OF FUNDS
Worin! c"pit"# is re2)ire' to fin"nce th"t portion of c)rrent "ssets which is notfin"nce' ,& c)rrent #i",i#ities( The in*est%ents represente' ,& c)rrent "ssets "re
con*erte' into c"sh ')rin! the oper"tin! c&c#e( This i%p#ies th"t o)r nee' for fin"ncin! is
for one s)ch c&c#e( 6n'er nor%"# circ)%st"nces e*er& )nit of in*est%ent in worin!
c"pit"# is con*erte' into c"sh "t the en' of the c&c#e "t "n "''e' *"#)e$ to the extent ofprofits(
Intern"# So)rces 0 E*er& profit",#e s"#e ,rin!s with it f)n's in excess of wh"t w"sexpen'e' on the !oo's so#'( In other wor's$ profits !ener"te' ,& the ,)siness contri,)te
tow"r's "''ition"# worin! c"pit"#( Whene*er we %e"s)re profits$ we %"tch the re*en)e
"!"inst "## expenses re#"tin! to the re*en)e$ whether it in*o#*es )se of f)n's in thec)rrent perio' or not( Th)s the profits %e"s)re' 'o not ref#ect the "ct)"# "%o)nt of f)n's
"*"i#",#e( In or'er to "ssess the "ct)"# f)n's !ener"te' fro% c)rrent oper"tions we sho)#'
"'' ,"c to the profits "## those ite%s of expenses not in*o#*in! )se of f)n's ')rin! the
c)rrent perio'( One %"4or ex"%p#e of s)ch "n ite% is 'epreci"tion( Th)s we co)#'s)%%"ri+e the i%port"nt possi,#e so)rces of f)n's "s0 F)n's !ener"te' fro% oper"tions$
i(e($ profit p#)s 'epreci"tion "n' other "%orti+"tions "n' s"#e of non-c)rrent "ssets$ "n&
s)rp#)s worin! c"pit"#(
F)n's fro% Oper"tions 0 F)n's fro% oper"tions represent the s"#e procee's of !oo's "n'
ser*ices ,& the co%p"n&( P"rt of these f)n's is )ti#i+e' for %eetin! the cost of inp)tss)ch "s %"teri"#$ personne# "n' other oper"tin! costs( Ap"rt fro% these we h"*e "#so to
%eet the interest co%%it%ents "n' costs expir"tion of the %"chiner& "n' e2)ip%ent(
7owe*er$ expir"tion of costs of the %"chiner& "n' e2)ip%ent .'epreci"tion/ is one ite%
which 'oes not re2)ire )se of f)n's in the c)rrent perio'( Th)s the f)n's pro*i'e' fro%
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the oper"tions "re in f"ct the re*en)es e"rne' fro% oper"tions ."s "#so non-oper"tin!
inco%es/ #ess "## i%%e'i"te costs of !oo's so#' re2)irin! )se of f)n's( In other wor's$ it
is net inco%e or profit "fter t"xes p#)s "## the non-c"sh expenses$ s)ch "s 'epreci"tion "n'"%ortis"tion(
Extern"# So)rces 0 Extern"# so)rces of f)n's "re reso)rces r"ise' for% o)tsi'e theor!"ni+"tion to ")!%ent f)n's "*"i#",i#it& for "n& of the )ses( Nor%"##& there "re two
w"&s of 'oin! this0 ,& contri,)tin! or r"isin! "''ition"# c"pit"# "n' ,& incre"se' #on!
ter% ,orrowin!( Short-ter% cre'itors "re not inc#)'e' "s " so)rce of f)n's since we h"*e"#re"'& 'efine' f)n's "s : c)rrent "ssets #ess c)rrent #i",i#ities;( Th)s worin! c"pit"#
represents #on! ter% in*est%ent in c)rrent "ssets "n' hence short ter% ,orrowin! wi## not
incre"se worin! c"pit"#( The so)rces of f)n's$ "s )s)"##& presente' in the f)n' f#ow
st"te%ent "re !i*en ,e#ow0
So)rces of F)n's
Oper"tions0
Net Profit "fter t"xes -----------A''0 Depreci"tion -----------
Other "%orti+"tions -----------F)n's pro*i'e' ,& oper"tions ----------------
New iss)e of sh"re c"pit"# ----------------
New iss)e of 'e,ent)res8,on's ----------------A''ition"# #on!-ter% ,orrowin! ----------------
S"#e procee's of fixe' "ssets ----------------
S"#e of #on! ter% in*est%ents ----------------
USES (APPLICATIONS) OF FUNDS
A ,)siness wo)#' re2)ire "''ition"# c"pit"# for two p)rposes0
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If the tr"'in! or ,)siness oper"tions "re )ns)ccessf)#$ the& %"& )se f)n's r"ther th"n
pro*i'e f)n's( The )ses of f)n's$ "s the& "re )s)"##& presente' in the f)n' f#ow
st"te%ent$ "re !i*en ,e#ow0
6ses of F)n's
Di*i'en's -------------Non-oper"tin! #osses not p"sse' thro)!h P L "cco)nt -------------
Re'e%ption of re'ee%",#e preference sh"re c"pit"# -------------
Rep"&%ent of 'e,ent)res8,on's -------------Rep"&%ent of #on! ter% #o"ns -------------
P)rch"se of fixe' "ssets -------------
P)rch"se of #on!-ter%-in*est%ent -------------
Incre"se in worin! c"pit"# -------------
FACTORS AFFECTING F6ND REB6IREMENTS
F)n' re2)ire%ents *"r& with the n"t)re "n' t&pe of ,)siness( Worin! c"pit"#
re2)ire%ents "re 'irect#& inf#)ence' ,& s"#es *o#)%e( F)n' re2)ire%ents for the ,)siness%"& ,e se"son"#( An i%port"nt "spect which %"& con'ition f)n' re2)ire%ent is the
*e#ocit& of circ)#"tion of c)rrent "ssets( In other wor's the #en!th of the oper"tin! c&c#e
wi## inf#)ence the nee' for f)n's( Shorter the ')r"tion of oper"tin! c&c#e f"ster is thecon*ersion of %one& in*este' in c)rrent "ssets into c"sh "n' hence #esser the nee' for net
worin! c"pit"#( Net worin! c"pit"# re2)ire%ent is "#so inf#)ence' ,& the ter%s
"*"i#",#e fro% the s)pp#iers( The cre'it ter%s exten'e' ,& the s)pp#iers wi## 'eter%ine
the "%o)nt of "''ition"# f)n's re2)ire'( We c"n s)%%"rise the nee' for worin! c"pit"#,& s"&in! th"t the ",i#it& of the fir% to circ)#"te the :c"sh-r"w %"teri"# in*entor& -
wor-in process - finishe' !oo's in*entor& - recei*",#es - c"sh; is the %ost *it"# "n'
i%port"nt f"ctor in 'eter%inin! the "%o)nt of worin! c"pit"#( 7owe*er the ex"ct"%o)nt nee'e' to ,e in*este' in "## these wi## ,e 'eter%ine' ,& the perio' "n' 2)"nt)%
of ho#'in! of e"ch of these e#e%ents(
ANAL9SING C7ANGES IN WORKING CAPITAL
In )n'erst"n'in! the fin"nci"# st"te%ents of " co%p"n&$ one of the first steps
in*o#*e' is the st)'& of the ch"n!es in c)rrent fin"nci"# position of the co%p"n& "n' there"sons for the ch"n!es( We c"n "tte%pt "t st)'&in! these ch"n!es "n' their c")ses ,&
)sin! the '"t" cont"ine' in the s)%%"ri+e' co%p"r"ti*e ,"#"nce sheet "n' profit #oss
"cco)nt of " co%p"n&( A st"te%ent of ch"n!es in worin! c"pit"# he#ps )s in #oc"tin!where these ch"n!es too p#"ce( In the first inst"nce we tr& to show the incre"se
.'ecre"se/ in in'i*i')"# ite%s "n' tr& to c#"ssif& the% in ter%s of incre"se "n' 'ecre"se
in worin! c"pit"#( Since worin! c"pit"# is %e"s)re' ,& s),tr"ctin! c)rrent #i",i#itiesfro% c)rrent "ssets$ "n& incre"se in c)rrent "ssets "n' 'ecre"se in c)rrent #i",i#ities shows
"n incre"se in worin! c"pit"#( Si%i#"r#&$ " 'ecre"se in c)rrent "ssets "n' "n incre"se in
c)rrent #i",i#ities represent " 'ecre"se in worin! c"pit"#(
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1ALANCE S7EET
1"#"nce sheet is the %ost si!nific"nt fin"nci"# st"te%ent( It in'ic"tes the fin"nci"#con'ition or the st"te of "ff"irs of " ,)siness "t " p"rtic)#"r %o%ent of ti%e( In the
#"n!)"!e of "cco)ntin!$ ,"#"nce sheet co%%)nic"tes infor%"tion ",o)t "ssets$ #i",i#ities
"n' owner3s e2)it& for " ,)siness fir% "s on " specific '"te( It pro*i'es " sn"pshot of thefin"nci"# position of the fir% "t the c#ose of the fir%3s "cco)ntin! perio'(
ASSETSAssets$ representin! econo%ic reso)rces "re the *"#)",#e possessions owne' ,& the fir%(
Assets "re the f)t)re ,enefits( The& represent0 ."/ store' p)rch"sin! power .e(!( c"sh/$ .,/
%one& c#"i%s .e(!( recei*",#es$ stoc/ "n' .c/ t"n!i,#e "n' int"n!i,#e ite%s th"t c"n ,e
so#' or )se' in the ,)siness to !ener"te e"rnin!s( T"n!i,#e ite%s inc#)'e #"n'$ ,)i#'in!$p#"nt$ e2)ip%ent or stocs of %"teri"#s "n' finishe' !oo's "n' "## s)ch ite%s which h"*e
ph&sic"# s),st"nce( Int"n!i,#e ite%s 'o not h"*e "n& ph&sic"# existence$ ,)t the& h"*e
*"#)e to " fir%( The& inc#)'e p"tents$ cop& ri!hts$ tr"'e n"%e or !oo'wi##(
Assets %"& ,e c#"ssifie' "s0 .
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with " ,"n "n' re"#i+e c"sh i%%e'i"te#&( The "%o)nt of 'isco)nt is the ,"n3s
co%%ission(
STOCK .or IN5ENTOR9/
Stoc or in*entor& inc#)'es r"w %"teri"#s$ wor-in-process "n' finishe' !oo's in c"se of
%"n)f"ct)rin! fir%s( A %erch"n'ise ,)siness %"& not h"*e r"w %"teri"# "n' wor-in-process in*entories "s it h"s no %"n)f"ct)rin! "cti*it&(
PREPAID EPENSES AND ACCR6ED INCOMESPrep"i' expenses "n' "ccr)e' inco%es "re "#so inc#)'e' inc)rrent "ssets( Prep"i'
expenses "re the expenses of f)t)re perio' p"i' in "'*"nce( Ex"%p#es of prep"i'
expenses "re prep"i' ins)r"nce$ prep"i' rent or t"xes p"i' in "'*"nce( The& "re c)rrent
"ssets ,ec")se their ,enefits wi## ,e recei*e' within the "cco)ntin! perio'( Accr)e'inco%es "re the ,enefits which the fir% h"s e"rne'$ ,)t the& h"*e not ,een recei*e' in
c"sh &et( The& inc#)'e ite%s s)ch "s "ccr)e' 'i*i'en'$ "ccr)e' co%%ission$ or "ccr)e'
interest(
LOANS AND AD5ANCES
Lo"ns "n' A'*"nces "re "#so inc#)'e' in c)rrent "ssets in In'i"( The& inc#)'e ')es fro%e%p#o&ees or "ssoci"tes$ "'*"nces for c)rrent s)pp#ies "n' "'*"nces "!"inst "c2)isition
of c"pit"# "ssets(
FIED ASSETS
Fixe' or #on!-ter% "ssets "re he#' for perio's #on!er th"n the "cco)ntin! perio'( The& "re
he#' for )se in ,)siness$ "n' not for the p)rpose of s"#e( Fixe' "ssets wo)#' inc#)'e #on!-
ter% in*est%ent "n' "## non-c)rrent "ssets(
T"n!i,#e fixe' "ssets
T"n!i,#e fixe' "ssets inc#)'e #"n'$ ,)i#'in!$ %"chiner&$ e2)ip%ent$ f)rnit)re etc( These"re nor%"##& recor'e' "t cost( Costs of t"n!i,#e fixe' "ssets "re "##oc"te' o*er their )sef)#
#i*es( The "%o)nt so "##oc"te' e"ch &e"r is c"##e' 'epreci"tion( Costs of t"n!i,#e fixe'
"ssets "re re')ce' e*er& &e"r ,& the "%o)nt of 'epreci"tion( Depreci"tin! "n "sset is "process of "##oc"tin! cost "n' 'oes not in*o#*e "n& c"sh o)t#"&(
Int"n!i,#e fixe' "ssets
Int"n!i,#e fixe' "ssets represent the fir%3s ri!hts "n' inc#)'e p"tents$ cop&ri!hts$fr"nchises$ tr"'e-%"rs$ tr"'e n"%es "n' !oo'wi##( P"tents "re the exc#)si*e ri!hts
!r"nte' ,& the !o*ern%ent en",#in! the ho#'er to contro# the )se of "n in*ention( Cop&
ri!hts "re the exc#)si*e ri!hts to repro')ce "n' se## #iter"r&$ %)sic"# "n' "rtistic wors(Fr"nchises "re the contr"cts !i*in! exc#)si*e ri!hts to perfor% cert"in f)nctions or to se##
cert"in ser*ices or pro')cts( Tr"'e %"rs "n' tr"'e n"%es "re the exc#)si*e ri!hts !r"nte'
,& the !o*ern%ent to )se cert"in n"%es$ s&%,o#s$ #",e#s$ 'esi!ns etc( Goo'wi##represents the excessi*e e"rnin! power of " fir% ')e to speci"# "'*"nt"!es th"t it
possesses( Costs of int"n!i,#e fixe' "ssets "re "%orti+e' o*er their )sef)# #i*es(
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Gross ,#oc
Gross ,#oc represents the ori!in"# cost of tot"# fixe' "ssets( When "cc)%)#"te'
'epreci"tion is s),tr"cte' fro% the !ross ,#oc$ the 'ifference is c"##e' the net ,#oc(
Lon!-ter% in*est%ents
Lon!-ter% in*est%ents represent the fir%3s in sh"res$ 'e,ent)res "n' ,on's of otherfir%s or !o*ern%ent ,o'ies for profits "n' contro#( These in*est%ents "re he#' for "
perio' of ti%e !re"ter th"n the "cco)ntin! perio'(
Other non-c)rrent "ssets
Other non-c)rrent "ssets inc#)'e "ssets th"t c"nnot ,e inc#)'e' in "n& of the ",o*e
c"te!ories( 6s)"##& the& represent 'eferre' ch"r!es( Prep"&%ents for ser*ices or ,enefits
for " perio' #on!er th"n the "cco)ntin! perio' "re referre' to "s 'eferre' ch"r!es "n'inc#)'e "'*ertisin!$ pre#i%in"r& expenses etc(
LIA1ILITIES
Li",i#ities "re 'e,ts p"&",#e in the f)t)re ,& the fir% to its cre'itors( The& representecono%ic o,#i!"tions to p"& c"sh or to pro*i'e !oo's or ser*ices in so%e f)t)re perio'(
Gener"##&$ #i",i#ities "re cre"te' ,& ,orrowin! %one& or p)rch"sin! !oo's or ser*ices oncre'it( Ex"%p#es of #i",i#ities "re cre'itors$ ,i##s p"&",#e$ w"!es "n' s"#"ries p"&",#e$
interest p"&",#e$ t"xes p"&",#e$ ,on's$ 'e,ent)res$ ,orrowin! fro% ,"ns "n' fin"nci"#
instit)tions$ p),#ic 'eposits etc(Li",i#ities "re of two t&pes0 .
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Pro*isions
Pro*isions "re other t&pes of c)rrent #i",i#ities( The& inc#)'e pro*ision for t"xes "n'
'i*i'en's( Gener"##&$ the "%o)nt of t"x is esti%"te' "n' shown "s pro*ision for t"xes ort"x #i",i#it&( Si%i#"r#&$ pro*ision for p"&in! 'i*i'en's to sh"reho#'ers %"& ,e cre"te' "n'
shown "s c)rrent #i",i#it&(
Expenses p"&",#e or o)tst"n'in! expenses
Expenses p"&",#e or o)tst"n'in! expenses "re "#so c)rrent #i",i#ities( The fir% %"& owe
p"&%ents to its e%p#o&ees "n' others "t the en' of the "cco)ntin! perio' for the ser*icesrecei*e' in the c)rrent &e"r( These p"&%ents "re p"&",#e within " *er& short perio'(
Ex"%p#es of o)tst"n'in! expenses "re w"!es p"&",#e$ rent p"&",#e$ or co%%ission
p"&",#e(
Inco%e recei*e' in "'*"nce
Inco%e recei*e' in "'*"nce is &et "nother ex"%p#e of c)rrent #i",i#it&( A fir% c"n
so%eti%es recei*e inco%e for !oo's or ser*ices to ,e s)pp#ie' in f)t)re( As !oo's or
ser*ices h"*e to ,e pro*i'e' within the "cco)ntin! perio'$ s)ch receipts "re shown "sc)rrent #i",i#ities(
Inst"#%ents of #on!-ter% #o"ns
Inst"#%ents of #on!-ter% #o"ns "re p"&",#e perio'ic"##&( Th"t portion of the #on! ter%
#o"n which is p"&",#e in the c)rrent &e"r wi## for% p"rt of c)rrent #i",i#ities(
Deposits fro% p),#ic
Deposits fro% p),#ic %"& ,e r"ise' ,& " fir% for fin"ncin! its c)rrent "ssets( These %"&
therefore ,e c#"ssifie' )n'er c)rrent #i",i#ities(
LONG-TERM LIA1ILITIES
Lon!-ter% #i",i#ities "re the o,#i!"tions or 'e,ts p"&",#e in " perio' of ti%e !re"ter th"nthe "cco)ntin! perio'( Lon!-ter% #i",i#ities )s)"##& represent ,orrowin! for " #on! perio'
of ti%e( The& inc#)'e 'e,ent)res$ ,on's "n' sec)re' #on! ter% #o"ns fro% ,"ns "n'
fin"nci"# instit)tions(
De,ent)res or ,on's
De,ent)res or ,on's "re iss)e' ,& " fir% to the p),#ic to r"ise 'e,t( A 'e,ent)re or "
,on' is " !ener"# o,#i!"tion of the fir% to p"& interest "n' ret)rn the princip"# s)% "s perthe "!ree%ent( Lo"n r"ise' thro)!h iss)e of 'e,ent)res or ,on's %"& ,e sec)re' or
)nsec)re'(
Sec)re' #o"ns
Sec)re' #o"ns "re the #on!-ter% ,orrowin!s with fixe' "ssets p#e'!e' "s sec)rit&( Ter%
#o"ns fro% fin"nci"# instit)tions "n' co%%erci"# ,"ns "re sec)re' "!"inst the "ssets ofthe fir%(
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EB6IT9
The fin"nci"# interests of the owners "re c"##e' owners3 e2)it&( The owners3 interest is
resi')"# in n"t)re$ ref#ectin! the excess of the fir%3s "ssets o*er its #i",i#ities( As#i",i#ities "re the c#"i%s of o)tsi'e p"rties$ e2)it& represents owners3 c#"i% "!"inst the
,)siness entit& "s of the ,"#"nce sheet '"te( 1)t the n"t)re of the owners3 c#"i% is not the
s"%e "s th"t of the cre'itors( Cre'itors3 c#"i%s "re 'efine' "n' h"*e to ,e %et within thespecifie' perio'( The c#"i% of the owners ch"n!e "n' the "%o)nt p"&",#e to the% c"n ,e
'eter%ine' on#& when the fir% is #i2)i'"te'( Since "ssets "re recor'e' "t cost$ there c"n
,e consi'er",#e 'ifference ,etween the owners3 ,oo c#"i% "n' the re"# c#"i%(
Initi"##&$ owners3 e2)it& "rises on "cco)nt of the f)n's in*este' ,& the%( 1)t it ch"n!es
')e to the e"rnin!s of the fir% "n' their 'istri,)tion( The fir%s3 e"rnin!s .or #osses/ 'o
not effect the cre'itors3 c#"i%s( Owners3 e2)it& wi## incre"se when the fir% %"ese"rnin!s "n' ret"ins who#e or p"rt( If #osses "re inc)rre' ,& the fir%$ owners3 c#"i% wi##
,e re')ce'(
Sh"re c"pit"#In c"se of " co%p"n&$ owners "re c"##e' sh"reho#'ers .or stocho#'ers/( Therefore$
owners3 e2)it& is referre' to "s sh"reho#'ers3 e2)it& of sh"reho#'ers3 f)n's( Sh"reho#'erse2)it& h"s two p"rts .i/ p"i'-)p sh"re c"pit"# "n' .ii/ reser*es "n' s)rp#)s .ret"ine'
e"rnin!s/ representin! )n'istri,)te' profits( P"i'-)p sh"re c"pit"# is the "%o)nt of f)n's
'irect#& contri,)te' ,& the sh"reho#'ers( If the sh"reho#'ers "re "ct)"##& re2)ire' to p"&%ore th"n the st"te' or p"r *"#)e per sh"re$ the "%o)nt is sep"r"te#& shown "s sh"re
pre%i)%(
Reser*es "n' s)rp#)sThe secon' p"rt of the owners3 e2)it& is referre' to "s ret"ine' e"rnin!s or reser*es "n'
s)rp#)s( The 'ifference ,etween the tot"# e"rnin!s to '"te "n' the tot"# "%o)nt of
'i*i'en's to '"te is reser*es "n' s)rp#)s( It represents tot"# )n'istri,)te' e"rnin!s( .Theter% 'eficit is )se' to represent excess of tot"# 'i*i'en's o*er tot"# e"rnin!s or #osses
inc)rre' ,& the fir%/( 6n'istri,)te' profits .reser*e/ %"& ,e e"r%"re' for so%e specific
p)rpose$ s)ch "s rep#"ce%ent or 'e,ent)re re'e%ption( Reser*es th"t "re not e"r%"re'"re c"##e' free reser*es(
Net worth
The ter% net worth is )se' for the s)% of sh"re c"pit"# "n' reser*es "n' s)rp#)s$ i(e($ theowners3 e2)it&(
Re#"tionship 1etween Assets$ Li",i#ities "n' Owners3 E2)it&Assets "re reso)rces of the fir% th"t "re "c2)ire' fro% f)n's pro*i'e' ,& o)tsi'ers$
nown "s #i",i#ities "n' f)n's pro*i'e' ,& owners$ nown "s owners3 e2)it&( In other
wor's$ "ssets represent the o)tsi'ers3 "n' owners3 in*est%ents( The re#"tionship is0
Tot"# Assets .TA/ Tot"# Li",i#ities .TL/ Owners3 E2)it& .OE/
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Or TA @ TL OE i(e($ owners3 e2)it& is the fir%s3 re%"inin! reso)rces
."ssets/ "fter the o,#i!"tions of o)tsi'ers .#i",i#ities/ h"*e ,een t"en c"re of( Th)s
ch"n!es in "ssets "n' #i",i#ities wi## c")se " ch"n!e in owners3 e2)it&( Ch"n!e in owners3e2)it& in the c"se of co%p"nies$ wi## ,e ref#ecte' in ret"ine' e"rnin!s or reser*es "n'
s)rp#)s( The p"i'-)p sh"re c"pit"# wi## not nor%"##& 'ecre"se in the #ife ti%e of "
co%p"n& ,)t it c"n incre"se whene*er f)n's "re r"ise' ,& iss)in! new sh"res(
Tot"# Assets .TA/ Net fixe' "ssets .NFA/ C)rrent "ssets .CA/
Tot"# Li",i#ities .TL/ Lon!-ter% #i",i#ities .LTL/ C)rrent #i",i#ities .CL/
i(e($ NFA CA LTL CL OE
i(e($ NFA .CA @ CL/ LTL OE
i(e($ NFA NCA LTL OE$ NCA net c)rrent "ssets
Net worin! c"pit"# !"p
The 'ifference ,etween c)rrent "ssets .CA/ "n' c)rrent #i",i#ities .CL/ is c"##e' net
worin! c"pit"# .NWC/ or net c)rrent "ssets .NCA/( NWC or NCA is th"t portion ofc)rrent "ssets th"t is not fin"nce' fro% c)rrent #i",i#ities therefore$ it %)st necess"ri#& ,e
fin"nce' fro% #on!-ter% f)n's( 1"n cre'it is "n i%port"nt co%ponent of c)rrent#i",i#ities th"t fin"nces c)rrent "ssets( 1)t it is " c)rrent #i",i#it& th"t 'oes not "rise
'irect#& fro% the fir%s3 oper"tions( Acco)nts p"&",#e "n' ,i##s p"&",#e "n' *"rio)s t&pes
of "ccr)"#s "rise spont"neo)s#& o)t of the fir%s3 oper"tions "n' "re therefore c"##e'spont"neo)s c)rrent #i",i#ities .SCL/( The 'ifference ,etween c)rrent "ssets "n'
spont"neo)s c)rrent #i",i#ities .th"t is$ c)rrent #i",i#ities #ess ,"n cre'it/ %"& ,e referre'
to "s net worin! c"pit"# !"p .NWCG/$ or oper"tin! c"pit"# .OC/( NWCG %)st of
necessit& ,e fin"nce' ,& ,"n ,orrowin! .11/ "n' #on!-ter% f)n's(
NFA CA @ . SCL 11 / LTL OE
NFA NWCG @ 11 LTL OENFA NWCG 11 LTL OE
Where 11 is ,"n ,orrowin! for fin"ncin! c)rrent "ssets not co*ere' ,& spont"neo)s
c)rrent #i",i#ities .SCL/(
C"pit"# e%p#o&e'
It %"& ,e 'efine' "s " net fixe' "ssets p#)s net c)rrent "ssets
CE NFA NCASince NFA NCA LTL OE$ it i%p#ies th"t c"pit"# e%p#o&e' e2)"#s #on!-ter% f)n's0
CE LTL OE
The "#tern"ti*e 'efinition of c"pit"# e%p#o&e' is tot"# interest ,e"rin! 'e,t or #o"n f)n's
.i(e($ #on!-ter% 'e,t p#)s ,"n ,orrowin!/ p#)s owners3 e2)it& or sh"reho#'ers f)n's .net
worth/( Fro% "sset si'e$ it %e"ns net fixe' "ssets p#)s net worin! c"pit"# !"p0CE NFA NWCG
Since ,"n ,orrowin! 'oes not "rise 'irect#& fro% the oper"tions of the fir%$ "n' th"t it
h"s to ,e r"ise' extern"##& "t " cost$ it is %ore #o!ic"# to )se the secon' 'efinition of
c"pit"# e%p#o&e' for "n"#&tic"# p)rposes(
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