Working capital is concerned with the management of the current assets and current liabilities. To be more precise the financing aspect of the current assets. It is an important and integral part of financial management as short-term survival is a pre-requisite to long-term success. There is a conflict between profitability and liquidity. If a firm does not have adequate working capital, i.e. if it does not invest sufficient funds in current assets, it may become illiquid (i.e. lose liquidity) and thus invite risk of bankruptcy. It will not be able to meet its current liabilities in time and lose its market and good of customers and suppliers. On the other hand, if the current assets are too large, it results larger current liabilities, a good part of which has to be raised through borrowings at market rates, thus adversely affecting profitability..

The basic objective of working capital is to provide adequate support for the smooth functioning of the normal business operations of a company. A business concern has to operate in an environment permeated with uncertainty and risk. Consequently the quantum of investment in current assets has to be made in a manner that it not only meets the needs of the forecasted sales but also provide a built in cushion in the form of safety stocks to meet unforeseen contingencies arising out of factors such as delay in arrival of raw material, sudden spurt in sales demand etc. Consequently the Company may take a conservative view and hold a large amount of inventory, to ward off risk. Or it may take an aggressive policy towards current assets, and hold the minimum possible inventory to secure the maximise profits, by reducing the cost of working capital borrowings and inventory holding at a barest minimum level. It is therefore apparent that the management of current assets inevitably leads to a trade-off between 'profitability' and 'liquidity'. The inherent conflict can be resolved through a dynamic working capital policy, securing the optimum possible benefits under both the norms. This dynamic policy has to be shaped keeping in view both the financing aspect of working capital, but also the quantum of current assets to be maintained or levels of inventory holding.

In the normal course of business a company will usually have access to non-interest bearing short-term liabilities such as sundry creditors, accrued expenses and other current liabilities as also provisions toward financing current assets. These are also called spontaneous liabilities as they arise more or less automatically in the context of current asset. The difference between the amounts of current assets and spontaneous liabilities needs to be financed by a combination of bank borrowings in the form of cash credit/overdraft arrangement and long-term sources of finance such as debentures and equity capital. Bank borrowings are external source. It is costly, but provide a flexible source of funds, according to seasonal needs. On the other hand the long-term sources such as equity capital is cost free and debentures may be less expensive. Equity capital though appearing to be cost-fee funds, puts the company under the obligation to make profits and declare dividends after paying its tax-obligation.

For the purpose of financing working capital we discussed the distinction between Net working capital and Gross working capital. Gross working capital is equal to the total current assets of a Company. Net working capital is defined as the difference between the Gross working capital (total current assets) and current liabilities, including provisions. It is considered that a company should have a favourable (minimum) current ratio (considered at 1.4), which signifies a ratio of 1 : 1.4 between current liabilities and current assets. The current ratio is worked out by dividing the current assets by the current liabilities

It is considered prudent and even insisted by the financing banks that the quantum of net working capital (the difference between current assets and current liabilities) should be financed by long term internal sources, like equity and debentures and built-in reserves. The balance of gross working capital in the first instance should be financed through spontaneous current liabilities, which are cost-free and the remaining part through bank borrowings or in part through bank.

Monitoring the current ratio is an important job of the finance manager responsible for, unless it has ready cash and bank balances it wold not be in a position to meet its accruing current liabilities according to time schedule.

This ratio supplements Current Ratio. It is represented as Quick Assets/Current Liabilities. Part of the current assets may not accrue into cash quickly and these sources though available will not be timely available to the business to discharge its current liabilities due for payment. Acid Test Ratio excludes stocks from current assets, but is otherwise the same as the current ratio. The idea behind this ratio is that stocks are sometimes a problem because they can be difficult to sell or use. An ideal position is that Acid Test Ratio must be 1 or more than 1.Thus,

Current ratio = Current Assets/Current Liabilities
Acid Test Ratio = (Current Assets - stocks) /Current Liabilities.

Having sufficient current assets to meet accruing current liabilities gives a solution only half a way. Accruing current liabilities have to be discharged by ready cash or bank balance. Thus if a company holds adequate finished goods, it will not be able to use to discharge its current obligations, unless the goods are sold and realised into cash. The demand for cash or liquid sources of funds is a flowing or continuous process and not one-time job. The tool of financial analysis to regulate and monitor this function is the fund flow analysis.

The fund flow statement also referred as the changes in financial position or statement of sources of funds and application of funds during the period. Very broadly funds are defined as total resources. Most commonly, funds are defined as working capital cash. A firm borrow from a bank or financial institution term loan on medium/long term basis, but when the repayment starts, the interest and instalment due during that year in fact becomes a current liability and has to be discharged through the current assets of the firm. The fund flow statement on working capital basis presents all operations/transactions that would influence a change in the net working capital of the business. It would cover the following.

• sources of working capital

• uses of working capital, and

• net change in working capital

1. operations,

2. issue of share capital,

3. long-term borrowings, and

4. sale of non-current assets

1. payment of dividend,

2. repayment of long-term liability

3. purchase of non-current assets

A major roadblock in the management of working capital is liquidity risk. Liquidity is the ability to convert an asset into cash equal to its current market value. An institution is said to have liquidity if it can easily meet its needs for cash either because it has cash on hand or can easily convert assets into cash. Assets can be converted to cash either through an outright sale of those assets or by using the assets to secure a loan.

The liquidity of a business organization depends on:

• The institution's short-term need for cash

• Cash on hand

• The liquidity of the institution's assets

• The institution's reputation in the marketplace

• How willing will counterparties be to transact trades with or lend to the institution?

Liquidity risk is financial risk from a possible loss of liquidity. It is the risk of having insufficient cash to sustain normal business activity.

"Liquidity risk is an emerging topic in the financial risk world. Proper liquidity management is crucial as liquidity risk can compound the consequences of other risks. In particular, the effects of credit risk and market risk complications are multiplied when combined with liquidity risk. Conversely, other risks can lead to liquidity risk. For example, credit risk can cause funding problems. If a counterparty defaults, the firm in question may be deprived of cash earmarked for current operating expenses and liabilities.

"To manage liquidity risk, a firm must be diligent in monitoring potential liquidity. Essential steps include closely noting cash flow, diversifying funding sources, and ensuring quick access to liquid assets. Liquidity risk should be estimated under potential stressed market conditions. "Stress-testing" a portfolio of assets can prepare a firm for possible liquidity problems.
[Source: Website of MIT Laboratory for Financial Engineering (LFE) -Project "Risk Psychology Net - Article - Liquidity Risk"]

ALM poses a threat more than the visible mismatches between current assets & liabilities that may accrue on account of a sudden fall in the value of the current assets, while current liability remains the same. This may result in the sudden evaporation of the net working capital held and may even come to consume part of the long term capital sources.

Asset-liability risk is a leveraged form of market risk. Because the capital (surplus) of a financial firm such as a bank or insurance company is small relative to its assets or liabilities, small percentage changes in assets or liabilities can translate into large percentage changes in capital. Consider the evolution over time of a hypothetical company's assets and liabilities. Over the period, the assets and liabilities may change only slightly, but those slight changes dramatically alter the company's capital (which is just the difference between assets and liabilities). Consider a hypothetical firm with Rs.80 Crore in assets, Rs.60 Crore of it in liabilities and Rs.20 Crore in equity capital. A fall of Rs.10 Crore (representing a fall of 12.5%) in asset will reduce capital by Rs.10 Crore i.e. 50% fall. The initial erosion takes place in the net-working capital, which is wiped out and current ratio turns negative. Subsequent erosion may result in progressively wiping long term sources of capital, resulting in a statement of bankruptcy, where the firm holds less assets and more debts.

The problem was not that the value of assets might fall or that the value of liabilities might rise. It was that capital that might be depleted by narrowing of the difference between assets and liabilities-that the values of assets and liabilities might fail to move in tandem.

ALM risk management needs both timely detection of mismatches between assets & liabilities maturing over a time and effecting appropriate steps to remedy the situation. Asset-liability management can be performed on a per-liability basis, matching a specific asset to support each liability. Alternatively, it can be performed across the balance sheet. With this approach, the net exposures of the organization's liabilities are determined, and a portfolio of assets is maintained which hedges those exposures. There are different tools of ALM in the field of risk management like GAP analysis. These are beyond the scope of this article.