Working Capital Management
Working capital management is concerned with current assets and current liabilities and their relationship to the rest of the firm. Working capital policies affect the future returns and risk of the company; consequently, they have an ultimate bearing on shareholder wealth.
What is Working Capital?
A business person usually sells on credit, stocks goods and keeps some cash in the bank and the office.
Fill in the Blanks:
1. The amount sold on credit becomes __________________________
2. The Stock of goods maintained by a business are called
3. Cash and the above two items when added up together usually†††††††
††† becomes ___________________________________
Working capital refers to the total investment in current assets.
Net working capital refers to the difference between current assets and current liabilities.
Working capital management involves two major types of decisions:
1. The level of investment in current assets.
2. The method of financing (short-term VS long-term)
Determination of the appropriate level of working capital involves a tradeoff between risk and profitability.
The above figure tells us that
1.†††††† More conservative policies involve holding a greater amount of current
††††††††† assets relative to sales.† More aggressive policies hold less.
2.†††††† More conservative working capital policies have lower expected
††††††††† profitability (measured as return on total assets) since more assets
††††††††† are used to produce a given level of income.
3.†††††† More conservative working capital policies have a lower risk of
††††††††† insufficient cash to pay bills and insufficient inventory to meet
4.†††††† The optimal level of working capital investment is the level which is
††††††††† expected to maximize shareholder wealth.
Nature of Current Assets
Current assets usually fluctuate from month to month. During months when sales are relatively high, firms usually carry a lot of inventory, accounts receivable and cash.
The level of inventory declines in other months when there is less selling activity. But at any given point of time, the firm always has some current assets.
Permanent current assets and Temporary current assets
The amount of current assets required to meet a firm's long-term minimum needs are called Permanent current assets.
Current assets that fluctuate due to seasonal or cyclical demand are called temporary current assets.
Need for financing of Current assets
Working Capital requirements are for a short period of time as Current Assets are self-liquidating.
Take a look at the following steps (a simple model):
1. Inventory purchased on credit.††††††††††††††††††††††††††† Accounts Payable
2. Inventory stocked in the Warehouse.†††††††††††††††††† Merchandise Inventory
3. Goods are sold on credit.†††††††††††††††††††††††††††††††††††† Accounts Receivable
4. Cash is collected.††††††††††††††††††††††††††††††††††††††††††††††† Cash
Usually somewhere between steps 1 and 4, money has to be paid to the supplier. Letís assume in this model that money is paid between steps 2 & 3. In this case Cash is not yet collected. So some sort of finance has to be arranged till Cash is collected for a short term. Once cash is collected then the money (from whichever source) that was arranged can be repaid. With the arrangement of Finance the steps above can be modified as under:
1. Inventory purchased on credit.
2. Inventory stocked in the Warehouse.
ř Finance arranged to pay the supplier†††††
3. Goods are sold on credit.
4. Cash is collected.
ř Finance that was arranged between steps 2 & 3 can now be re-paid.
The above cycle gets repeated.
So Financing needs are short term for Working Capital.
Conservative Policy of Financing:
(LOW Risk; LOW Return approach)
All fixed assets + permanent curr. assets + part of temporary curr. Assets by long-term debt
Aggressive policy of financing :
(HIGH Risk; HIGH Return approach)
(SHORT TERM FINANCING/LOW LIQUIDITY)
If you adopt a financing plan which uses short term funds, and your asset liquidity is low then it is an aggressive† and risky approach for the following reasons:
1. Profit factor - There is a possibility of high profits because your assets are less liquid and therefore well invested in the business.
2. Profit factor - You are using short term financing and hence the interest costs could be low resulting in lesser interest expense thereby helping profits.
3. Risk Factor - Since the financing is short term there is every possibility that the interest rates could go up resulting in a higher interest expense when the finances need to be renewed or the lender may refuse to renew.
4. Risk Factor - Since the assets are less liquid there may not be enough cash to meet short term obligations.
(SHORT TERM FINANCING/HIGH LIQUIDITY†††† OR
LONG TERM FINANCING/LOW LIQUIDITY)
This sort of plan is considered moderate because:
1. Risk factor (Short term/Highly liquid)- Even though borrowing is short term with the possibility of the financing arrangement not being renewed or a higher interest expense (which is the risk factor) the Assets are highly liquid hence even if the loan has to be repaid funds would be available.
2. Profit factor (Short term/Highly liquid)-† With short term financing the interest cost could be low and therefore help profits but the Assets being less liquid would not help returns (profits).
3. Risk factor (Long term/Low liquid)- Since the financing arrangement is long term there will not be any threat of immediate repayments but the assets being less liquid could be a problem.
4. Profit factor (Long term/Low liquid)- When the assets are kept less liquid it would help the profits because they would be well invested but the interest cost could be high because of long term borrowing.
(Long term Financing/Highly liquid assets)
1. Risk Factor - This will be negligible because there is no threat of immediate repayment as the borrowing is long term and in any case if anything has to be repaid the business would have the finance anyway as the assets are highly liquid.
2. Profit Factor - Profitability will be low because the Assets are highly liquid and the interest rates could be high too.