WORKING CAPITAL MANAGEMENT

The level of current assets is a key factor in a companys liquidity position. A company must have or be
able to generate enough cash to meet its short-term needs if it is to continue in business. Therefore,
working capital management is a key factor in the companys long-term success: without the oil of
working capital, the engine of non-current assets will not function. The greater the extent to which
current assets exceed current liabilities, the more solvent or liquid a company is likely to be, depending on
the nature of its current assets.
The two main objectives of working capital management are to increase the protability of a
company and to ensure that it has sufcient liquidity to meet short-term obligations as they fall due
and so continue in business (Pass and Pike 1984). Protability is related to the goal of shareholder wealth
maximisation, so investment in current assets should be made only if an acceptable return is obtained.
While liquidity is needed for a company to continue in business, a company may choose to hold more
cash than is needed for operational or transaction needs, for example for precautionary or speculative
reasons. The twin goals of protability and liquidity will often conict since liquid assets give the lowest
returns.

What is Working Capital and Working Capital Management?

Working capital plays the same role in the business as the role of heart in the human body. Just like heart
gets blood and circulates the same in the body, in the same way in working capital, funds are generated
and then circulated in the business. As and when this circulation stops the business becomes lifeless.
Thus, prudent management of Working capital is necessary for the success of a business.
Capital:-Working capital management is an important aspect of financial management. In business,
money is required for fixed assets and working capital. Fixed assets include land and building, plant and
machinery, furniture and fittings etc. Fixed assets are acquired to be retained in the business for a long
period and yield returns over the life of such assets. The main objective of working capital management is
to determine the optimum amount of working capital required. Generally, management of working capital
means management of current assets.
Two Concepts of Working Capital:
GROSS WORKING CAPITAL is total current assets.
NET WORKING CAPITAL is current assets less current liabilities.

How can we determine the level of working capital that should be carried by the business?
It will depend in your current investment policy.
Three basic alternative policies are:
1. Conservative or Relaxed Current Asset Investment Policy
- maintaining larger cash balance perhaps even investing in short-term securities, offering more generous
credit erms to customers and holding higher level of inventory.
- An aggressive policy will increase profitability since less cash will be tied up in current assets, but it will
also increase risk since the possibility of cash shortages or running out of inventory is increased

2. Aggressive or Restricted Current Asset Investment Policy

- the company choose to operate with lower levels of inventory, trade receivables and cash for a given
level of activity of sales.
- Such a policy will give rise to a lower risk of financial problems or inventory problems, but at the expense
of reducing profitability.
3. Moderate Current Asset Investment Policy
- would tread a middle path between the aggressive and conservative approaches.
It should be noted that the working capital policies of a company can be characterised as aggressive,
moderate or conservative only by comparing them with the working capital policies of similar companies.
There are no absolute benchmarks of what may be regarded as aggressive or otherwise, but these
characterisations are useful for analysing the ways in which individual companies approach the
operational problem of working capital management.

How will the working capital be finance?

Three Financing Policies:
1. Matching Funding Policy - one which finances fluctuating curren assets with short-term
funds and permanent current assets with long-term funds.
2. Conservative Funding Policy- uses long-term funds to finance not only non-current
assets and permanent current assets, but some fluctuating current assets as well. There is less
reliance on short-term funding, the risk of such a policy is lower, but the higher cost of long-term
finance means that probability is reduced as well.
3. Aggressive Funding Policy-

How will the business decide on an appropriate working capital?

The amount of capital that a company should have depends on the amount of risk it is willing to take. The
primary consideration therefore is the trade-off between returns (profitability) and the risk (risk of illiquidity)
or simply the RISK RETURN TRADE-OFF, which means:

1. Greater risk = greater potential for larger returns

2. More current assets = greater liquidity but will yield lower returns (profit)
3. Fixed assets earn greater returns than current assets
4. Long-term financing has less liquidity risk than short-term debt, but has higher explicit cost, hence,
lower return

How will the working capital affect financing decision?

The level of current assets is a key factor in a companys liquidity position. A company must have or be
able to generate enough cash to meet its short-term needs if it is to continue in business. Therefore,
working capital management is a key factor in the companys long-term success: without the oil of
working capital, the engine of non-current assets will not function. The greater the extent to which current
assets exceed current liabilities, the more solvent or liquid a company is likely to be, depending on the
nature of its current assets.
Because working capital management is so important, a company will need to formulate clear policies
concerning the various components of working capital. Key policy areas relate to the level of investment
in working capital for a given level of operations and the extent to which working capital is financed from
short-term funds such as a bank overdraft. A company should have working capital policies on the
management of inventory, trade receivables, cash and short-term investments in order to minimise the
possibility of managers making decisions which are not in the best interests of the company. Examples of
such suboptimal decisions are giving credit to customers who are unlikely to pay and ordering
unnecessary inventories of raw materials. Sensible working capital policies will reflect corporate decisions
on: the total investment needed in current assets, i.e. the overall level of investment; the amount of
investment needed in each type of current asset, i.e. the mix of current assets; and the way in which
current assets are to be financed. Working capital policies need to consider the nature of the companys
business since different businesses will have different working capital requirements. A manufacturing
company will need to invest heavily in spare parts and components and might be owed large amounts of
money by its customers. A food retailer will have large inventories of goods for resale but will have very
few trade receivables. The manufacturing company clearly has a need for a carefully thought out policy
on receivables management, whereas the food retailer may not grant any credit at all. Working capital
policies will also need to reflect the credit policies of a companys close competitors, since it would be
foolish to lose business because of an unfavourable comparison of terms of trade. Any expected
fluctuations in the supply of or demand for goods and services, for example due to seasonal variations in
business, must also be considered, as must the impact of a companys manufacturing period on its
current assets.

How does Working capital affects both the liquidity and profitability of a business?
Short term Investment decisions are concerned with the decisions about the level of cash, inventory and
debtors etc. (working capital) Efficient cash management, Inventory management and receivable
management are essential ingredients of sound working capital management.
The working capital should be neither more or less than required. Both the situations are harmful. If the
amount of working capital is more than required, it will no doubt increase the liquidity but decrease the
profitability. Similarly if there is a shortage of working capital, it will face the problem of meeting day to day
requirements.
Thus optimum amount of current assets and current liabilities should be determined so that the
profitability of the business remains intact and there is no fall in the liquidity.

What are the benefits of having an adequate working capital?

Following are the various advantages of having adequate working capital:
1.
2.
3.
4.
5.
6.
7.

Goodwill
Cash Discount.
Easy loan from banks
Exploitation of good opportunities
Distribution of dividends
High morale
Sense of security and confidence

What are the disadvantages of excessive working capital?

The business should have neither redundant or excess working capital nor shortage or inadequate
working capital. But adequate working capital is always preferable as compared to inadequate working
capital. Following are the various disadvantages of excessive or redundant working capital:
1. Loss of Goodwill: excess working capital brings an opportunity to invest in low rate of
interest bearing securities, which ultimately affect the return on investment of the shareholders.
The shareholders lose confidence in the company which ultimately reduce the goodwill.
2. Misuse of Funds: excess of working capital diverts the attention of the company to
invest wisely in the most profitable investments. Due to the excess working capital it will be very
much difficult to put control on the various purchases.
3. Inefficient management: excess working capital leads to the inefficiency of the business
because the management is not interested to invest the funds in expanding the business.
4. Low rate of return on Capital: excess working capital indicates the presence of idle
funds available in the business. The idle funds does not carry any interest which ultimately leads
to low rate of interest on the capital employed. The low rate of return on capital ultimately affects
the earnings of the shareholders in terms of reduction of dividends.
How can we avoid problems of shortage and surplus of funds?
Financial Planning is required to avoid shortage or surplus of finance. Importance of financial planning is:
a) By planning utilization of finance, it reduces waste , duplication of efforts and gaps in the planning.
b) It helps in coordinating the various business activities such as sales, purchases, production, finance etc.
c) It is a technique of control. It helps in setting up standard and compare with the actual performance. The
deviations, if any are then analysed. Causes found out and corrective measures are taken.
(d)It helps in avoiding shocks and surprises as proper provision regarding Shortage or surplus is made in advance by
anticipating future receipts and Payments.

Problem:
Currently I have P500,000 current assets of which 15% are permanent and P700,000 in fixed assets. The current
long-term rate is 11% and the current short-term rate is 8.5%. (TAX rate 40%). Now, I am confused as to which
financing plan to pursue whether to apply the conservative with 80% of assets financed by long-term sources or apply
the aggressive with only 60% of assets financed by long-term sources? Which plan can you recommend and what
are the risks associated with each plan?