What is Working Capital Management?

Working capital management is a managerial accounting strategy focusing on maintaining efficient levels of both components of working capital (current assets and current liabilities) in respect to each other.

Working capital management ensures a company has sufficient cash flow in order to meet its short-term debt obligations and operating expenses. The management of working capital is concerned with the management of the assets and liabilities in the top half of the balance sheet.

Importance of Working Capital Management

The management of working capital plays an important role in maintaining the financial health of the firm during the normal course of business. The following figure portrays the flow of resources through the firm. By far the major flow, in terms of its yearly magnitude, is the working capital cycle. The loop starts at the cash and marketable securities account, goes through the current accruals accounts as direct labor and materials are purchased to produce the inventory, which is in turn to sold and generates accounts receivable, which are finally collected to replenish cash. In the following figure, a square is a balance sheet account and an arrow indicates a flow.

Short-Term Strategies
Restricting credit policy

Operating more and more with customers materials, thereby reducing the inventory level
Reducing the service level

Slashing developmental expenditure over the short-term cutting back on its R&D budget, training and development budget or product promotional expenditure, etc.
Improving profitability through short-term measures like improving capacity utilization through letting out facilities, exploiting demand by subcontracting, negotiating with the bank for softer terms and higher credit limits. Negotiating with the creditors like deferring payment to creditors, converting the loan into equity, etc.

Long-Term Strategies
Reducing the working capital needs Reducing the inventory holding requirement Improving product quality & then demanding restricted credit terms R&D efforts leading to improved operational efficiency Cost reduction through higher capacity utilization Improving capacity utilization Removing input constraints Plant modernization and improvement for higher plant availability Capacity expansion Quality control efforts Product promotion

Cash Management
The cash management function is a general designation for two distinct corporate activities: cash flow acceleration and liquidity account allocation. The former problem concerns procedures for speeding cash collections from customers and slowing cash disbursements to suppliers so as to optimize the firm's use of cash. The latter problem, on the other hand, takes the firm's cash flow as given and determines the minimum cash balance, the excess to be held in the form of marketable securities.

Importance of Cash Management

Some observations from Business Week (April 28, 2003):
cash flow is a better way to value companies Earnings are an accounting fiction more cash equals more value Everything including how much investors are willing to pay for a stock ties back to expectations about cash Standard & Poor's added liquidity analytics to its ratings in 2002; many companies have had their debt downgraded, primarily due to cash concerns. money is tied up when customers don't pay their invoices, suppliers are paid too quickly or not fast enough, and inventories sit unsold Corporate America has more than $620 billion 35% of total sales blocked by inefficient cash flow management.

The Money Market

It is important for the student of working capital management to be familiar with the basic instruments of the money market that are used by many firms as investment alternatives to cash and larger firms as financing vehicles. While all the instruments are traded in this market are quite safe relative to other investments (such as common stocks), they differ somewhat in risk and return. Some of the popular money market instruments are Treasury bills, commercial paper, certificate of deposits, bankers acceptance, repurchase agreements, and euro dollars.

Money Market Instruments

Treasury bills government-backed securities issued on a discount basis in minimum denomination of $10,000. Maturities range from 3 months to 1 year. Commercial paper a short-term unsecured promissory note issued in the open market and represents the obligation of the issuing corporation, and rates are determined in part by the creditworthiness of the corporation. Typically, commercial paper is issued as a zero-coupon instrument, with a maturity of 50 days or less, but not more than 270 days.

Certificate of deposits a financial asset with maturity from a few weeks to several years issued by a bank or thrift that indicates a specified sum of money has been deposited at the issuing depository institutions.

 Bankers acceptance a promissory note issued by a business debtor, with a stated maturity date, arising out of a business transaction. Called bankers acceptance because a bank accepts the ultimate responsibility to repay the loan to its holder by endorsing the note, in return for a fee. Repurchase agreements the sale of a security with a commitment by the seller (usually government securities dealers) to buy the security back from the purchaser at a specified price at a designated future date. Basically, a RP is a collateralized loan, where the collateral is a security. Eurodollars U.S. dollar-denominated deposits at foreign banks or foreign branches of American banks. By locating outside of the United States, eurodollars escape regulation by the Federal Reserve Board.

Flotation and Check Clearing

Float is the term for the dollar amount of checks that a firm could cash were they not in the mail. Float is basically the difference between bank cash and book cash. Positive (disbursement) float: bank balance > book balance (e.g. writing a cheque reduces book cash before bank cash) Negative (collection) float: bank balance < book balance (e.g. receiving and depositing a cheque increases book cash before bank cash)

Must keep track of float to know true cash on hand.

 Float management involves minimizing collection float and maximizing disbursement float.

Electronic Data Interchange (EDI) may make traditional float management obsolete in the future.
Collection float is composed of: Mail float (time cheques are in the postal system) Processing float (time taken for receiver of cheque to deposit it to the bank) Clearing float (time taken for banking system to clear the cheque)

 Disbursement Float: The value of the checks that have been written and disbursed but have not yet fully cleared through the

banking system and thus have not been deducted from the account
on which they are written. Collection Float: The amount of checks that have been received and deposited but have not yet been made available to the account in which they were deposited. Net Float: The difference between disbursement Float and collection Float; the difference between the balance shown in the

checkbook and the balance shown on the banks book.