Chapter 26

WORKING CAPITAL MANAGEMENT

OUTLINE

• Characteristics of Current Assets

• Factors Influencing Working Capital Requirements

• Level of Current Assets

• Current Assets Financing Policy

• Profit Criterion for Current Assets

• Operating Cycle Analysis

• Cash Requirement for Working Capital

CHARACTERISTICS OF CURRENT ASSETS

• Short life span• Swift transformation into other asset forms

Current Assets Cycle

Accounts receivable

Finished goods

Wages, salaries, factory overheads

Work-in- process

Raw materials

Cash Suppliers

FACTORS INFLUENCING WORKING

CAPITAL REQUIREMENTS

• Nature of Business

• Seasonality of Operations

• Production Policy

• Market Conditions

• Conditions of Supply

WORKING CAPITAL POLICY

Two important issues in working capital policy are:

• What should be the level of investment in current

assets?

• What mix of long-term and short-term financing should

the firm employ to support current assets?

LEVEL OF CURRENT ASSETS

Flexible Restrictive (Conservative) (Aggressive)

Policy Policy Liquidity High Low Inventories Large Small Debtors High Low

A flexible policy results in fewer production stoppages, ensures quicker deliveries to customers, and stimulates sales .. but

HIGHER INVESTMENT IN CURRENT ASSETS

A restrictive policy leads to more production stoppages, delayed deliveries to customers, and lost sales … but

LOWER INVESTMENT IN CURRENT ASSETS

CAPITAL REQUIREMENTS

AND THEIR FINANCING

Capitalrequirements

Fluctuating current asset requirement

Permanent current asset-requirement

Fixed asset requirement

Time

A

B

C

CURRENT ASSETS FINANCING

POLICY

According to the maturity principle, fixed assets and

permanent current assets should be supported by long-

term sources of finance whereas fluctuating current assets

must be supported by short-term sources of finance.

PROFIT CRITERION FOR

WORKING CAPITAL

• Investment in current assets is easily reversible.

• For reversible investments, the criterion of net profit per

period (which here means residual income) is equivalent

to the criterion of net present value

OPERATING CYCLE AND CASH CYCLE

Order placed Stock arrives Goods sold Cash received

Inventory period Accounts receivable period

Accounts payable period

Firm receives Cash paid for invoice materials

Operating cycle

Cash cycle

Average inventoryInventory period =

Average COGS / 365 Average accounts receivable

Accounts receivable period = Annual sales / 365 Average accounts payable

Average payable period = Average COGS / 365

ILLUSTRATION

Financial Information for Horizon Limited

Balance Sheet Data

Profit and Loss Beginning of End of

Account Data 20X0 20X0

Sales 800 Inventory 96 102

Cost of goods 720 Account receivable 86 90

Sold Accounts payable 56 60

(96 + 102) / 2

Inventory period = = 50.1 days

720 / 365

(86 + 90) / 2Accounts receivable period = = 40.2 days

800 / 365

(56 + 60) / 2Accounts payable period = = 29.4 days

720 / 365 Operating cycle = 50.1 + 40.2 = 90.3 days

Inventory Accounts period receivable

period

Cash cycle = 90.3 - 29.4 = 60.9 days Operating Accounts

cycle payable period

CASH REQUIREMENT FOR

WORKING CAPITAL

Step 1 : Estimate the cash cost of various current assets

required by the firm.

Step 2 : Deduct the spontaneous current liabilities from

the cash cost of current assets

SUMMING UP

• Current assets have a short life span and are swiftly transformed into other asset forms.

• The working capital needs of a firm are influenced by numerous factors : nature of business, seasonality of operations, production policy, market conditions, and supply conditions.

• Determining the optimal level of current assets involves a tradeoff between carrying costs and shortage costs.

• According to the matching, the maturity of the sources of finance should match the maturity of assets being financed.

• The operating cycle of a firm begins with the acquisition of raw materials and ends with the collection of receivables.

• The cash requirement of working capital is calculated by estimating the cash cost of various current assets required by the firm and deducting the spontaneous current liabilities from the cash cost of current assets.