Working Capital Management

Moving from the general to the particular, if you are also acquainted with any of my working capital and strategic debtor management Theory and Business texts referenced at the end of this Chapter (2013) you will appreciate that once a project is up and running, companies must ensure that their periodic financial requirements, relative to short-term cash inflows (working capital) still satisfy overall wealth maximization criteria. Within the framework of investment and finance summarized in Figure 1.3, the efficient management of current assets and current liabilities therefore, poses two fundamental problems for financial management:

o Given sales and cost considerations, a firm's optimum investments in inventory, debtors and cash balances must be specified.

o Given these amounts, a least-cost combination of finance must be obtained.

Explained simply, using our earlier analogy:

Capital budgeting is the engine that drives the firm. But working capital management provides the fuel that moves it foreword.

You should also be familiar with the following glossary of terms, their interpretation and implications for financial management.

Working capital: a company's surplus of current assets over current liabilities, which measures the extent to which it can finance any increase in turnover from other fund sources. In other words, it represents the capital available for conducting its day to day operations.

Current assets: items held by a company with the objective of converting them into cash within the near future. The most important items are debtors or account receivable balances (money due from customers), inventory (stocks of raw materials, work in progress and finished goods), cash and "near" cash (such as short term investments and tax reserve certificates).

Current liabilities: short term sources of finance, which are liable to fluctuation, such as trade creditors (accounts payable) from suppliers, bank overdrafts, loans and tax payable.

If working capital, as defined, exceeds net current operating assets (stocks plus debtors, less creditors) the company has a cash surplus, represented by cash or near cash. If the reverse holds, it has a cash deficit, represented by overdrafts, loans and tax payable. Thus, the strategic management of working capital can be conveniently subdivided into the control of stocks, debtors, cash and creditors.

Referring back to Figure 1:2 (Corporate Economic Performance, Winners and Losers), from a working capital perspective companies must generate sufficient cash to meet their immediate obligations, or cease trading altogether. Cyclically, unprofitable firms may continue if they can borrow temporarily until conditions improve. But otherwise, without access to sufficient liquid resources they will remain technically insolvent and eventually fail. Working capital is therefore essential to a company's long term economic survival. For this reason, conventional accounting wisdom dictates that the more current assets "cover" current liabilities (particularly cash or near cash, rather than inventory) the more solvent the company. In other words, the greater the degree to which it can meet its short term obligations as they fall due.

However, you will also recall from my previous texts on the subject, that this conventional definition of working capital is a static Balance Sheet concept. It only defines an excess of permanent capital (equity and debt) plus long-term liabilities over the fixed assets of the company at one point in time. This "snapshot" may bear no relation to a company's dynamic cash flow position, which fluctuates over time. Moreover, it depends on generally accepted accounting principles (GAAP) based on accruals and prepayments, such as definitions of capital, revenue, profit (including retentions), when revenue should be recognized and the distinction between the long and short term, typically twelve months from the date the Balance Sheet is "struck" for published financial statements.

For these reasons, the Exercises throughout this study:

Subscribe to a more flexible definition of working capital and its interpretation, namely an investment in current assets irrespective of their financing source.

Reject the accounting conventions with which you may be familiar, that firms should strive to maintain a short term 2:1 working capital (solvency) ratio of current assets to current liabilities, underpinned by a 1:1 "quick" asset (liquidity) ratio of debtors plus cash to current liabilities. Both policies are invariably sub-optimal as normative wealth maximization criteria

Accept that management's strategic objective should be to minimize current assets and maximize current liabilities compatible with their liquidity (debt paying ability) based upon future cash profitability.

These points were proven in the previous texts by reference to the interrelationship between a firm's short-term operating and financing cycles in an ideal world, whereby:

Inventory is purchased on credit using "just in time" (JIT) inventory control techniques. Finished goods are sold for cash on delivery (COD).

Cash surpluses do not lie idle, but are reinvested or distributed as a dividend. So that:

The operating cycle (conversion of raw material to cash and its reinvestment or distribution) is shorter than the financing cycle (creditor turnover).

As a consequence, current liabilities may exceed current assets without any threat of insolvency.

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