The Accounting Concept of Working Capital Management: A Critique
All companies require working capital. But the actual amount will depend on many economic factors that may be unique to each. Certainly, there is no standard requirement that firms should maintain solvency and liquidity ratios of 2:1 and 1:1 respectively. Think manufacturing relative to retailing, or even different types of retailing. All we can say financially is that for a given level of activity, an optimum level of investment is budgeted for.
For example, consider a trading company that receives all customer orders for cash, (say over the Internet). Having added a mark-up, it then purchases these items at cost from a wholesaler on credit using "just in time" (JIT) inventory control techniques. The company need hold no current assets, apart from periodic cash balances to satisfy its supplier's invoices when they fall due. From a Balance Sheet perspective, the company's total current liabilities may far exceed its current assets. Yet, contrary to accounting convention, at no point in time is it technically insolvent.
As we illustrated in Chapter One, this simple example "benchmarks" an ideal relationship between a particular firm's short-term operating (investment) and financing (funds) cycles as a guide to efficient working capital management. To extend the analogy:
Whether a company "trades" or "manufactures", buys and sells on a cash or credit basis, it should only hold minimum levels of inventory, debtors and precautionary cash balances to meet anticipated demand and satisfy its future debt paying ability. Hopefully, this is defined by the following inequality.
Operating cycles (conversion of raw material to cash) < Financing cycles (creditor turnover)
The question now is how to define this inequality more precisely, given a company's attitude towards risk under conditions of uncertainty.
Exercise 3.1: Working Capital Investment and Risk
Efficient working capital management is determined by an optimal trade-off between liquidity and profitability to create wealth. Inefficient management ties up finance in excess or idle current assets, which not only reduces liquidity but also limits investment in long term assets and therefore future profitability. Following this line of logic we have observed that a company's working capital policy should therefore be a function of two inter-related decisions.
o Investment, which identifies and selects a minimum (optimum) portfolio mix of current assets for a predetermined level of uncertain future demand.
o Finance, which identifies potential fund sources (equity and debt, long or short) required to sustain investments and the risk-adjusted return expected by each. An optimum combination is then selected to minimize the overall cost of borrowing, defined by the weighted average cost of capital (WACC).
Leaving aside the finance decision until the next Exercise, let us focus on the structure of current asset investment. Under conditions of uncertainty, all companies must hold minimum levels of inventory and cash, including precautionary balances to satisfy variations in demand. For creditor firms, the level of debtors (accounts receivable) will also be dictated by their terms of sale. But how do individual company attitudes towards risk determine these policy variables?
Given different attitudes towards risk (preference, aversion and neutrality) compare and contrast a company's investment in current assets
An Indicative Outline Solution
From a corporate policy perspective, we can define risk preference, aversion and neutrality in terms of aggression, conservatism and moderation.
An aggressive working capital policy is characterized by minimal levels of inventory and precautionary cash balances. Such a policy would minimize costs. However, it could inhibit sales and hence anticipated revenue and returns because the company might not be able to respond to fluctuations in demand.
Conversely, a conservative policy requires higher levels of inventory and cash to counteract risk. So, it may generate lower expected returns than an aggressive strategy.
A moderate working capital policy (neutrality) obviously resides somewhere between risk preference and aversion, relative to the expected returns it delivers.
Perhaps you have noticed that so far nothing has been said about debtor (account receivables) policies. This is because there is a fundamental difference between the previous treatment of inventory and cash balances and the level of debtors, which further explains why the latter underpinned by a company's "terms of sale" determine the efficient management of working capital management.
For example, conservative, high levels of stock and cash imply security. But there is no such thing as a "secure" level of debtors. A high level of debtors could mean that a company has relaxed its terms of sale without any increase in demand. Alternatively, its collection procedures may have become more ineffectual.
Whatever the truth of the matter, to summarize our position so far:
If we characterize an aggressive working capital policy as risky, then a reduction in inventory and cash balances would be aggressive but an increase in the level of debtors would also be aggressive.