Throughout all the previous texts in my bookboon series (referenced at the end of this Chapter) we defined Strategic Financial Management in terms of two inter-related policies:
The determination of a maximum net cash inflow from investment opportunities at an acceptable level of risk, underpinned by the acquisition of funds required to support this activity at minimum cost.
You will also recall that if management employ capital budgeting techniques, which maximise the expected net present value (NPV) of all a company's investment projects, these inter-related policies should conform to the normative objective of business finance, namely, the maximisation of shareholders wealth.
Having dealt comprehensively with the pivotal role of capital budgeting and fixed asset formation elsewhere in the "Strategic Financial Management" texts of the bookboon series, the initial purpose of this study is to focus on current asset investment and the strategic importance of working capital management. Not only do current assets comprise more than 50 per cent of many firms' total asset structure, but their financing is also an integral part of project appraisal that is frequently overlooked.
We shall then explain why the "terms of sale" (credit terms) offered to customers determine a company's sales turnover and hence the debtor, inventory and cash balances, which define its working capital requirements. Properly conceived, debtor (accounts receivable) policies should underpin the profitability of fixed asset formation, without straining liquidity or compromising a firm's future plans.
Comprehensive, yet concise, all the material is presented logically as a guide to further study, using the time- honored approach adopted throughout all my bookboon series. Each Chapter begins with theory, followed by its application and an appropriate critique. From Chapter to Chapter, summaries of the text so far are presented to reinforce the major points. Each Chapter also contains Activities (with indicative solutions) to test understanding at your own pace.
Objectives of the Text
The text assumes that you have prior knowledge of Financial Accounting and an ability to interpret corporate financial statements using ratio analysis. So, at the outset, you should be familiar with the following glossary of terms:
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.
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) and cash or near cash (such as short term loans 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 and tax payable.
On completion of this text you should be able to:
- Distinguish between the internal working capital management function and an external interpretation of a firm's working capital position revealed by its published accounts,
- Calculate the working capital operating cycle and financing cycle from published accounting data and analyse the inter-relationships between the two,
- Define the dynamics of a company's credit-related funds system,
- Explain how the terms of sale, which comprise the credit period, cash discount and discount period, affect the demand for a firm's goods and services,
- Understand the impact of alternative credit policies on the revenues and costs which are associated with a capital budgeting decision,
- Appreciate the disparities between the theory and practice of working capital management, given our normative wealth maximisation assumption.