Outline of the Text
The remainder of our study is divided into three sections.
Part Two begins by explaining the relationship between working capital management and financial strategy. You are reminded that the normative objective of financial management is the maximisation of the expected net present value (NPV) of all a company's investment projects. Because working capital is an integral part of project appraisal, we shall define it within this context.
We then reveal why the traditional accounting concept of working capital is of limited use to the financial manager. The long-standing rule that a firm should strive to maintain a 2:1 ratio of current assets to current liabilities is questioned. Using illustrative examples and Activities you will be able to confirm that:
- Efficient working capital management should be guided by cash profitability, which may conflict with accounting definitions of solvency and liquidity developed by external users of published financial statements,
- An optimal working capital structure may depart from accounting conventions by reflecting a balance of credit-related cash flows, which are unique to a particular company.
Part Three initially considers how the terms of sale offered by a company to its customers is a form of price competition, which can influence the demand for its goods and services. We shall begin by using the time value of money concept within a framework of "effective prices" to explain how the availability of credit periods and cash discounts for prompt payment provide customers with reductions in their cash price.
Items bought on credit will be shown to create a utility in excess of their eventual purchase price measured by the debtors' opportunity to utilize this amount during the credit period, or discount period. By conferring enhanced purchasing power upon its customers, a company's terms of sale will be seen to have true "marketing" significance. They represent an aspect of financial strategy, whereby the creditor firm can translate potential demand into actual demand and increase future profitability. Your Activities will confirm this.
For the provider of goods and services (the creditor firm) we then explain why the availability of trade credit is not without cost:
- Invoiced payments for accounts receivable, which are deferred or discounted, represent a claim to cash that has a value inversely related to the time period in which it is received,
- Credit policies are a key determinant of the structure, amount and duration of a firm's total working capital commitment tied to its price-demand function,
- Alternative credit policies, therefore, produce different levels of profit.
So, when a firm decides to sell on credit, or revise credit policy variables, it should ensure that the incremental benefits from any additional investment exceed the marginal costs.
Part Four challenges the extent to which companies adhere to standard industry terms based on empirical evidence. Given our critique of conventional working capital analysis compared to a time-honored theoretical framework for analysing effective prices associated with different credit terms.
- Typical cash discounts confer unnecessary benefits on cash customers,
- Non-discounting customers often remit payment beyond the permitted credit period,
- Standard industry terms produce a sub-optimal investment in working capital, which do not make an efficient contribution to profit.
Having applied different credit policy variables to practical illustrations throughout the text to evaluate why adhering to existing terms or setting terms equal to those of competitors can fail to maximise the combined profit on output sold and the terms of sale extended to different classes of customer, we shall draw the following conclusion:
If a company is unique with respect to its revenue function, cost function, access to the capital market and customer clientele, it is possible to prove mathematically, that its optimal debtor policy will be unique. And so too, will be its net investment in working capital.
Because it is a theme that we shall develop throughout the text, using your previous knowledge of published company financial statements:
Briefly explain the overall limitations of a Balance Sheet as a basis for analysing the data it contains.
Balance Sheets only show a company's position on a certain date. Moreover, each represents a "snapshot" that is also several months old by the time it is published. For these reasons, they are a record of the past, which should not be regarded as a reliable guide to current activity, let alone the future. For this we need to turn to stock market analysis, press and media comment.
Moreover, a Balance Sheet does not even provide a true picture of the past. It shows historically, how much money was spent (equity, debt and reserves) but not whether it has been spent wisely.
Fixed assets recorded at "cost" do not give any indication of their current realizable value, nor their future worth in terms of income earning potential.
Working capital data may be equally misleading. Stocks, debtors, cash, creditors, loans and overdrafts may change considerably over a short period.
Finally, a Balance Sheet reveals little about market conditions, the true value of goodwill, brand names, intellectual property, or the quality of management and the workforce.
Summary and Conclusions
In reality we all understand that firms pursue a variety of objectives, which widen the neo-classical profit motive to embrace different goals and different methods of operation. Some of these dispense with the assumption that firms maximise anything, particularly in an overcrowded, small company sector. Invariably, even where objectives exist, short term survival not only takes precedence over profit maximisation but also management's satisfying behavior. And in such circumstances, mimicking the sector's working capital structure and setting credit terms equal to competitors may be all that seems feasible.
Similarly, in the case of oligopolistic sectors, much larger firms may feel the need (or are forced) to react to the policy changes of major players. But here fear, rather than desperation, may be the incentive to adhere to over-arching working capital profiles and industry terms.
As we shall discover, therefore, for most firms across the global economy:
- Debtor policy still represents an institutionalized, supportive function of financial management, which may inhibit profitability and be suboptimal.
- As a corollary, the efficient management of working capital, which should determine optimum net investments in inventory, debtors and cash associated with the terms of sale, may be way off target.
- As a consequence, the derivation of anticipated net cash inflows associated with a firm's capital investments, which justifies the deployment of working capital, may fail to maximise shareholder wealth.
Hill, R.A., bookboon.com.
Strategic Financial Management, (SFM), 2008.
Strategic Financial Management: Exercises (SFME), 2009.
Portfolio Theory and Financial Analyses (PTFA), 2010.
Portfolio Theory and Financial Analyses: Exercises (PTFAE), 2010.
Corporate Valuation and Takeover, (CVT ), 2011.
Corporate Valuation and Takeover: Exercises (CVTE ), 2012.