Working Capital Management

The Objectives and Structure of Working Capital Management

Introduction

For those familiar with my bookboon series, we have consistently defined the normative objective of financial management as the determination of a maximum inflow of project cash flows commensurate with an acceptable level of risk. We have also assumed that the funds required to support acceptable investment opportunities should be acquired at minimum cost. You will recall that in combination, these two policies conform to the normative objective of business finance, namely, shareholders wealth maximisation.

As we first observed in Chapter Two (Section 2.1) of "Strategic Financial Management" (SFM 2008) any analyses of investment decisions can also be conveniently subdivided into two categories: long-term (strategic) and short-term (operational).

The former might be unique, irreversible, invariably involve significant financial outlay but uncertain future gains. Without sophisticated forecasts of periodic cash outflows and returns, using capital budgeting techniques that incorporate the time value of money and a formal treatment of risk, the financial penalty for error can be severe.

Conversely, operational decisions tend to be divisible, repetitious and may be reversible. Within the context of capital investment they are the province of working capital management, which lubricates a project once it is accepted.

You should also remember, from your accounting studies (confirmed by the previous Chapter) that from an external user's perspective of periodic published financial statements:

Working capital is conventionally defined as a firm's current assets minus current liabilities on the date that a Balance Sheet is drawn up.

Respectively, current assets and current liabilities are assumed to represent those assets that are soon to be converted into cash and those liabilities that are soon to be repaid within the next financial period (usually a year).

From an internal financial management stance, however, these definitions are too simplistic.

Working capital represents a firm's net investment in current assets required to support its day to day activities.

Working capital arises because of the disparities between the cash inflows and cash outflows created by the supply and demand for the physical inputs and outputs of the firm.

For example, a company will usually pay for productive inputs before it receives cash from the subsequent sale of output. Similarly, a company is likely to hold stocks of inventory input and output to solve any problems of erratic supply and unanticipated demand.

For the technical purpose of investment appraisal management therefore incorporate initial working capital into NPV project analysis as a cash outflow in year zero. It is then adjusted in subsequent years for the net investment required to finance inventory, debtors and precautionary cash balances, less creditors, caused by the acceptance of a project. At the end of the project's life, funds still tied up in working capital are released for use, elsewhere in the business. This amount is treated as a cash inflow in the last year, or thereafter, when available.

The net effect of these adjustments is to charge the project with the interest foregone, i.e. the opportunity cost of the funds that were invested throughout its entire life. All of which is a significant departure from the conventional interpretation of published accounts by external users, based on the accrual concepts of Financial Accounting and generally accepted accounting principles (GAPP) which we shall explore later (and which you should be familiar with).

Activity 1

If you are unsure about the treatment of a project's working capital using discounted cash flow (DCF) analyses, you should read the following chapters from my bookboon series:

a) Chapter Two (Section 2.1) "Strategic Financial Management" (SFM2008).

b) Chapter Three "Strategic Financial Management: Exercises" (SFME2009) and work through the Review Activity.

 
< Prev   CONTENTS   Next >