The Objectives of Working Capital Management
The internal management of working capital can be distinguished from the capital budgeting decision that it underpins by:
a) The Production Cycle
Unlike fixed asset investment, the working capital planning horizon, which defines the cyclical conversion of raw material inventory to the eventual receipt of cash from its sale, can be measured in months rather than years. Working capital can also be increased by smaller physical and monetary units. Such divisibility has the advantage that average investment in current assets can be minimised, thereby reducing its associated costs and risk.
b) The Financing Cycle
Because the finance supporting working capital input (its conversion to output and the receipt of cash) can also be measured in months, management's funding of inventory, debtors and precautionary cash balances is equally flexible. Unlike fixed asset formation, where financial prudence dictates the use of long-term sources of finance wherever possible, working capital cycles may be supported by the long and short ends of the capital market. Finance can also be acquired piecemeal. Consequently, greater scope exists for the minimisation of capital costs associated with current asset investments.
Despite these differences arising from the time horizons of capital budgeting and working capital management, it is important to realize that the two functions should never conflict. Remember that the unifying objective of financial management is the maximisation of shareholders wealth, evidenced by an increase in a corporate share price. This follows logically from a combination of:
- Investment decisions, which identify and select investment opportunities that maximise anticipated net cash inflows in NPV terms,
- Finance decisions, which earmark potential funds sources required to sustain investments, evaluate the return expected by each and select the optimum mix which minimises their overall capital cost.
The inter-relationships between investment and financing decisions are summarized in Figure 2.1.
Figure 2.1: Corporate Financial Objectives
The diagram reveals that a company wishing to maximise its market price per share would not wish to employ funds unless their marginal yield at least matched the rate of return its investors can earn elsewhere. The efficient management of current assets and current liabilities within this framework therefore poses two fundamental problems for financial management:
- Given sales and cost considerations, a firm's optimum investments in inventory, debtors and cash balances must be specified.
- Given these amounts, a least-cost combination of finance must be obtained.
The Structure of Working Capital
Ultimately, the purpose of working capital management is to ensure that the operational cash transactions to support the demand for a firm's products and services actually take place. These define a firm's working capital structure at any point in time, which is summarized in Figure 2.2 below. We shall refer to aspects of this diagram several times throughout the text, but for the moment, it is important to note the three square boxes and two dotted arrows.
- The cash balance at the centre of the diagram represents the total amount available on any particular day.
- This will be depleted by purchases of inventory, plus employee remuneration and overheads, which are required to support production.
- The receipt of money from sales to customers will replenish it.
- A cash deficit will require borrowing facilities.
- Any cash surplus can be retained for reinvestment, placed on deposit or withdrawn from the business.
Figure 2.2: The Structure and Flow of Working Capital
If the cycle of events that defines the conversion of raw materials to cash was instantaneous, there would never be a cash surplus (or deficit) providing the value of sales matched their operational outlays, plus any allowances for capital expenditure, interest paid, taxation and dividends. For most firms, however, this cycle is interrupted as shown by the circles in the diagram.
On the demand side, we can identify two factors that affect cash transactions adversely. Unless the firm requires cash on delivery (COD) or operates on a cash and carry basis, customers who do not pay immediately represent a claim to cash from sales, which have already taken place. These define the level of debtors outstanding at a particular point in time. Similarly, stock purchases that are not sold immediately represent a claim to cash from sales, which have yet to occur. For wholesale, retail and service organizations these represent finished goods. For a manufacturing company there will also be raw materials and items of inventory at various stages of production, which define work in progress.
On the supply side, these interruptions to cash flow may be offset by delaying payment for stocks already committed to the productive process. This is represented by creditors. The net effect on any particular day may be a cash surplus, deficit or zero balance.
- Surpluses may be invested or distributed, deficits will require financing and zero balances may require supplementing.
Thus, we can conclude that a firm's working capital structure is defined by its forecast of overall cash requirements, which relate to:
- Debtor management
- Methods of inventory (stock) control
- Availability of trade credit
- Working capital finance
- Re-investment of short-term cash surpluses.
In fact, if you open any management accounting text on the subject you will find that it invariably begins with the preparation of a cash budget. This forecasts a firm's appetite for cash concerning the period under review, so that action can be planned to deal with all eventualities. The conventional role of the financial manager is then to minimise cash holdings consistent with the firm's needs, since idle cash is unprofitable cash.
You will recall from your accounting studies that the cash budget is an amalgamation of information from a variety of sources. It reveals the expected cash flows relating to the operating budget, (sales minus purchases and expenses), the capital budget, interest, tax and dividends. Long or short term, the motivation for holding cash is threefold.
- The transaction motive ensures sufficient cash to meet known liabilities as they fall due.
- The precautionary motive, based on a managerial assessment of the likelihood of uncertain events occurring.
- The speculative motive, which identifies opportunities to utilize cash temporarily in excess of requirements.
Given sales and cost considerations, the minimum cash balances required to support production are therefore identified. Within the context of working capital these depend upon the control of stocks, debtors and creditors, plus opportunities for reinvestment and borrowing requirements.
Again using your knowledge from previous accounting studies, it would be useful prior to Chapter Three if you could:
a) Define a company's working capital and its minimum working capital position.
b) Explain how external users of published accounts interpret the working capital data contained in corporate annual statements using conventional ratio analysis based on solvency and liquidity criteria.
We shall then use this material as a basis for further discussion.
Summary and Conclusions
Having surveyed the management of working capital management and the pivotal role of cash budgeting, we have observed that most textbooks covering the subject then proceed to analyse its component parts individually. Invariably they begin with inventory (stock) control decisions, before moving on to debtors, creditors and short-term finance, including the reinvestment of cash surpluses. Your conclusion might well be that "real world" working capital management is also divisible and therefore less problematical than any other finance function.
On both counts this is a delusion. For the purposes of simplicity, illustrations of working capital and investments in current assets and liabilities throughout the literature tend to regard market conditions, demand and hence sales and cost considerations as given. Unfortunately, this is tantamount to trading within a closed environment, oblivious to the outside world. Yet, we all know that business is a dynamic process, susceptible to change, which is forged by a continual search for new external investment opportunities. So, there is no point in companies holding more cash and inventory, or borrowing, if the aim is not to increase sales. And even then, the only reason to increase sales is to enhance cash profitability through new investment.
Thus, the key to understanding the structure and efficient management of working capital does not begin with a cash budget followed up by inventory control and a sequential analysis of other working capital items. On the contrary, like all other managerial functions, it should be prefaced by an appreciation of how the demand for a company's goods and services designed to maximise corporate wealth is created in the first place. And as we shall discover in future Chapter's from a working capital perspective, the strategic contributory factor relates to debtor policy, namely:
How the terms of sale offered by a company to its customers can influence demand and increase turnover to produce maximum profit at minimum cost.
1. Hill, R.A., bookboon.com.
Strategic Financial Management, (SFM), 2008.
Strategic Financial Management: Exercises (SFME), 2009.