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Working Capital Management

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I.  What is Working Capital?

A.  Working capital refers to the firm's current assets while net working capital refers to current assets less current liabilities.   Current Ratio and Quick Ratio both attempt to measure a firm's liquidity and management of working capital.

 

B.  Current Assets

       Current Assets Accounts - Cash, Marketable Securities (short-term investments), Accounts Receivable, and Inventory

       Risk-Return Trade-off of Current Asset Investment - having lots of cash, marketable securities, inventory, and a generous accounts receivable terms makes the company very “safe” but all of these assets earn very low rates of return compared to investing in long-term assets. 

 

C.  Current Liabilities

       Current Liability Accounts - Accruals, Accounts Payable, Notes Payable, and Commercial Paper

       Risk- Return Trade-off of Short-term Debt versus Long-term Debt (p. 615-616) - using short-term financing over long-term financing has advantages and disadvantages.  The three advantages are speed (short-term loans can be arranged quicker than long-term loans), flexibility (short-term loans usually have fewer restrictions than long-term loans), and interest rates are less (short-term rates are typically lower than long-term rates).  The main disadvantage of using short-term debt as a more permanent source of financing is the unstable interest expense.  Short-term interest rates fluctuate a great deal compared to long-term interest rates.  During periods of tight credit markets, there may be increased risk of default if a firm has a heavy reliance upon short-term debt.

 

 

II.  Working Capital Policy

A.  Working Capital Policy

A firm’s working capital policy has two components:

1.  policies regarding the appropriate level of current assets (Current Asset Investment Policy)

2.  policies regarding the use of short-term financing (Current Asset Financing Policy)

 

B.  Alternative Current Asset Investment Policies (p. 573)

These policies are general strategies that firms may follow with regard to their overall level of current assets investment or holdings.

 

1.  Relaxed Current Asset Investment Policy - relatively large amounts of cash, marketable securities and inventories are carried and sales are stimulated by a liberal (generous) trade credit policy resulting in high levels of receivables.  This is a low risk strategy because the firm always has plenty of cash and inventory on hand.  The return is low because more money is invested in low yielding assets.

 

2.  Restricted Current Asset Investment Policy - holdings of cash securities, inventories, and receivables are minimized.  This is a high risk strategy because the firm tries to keep the bare minimum of cash and inventory.  The potential return is high because less money is invested in low yielding assets.

 

3.  Moderate Current Asset Policy - balance between relaxed and restricted current asset investment policies (moderate risk - moderate potential return).

 

C.  Alternative Current Asset Financing Policies (p. 612-614)

These policies are general strategies that firms may follow with regard to how current assets are to be financed.  Current assets can be classified as permanent or temporary.  Permanent current assets are the current assets that the company needs to maintain throughout the entire year.  Temporary current assets are those that are due to seasonal fluctuations.  With respect to the current asset financing policy, the question is how will the permanent current assets and temporary current assets be financed (long-term or short-term financing).

 

1.  Moderate (Maturity Matching or Self-Liquidating) Approach - the maturity of the firm's assets is matched with the maturity of the firm's liabilities.  This means that all long-term assets including the permanent level of current assets are financed with long-term sources of financing.  Temporary current assets are financed with short-term debt.

 

2.  Aggressive Approach - the firm uses some short-term debt to finance some of its permanent level of current assets, which means the firm must raise even more short-term debt during seasonal fluctuations.  The firm is "rolling over" short-term and using it more as a permanent source of financing.  This is considered a risky approach with high potential for return (see risk-return trade-off of short-term liabilities).

 

3.  Conservative Approach - the firm uses long-term financing for all of its long-term assets, permanent current assets, and even some of it temporary current assets.  The firm has periods of excess liquidity (cash) where the firm invests in marketable securities but relies less on short-term debt during seasonal fluctuations.  This is considered a low risk approach with low return potential.

 

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