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Working Capital Management

Chapter Two: Working Capital Management

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Defining Working Capital

The term working capital refers to the amount of capital which is readily available to an organisation. That is, working capital is the difference between resources in cash or readily convertible into cash (Current Assets) and organisational commitments for which cash will soon be required (Current Liabilities).

Current Assets are resources which are in cash or will soon be converted into cash in "the ordinary course of business".

Current Liabilities are commitments which will soon require cash settlement in "the ordinary course of business".

Thus:

WORKING CAPITAL = CURRENT ASSETS - CURRENT LIABILITIES

In a department's Statement of Financial Position, these components of working capital are reported under the following headings:

Current Assets

                         Liquid Assets (cash and bank deposits)

                         Inventory

                         Debtors and Receivables

Current Liabilities

                         Bank Overdraft

                         Creditors and Payables

                         Other Short Term Liabilities

The Importance of Good Working Capital Management

Working capital constitutes part of the Crown's investment in a department. Associated with this is an opportunity cost to the Crown. (Money invested in one area may "cost" opportunities for investment in other areas.) If a department is operating with more working capital than is necessary, this over-investment represents an unnecessary cost to the Crown.

From a department's point of view, excess working capital means operating inefficiencies. In addition, unnecessary working capital increases the amount of the capital charge which departments are required to meet from 1 July 1991.

Approaches to Working Capital Management

The objective of working capital management is to maintain the optimum balance of each of the working capital components. This includes making sure that funds are held as cash in bank deposits for as long as and in the largest amounts possible, thereby maximising the interest earned. However, such cash may more appropriately be "invested" in other assets or in reducing other liabilities.

Working capital management takes place on two levels:

                         Ratio analysis can be used to monitor overall trends in working capital and to identify areas requiring closer management (see Chapter Three).

                         The individual components of working capital can be effectively managed by using various techniques and strategies (see Chapter Four).

When considering these techniques and strategies, departments need to recognise that each department has a unique mix of working capital components. The emphasis that needs to be placed on each component varies according to department. For example, some departments have significant inventory levels; others have little if any inventory.

Furthermore, working capital management is not an end in itself. It is an integral part of the department's overall management. The needs of efficient working capital management must be considered in relation to other aspects of the department's financial and non-financial performance.

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