Working Capital Policy An Overview

Introduction
Financial management of any business concern involves Management of long term Assets (Infrastructures)- Capital expenditure Budgeting Management of long term Funds- Capital Structure Decisions Management of short term Assets & Liabilities- Working capital management

Adequacy of Working Capital

of CA and CL Basic decision relating to liquidity of the company and payment of current assets. Factors of Conversion of CA into cash -Management of cash and marketable securities -Credit policy -Inventory management -Management of Fixed Assets
Level

Working Capital Policy

Working Capital policy refers to the firms policies on four sub issues: How much WC is used? The extent to which WC is supported by short vs. long term financing The nature/source of various short term financing used How is each component of WC is managed

3D Nature of Working Capital Management

Dimension I Profitability, Risk, & Liquidity

Dimensions of Working Capital

Liquidity versus Profitability- A Risk- Return Trade-off

Working

capital policy maintains and provide sufficient liquidity to the firm. The decision on how much working capital be maintained involves a trade-off i.e., having a large net working capital may reduce the liquidity-risk faced by the firm, but it can have a negative effect on the cash flows. Therefore, the net effect on the value of the firm should be used to determine the optimal amount of working capital.

Current Assets Investment Policy

Current Asset Investment Policy (Policy A) Relatively large amounts of cash, marketable securities, and inventories are carried; and a liberal credit policy results in a high level of receivables. Restricted Current Asset Investment Policy (Policy C) Holdings of cash, marketable securities, inventories, and receivables are constrained. Moderate Current Asset Investment Policy (Policy B) Between the relaxed and restricted policies.
Relaxed

Working Capital Issues

Optimal Amount (Level) of Current Assets Assumptions 50,000 maximum units of production Continuous production Three different policies for current asset levels are possible
Policy A Policy B Policy C Current Assets

ASSET LEVEL (Rs.) 0

25,000 OUTPUT (units)

50,000

Impact on Liquidity
Optimal Amount (Level) of Current Assets
Liquidity Analysis Policy Liquidity A High B Average C Low
Policy A ASSET LEVEL ($) Policy B Policy C Current Assets

Greater current asset levels generate more liquidity; all other factors held constant.

25,000 OUTPUT (units)

50,000

Impact on Expected Profitability

Optimal Amount (Level) of Current Assets
Return on Investment =
ASSET LEVEL (Rs.)

Net Profit Total Assets Let Current Assets = (Cash + Rec. + Inv.) Return on Investment = Net Profit Current Assets+ Fixed Assets

Policy A Policy B Policy C Current Assets

25,000 OUTPUT (units)

50,000

Impact on Expected Profitability

Optimal Amount (Level) of Current Assets Profitability Analysis Policy Profitability A Low B Average C High
As current asset levels decline, total assets will decline and the ROI will rise.
Policy A Policy B Policy C Current Assets

ASSET LEVEL (Rs.) 0

25,000 OUTPUT (units)

50,000

Impact on Risk
Optimal Amount (Level) of Current Assets
Decreasing

cash reduces the firms ability to meet its financial obligations. More risk! Stricter credit policies reduce receivables and possibly lose sales and customers. More risk! Lower inventory levels increase stockouts and lost sales. More risk!

ASSET LEVEL (Rs.)

Policy A Policy B Policy C Current Assets

25,000 OUTPUT (units)

50,000

Impact on Risk
Optimal Amount (Level) of Current Assets Risk Analysis Policy Risk A Low B Average C High
Risk increases as the level of current assets are reduced.
Policy A Policy B Policy C Current Assets

ASSET LEVEL (Rs.) 0

25,000 OUTPUT (units)

50,000

Summary of the Optimal Amount of Current Assets

SUMMARY OF OPTIMAL CURRENT ASSET ANALYSIS Policy Liquidity Profitability Risk A High Low Low B Average Average Average C Low High High
1. Profitability varies inversely with liquidity. 2. Profitability moves together with risk. (risk and return go hand in hand!)

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