Chapter 26

WORKING CAPITAL
MANAGEMENT

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 OUTLINE

• Characteristics of Current Assets

• Factors Influencing Working Capital Requirements

• Level of Current Assets

• Current Assets Financing Policy

• Profit Criterion for Current Assets

• Operating Cycle Analysis

• Cash Requirement for Working Capital

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 CHARACTERISTICS OF CURRENT ASSETS
• Short life span
• Swift transformation into other asset forms

Current Assets Cycle

Finished
goods

Accounts Work-in-
receivable process
Wages, salaries,
factory overheads
Raw materials

Cash Suppliers

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 FACTORS INFLUENCING WORKING
CAPITAL REQUIREMENTS

• Nature of Business

• Seasonality of Operations

• Production Policy

• Market Conditions

• Conditions of Supply

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 WORKING CAPITAL POLICY

Two important issues in working capital policy are:

• What should be the level of investment in current

assets?

• What mix of long-term and short-term financing should

the firm employ to support current assets?

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 LEVEL OF CURRENT ASSETS
Flexible Restrictive
(Conservative) (Aggressive)
Policy Policy
Liquidity High Low
Inventories Large Small
Debtors High Low

A flexible policy results in fewer production stoppages, ensures

quicker deliveries to customers, and stimulates sales .. but
HIGHER INVESTMENT IN CURRENT ASSETS

A restrictive policy leads to more production stoppages, delayed

deliveries to customers, and lost sales … but
LOWER INVESTMENT IN CURRENT ASSETS
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CAPITAL REQUIREMENTS
AND THEIR FINANCING
Fluctuating current
asset requirement

Capital
requirements
A

C Permanent current
asset-requirement

Fixed asset
requirement

Time

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 CURRENT ASSETS FINANCING
POLICY

According to the maturity principle, fixed assets and

permanent current assets should be supported by long-

term sources of finance whereas fluctuating current assets

must be supported by short-term sources of finance.

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 PROFIT CRITERION FOR
WORKING CAPITAL

• Investment in current assets is easily reversible.

• For reversible investments, the criterion of net profit per

period (which here means residual income) is equivalent

to the criterion of net present value

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 OPERATING CYCLE AND CASH CYCLE
Order placed Stock arrives Goods sold Cash received

Inventory period Accounts

receivable period

Accounts
payable period

Firm receives Cash paid for

invoice materials
Operating cycle

Cash cycle
Average inventory
Inventory period =
Average COGS / 365
Average accounts receivable
Accounts receivable period =
Annual sales / 365
Average accounts payable
Average payable period =
Average COGS / 365

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 ILLUSTRATION
Financial Information for Horizon Limited
Balance Sheet Data
Profit and Loss Beginning of End of
Account Data 20X0 20X0
Sales 800 Inventory 96 102
Cost of goods 720 Account receivable 86 90
Sold Accounts payable 56 60

(96 + 102) / 2
Inventory period = = 50.1 days
720 / 365

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 (86 + 90) / 2
Accounts receivable period = = 40.2 days
800 / 365

(56 + 60) / 2
Accounts payable period = = 29.4 days
720 / 365
 
Operating cycle = 50.1 + 40.2 = 90.3 days
Inventory Accounts
period receivable
period

Cash cycle = 90.3 - 29.4 = 60.9 days

Operating Accounts
cycle payable period

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 CASH REQUIREMENT FOR
WORKING CAPITAL

Step 1 : Estimate the cash cost of various current assets

required by the firm.

Step 2 : Deduct the spontaneous current liabilities from

the cash cost of current assets

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 SUMMING UP
• Current assets have a short life span and are swiftly
transformed into other asset forms.
• The working capital needs of a firm are influenced by
numerous factors : nature of business, seasonality of
operations, production policy, market conditions, and
supply conditions.
• Determining the optimal level of current assets involves
a tradeoff between carrying costs and shortage costs.
• According to the matching, the maturity of the
sources of finance should match the maturity of assets
being financed.
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• The operating cycle of a firm begins with the acquisition
of raw materials and ends with the collection of
receivables.
• The cash requirement of working capital is calculated by
estimating the cash cost of various current assets
required by the firm and deducting the spontaneous
current liabilities from the cash cost of current assets.

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