Working Capital

Management

8-1

Working Capital Concepts

Net Working Capital
Current Assets - Current Liabilities

Gross Working Capital

The firms investment in current assets

Working Capital Management

The administration of the firms current assets and
the financing needed to support current assets
8-2

Significance of Working
Capital Management

8-3

In a typical manufacturing firm, current

assets exceed one-half of total assets
Excessive levels can result in a substandard
Return on Investment (ROI)
Current liabilities are the principal source of
external financing for small firms
Requires continuous, day-to-day managerial
supervision
Working capital management affects the
companys risk, return, and share price

Working Capital Issues

Optimal Amount (Level) of Current Assets

8-4

Policy A

ASSET LEVEL (Rs.)

Assumptions
50,000
maximum
units of production
Continuous
production
Three
different
policies for current
asset levels are
possible

Policy B
Policy C

Current Assets

25,000
OUTPUT (units)

50,000

Impact on Liquidity
Optimal Amount (Level) of Current Assets

Greater current asset

levels generate more
liquidity;
all
other
factors held constant.
8-5

Policy A

ASSET LEVEL (Rs.)

Liquidity Analysis
Policy
Liquidity
A
High
B
Average
C
Low

Policy B
Policy C

Current Assets

25,000
OUTPUT (units)

50,000

Impact on
Expected Profitability
Optimal Amount (Level) of Current Assets
Return on Investment =

Let Current Assets =

(Cash + Rec. + Inv.)
Return on Investment =
Net Profit
Current + Fixed Assets
8-6

Policy A

ASSET LEVEL (Rs.)

Net Profit
Total Assets

Policy B
Policy C

Current Assets

25,000
OUTPUT (units)

50,000

Impact on
Expected Profitability
Optimal Amount (Level) of Current Assets

As current asset levels

decline, total assets will
decline and the ROI will
rise.
8-7

Policy A

ASSET LEVEL (Rs.)

Profitability Analysis
Policy
ROI
A
Low
B
Average
C
High

Policy B
Policy C

Current Assets

25,000
OUTPUT (units)

50,000

Impact on Risk
Optimal Amount (Level) of Current Assets

8-8

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!

Policy A

ASSET LEVEL (Rs.)

Policy B
Policy C

Current Assets

25,000
OUTPUT (units)

50,000

Impact on Risk
Optimal Amount (Level) of Current Assets

Risk increases as the

level of current assets
are reduced.
8-9

Policy A

ASSET LEVEL (Rs.)

Risk Analysis
Policy
Risk
A
Low
B
Average
C
High

Policy B
Policy C

Current Assets

25,000
OUTPUT (units)

50,000

Summary of the Optimal

Amount of Current Assets
SUMMARY OF OPTIMAL CURRENT ASSET ANALYSIS
Policy
A
B
C

Liquidity
High
Average
Low

ROI
Low
Average
High

Risk
Low
Average
High

1.ROI moves together with risk

(risk and return go hand in hand!)
2.ROI varies inversely with liquidity
8-10

Classifications of
Working Capital

Components

Cash, marketable securities,

receivables, and inventory
Time

8-11

Permanent

Temporary

Permanent
Working Capital

RUPEE AMOUNT

The amount of current assets required to

meet a firms long-term minimum needs

Permanent current assets

TIME
8-12

Temporary
Working Capital

RUPEE AMOUNT

The amount of current assets that varies

with seasonal requirements

Temporary current assets

Permanent current assets

TIME
8-13

Hedging (or Maturity

Matching) Approach
A method of financing where each asset would be offset with a
financing instrument of the same approximate maturity

RUPEE AMOUNT

Short-term financing**

Current assets*
Long-term financing
Fixed assets

TIME
8-14

Hedging (or Maturity

Matching) Approach

RUPEE AMOUNT

Short-term financing**

Current assets*
Long-term financing
Fixed assets

TIME
8-15

(Conservative Approach)

Long-Term Financing Benefits

Long-Term Financing Risks

Borrowing more than what is necessary

Borrowing at a higher overall cost (usually)

Result

8-16

Less worry in refinancing short-term obligations

Less uncertainty regarding future interest costs

Manager accepts less expected profits in exchange

for taking less risk

(Conservative Approach)
Firm can reduce risks associated with short-term borrowing by
using a larger proportion of long-term financing

RUPEE AMOUNT

Short-term financing

Current assets
Long-term financing
Fixed assets

TIME
8-17

Aggressive Approach

Short-Term Financing Benefits

Short-Term Financing Risks

Refinancing short-term obligations in the future

Uncertain future interest costs

Result

8-18

Borrowing only what is necessary

Manager accepts greater expected profits in

exchange for taking greater risk

(Aggressive Approach)
Firm increases risks associated with short-term borrowing by
using a larger proportion of short-term financing

RUPEE AMOUNT

Short-term financing

Current assets

Long-term financing
Fixed assets

TIME
8-19