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Working capital is a financial standard of measurement which depicts the operating liquidity available to a business. It is considered a part of operating capital in conjunction with fixed assets, like a plant and equipment. Adequate working capital is necessary to guarantee that a firm is able to continue its operations, that it has enough funds to pay off maturing short-term and long-term debts, as well as pay for impending operational expenses. However, too much working capital can bring a greater cost of capital.
EXAMPLE
A company may be enriched with assets and profitability but lack liquidity if those assets cannot be easily converted into cash.The management of working capital comprises administering inventories, accounts receivable, accounts payable, and cash.
When we calculate working capital, we are referring to net working capital, calculated as current assets minus current liabilities.
The resulting figure is widely used in valuation techniques like discounted cash flows. Now, if current assets are less than current liabilities, then this business or firm is said to have a working capital deficiency, also known as a working capital deficit.
Under the umbrella of current assets and current liabilities are three important accounts that represent the scope of the business where managers have the most explicit impact:
The current portion of debt is also critical because it represents a short-term claim to current assets and is often secured by long-term assets. Common types of short-term debt are bank loans and lines of credit.
Inventory is a special case in which even non-financial managers have a stake. Too much inventory on hand will reduce the risk of a company failing to satisfy customer needs, but it can also reduce profitability.
EXAMPLE
In the computer industry, an example of reduced profitability is where inventories regularly lose value because of the fast-moving nature of the industry.In any company, large or small, there is an inherent tradeoff between liquidity and profitability. Large companies possess resources to help them manage this tradeoff, such as an accounting department, negotiating power with their suppliers, or access to the capital markets. For the entrepreneur, however, who is often resource-starved and doesn’t have enough operating history to secure additional credit, managing this tradeoff can feel like walking a tightrope.
EXAMPLE
Consider the case of a new customer for a small company. This new customer has the potential to offer huge growth in the company’s sales, but this growth in sales will be accompanied by a subsequent growth in variable costs. The company may not have the resources (i.e., working capital) to meet these variable costs that come with increased sales.Recall that working capital is a calculation of the overall operating liquidity an organization has access to at a given moment, derived through a simple calculation from the balance sheet, where we subtract current liabilities from current assets.
While short-term planning is predominantly what is used in respect to working capital (due to the short-term nature of the inputs and outputs involved), it is reasonable to set long-term policies and strategies for incorporating changes in working capital into financial strategy. The primary benefits of leveraging working capital are liquidity and profitability, each of which can be viewed through a longer-term lens.
Working capital is the amount of capital that is readily available to an organization. Working capital is the difference between cash resources or assets readily convertible into cash (current assets) and cash obligations (current liabilities). As a result, the decisions relating to working capital are almost always current (i.e., short term) decisions. In other words, working capital management differs from capital investment decisions – specifically in terms of discounting and profitability.
Working capital management applies different criteria in decision making. The main considerations are cash flow/liquidity and profitability/returns on capital. The most widely used measure of cash flow is the net operating cycle or cash conversion cycle, a metric that shows the length of time a business will lack cash, in the event it diverts investment dollars into resources to bolster customer sales.
The cash conversion cycle indicates the firm’s ability to convert its resources into cash and informs management of the liquidity risk entailed by growth. Because this number effectively corresponds to the time that the firm’s cash is tied up in operations and unavailable for other activities, management generally aims at shortening the cash conversion cycle as much as possible.
However, there are risks involved in shortening the cycle. It is possible that a firm could attain a negative cash conversion by securing payment from customers before paying suppliers, but such a tactic of enforced collections and slack payments is not generally viable long-term.
The purpose of studying and calculating the cash conversion cycle is to modify the policies connected to credit purchase and credit sales. A firm can adjust its requirements for payment on credit purchases and obtaining payment from debtors based on the cash conversion cycle. If the firm is in a position of effective cash liquidity, it can continue its former credit policies.
A firm’s management uses an amalgam of policies and techniques to manage its working capital, steered by guidelines surrounding cash flow, liquidity, profitability, and return on capital. These policies purport to manage the current assets, which are typically cash and cash equivalents, inventories and debtors, and the short-term financing, in a manner that results in acceptable cash flows and returns. In keeping with any determination involving the management of capital, the goal of the firm should be to reduce the overall cost of capital to a minimum while raising the value to the shareholders to a maximum. To optimally manage cash flow, a firm should determine that cash balance that ensures the business can meet daily expenses, but that lessens cash holding costs, or the opportunity cost of holding cash versus investing it.
Businesses should determine the amount of inventory that enables continuous production but decreases the investment in raw materials and respective reordering costs, thereby resulting in increased cash flow. Businesses also need to address the concerning issue of managing debtors, by adopting the appropriate credit policy that ensures that any impact on cash flows and the cash conversion cycle will be counterbalanced by increased revenue and return on capital. In addition, management should put relevant credit scoring policies and techniques in place to ensure the risk of default on any new business is within an acceptable range.
Lastly, an area of concern for management to consider when choosing a working capital policy is short-time financing. It is imperative for a firm to determine the fitting source of financing, considering the cash conversion cycle. Ideally, inventory is financed by credit bestowed by the supplier, although in certain situations, it may be necessary to use a bank loan.
One of the objectives within working capital management and general financing decisions is to match the maturity of liabilities with the life expectancy of assets. This allows liabilities to be self-liquidating. If the maturity of liabilities is less than the life expectancy of assets, a firm faces refinancing risk since it will have to raise new capital to pay off liabilities. If the maturity of liabilities is longer than the life expectancy of assets, then there should be sufficient working capital available to pay off debts. The mismatching of liabilities with assets can occur if financing is not available.
EXAMPLE
Suppose long-term financing is not available. Short-term sources of financing may have to be used. Mismatching can also be intentional. A company could expect long-term interest rates to fall. The firm may want to finance assets with short-term maturities since it can refinance in a few years at a much lower rate.Source: THIS TUTORIAL HAS BEEN ADAPTED FROM "BOUNDLESS FINANCE" PROVIDED BY LUMEN LEARNING BOUNDLESS COURSES. ACCESS FOR FREE AT LUMEN LEARNING BOUNDLESS COURSES. LICENSED UNDER CREATIVE COMMONS ATTRIBUTION-SHAREALIKE 4.0 INTERNATIONAL.