Working Capital Management

The key difference between long term financial management and short term financial management (also referred to as working capital management) is in terms of the timing of cash. While long term financial decisions like buying capital equipments or issuing debentures involve cash flows over an extended period of time (5 to 15 years, or even more) short term financial decisions typically involve cash flows within a year or within the operating cycle of the firm.

There are two concepts of working capital: gross working capital and net working capital. Gross working capital is the total of all current assets. The constituents of current assts are shown in Part A. Net working capital is the difference between current assets and current liabilities. The constituents of current liabilities are shown in Part B Management of working capital refers the management of current assets as well as current liabilities. The major thrust, of course is on the management of current asset. This is understandable because current liabilities arise in the context of current assets.

Working capital management is a significant facet of financial management. Its importance stems from two reasons:

1. Investment in current assets represents a substantial portion of total investment.
2. Investment in current assets and the level of current liabilities have to be geared quickly to changes in sales. To be sure, fixed asset investment and long term financing are also responsive to variation in sales. However, this relationship is not as immediate as it is in the case of working capital components.

Constituents of Current Assets and Current Liabilities

Part A: Current Assets

Raw materials and components
Work in process
Finished goods
Sundry debtors
Loans and advances
Cash and bank balances

Part B: Current Liabilities

Sundry creditors Trade advances
Borrowing (short term)
Commercial banks

This discusses various facets of working capital management. It is divided ten sections as follows:

1. Characteristics of current assets
2. Factors influencing working capital requirements
3. Working capital policy
4. Operating cycle and cash cycle
5. Cash requirements for working capital
6. Cash Management
7. Credit management
8. Inventory management
9. Management of payables and accruals
10. Ten commandments of working capital management

Characteristics of Current Assets:

In the management of working capital, two characteristics of current assets must be borne in mind: (1) short life span and (2) swift transformation to other asset forms. Current assets have a short life span. Cash balances may be held idle for a week or two, accounts receivable my have a life span of 30 to 120 days, and inventories may be held for 30 to 100 days. The life span of current assets depends upon the time required in the activities of procurement, production sales and collection and the degree of synchronization among them.

Each current asset is swiftly transformed into asset forms: cash is used for acquiring raw materials, raw materials are transformed into finished goods (this transformation may involve several stages of work in process) finished goods, generally sold on credit are converted into sundry debtors (accounts receivable); and finally sundry debtors on realizations generate cash.

The short life span of working capital components and their swift transformation from one form no another has certain implications:

1. Decisions relating to working capital management are repetitive and frequent.
2. The difference between profit and present value is insignificant.
3. The close interaction among working capital components implies that efficient management of one component implies that efficient management of one component cannot be undertaken without simultaneous consideration of other components. For example, if the firm has a large accumulation of finished foods inventory, it may have to provide more liberal credit terms or show laxity in credit collection. Another example: If the firm has a cash crunch, it may have to offer generous discounts.