There are two concepts of working capital: gross working capital and net working capital. Gross working capital is the total of all current assets. Net working capital is the difference between current assets and current liabilities.
Working capital management is a significant facet of financial management. Financial managers spend a great deal of time on working capital management.
In the management of working capital, two characteristics of current assets must be borne in mind:
1. Short life span, and
2. Fast transformation into other asset forms.
The working capital needs of a firm are influenced by numerous factors. The important ones are:
1. nature of business,
2. seasonality of operations,
3. production policy,
4. market conditions, and
5. conditions of supply
An important working capital policy decision is concerned with the level of investment in current assets. Determining the optimal level of current assets involves a trade off between costs that rise with current assets and costs that fall with current assets. The former are referred to as carrying costs and the latter as shortage costs.
Several strategies are available to a firm for financing its capital requirements. An important one is based on the matching principle. According to this principle, the maturity of the sources of finance should match the maturity of the assets being financed. This means that 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.
The operating cycle of a firm begins with acquisition of raw materials and ends with the collection of receivables. If the accounts payable is subtracted from the operating cycle, one gets the cash cycle.
Information about the operating cycle is helpful in (1) forecasting working capital, and (2) control of working capital.
The cash requirement for working capital needs may be estimated with the help of a two step procedure: (1) Estimate the cash cost of various current assets required by the firm. (2) Deduct the spontaneous current liabilities from the cash costs of current assets.
Cash, the most liquid asset, is of vital importance to the daily operations of business firms. Crucial for the solvency of the business, it is referred to as the life blood of a business firm.
There are three primary reasons for a firm to hold cash: (1) to meet the needs of day-to-day transactions; (2) to protect the firm against uncertainties characteristics its cash flows; and (3) to take advantage of unexpected investment opportunities. While cash serves these functions, it is an idle resource which has an opportunity cost. Hence, it should be carefully planned and controlled.
The principle method of short term cash forecasting is the receipts and disbursement method. The cash budget, prepared under this method, shows the timing and magnitude of expected cash receipts and payments over the forecast period, irrespective of how they are classified in accounting.
To enhance the efficiency of cash management, collections and disbursement must be properly monitored. In this context, the following are helpful: prompt billing, expeditious collection of checks, control of payables, and playing the float.
Companies often have surplus funds for short periods of time before they are required for capital expenditures, loan repayment, or some other purpose. These funds can be deployed in a variety of ways.
Business firms sell on credit. Credit is granted to facilitate sales.
The important dimensions of a firm’s credit policy are: credit standards, credit, cash discount, and collection effort.
In general, liberal credit standards tend to push sales up by attracting more customers. This is, however, accompanied by a higher incidence of bad debt loss, a larger investment in receivables, and a higher cost of collection. Stiff credit standards have opposite effects.
Lengthening of the credit period pushes sales up. This is however, accompanied by a larger investment in receivables and a higher incidence of bad debt loss. Shortening of the credit period has the opposite effects.
Liberalizing the cash discount policy tends to enhance sales, reduce the average collection period, and increases the cost of discount. Tightening the cash discount policy has the opposite effects.
A rigorous collection program tends to decrease sales, shorten the average collection period reduce bad debt percentage and increase the collection expense. A lax collection program has the opposite effects.
In judging the creditworthiness of an applicant the three basic factors – the three C’s – are character, capacity, and collateral.