Working Capital Management
Financial management decisions are divided into the management of assets (investments) and liabilities (sources of financing), in the long-term and the short-term. It is common knowledge that a firm’s value cannot be maximized in the long run unless it survives the short run. Firms fail most often because they are unable to meet their working capital needs; consequently, sound working capital management is a requisite for firm survival.
About 60 percent of a financial manager’s time is devoted to working capital management, and many of the potential employees in finance-related fields will find out that their first assignment on the job will involve working capital. For these reasons, working capital policy and management is an essential topic of study. In many text books working capital refers to current assets, and net working capital is defined as current assets minus current liabilities. Working capital policy refers to decisions relating to the level of current assets and the way they are financed, while working capital management refers to all those decisions and activities a firm undertakes in order to manage efficiently the elements of current assets.
The term working capital originated with the old Yankee peddler, who would load up his wagon with goods and then go off on his route to peddle his wares. The merchandise was called working capital because it was what he actually sold, or “turned over”, to produce his profits. The wagon and horse were his fixed assets. He generally owned the horse and wagon, so they were financed with “equity” capital, but he borrowed the funds to buy the merchandise. These borrowings were called working capital loans, and they had to be repaid after each trip to demonstrate to the bank that the credit was sound. If the peddler was able to repay the loan, then the bank would issue another loan, and these were sound banking practices. The days of the Yankee peddler have long since pasted, but the importance of working capital remains. Current asset management and short-term financing are still the two basic elements of working capital and a daily headache for the financial managers.
Working capital, sometimes called gross working capital, simply refers to the firm’s total current assets (the short-term ones), cash, marketable securities, accounts receivable, and inventory. While long-term financial analysis primarily concerns strategic planning, working capital management deals with day-to-day operations. By making sure that production lines do not stop due to lack of raw materials, that inventories do not build up because production continues unchanged when sales dip, that customers pay on time and that enough cash is on hand to make payments when they are due. Obviously without good working capital management, no firm can be efficient and profitable.
Statements about the flexibility, cost, and riskiness of short-term debt versus long-term debt depend, to a large extent, on the type of short-term credit that actually is used. Short-term credit is defined as any liability originally scheduled for payment within one year. There are numerous sources of short-term funds, such as accruals, accounts payable (trade credit), bank loans, and commercial paper. The major elements of current liabilities are trade creditors and bank overdrafts, and these are further analyzed.