Page 236 - DMGT207_MANAGEMENT_OF_FINANCES

Unit 10: Working Capital Management

Notes
Table 10.1: The Effects of Changing Ratios in Profits and Risks
Ratio Change in Ratio Effect on profits Effect on risk
Current Assets Increase Decrease Decrease
Total Assets Decrease Increase Increase
Current Liabilities Increase Increase Increase
Total Assets Decrease Decrease Decrease

Self Assessment

Fill in the blanks:
3. If the firm has inadequate working capital, it is said to be………………….. .
4. ………………….. implies that the company has too large funds for its requirements,
resulting in a low rate of return a situation.

10.3 Managing Working Capital

This involves two processes:
1. Forecasting requirements of funds: Changes in firms operation can have almost immediate
effects on the working capital.

Example: if the suppliers increase the price of raw materials, more money will be tied up
in inventory than earlier. Even if the firm can increase the price of its final product, additional
working capital will be required to support its sales efforts.

Did u know? A proactive manager with charges in operating activities will estimate the
working capital requirement and take necessary action for funds.
2. Arranging funds: Once the requirement has been estimated, the manager will arrange the
necessary funds from the best source, for the lowest cost and for the time period involved.
The effective management of working capital is the primary means of achieving the firm’s goal
of adequate liquidity. It is after all, the working capital – cash, marketable securities, receivables
and inventory – that will be available to pay bills and meet obligations. It is the net working
capital i.e., difference of current assets over current liabilities – that gives the degree of protection
against problems that might cause a shortage of funds.
Managing working capital requires a number of actions, including the following:
1. Monitoring levels of cash receivables and inventory: On a daily or weekly basis, the
manager should know how much funds are tied up in each of the current asset accounts.
Ratio analysis offers a quick and reasonable accurate method of doing this. By comparing
ratios with previous periods and industry norms, the managers can identify the variation
and investigate. The following ratios can be used:
(a) Current assets/total assets
(b) Current assets/current liabilities
(c) Current assets – inventory/current liabilities
(d) Cash and marketable securities/current assets

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