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Unit 1: Introduction to Working Capital Management

2. What additional informations are required while evaluating the additional working Notes
capital requirement and expansion plans?
3. What steps must be taken to manage the working capital effectively under inflationary
situation? What would be the effect of expansion plan on working capital
requirement?

Source: Sudhindra Bhat, Financial Management – Principles and Practice, Excel Books.

Self Assessment

State whether the following statements are true or false:
9. Working capital requirement of a concern is not influenced by the size of its business.
10. There is a high degree of direct co-relationship between the quantum of working capital;
and the velocity or speed with which the sales are affected.
11. The working capital requirement of a concern decrease with the growth and expansion of
its business activities.

1.4 Levels of Working Capital Investment

In a “perfect” world, there would be no necessity for working capital assets and liabilities. In
such a world, there would be no uncertainty, no transaction costs, information search costs,
scheduling costs, or production and technology constraints. The unit cost of producing goods
would not vary with the amount produced. Firms would borrow and lend at the same interest
rate. Capital, labor, and product markets would reflect all available information and would be
perfectly competitive. In such a world, it can be shown that there would be no advantage for
invest or finance in the short-term.
But the world in which real firms function is not perfect. It is characterized by the firm’s
considerable uncertainty regarding the demand, market price, quality, and availability of its
own products and those of suppliers. There are transaction costs for purchasing or selling goods
or securities. Information is faced with limits on the production capacity and technology that it
can employ. There are spreads between the borrowing and lending rates for investments and
financing of equal risk. Information is not equally distributed and may not be fully reflected in
the prices in product and labor markets, and these markets may not be perfectly competitive.
These real-world circumstances introduce problems with which the firm must deal. While the
firm has many strategies available to address these circumstances, strategies that utilize investment
or financing with working capital accounts often offer a substantial advantage over other
techniques.

Example: Assume that the firm is faced with uncertainty regarding the level of its future
cash flows and will incur substantial costs if it has insufficient cash to meet expenses. Several
strategies may be formulated to address this uncertainty and the costs that it may engender.
Among these strategies are some that involve working capital investment or financing such as
holding additional cash balances beyond expected needs, holding a reserve of short-term
borrowing capacity. One of these strategies (or a combination of them) may well be the least
costly approach to the problem.
Similarly, the existence of fixed set-up costs in the production of goods may be addressed in
several ways, but one possible alternative is hold inventory.

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