Page 15 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Working Capital Management

Notes By these examples, we see that strategies using working capital accounts are some of the possible
ways firms can respond to many of the problems engendered by the imperfect and constrained
world in which they deal. One of the major features of this world is uncertainty (risk), and it is
this feature that gives rise to many of the strategies involving working capital accounts. Moreover,
a firm’s net working capital position not only is important from an internal standpoint; it also
is widely used as one measure of the firm’s risk. Risk, as used in this context, deals with the
probability that a firm will encounter financial difficulties, such as the inability to pay bills on
time. All other things being equal, the more net working capital a firm has, the more likely that
it will be able to meet current financial obligations. Because net working capital is one debt
financing. Many loan agreements with commercial banks and other lending institutions contain
provision requiring the firm on maintain a minimum net working capital position. Likewise,
bond indentures also often contain such provisions. The overall policy considers both the level
of working capital investment and its financing. In practice, the firm has to determine the joint
impact of these two decisions upon its profitability and risk.
The size and nature of a firm’s investment in current assets is a function of a number of different
factors, including the following:
1. The type of products manufactured.
2. The length of the operating cycle.

3. The sales level (because higher sales require more investment in inventories and
receivables).
4. Inventory policies (for example, the amount of safety stocks maintained; that is, inventories
needed to meet higher than expected demand or unanticipated delays in obtaining new
inventories).

5. Credit policies.
6. How efficiently the firm manages current assets. (Obviously, the more effectively
management economizes on the amount of cash, marketable securities, inventories, and
receivables employed, the smaller the working capital requirements).
For the purposes of discussion and analysis, these factors are held constant in the rest of our
analysis.

Self Assessment

Fill in the blanks:
12. The unit cost of producing goods would not vary with the amount ……………………
13. There are …………………….between the borrowing and lending rates for investments
and financing of equal risk.
14. ……………………….deals with the probability that a firm will encounter financial
difficulties, such as the inability to pay bills on time.
1.5 Optimal Level of Working Capital Investment

The optimal level of working capital investment is the level expected to maximize shareholder
wealth. It is a function of several factors, including the variability of sales and cash flows and the
degree of operating and financial leverage employed by the firm. Therefore no single working
capital investment policy is necessarily optimal for all firms.

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