Page 17 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Working Capital Management

Notes 1.6 Overall Working Capital Policy

The goal of a company is to create value for its shareholders. In order to create this value, the
company has to create a competitive advantage to exploit inconsistencies in the market in which
it operates; both its trading and financial environments. As such, Lawrence needs to develop a
comprehensive strategic, financial, and implementation plan to facilitate a successful Working
Capital Policy, while fully leveraging existing resources and making their bottom line more
profitable while managing risks and events that would threaten the success of the endeavor.

Working capital management involves decisions with regard to levels of cash, receivables, and
inventory. Too much working capital is costly, reducing profitability and return on capital.
However, too little can also be costly in terms of lost opportunities and the company may suffer
increases in cost of capital due to too little cash if it cannot pay bills on time.

A business firm can adapt any of the following working capital policies:
1. Conservative working capital policy
2. Aggressive working capital policy
3. Moderate working capital policy
Let us understand each of them one by one.
1. Under conservative approach, the firm carries high investment in current assets such as
cash, marketable securities and carries large amount of inventories and grants generous
terms of credit to customers resulting in a high level of debtors. The consequences of
conservative working capital policy are quick deliveries to customers and more sales due
to generous credit terms.
2. Under aggressive working capital policy, investment in current assets is very low. The
firm keeps less amount of cash and marketable securities, manages with less inventories
and tight credit terms resulting in low level of debtors. The consequences of aggressive
working capital policy are frequent production stoppages, delayed deliveries to customers
and loss of sales.
3. Moderate approach is always maintaining required amount of current assets depending
upon sales. A trade off between two costs namely carrying cost and shortage cost determines
the optimal level of current assets. Costs that rise with current assets i.e. that cost of
financing a higher level of current assets form carrying costs. Shortage costs are in the
form of disruption in production schedule, loss of Sales and loss of goodwill.

The optimum level of current assets is denoted by the total costs (= carrying costs + shortage
costs) minimized at that level.

Self Assessment

Fill in the blanks:
18. The goal of a company is to create value for its .........................

19. Under ......................... working capital policy, investment in current assets is very low.
20. Too much working capital is costly, reducing ......................... and .........................

1.7 Summary

Working capital is a financial metric which represents operating liquidity available to a
business.

12 LOVELY PROFESSIONAL UNIVERSITY