Page 220 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Unit 13: Integration of Working Capital and Capital Investment Process

Self Assessment Notes

Fill in the blanks:
7. If cash flows are ............................., short-term borrowing will occur after cash and marketable
securities are reduced to their minimum.

8. If the sum of the cost are ............................. than the receipts, and liquid assets are at minimum,
short term borrowing will be employed.
9. In simulating financial decisions, the strategy that produces the best simulated results is
not necessarily the ............................. financing strategy.
10. The financial planning process is composed of many variables and occurs in an
............................. and ............................. environment.

13.3 Role of Working Capital in the Investment Process

For operating a firm working capital is as crucial as fixed capital. It is the net amount of short
term assets – current assets minus current liabilities – of the firm which gives it some latitude at
several activities For instance, by holding inventories at various stages of the production process
the firm can run larger batches and is less vulnerable to strikes, and the presence of accounts
receivable on the balance sheet reflects the fact that the firm is willing to sell goods to customers
that are solvent but short of cash.
Working capital is a prime measure of liquidity of the firm. Current assets include financial
assets such as cash money and accounts receivable but also real assets such as inventories since
it is thought that they can relatively easily be converted into cash. Current liabilities consist of
(accounts) payable(s) and short-term debt.
The various parts of working capital display their own patterns over the business cycle. When a
firm is experiencing a negative shock to demand, its inventories of final products will generally
rise. Later on, when it becomes clear that this demand shock was the beginning of a recession
and the firm is in financial distress, the firm will try to shed inventories of all kinds, to collect
accounts receivable, and try to postpone payments of debts. That is, as the recession gets worse,
the liquidity of firms measured as working capital decreases as does the cash flow.

Example: Southeastern’s sales totaled ` 7.8 crore in 2003. In the past, inventories had
been tightly controlled and were dictated to a considerable extent by production considerations.
Inventory turnover in 2003 was 6.3 times, a figure considered quite good by industry standards.
However, southeastern management had become increasingly concerned over sales lost due to
stockouts of finished goods inventories. At year-end 2003, total inventories were ` 8,00,000, of
which ` 2,00,000 was in finished goods.

Motivated by the problem of stock-outs, management initiated a study to determine whether
finished goods inventories should be increased. From historical records of orders received and
filled, management estimated that at the present inventory level, lost sales due to stock-outs
were running at an annual rate of ` 6,25,000. Since variable costs totaled about 60 per cent of
sales, lost contribution amounted to about ` 2,50,000.
The magnitude of the lost contribution figure convinced management that further study was
necessary. Lost sales were estimated at four alternative levels of finished goods inventories,
each of which represented an incremental increase over current levels. The results are listed in
table. The analysis showed that if finished goods inventories were increased from the current
level of ` 2,00,000 to ` 2,78,000, lost sales would decline from ` 6,25,000 to ` 4,75,000 and an
additional contribution of ` 60,000 would be realised. Similarly, the additional contribution at
inventory levels B, C, and D also was determined.

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