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Working Capital

current assets - current liabilities = net working capital

If net working capital is positive, that means that the firm expects to have more cash over the next 12 months that what it expects to pay out.

The main decision for management here is: "how should short-term operating cash flows be managed"?   On the balance sheet, this involves comparing the upper portion of the assets side (short term assets) with the upper portion of the liabilities side (short term liabilities).  The key here is to make sure that there is not a mismatch between the timing of the short term liabilities and short term assets.   Financial managers must manage any gaps in timing, and manage risks that the company might be short of cash (even if they are profitable, or growing).

Working capital (also known as net working capital) is a financial metric which represents the amount of day-by-day operating liquidity available to a business. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. It is calculated as current assets minus current liabilities. A company can be endowed with assets and profitability, but short of liquidity, if these assets cannot readily be converted into cash.

Current assets and current liabilities include three accounts which are of special importance. These accounts represent the areas of the business where managers have the most direct impact:

In a situation where a company carries more cash than the mininum amount needed to maintain operations, the excess portion is usually excluded from working capital.

In addition, the current (payable within 12 months) portion of debt is critical, because it represents a short-term claim to current assets. Common types of short-term debt are bank loans and lines of credit.

Management of W.C.

Decisions relating to working capital and short term financing are referred to as working capital management. These involve managing the relationship between a firm's short-term assets and its short-term liabilities. The goal of Working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses.

Decision criteria

By definition, Working capital management entails short term decisions - generally, relating to the next one year period - which are "reversible". These decisions are therefore not taken on the same basis as Capital Investment Decisions (NPV or related, as above) rather they will be based on cash flows and / or profitability.

• One measure of cash flow is provided by the cash conversion cycle - the net number of days from the outlay of cash for raw material to receiving payment from the customer. As a management tool, this metric makes explicit the inter-relatedness of decisions relating to inventories, accounts receivable and payable, and cash. Because this number effectively corresponds to the time that the firm's cash is tied up in operations and unavailable for other activities, management generally aims at a low net count.

• In this context, the most useful measure of profitability is Return on capital (ROC). The result is shown as a percentage, determined by dividing relevant income for the 12 months by capital employed; Return on equity (ROE) shows this result for the firm's shareholders. Firm value is enhanced when, and if, the return on capital, which results from working capital management, exceeds the cost of capital, which results from capital investment decisions as above. ROC measures are therefore useful as a management tool, in that they link short-term policy with long-term decision making. See Economic value added (EVA).

Management of working capital

Guided by the above criteria, management will use a combination of policies and techniques for the management of working capital. These policies aim at managing the current assets (generally cash and cash equivalents, inventories and debtors) and the short term financing, such that cash flows and returns are acceptable.

• Cash management. Identify the cash balance which allows for the business to meet day to day expenses, but reduces cash holding costs.

• Inventory management. Identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials - and minimizes reordering costs - and hence increases cash flow; see Supply chain management; Just In Time (JIT); Economic order quantity (EOQ); Economic production quantity (EPQ).

• Debtors management. Identify the appropriate credit policy, i.e. credit terms which will attract customers, such that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence Return on Capital (or vice versa); see Discounts and allowances.

• Short term financing. Identify the appropriate source of financing, given the cash conversion cycle: the inventory is ideally financed by credit granted by the supplier; however, it may be necessary to utilize a bank loan (or overdraft), or to "convert debtors to cash" through "factoring".

Other managerial finance decisions to make:

1.  What long term investments should the company pursue? (capital budgeting decision)

2.  How can cash be raised for these investments? ( capital structure decision for a firm.

3.  How much short-term cash does the company need to pay its bills? (net working capital decision)

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