Financial Management MGT201
WORKING CAPITAL MANAGEMENT
After going through this lecture, you would be able to have an understanding of the following topic:
· Working Capital Management
Working Capital Management is another important area of financial management.
· Financial Management Course
Earlier in the course we studied:
Capital Budgeting: Focuses on Fixed Assets side of Balance Sheet
Capital Structure (& Corporate Financing): Focuses Liabilities Side (Long Term Debt
& Equity) of Balance Sheet
Now another important area is:
Working Capital Management: Focuses Current Assets & Liabilities of Balance Sheet
in day-to-day operation
· Generally Working Capital (Gross) = Current Assets
Current Assets = Inventory + Accounts Receivables + Cash + Marketable Securities +
...(The mentioned items are four major items)
Working Capital is different from "Capital" (as used in Capital Budgeting) which refers
to Capital Expenditure in Fixed Assets
Also it is different from "Capital" (as used in Capital Structure) which refers to
Financing in the form of Debt or Equity (Loans or share capital)
· Net Working Capital = Current Assets Current Liabilities
Net working capital is slightly different from gross working capital.
working capital is different from Net Worth
= Assets Liabilities = Equity
= Stock + Retained Earnings
= Accounts Payables + Accruals + Short Term Loans + ... (as well as other minor
· Important Measure of the Short-term Liquidity of a Firm
Working capital is a measure of how easy it is for a firm to convert short-term assets
into "Liquid" Cash in order to meet the Current Obligations by selling assets
Some ratios to measure liquidity of firm are:
Current Ratio = Current Assets / Current Liabilities
Acid Test or Quick Ratio = Quick Assets / Current Liabilities
· Quick Assets = Current Assets Inventory
· Fundamental Tradeoff in Working Capital (or Current Assets)
Decision in working capital management is how much working capital should be maintained by
a firm. It requires how much money needs to be invested in Inventory, Accounts Receivables,
Marketable Securities and how much cash should be maintained.
Advantages of Large Current Assets: less risk of shortages & interruptions and less loss
of sales due to availability of funds for loan payments and purchases and inventory.
High Liquidity so better CREDIT Rating.
Advantages of Small Current Assets: Less investment in current assets means less
amount of money tied to the assets which are generating no return. So lower
Opportunity Cost of Capital.
Find the Optimum Current Assets (working capital) At Any Given Time and for a
Given Level of Sales & Growth:
· For this Alternative Investment Policies have been proposed and a good
business judgment is required
Working Capital Policies:
· What is the Optimum Working Capital (or Current Assets) for a Firm at any given time given in
level of Sales and Growth Strategy? This requirement fluctuates with time depending on sales
Financial Management MGT201
Practically the following policies are used by the mangers to decide what is the best amount of
current assets or mix of assets to be kept for the firm:
· "Fat Cat" or Relaxed Policy
It requires Large Amount of Current Assets not to loose any sales i.e. when a customer
places order for a large amount, there is no shortage of inventory
Occurs when High sales driven by lot of credit facility to buyers
Good Credit Rating because High Liquidity and good Current Ratio
Case: Wall Mart retail chain during New Year and Christmas
"Lean & Mean" or Restricted Policy
Small Amount of Current Assets
It increases turnover and therefore Profits
· Current Asset Turnover = Sales / Current Assets. Higher than 20.
· Lowers Carrying Costs of Inventory
Frees up cash and speeds up production (operational efficiency)
Small Current Assets means Lower Opportunity Cost of Capital. Firms have raised
Capital from Investors (Debt Holders and Shareholders) which comes at a Cost (the
WACC includes Interest paid to Debt Holders and Dividends paid to Shareholders).
Firms must mobilize the capital in high-return investments in order to repay their
"Zero Working Capital Policy" (Extreme form of Lean & Mean Policy)
It can not be 0 in reality but its objective is to minimize.
· Japanese Just in Time (JIT) i.e. Toyota Motor Co. It means the spare partsreach
just a few hours ago from the assembly time.
· Moderate Policy
In between the Fat Cat and Lean & Mean Policies
Impact of working capital on Firm Value:
There is a link between working capital policy and our basic objective of financial management of
maximizing shareholder's wealth.
EVA (Economic Value Added)
EVA (in Rupees)
= Net Operating Income discounted by the Tax (WACC x Total Capital)
= (NOI x (1-Tc)) - (WACC % x Tot Capital)
In other words, EVA (in Rupees)
= Revenues generated by firm Cost of capital by firm
Total Capital = Market Value of Debt + Market Value of Equity
If Working Capital is reduced, then cash is freed up from the assets to which it was tied
up and can be used to reduce dependence on External Financing (Debt and Equity).
Total External Capital is reduced and WACC is reduced. It raises EVA of the firm.
Higher EVA means Higher Market Value of Firm (V) and Maximization of Shareholder
Wealth which is a fundamental objective of Financial Management.
ROE (Return on Equity)
= Profit Margin x Asset Turnover x Leverage Factor (or Equity Multiplier)
= (Net Income/Sales) x (Sales/Assets) x (Total Assets/Equity)
= Net Income / Equity
If Working Capital is reduced, then cash which is freed up can be used to reduce
requirement for External Capital and Total Liabilities. By Total Assets reduced, Asset
Turnover Rises, and ROE Rises
Financial Management MGT201
Objective is to keep ROE Higher than rE (Required Return) and this means keeping
capital mobilized and invested at all times to generate returns higher than WACC
(which can not be done by simple cash holdings).
First we talk about first item of working capital in balance sheet i.e. cash
· Advantages of Cash
Need cash for Liquidity, Good Credit Rating, and Meet Unexpected Expenses & to Get
Trade Discounts. "Need Cash to Pay the Bills."
BUT cash (and even Current Business Accounts in banks) earns NO RETURN (i.e.
Interest or Markup)
· When Interest Rates are high, the Opportunity Cost of holding cash rises.
Business Competition forces firms to sell on CREDIT but that leads to Problems in
RECOVERY of Receivables (i.e. Bad Debts and Write-offs).
· Balance Sheet Perspective
"Cash is King" and "Only Cash Can Pay the Bills"
Cash Budget (Detailed Short Term)
Projected Cash Inflows and Outflows to estimate Monthly Cumulative Net cash Surplus
· Take into account Credit Purchases and Credit Sales and Expected Collection
(Cash Recovery) Time
· Shortfall tells you how much Short-term Financing is required
Importance of Timing of Collections and Payments and Target Cash Balance
Monthly Cash Budget
Sales (Expected Forecasts `000 Rs.)
Collections (`000 Rs.)
-Current month Sales (30%)
-Previous month Sales (70%)
Purchases Raw Material (`000 Rs.)
-70% of Next Month Sales
-Payments (paid next month)
Other Expenses (`000 Rs.)
- Interest & Dividends
Net Cash for Month
Target Cash Balance
Net Cumulative Cash
The above is the cash budget for a firm for a period of four months with the most important
items. We have forecasted the cash in the form of cash receipts from sales and in the form of cash
payments for expenses. Shortfall or negative balance tells you how much Short-term Financing is
required to fill the gap.
Cash Management Policies:
· Interest-based Policy (Minimize Cash holdings when Interest rates are High)
When Interest Rates are high, the Opportunity Cost of keeping capital in form of Cash
(generating zero returns) is higher.
Try to make Collections quickly and keep as much cash as possible in profit-earning
Marketable securities and Investments in Projects
Financial Management MGT201
Cash Flow Synchronization Policy
Use "Billing Cycles" to time the Cash Outflows just after the Cash Inflows
Example: Salaries paid on 3rd of Every Month. Electricity Bill paid on the 18th of
Every Month. Aim for Cash Collections on the 1st and 15th of every month just few
days before Cash Outflows.
Speed up Cash Collection Policy
Business Competition forces firms to Sell on CREDIT but that leads to Problems in
RECOVERY of Receivables (i.e. Bad Debts and Write offs).
Collection Staff, Letters, Collection Agency
Use Technology: Electronic Wire Transfer, Automatic Debit, Credit Cards
Float Policy (Keep Track of Cheques Clearance)
Takes 1-2 days in Pakistan for cheque to turn into cash in your account from the date of
Aim to make your own Cheque Clearing process quicker (minimize your Collections
Float) than your Supplier's. That way, you will encash cheques before others can
So, you will have a Positive Net Float in your Bank account. This cash can be used for
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