Working Capital Policy – An Overview

IntroductionFinancial management of any business concern involves Management of long term Assets

(Infrastructures)- Capital expenditure Budgeting

Management of long term Funds- Capital Structure Decisions

Management of short term Assets & Liabilities- Working capital management

Adequacy of Working Capital Level of CA and CL Basic decision relating to liquidity of the company and payment of current assets. Factors of Conversion of CA into cash-Management of cash and marketable securities -Credit policy-Inventory management-Management of Fixed Assets

Working Capital PolicyWorking Capital policy refers to the firm’s

policies on four sub issues: How much WC is used? The extent to which WC is supported by

short vs. long term financing The nature/source of various short term

financing used How is each component of WC is

managed

3D Nature of Working Capital Management

Dimension IProfitability,

Risk, & Liquidity

Dimension II

Composition & Level

of CA

Dimension IIIComposition & Level

of CL

Dimensions of Working Capital

Liquidity versus Profitability- A Risk- Return Trade-off Working capital policy maintains and provide

sufficient liquidity to the firm. The decision on how much working capital be

maintained involves a trade-off i.e., having a large net working capital may reduce the liquidity-risk faced by the firm, but it can have a negative effect on the cash flows.

Therefore, the net effect on the value of the firm should be used to determine the optimal amount of working capital.

Current Assets Investment Policy

Relaxed Current Asset Investment Policy (Policy A)

Relatively large amounts of cash, marketablesecurities, and inventories are carried; and a liberal credit policy results in a high level of receivables. Restricted Current Asset Investment Policy

(Policy C)Holdings of cash, marketable securities, inventories, and receivables are constrained. Moderate Current Asset Investment Policy

(Policy B)Between the relaxed and restricted policies.

Working Capital Issues

Assumptions 50,000 maximum

units of production

Continuous production

Three different policies for current asset levels are possible

Optimal Amount (Level) of Current Assets

0 25,000 50,000OUTPUT (units)

ASSE

T LE

VEL

(Rs.)

Current Assets

Policy C

Policy APolicy B

Impact on Liquidity

Liquidity AnalysisPolicy Liquidity A High B Average C LowGreater current asset levels generate more

liquidity; all other factors held constant.

Optimal Amount (Level) of Current Assets

0 25,000 50,000OUTPUT (units)

ASSE

T LE

VEL

($)

Current Assets

Policy C

Policy APolicy B

Impact on Expected Profitability

Return on Investment =Net Profit

Total AssetsLet Current Assets = (Cash + Rec. + Inv.)

Return on Investment = Net Profit

Current Assets+ Fixed Assets

Optimal Amount (Level) of Current Assets

0 25,000 50,000OUTPUT (units)

ASSE

T LE

VEL

(Rs.)

Current Assets

Policy C

Policy APolicy B

Impact on Expected Profitability

Profitability AnalysisPolicy Profitability A Low B Average C HighAs current asset levels

decline, total assets will decline and the

ROI will rise.

Optimal Amount (Level) of Current Assets

0 25,000 50,000OUTPUT (units)

ASSE

T LE

VEL

(Rs.)

Current Assets

Policy C

Policy APolicy B

Impact on Risk

Decreasing cash reduces the firm’s ability to meet its financial obligations. More risk!

Stricter credit policies reduce receivables and possibly lose sales and customers. More risk!

Lower inventory levels increase stockouts and lost sales. More risk!

Optimal Amount (Level) of Current Assets

0 25,000 50,000OUTPUT (units)

ASSE

T LE

VEL

(Rs.)

Current Assets

Policy C

Policy APolicy B

Impact on Risk

Risk AnalysisPolicy Risk A Low B Average C HighRisk increases as the level of current assets

are reduced.

Optimal Amount (Level) of Current Assets

0 25,000 50,000OUTPUT (units)

ASSE

T LE

VEL

(Rs.)

Current Assets

Policy C

Policy APolicy B

Summary of the Optimal Amount of Current Assets

SUMMARY OF OPTIMAL CURRENT ASSET ANALYSISPolicy Liquidity Profitability Risk A High Low Low B Average Average Average C Low High High 1. Profitability varies inversely with liquidity. 2. Profitability moves together with risk.

(risk and return go hand in hand!)

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