Working Capital Management in Finance
Working Capital can be simply defined as a firm’s net working capital as its current assets minus current liabilities. Net working capital is the capital required in the short term asset accounts such as cash, inventory and account receivable, as well as short-term liability accounts such as accounts payable.
Most projects require the form to invest in net working capital. The main components of net working capital are cash, inventory, receivables and payables. Working capital includes the cash that is needed to run the firm on a day to day basis. It does not include excess cash, which is cash that is required to run the business and can be invested at a market rate. Excess cash may be viewed as part of the firm’s capital structure, offsetting firm debt. Increase in net working capital represents an investment that reduces the cash that is available to the firm. Therefore, working capital alters a firm’s value by affecting its free cash flow.
The level of working capital reflects the length of time between when cash goes out of a firm at the beginning of the production process and when it comes back in. A company first buys inventory from its suppliers, in the form of either raw materials or finished goods. Even if the inventory is in the form of finished goods, it may sit on the shelf for some time before it is sold. A firm typically, buys its inventory on credit, which means that the firm does not have to pay cash immediately at the time of purchase. When the inventory is disposed of, it is often sold on credit. A firm’s cash cycle is the length of time between when the firm pays cash to purchase its initial inventory and when it receives cash from the sale of the output produced from that inventory.
Cash Conversion Cycle (CCC) = Inventory Days + Accounts Receivable Days – Accounts Payable Days
Inventory Days = Inventory/ Avg. Daily Cost of Goods Sold
Accounts Receivable Days = Accounts Receivable/ Avg. Daily Sales
Accounts Payable Days = Accounts Payable/ Avg. Daily Cost of goods sold
The firm’s operating cycle is the average length of time between when a firm originally purchases its inventory and when it receives the cash back from selling its product. If the firm pays cash for its inventory, this period is identical to the firm’s cash cycle. However, most firms buy their inventory on credit, which reduces the amount of time between the cash investment and the receipt of cash from that investment.
The longer a firm’s cash cycle, the more working capital it has, and the more cash it needs to carry to conduct its daily operations.
Any reduction in the working capital requirements generates a positive free cash flow that the firm can distribute immediately to shareholders. For example, if a firm is able to reduce its required net working capital by $50,000, it will be able to distribute this $50,000 as a dividend to its shareholders immediately.
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