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Friday, August 26, 2011

Working Capital Management in Finance

In Finance, Working Capital policy involves decisions about a company’s current assets and current liabilities – what they consist of, how they are used and how their mix affects the risk versus return characteristics of a company. Both the terms working capital and net working capital normally denote the difference between a company’s current assets and current liabilities. The two terms are often used interchangeably.

Working capital policies, through their effect on the firm’s expected future returns and the risk associated with these returns, ultimately have an impact on shareholders’ wealth. Effective working capital policies are crucial to a firm’s long-run growth and survival. For example, a company lacks the working capital needed to expand production and sales, it may lose revenues and profits. Working capital is used by firms to maintain liquidity that is the ability to meet their cash obligations as they come due. Otherwise, it may incur the costs associated with a deteriorating credit rating, a potential forced liquidation of assets, and possible bankruptcy.

Working capital management is a continuing process that involves a number of day-to-day operations and decisions that determine the following:

  • The firm’s level of current assets
  • The proportions of short-term and long-term debt the firm will use to finance its assets
  • The level of investment in each type of current assets
  • The specific sources and mix of short-term credit (current liabilities) and the firm should employ

Working capital differs from fixed capital in terms of the time required to recover the investment in a given asset. In the case of fixed capital or long term assets such as land, buildings and equipment, a company usually needs several years or more to recover the initial investment. In contrast, working capital is turned over or circulated, at a relatively rapid rate. Investments in inventories and accounts receivable are usually recovered during a firm’s normal operating cycle, when inventories are sold and receivables are collected.

Importance of working capital

A company needs working capital to operate and survive. In many industries, working capital constitutes a relatively large percentage of total assets. In the manufacturing sector, for example, current assets comprise about 40 percent of the total assets of all US manufacturing corporations. Among the wholesaling and retailing sectors, the percentages are even higher – in the 50 to 60 percent range.

A firm’s net working capital position is not only important from an internal standpoint; it is also widely used as one measure of the firm’s risk. Risk deals with the probability that a firm will encounter financial difficulties, such as the inability to pay bills on time. All other things being equal, the more net working capital a firm has, the more likely it is able to meet current financial obligations. Because net working capital is one measure of risk, a company’s net working capital position affects its ability to obtain debt financing. Many loan agreements with commercial banks and other lending institutions contain a provision requiring the firm to maintain a minimum working capital.

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Our other articles on Finance include Present Value, Net Present Value, Internal Rate of Return, Present Value Annuity, Private Equity & Venture Capital

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