The Fundamentals of Working Capital Management - Free Essay Example

The Fundamentals of Working Capital Management Working Capital refers to the company’s current or short-lived assets. This includes cash, marketable securities, notes receivable, account receivable, inventories and other current assets. Non-current assets are referred to as capital assets. These are long-term assets and are mostly depreciable in nature. In evaluating an investment in capital assets, the future cash flows, the risk of those cash flows as well as the opportunity cost of the funds invested must be taken into consideration. Working capital provides the resources to put up a capital asset in operation while the capital asset in turn is expected to generate future cash flows to become future working capital. Factors that affect the level of investments in working capital †¢ Type of business/product †¢ Length of the operating cycle †¢ Degree of uncertainty of the business †¢ Practices and traditions Aggressive vs. Conservative Working Capital Management Aggressive |Conservative | |Preference for minimum level of working capital |Maintains maximum level of working capital | |Advantages |Disadvantages |Advantages |Disadvantages | |Saves on carrying costs |Losses due to stock outs |Avoids risk of losses due to |High carrying costs | | | |stock outs | | |Maintains active relationship |Bad credit reputation |Good credit reputation |Lost opportunities when funds | |with bankers | | |are tied up in non-earning | | | | |working capital assets | Measuring Working Capital Effectiveness Liquidity : the ability of a firm to turn around resources to fund current requirements, invest excess capital and avoid costly borrowings. Ratios associated with measuring liquidity: Current Ratio = Current Assets / Current Liabilities Accounts Receivable Turnover = Sales / Accounts Receivable (A/R) Days’ Sales Outstanding = 365 days / A/R Turnover Inventory Turnover = Cost of Goods Sold / Inventories Average Stocking Period = 365 days / Inventory Turnover Quick Ratio = (Current Assets–Inventories) / Current Liabilities Cash Operating Cycle: the sum of the average inventory stocking period and the days’ sales outstanding. The shorter this cycle is, the better is the liquidity. Stretching of Suppliers’ Payable is one way to maximize the use of funds. It is an advantage particularly when the firm has a strong bargaining power with its suppliers. Accounts Payable Turnover = Cost of Goods Sold/Accounts Payable Average Payment Period = 365 days / Accounts Payable Turnover