Working in capital management

Financial management decisions are divided into the management of assets (investments) and liabilities (sources of financing), in the long term and in the short term. It is well known that the value of a company cannot be maximized in the long term unless it survives the short term. Businesses most often fail because they can’t meet their working capital needs; therefore, good management of working capital is a requirement for the survival of the company.

About 60 percent of a financial manager’s time is spent managing working capital, and many prospective employees in finance-related fields will find that their first job assignment will involve working capital. For these reasons, working capital policy and management is an essential subject of study. In many textbooks, working capital refers to current assets, and net working capital is defined as current assets minus current liabilities. Working capital policy refers to decisions related to the level of current assets and how they are financed, while working capital management refers to all those decisions and activities that a company undertakes to manage efficiently the elements of current assets.

The term working capital originated with the old Yankee traveling salesman, who loaded his cart with merchandise and then went out on his way to sell his wares. The commodity was called working capital because it was what he actually sold, or “gave up,” to produce his profit. The cart and the horse were his fixed assets. Usually he owned the horse and cart, so they were financed with “stock” capital, but he borrowed the funds to buy the merchandise. These loans were called working capital loans and had to be paid back after each trip to prove to the bank that the credit was strong. If the peddler could repay the loan, then the bank would make another loan, and this was sound banking practice. The days of the Yankee peddler are long gone, but the importance of working capital remains. Current asset management and short-term financing remain the two basic elements of working capital and a daily headache for financial managers.

Working capital, sometimes called gross working capital, simply refers to the company’s total current (short-term) assets, cash, marketable securities, accounts receivable, and inventory. While long-term financial analysis is primarily concerned with strategic planning, working capital management deals with day-to-day operations. By making sure that production lines don’t stop due to a lack of raw materials, that inventories don’t build up because production continues unabated when sales slow, that customers pay on time, and that there is enough cash on hand to make payments when due. Obviously, without good working capital management, no company can be efficient and profitable.

Statements about the flexibility, cost and risk of short-term versus long-term debt depend, to a large extent, on the type of short-term credit actually used. Short-term credit is defined as any liability originally scheduled for payment within one year. There are numerous sources of short-term funds, such as accruals, accounts payable (trade credit), bank loans, and commercial paper. The main elements of current liabilities are trade creditors and bank overdrafts, and these are discussed further.