Aspects and Elements Related to Working Capital Management

This area of finance known as Working capital management, is concerned with management of the firm’s current accounts to achieve his goal which is the balance between profit and risk that maximizes the firm’s value by managing each of the firm’s current assets (Cash, Marketable securities, Accounts receivables and Inventories) and current liabilities represent the firm’s short term financing.? – Net Working Capital: is defined as current assets minus current liabilities. – Liquidity Ratios provide information about the firm’s ability to meet its short term financial obligations 1.

Working Capital Ratio (Current Ratio) is the ratio of current assets to current liabilities, but inventory may include many items that are difficult to liquidate quickly. 2. Quick Ratio (Acid Ratio) is the ratio of current assets excluding the inventory to current liabilities. 3. Cash Ratio is the most conservative liquidity ratio, it exclude all current assets except the most liquid: cash and cash equivalents such as marketable securities and time deposits over current liabilities. it is an indication of the firm’s ability to pay off current liabilities if for some reason immediate payment were demanded.? Working Capital policy: refers to the firm’s policies regarding 1. Target levels for each category of current assets. 2. How current assets will be financed. – The Cash Conversion Cycle:- It is used to analyze the effectiveness of the firm’s working capital management. So it focuses on the length of time between when the company makes payments and when it receives cash inflows. Can be expressed by this equation: CCC (in days) = Inventory conversion period + Receivables conversion period – Payables deferral period Inventory conversion period represents the average time required to convert materials into finished goods. – Receivables conversion period (Day sales outstanding) represents the average length of time required to convert the firm’s receivables into cash. – Payables deferral period represents the average length of time between the purchase of materials and labor and the payment of cash for them.? ——————————————————————————————————- ? Lawrence J. Gitman; ‘Principals of the Managerial Finance’; Fifth edition; P. 473-474 ?

Internet Center for Management ; Business Administration, Inc. ; NetMBA. com. ? Eugene F. Brigham; Joel F. Houston; ”Fundamentals of Financial Management”; Fourth edition; P. 549-551 Managing the Cash Conversion Cycle – As we can say that the sound of working capital policy is designed to minimize the time between cash expenditures on materials and the collection of cash on sales. This could be happened by: 1- Turn over inventory as quickly as possible, avoiding stock outs that might result in a loss of sales. 2- Collect accounts receivable as quickly as possible without losing future sales. – Pay accounts payable as late as possible without damaging the firm’s credit rating.? Alternative Current Asset Investment Policies:- – The Cash Conversion Cycle highlights the strengths and weakness of the firm’s working capital policy, which depend on critically on current asset management and the financing of current assets. There are different policies for financing current assets. 1) Relaxed Current Asset Investment Policy – A policy under which relatively large amounts of cash, marketable securities, and inventories are carried and under which sales are stimulated by a liberal credit policy resulting in a high level of receivables. ) Restricted Current Asset Investment Policy – A policy under which holdings of cash, marketable securities, inventories and receivables are minimized. 3) Moderate Current Asset Investment Policy – A policy that is between the relaxed and restricted policies. Managing the Components of Working Capital – There are four main components:- – The Reasons of holding cash 1. Transaction Balance is a cash balance necessary for day to day operations 2. Compensation Balance is a bank balance that a firm must maintain to compensate the bank of services rendered or for granting a loan. .

Pre-cautionary Balance is a cash balance held in reserve for random, unforeseen fluctuations in cash inflows and outflows. 4. Speculative Balance is a cash balance that is held to enable the firm to take advantage of any bargain purchases that might arise.? ———————————————————————————————- ? Lawrence J. Gitman; ‘Principals of the Managerial Finance’; Eighth edition; P. 741-2 ? Eugene F. Brigham; Joel F. Houston; ”Fundamentals of Financial Management”; Fourth edition; P. 554-559 Advantage of Holding Adequate Cash or Marketable Securities: is for taking trade discount, help the firm to maintain its credit rating, for taking an advantage of favorable business opportunities or to meet emergencies – Inventory levels depend heavily upon sales and there is a necessity of forecasting sales before establishing target inventory levels (cash budgeting). – The goals of Inventory Management are (1) to ensure that the inventories needed to sustain operations are available, but (2) to hold the costs of ordering and carrying inventories to the lowest possible level – Systems are used for inventory level control. A balance due from a customers, it has an important benefits to the firm increased its sales. – Every firm must have a Credit Policy determining these variables: 1. Credit period. 2. Discounts given for early payment. 3. Credit standards. 4. Collection policy.? Alternative Current Assets Financing Policies:- – The firm’s financing requirements can be separated into: – Are the financing requirements for the firm’s fixed assets plus the permanent portion of the firm’s current assets, these requirements remaining unchanged over the year. Are the financing requirements for the temporary current assets which vary throughout the year.? Financial Policies:- 1. Maturity Matching or ”Self Liquidating” Approach:- – Calls for matching assets and liabilities maturities, this strategy minimize the risk that the firm will be unable to pay off its maturity obligations.? ? Eugene F. Brigham; Joel F. Houston; ”Fundamentals of Financial Management”; Fourth edition; P. 573-574 ? Lawrence J. Gitman; ‘Principals of the Managerial Finance’; Fifth edition; P. 477

The financial manager with unusual insight and timing could construct a financial policy (plan) for working capital. The difficulty rests in determining precisely what part of current assets is temporary and what part is permanent, the exact timing of asset liquidation is also a difficult matter. To compound the problem, we are never quite sure how much short term or long term financing is available at given time while the precise synchronization of temporary current assets and short term financing may be the most desirable and logical policy, but other alternatives must be considered.? 2. Aggressive Approach:- Which is the firm finances all of its fixed assets with long term capital and the part of its permanent current assets with short term. 3. Conservative Approach:- – Indicates that long term capital is being used to finance all permanent asset requirements and also to meet same of the seasonal needs so the firm uses a small amount of short term, nospontaneous credit to meet its peak requirements but also meets a part of its seasonal needs by storing liquidity in the form of marketable securities.? ? Eugene F. Brigham; Joel F. Houston; ”Fundamentals of Financial Management”; Fourth edition; P. 74-576 ? Stanley B. Block; Geoffrey A. Hirt; ”Foundations of Financial Management”; Eleventh edition; P. 155 ;; 1. Eugene F. Brigham; Joel F. Houston; ”Fundamentals of Financial Management”; Fourth edition; South Western – Thomson; 2004. 2. Stanley B. Block; Geoffrey A. Hirt; ”Foundations of Financial Management”; Eleventh edition; Mc Graw – Hill Irwin; 2005. 3. Lawrence J. Gitman; ”Principals of the Managerial Finance”; Fifth ; Eighth editions; Harper and Row, Publishers, New York; 1988. 4. Internet Center for Management ; Business Administration, Inc. ; NetMBA. com. Copyright © 2002-2007.

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