Section C Questions: Working Capital Flashcards
Similarities and differences in working capital investment and working capital financing
Working Capital Investment
-Working capital investment policy is concerned with the level of investment in current assets, with one company being compared with another.
-Working capital investment policy is therefore assessed on an inter-company comparative basis
Working Capital Financing
- Working capital financing policy is concerned with the relative proportions of short-term and long-term finance used by a company
-Working capital financing policy uses an analysis of current assets into permanent current assets and fluctuating current assets.
-Working capital financing policy relies on the matching principle, which is not used by working capital investment policy. The matching principle holds that long-term assets should be financed from a long-term source of finance. Non-current assets and permanent current assets should therefore be financed from a long-term source, such as equity finance or bond finance, while
fluctuating current assets should be financed from a short-term source, such as an overdraft or a short-term bank loan.
Both working capital investment policy and working capital financing policy use the terms conservative, moderate and aggressive.
In investment policy, the terms are used to indicate the comparative level of investment in current assets on an inter-company basis. One company has a more aggressive approach compared to another company if it has a lower level of investment in current assets, and vice versa for a conservative approach to working capital investment policy.
Profitability v liquidity objectives of working capital management
The profitability objective reflects the primary financial management objective of maximising shareholder wealth, while liquidity is needed in order to ensure that financial claims on an organisation can be settled as they become liable for payment.
The two objectives are in conflict, because liquid assets such as bank accounts earn very little return or no return, so liquid assets decrease profitability. Liquid assets, in fact, incur an opportunity cost equivalent either to the cost of short-term finance or to the profit lost by not investing in profitable projects.
Whether profitability is a more important objective than liquidity depends in part on the particular circumstances of an organisation
Liquidity may be the more important objective when short-term finance is hard to find, while profitability may become a more important objective when cash management has become too conservative.
