Working capital

Question 1

What is the concept of working capital?

Answer 1

Working capital finance concerns the optimal level, mix and use of current assets and the means used to acquire them, notably current liabilities. The objective is to minimize the cost of maintaining liquidity (quick convertibility to cash) while guarding against the risk of insolvency

From a financial analyst’s perspective, working capital = current assets. Its components include cash, marketable securities, receivables and inventory

From the accounting perspective, net working capital = current assets - current liabilities

Question 2

What are the effects of a working capital policy?

Answer 2

A firm that adopts a conservative working capital policy seeks to minimize liquidity risk by increasing working capital

This policy is reflected in a higher current ratio (current assets / current liabilities) and acid test ratio (quick assets / current liabilities). The firm forgoes the potentially higher returns available from using the additional working capital to acquire long-term assets

To increase profitability, an aggressive policy reduces liquidity and accepts a higher risk of short-term cash-flow problems. This policy is reflected in a lower current ratio and acid test ratio

Working capital policy applies to short-term decisions and capital structure finance applies to long-term decisions

Working capital ratios are meaningful only in terms of norms and trends. Thus, a firm’s ratios must be normal or average ratios from competitors or based on industry averages

Question 3

What are the effects of carrying excessive amount of current assets?

Answer 3

Carrying excessive current assets (i.e. inventories) increases costs. The carrying costs of inventory usually increase in proportion to the quantity of inventory.

Thus, the firm with excess inventory incurs not only the opportunity costs of funds invested in inventory but also the costs of storage and insurance

Spoilage and obsolescence costs increase as inventories increase

Question 4

What is the optimal level of current assets that a firm should have?

Answer 4

The optimal level of current assets varies with the industry in which a firm operates. For example, a grocery store has spoilable inventory and cannot carry more than a few days of sales. Moreover, the grocery has no receivables. It also can operate with lower cash reserves than firms in many industries because its sales do not vary greatly from week to week. In contrast, a uranium mine must have a high level of cash to meet ongoing expenses because its sales may be irregular

Question 5

What is permanent working capital (vs. temporary)?

Answer 5

Permanent working capital is the minimum level of current assets maintained by a firm. Temporary working capital, however, fluctuates seasonally

Permanent working capital is similar to the firm’s fixed assets and should increase as the firm grows. It differs because the items included in working capital turn over relatively rapidly although their minimum total is maintained or increased over the long term

Permanent working capital generally is financed with long-term debt

Question 6

Why is financing with short-term debt risky?

Answer 6

Financing with short-term debt is risky because:

1. Assets may NOT be liquidated in time to pay the debt
2. Interest rates may rise
3. Loans may NOT be renewed