CAT / FIA FFM Syllabus A. Working Capital Management - Working Capital Management - Notes ^{1 / 8}

What is it and why is it important?

Working capital is simply the money needed for day to day business.

This money is needed to keep the company alive.

It is the management of each current asset and each current liability that is essential to the business.

• Working capital = net current assets = current assets - current liabilities

Liquidity v profitability problem

• Consider this. 
  You are the MD of a new company selling i-pads. 
  Demand is looking good. 
  Your natural inclination is probably to buy more in, to sell in the future.

  We call this a short-term investment .

• You have invested in inventory to boost profits - this is one of the objectives of working capital.

  However, you know you also have to pay the lease on your office - luckily you have set aside a little for this.

  We call this liquidity.

• Maintaining enough to pay short term payables. 
  This is another of the objectives of working capital.
  So we would like to use the working capital for both Short-term investment and Liquidity

• Hopefully you can see that part of you wants to invest the money and another wishes to save to pay bills. 

  This is the conflict of working capital objectives. 
  Minimising the risk of insolvency while maximising the return on assets.

Managing working capital

The management of working capital is important to the financial health of businesses of all sizes. 

The amounts invested in working capital are often high in proportion to the total assets employed and so it is vital that these amounts are used in an efficient and effective way.

However, there is evidence that small businesses are not very good at managing their working capital. 

The finance profession recognises the three primary reasons offered by economist John Maynard Keynes to explain why firms hold cash. 

These are:

1. Speculation

   To take advantage of special opportunities that if acted upon quickly will favour the firm. 

   An example of this would be purchasing extra inventory at a discount.

2. Precaution

   As an emergency fund for a firm.

3. Transaction

   Firms hold cash in order to satisfy the cash inflow and cash outflow needs that they have.

   Efficient management of working capital is extremely important to any organisation. 

   Holding too much working capital is inefficient, holding too little is dangerous to the organisation’s survival.