Management of Working Capital

The management and control of working capital is of vital importance to companies and forms a major workload function of the finance manager and accountant. By working capital, the commonly accepted descriptive term for these resources, we mean the company’s investment in short-term assets; traditionally these relate to items coming under the balance-sheet heading of current assets (in practice, of course, all capital is working, whether invested in fixed or current assets). Thus inventories (stocks), accounts receivable (debtors), short-term investments and cash balances all come within the term working capital. (The words in brackets represent alternative descriptions of the asset; throughout this book these terms are used synonymously.) Apart from the efficient operation and control of these assets, the finance manager will also be concerned with their financing. In this the finance manager will be faced with numerous alternative sources, both short-term and long-term. Short-term financing is generally shown under the heading of current liabilities and includes items such as bank overdrafts and credit received from suppliers. The efficient financing of current assets by short-term liabilities also comes within the scope of working-capital management and is therefore included in the text.

For the manufacturing and distributive trades, inventories (or stocks) constitute a substantial portion of the total assets employed and, as will be seen, a good deal of control and management can be applied to them. Inventories can be broken down into the following types:

Accounts receivable or debtors represent sales that are made on credit — that is, the payments for goods are made sometime after delivery or after change in legal possession. The level of accounts receivable are a function of the level of sales, the credit terms, the riskiness of the individual customers given credit, and any seasonal influences. Although the total figure of accounts receivable may be fairly constant over time, its individual component items are continually changing and these, therefore, need careful recording and monitoring. Apart from certain retailers such as supermarkets or small ‘high street’ shops, most companies in fact offer credit to their customers, and by so doing the business is providing a financial service as well as the basic goods or other services. Such credit terms are desired by customers as (a) they may be short of ready cash at that moment in time, or (b) they can earn a return on the cash held during the period of credit. By making the credit terms more attractive, management can increase sales turnover; however, granting credit also involves costs of the finance tied up in accounts receivables, increased administration expenses and the probabilities of bad debts occurring. The management of accounts receivable is therefore primarily concerned with the trade-off between the profits from increased sales generated by credit policies and the costs of such policies.

Cash forms the method of collecting revenues and paying various costs and expenses of the business. At any one time there is almost certainly going to be a stock of cash in hand or some liability of cash owing. This is shown in the balance sheet under the headings cash in hand and bank balances or, if there is a negative bank balance, as a bank overdraft. (Note that from now on cash and current-account bank accounts will be used synonymously and deposit accounts will be treated separately with marketable securities as ‘liquid assets’; the reason for the differentiation is that payments are made out of the current accounts and that it takes some time to convert deposit accounts and marketable securities into current-account cash.) The reasons for holding cash have traditionally been divided into three categories as postulated by Keynes¹, the transaction’s motive, the precautionary motive and the speculative motive. Each of these will be considered in turn.

Figs. 1.2, 1.3, 1.4 and 1.5 showed a typical asset structure of a firm and of its possible financing. Using long-term finance solely is the most conservative as regards the certainty of finance but it is probably the most costly in terms of interest rates and in creating surplus cash. At the other extreme, using solely short-term finance runs the risk of the finance not being renewed and of the very possible consequent bankruptcy. Short-term relates to finance that is typically repayable within one year; medium and long-term finance is that which typically extends beyond one year, e.g. debentures, preference shares, ordinary shares, retained earnings. In between these two extremes lie a host of financing strategies which a company can adopt. One, which was depicted in Fig. 1.3, is to finance the permanent segment of the current assets by long-term capital and the fluctuating current assets by short-term capital ; of course, this involves recognising the ‘permanent’ element of current assets. In practice, most firms adopt a policy of financing some part of their current assets by long-term finance ; the traditional textbook solution is that one-half should be financed in this way (the current ratio being 2·0; this ratio is described in Chapter 6). Specific industries have variations on these figures of course.

The component items of, and the overall position of, working capital is analysed by outside parties for credit extension, lending and investment purposes. Interested parties include:

Forecasting is a vital ingredient in the making of both long-term and short-term plans. For example, in the control and management of working capital we are attempting to optimise the future profitability-risk profile of the firm and this will require, amongst other things, forecasts of the future demand for inventory, the level of future interest rates and the availability of future finance. Many of the formal decision models discussed previously in the book rely on forecasts of demand functions as one input and the ‘optimal’ solutions produced therefrom are dependent upon the forecasting accuracy. The focal point for the planning of working capital is the sales forecast; from this, fairly reliable assumptions can be made as regards the management of inventory, debtors, cash and their funding. Table 7.1 shows the relationships between the sales figures and the various components of working capital — clearly sales has an extremely important impact.