JOMO KENYATTA UNIVERSITY OF AGRICULTURE AND TECHNOLOGY
2105
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Working capital
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2105
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JOMO KENYATTA UNIVERSITY OF AGRICULTURE AND TECHNOLOGY
Working capital is a financial metric which represents the amount of day-by-day operating liquidity available to a business. Is the companies’ investment- current assets such as cash in hand and at bank, short term securities like treasury bonds, debtors, stock (excluding obsolete and slow moving...
JOMO KENYATTA UNIVERSITY OF AGRICULTURE AND TECHNOLOGY
2105
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FINANCIAL MANAGEMENT
WORKING CAPITAL MANAGEMENT
6.1 Introduction
Working capital is a financial metric which represents the amount of day-by-day operating
liquidity available to a business. Is the companies’ investment- current assets such as cash in
hand and at bank, short term securities like treasury bonds, debtors, stock (excluding obsolete
and slow moving stock and damaged stocks), prepayments, bills of exchange in favour of the
company etc. Along with fixed assets such as plant and equipment, working capital is
considered a part of operating capital. It is calculated as current assets minus current liabilities.
A company can be endowed with assets and profitability, but short of liquidity, if these assets
cannot readily be converted into cash.
The firm’s balance sheet provides information about the structure of the firm’s investments on
the one hand and the structure of its financing sources on other hand. The structures chosen
should consistently lead to the maximization of the value of the owner’s investment in the firm.
Important components of the firm’s financial structure include the level of investment in current
assets and the extent of current liability financing.
The goal of short-term financial management is to manage each of the firm’s current assets
(inventory, accounts receivable, cash, and marketable securities) and current liabilities (accounts
payable, accruals and notes payable) to achieve a balance between profitability and risk that
contributes positively to the firm’s value. This chapter does not discuss the optimal level of
current assets and current liabilities that a firm should have. That issue is unresolved in the
financial literature. Here we first use net working capital to consider the basic relationship
between current assets and current liabilities and then use the cash conversion cycle to
consider the key aspects of current asset management.
,6.2 The trade-off between profitability and risk
Profitability, in this context, is the relationship between revenues and costs generated by using
the firm’s assets- both current and fixed – in productive activities. A firms profit can be
increased by (1) increasing revenues or (2) decreasing costs. Risk, in the context of short term
financial management, is the probability that a firm will be unable to pay its bills as they come
due. A firm that cannot pay its bills as they come due is said to be technically insolvent. It is
generally assumed that the greater the firm’s net working capital, the lower its risk. In other
words, the more net working capital the more liquid the firm and therefore the lower its risk of
becoming technically insolvent.
Current assets and current liabilities include three accounts which are of special importance.
These accounts represent the areas of the business where managers have the most direct im-
pact:
The goal of Working capital management is to ensure that the firm is able to:
Continue its operations and
That it has sufficient cash flow to satisfy both maturing short-term debt and
Upcoming operational expenses.
One of the main advantages of looking at the working capital position is being able to foresee
any financial difficulties that may arise. Even a business that has billions of Shillings in fixed
assets will quickly find itself in bankruptcy court if it can't pay its monthly bills. Under the best
circumstances, poor working capital leads to financial pressure on a company, increased
borrowing, and late payments to creditor - all of which result in a lower credit rating. A lower
credit rating means banks charge a higher interest rate, which can cost a corporation a lot of
money over time.
, A financial manager should manage the above items efficiently so as to ensure that the
company holds optimum levels of working capital neither too little nor too much working
capital should be avoided.
Dangers of holding excessive working capital
It ties up the company’s funds which should have otherwise been invested elsewhere to
earn a return for the company.
Excessive working capital may lead to speculative profits due to high levels of debtors, stock
and other receivables. This may lead the management to pursue a liberal dividend policy
which may affect liquidity of the company.
High levels of working capital may lead to misuse and theft (pilferage) of working capital
items like stock, which will amount to big loss of the part of the company.
Excessive working capital increase the company’s holding costs like storage/warehousing
charges- This reduces co. profits
Excessive working capital may lead to liberal credit policy on the part of the company and
this will increase the costs of bad debts and opportunity costs.
Dangers of holding inadequate working capital
The company may experience financial problems and in the extreme, it may be unable to
meet its obligations as and when they fall due. This may lead to cut-off of credit facilities
from creditors.
Interruption of company’s operations hence reduction in profits of stocks outs and low cash
balance levels which facilitate day to day operations.
Such a situation can lead to loss of sales, this goodwill which may reduce the company’s
profits and market share in the industry in the long run.
Inadequate working capital increase the company’s costs such as salaries paid to employees
who are underutilized, wear and tear of idle machines etc.
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