Working Capital Management involves the financing and management of the current assets of the firm. The financial executive probably devotes more time to working capital management than any other activity. Current assets, by their nature, are changing daily, if not hourly, and managerial decisions must be made. “How much inventory is to be carried, and how do we get the funds to pay for it?” Unlike long-term decisions, there can be no deferral of action. While long-term decisions involving plant and equipment or market strategy may well determine the eventual success of the firm, short-term decisions on working capital determine whether the firm gets to long-term.
In this article we examine the nature of asset growth, the process of matching sales and production, financial sapects of working capital management, and the factors that go into development of an optimum policy.
The Nature of Asset growth
Any company that produces and sells a product, whether the product is consumer or manufacturer oriented, will have current assets and fixed assets. If a firm grows, those assets are likely to increase over time. The key to current asset planning is the ability of management to forecast sales accurately and then to match the production schedules with the sales forecast. Whenever actual sales are different from forecasted sales, unexpected buildups or reductions in inventory will occur that will eventually affect receivables and cash flow.
In the simplest case, all of the firm`s current assets will be self-liquidating assets (sold at the end of a specified time period). Assume that at the start of the summer you buy 100 tires to be disposed of by September. It is your intention that all tires will be sold, receivables collected, and bills paid over this time period. In this case your working capital (current asset) needs are truly short-term.
Now let us begin to expand the business. In stage two you add ratios, seat covers, and batteries to your operation. Some of your inventory will again be completely liquidated, while other items will form the basic stock for your operation. To stay in usiness, you must maintain floor displays and multiple items for selection. Furthermore, not all items will sell. As you eventually grow to more than one store, this “permanent” aggregate stock of current assets will continue to increase. Problems of inadequate financing arrangements are often the result of the businessperson`s failure to realize the firm is carrying not only self-liquidating inventory, but also the anomaly of “permanent” current assets.
The movement from stage one to stage two for a typical business is depicted in figure 1-1. In Panel A the buldup in current assets is temporary and part is permanent. (Fixed assets are included in the illustrations)
Controlling Assets – Matching Sales and Production
In most firms, fixed assets grow slowly as productive capacity is increased and old equipment is replaced, but current assets fluctuate in the short run, depending on the level of production versus the level of sales. When the firm produces more than it sells, inventory rises. When sales rise faster than production, inventory declines and receivables rise.
Some firms employ level production methods to smooth production schedules and use manpower and equipment efficiently at a lower cost. One consequence of level production is that current assets go up and when sales and production are not equal. Other firms may try to match sales and production as closely as possible in the short run. This allows current assets to increase or decrease with the level of sales and eliminates the large seasonal bulges or sharp reductions in current assets that occur under level production.
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