Working capital management is crucial for a company's financial health. It's about balancing current assets and liabilities to keep operations running smoothly. Without enough working capital, a business might struggle to pay bills or miss growth opportunities.

The working capital cycle shows how long it takes to turn inventory into cash. Companies aim for a shorter cycle to generate cash faster. Different policies, from aggressive to conservative, offer trade-offs between risk and profitability in managing working capital.

Working Capital and Its Management

Importance of working capital

• Represents the difference between a company's current assets (cash, accounts receivable, inventory) and current liabilities (accounts payable, short-term debt)
• Essential for meeting short-term financial obligations and maintaining smooth operations
• Ensures ability to pay bills, maintain inventory, and extend credit to customers
• Insufficient working capital can lead to liquidity problems, missed opportunities (business expansion), and potential bankruptcy

Components of working capital cycle

• Also known as the cash conversion cycle, represents the time taken to convert investments in inventory and resources into cash from sales
• Inventory days: Average number of days to sell inventory
• Accounts receivable days: Average number of days to collect payments from customers
• Accounts payable days: Average number of days to pay suppliers
• Calculated as: $Inventory\ days + Accounts\ receivable\ days - Accounts\ payable\ days$
• Shorter cycle indicates faster cash generation, while longer cycle may lead to increased financing requirements and liquidity risk (inability to meet short-term obligations)

Working Capital Policies and Trade-offs

Types of working capital policies

• Strategies employed to manage current assets and liabilities
• Aggressive policy:
  • Minimizes investment in current assets (inventory, accounts receivable)
  • Maximizes use of short-term financing (accounts payable, short-term debt)
  • Higher risk but potentially higher returns due to reduced carrying costs and increased cash availability
• Moderate policy:
  • Balances investment in current assets and use of short-term financing
  • Maintains moderate levels of inventory, accounts receivable, and accounts payable
  • Moderate risk and returns, balancing liquidity and profitability
• Conservative policy:
  • Maintains higher levels of current assets (inventory, accounts receivable)
  • Relies less on short-term financing and more on long-term funds
  • Lower risk but potentially lower returns due to increased carrying costs and reduced cash availability

Risk vs profitability in working capital

• Balancing trade-off between liquidity risk and profitability
• Liquidity risk:
  1. Risk of insufficient cash or liquid assets to meet short-term obligations
  2. Higher current asset levels reduce liquidity risk but may lower profitability
• Profitability:
  1. Ability to generate profits from operations
  2. Lower current asset levels and higher short-term financing usage can increase profitability but may raise liquidity risk
• Optimal balance depends on industry, business model, and risk tolerance
• Effective management involves continuously monitoring and adjusting current asset and liability levels to maintain desired risk-profitability balance