Controlling the Components of Working Capital
Working capital (WC) can be controlled by changing the levels of current assets and/or current liabilities through a number of mechanisms.
Learning Objectives
- Discuss how a company can adjust its working capital
Key Takeaways
Key Points
- Increasing current assets or decreasing current liabilities increases WC, and vice versa.
- Four common mechanisms for controlling WC are cash management, inventory management, debtors management, and financing management.
- Having too little WC impairs a company’s ability to meet it’s financial obligations, while having too much WC can also be bad because it means that there are assets that are not being invested in the long-term.
Key Terms
- current liabilities: All liabilities of the business that are to be settled in cash within the fiscal year or the operating cycle of a given firm, whichever period is longer.
- Current Asset: An asset on the balance sheet, such as cash, accounts receivable, and inventory that is expected to be sold or otherwise used up in the near future, usually within one year or one business cycle, whichever is longer.
Controlling the Components of Working Capital
Each company has different demands for how much Working Capital (WC) they need, but all companies prefer to have positive WC (recall that WC = current assets – current liabilities). Having too little WC impairs a company’s ability to meet it’s financial obligations. It is hard to pay expenses or debts that come due in the short-term. Having too much WC can also be bad because it means that there are assets that are not being invested. Holding too many short term assets slows future growth of the company. Thus, managing WC to an acceptable level is one of the most important jobs of management.
Walmart CFO: Charles Holley, the Chief Financial Officer (CFO) of Wal-Mart, is in charge of making sure all of Wal-Mart’s assets are allocated as optimally as possible.
WC can be adjusted by increasing or decreasing its two components: current assets (CA) and current liabilities (CL). Increasing CA or decreasing CL increases WC, and vis versa. Management can enact a number of policies, some of which are highlighted below:
- Cash management: Identify the cash balance that allows the business to meet day to day expenses, but reduces cash holding costs. Cash is a CA.
- Inventory management: Identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials–and minimizes reordering costs–and hence increases cash flow. Inventory is a CA.
- Debtors management: Identify the appropriate credit policy, such as credit terms, that will attract customers, such that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence Return on Capital (or vice versa). Credit extended to customers (accounts receivable) is a CA.
- Financing management: Identify the appropriate source of financing. Short-term financing (as well as long-term financing that comes due in the next year or operating cycle) is a CL.
By adjusting these four primary influencers on CA and CL, management can change WC to a desirable level.
