Current asset management, Cheat Sheet of Financial Management

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Current Assets

Management

Chapter contents

3.1 Working capital terminologies

3.2 Alternative current asset

investment policies

3.3 Cash management

3.4 Receivables management

3.5 Managing inventory

FM II 2

Working capital terminology

 Gross working capital – total current assets.  Net working capital – current assets minus non-interest bearing current liabilities.  Working capital policy – deciding the level of each type of current asset to hold, and how to finance current assets.  Working capital management – controlling cash, inventories, and A/R, plus short-term liability management.  Example: Determine the Net working capital of the organization based on the following data?

ABC Company

 - December31, Balance sheet - Cash …………………………………………… 3, - Accounts receivable(A/R)……………………….2, - Inventory………….……………………………..1, - Other current assets……………………………...2, - Equipment…………………………………….…3, 

• Total asset…………………………………………………..……...…...11, - Accounts payable (A/P).…………………………...1, - Wages payable …………………………………….1, - Salaries payable …………………………..………. 2, - Other current liabilities ……………………………... - Long term liability………………………………… 1, - Total liabilities.…………………………………………………7,
  • Capital,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,4,
• Total liability and capital……………………………………..………….11, - FM II

 Under a broader context, we can classify working capital as permanent and temporary working capitals. Permanent working capital /permanent

current assets/ is the amount of current

assets required to meet minimum

needs to ensure effective utilization of

fixed assets and for maintaining the

circulation of current assets

Financial Management II 7

For example, every manufacturing firm has to maintain a minimum level of raw materials, work-in-process, finished goods and cash balance.

Temporary working capital or

temporary current assets, on the

other hand, are the investment in

current assets that varies with

seasonal requirements

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3.2 Working Capital Investment Policy  Increasing the proportion of current assets to fixed assets lowers the profitability of assets (rate of return on assets) but decreases risk (or increase the liquidity position of a firm to meet unexpected future funds requirement).  Decreasing the proportion of current assets to fixed assets increases profitability of assets but it increases the risk (or reduces the liquidity position of a firm to meet unexpected future funds requirement). 10

There are three alternative working capital investment policies.  Conservative ,  Moderate and  Aggressive 11

Aggressive working Capital

investment policy

The company holds a relatively small

proportion of its total assets in the

form of current assets.

Yields a higher expected profitability

 Higher risk in contrast to

conservative policy.

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Moderate working capital investment policy Expected Profitability and Risk levels fall between those of conservative policy and aggressive policy. 14

 Character of firms’ operations. ❖ In certain industries the demand for working capital is subject to wide fluctuations due to seasonal variations.  Length of production cycles, ❖The longer the manufacturing process, the larger is the amount of working capital investment required. FM II 16

 Rate of inventory turnover, ❖A firm having a high rate of inventory turnover will need lower amount of working capital investment as compared to a firm having a low rate of turnover.  Seasonal factors and credit policy, ❖During the busy season, a firm requires larger working capital investment than in the slack season. ❖A firm that purchases on credit and sells its products/services on cash requires lesser amount of working capital investment. On the other hand, a firm buying its requirements for cash and allowing credit to its customers, shall need larger amount of working capital investment FM II 17

How does SKI’s working capital policy compare with its industry? SKI appears to have large amounts of working capital given its level of sales. Working capital policy is reflected in current ratio, turnover of cash and securities, inventory turnover, and DSO. These ratios indicate SKI has large amounts of working capital relative to its level of sales. SKI is either very conservative or inefficient.

Is SKI inefficient or just conservative? A conservative (relaxed) policy may be appropriate if it leads to greater profitability. However, SKI is not as profitable as the average firm in the industry. This suggests the company has excessive working capital.