Investment Decisions for Current Assets
Dr D. M. L. Kasilo
(MBA, CPA, PhD)
1Working Capital: What is it?
As a matter of principal, any understanding of financial management theories and best practices depends much on ones understanding of the balance sheet model. Figure 1, is adopted to facilitate discussions on working capital management practices.
Figure 1:The Balance Sheet Model? Financial Expression of an Entity
Balance Sheet as at March 31, 2000
ASSETS LIABILITIES AND SHAREHOLDERS EQUITY
1. Gross Working Capital = Level of Investment in Current Assets
Working capital (gross) refers to total current assets that sustain day-to-day business operations. According to the balance sheet model (figure 1), the main components of current assets include: Cash, Marketable Security, Notes Receivable, Accounts Receivable, and Inventories of Raw materials, Work-in-Progress, and Finished goods
Inefficient management of working capital can dramatically affect a company's cash flow. Take about one minute; ponder the impact to cash flows of inefficient management of each major component of current assets.
1.1.2Financing Level of Investment in Current Assets/Gross Working Capital
(i)Current assets [gross working capital] have to be financed. This needs short-term financing decisions. The question, `how do we finance current assets' needs of the corporation' has to be answered.
(ii)Current liabilities are the main sources of financing current assets, that is, current liabilities mainly finance current assets: According to the balance sheet model (figure 1), typical current liabilities include: - NOTES PAYABLE, ACCOUNTS PAYABLE, ACCRUED LIABILITIES, and BANK LOANS/OVERDRAFT
1. General Approach
1.2.1Since payment of current liabilities uses current assets, it must be carefully undertaken so that the corporation remains technically solvent: it must posses the necessary liquidity for the day-to-day business operations.
1.2.2There are two very important considerations in managing working capital needs: Economic Cycles and Seasonality of a Corporation's Lines of Businesses
Growing/Booming, stagnant or Recession. Changes in economic conditions affect demand for the product/service. The impact is seen in changes in sales volume; that affects receivable and inventories.
(b)Seasonality of a Company's Lines of Businesses.
The questions are:
-When is the peak period for sales?
-When is the trough for sales?
Therefore, given the economic cycle and the seasonality of the products/businesses, how does the corporation manage its gross working capital and current liabilities such that it remains technically solvent?
Q1.HOW DOES A CORPORATION MANAGE EACH COMPONENT OF CURRENT ASSETS SO THAT IT REMAINS TECHNICALLY SOLVENT?
Q2.HOW DOES A CORPORATION MANAGE EACH COMPONENT OF CURRENT LIABILITIES SUCH THAT IT REMAINS TECHNICALLY SOLVENT?
Overall, What Should be the Net Working Capital Management Strategy for the Corporation?
The above questions are partly answered in the following sections.
2.Working Capital Management Fundamentals
The challenges to working capital managers is how to KEEP THE FIRM TECHNICALLY SOLVENT WHILE INCREASING PROFITABILITY YEAR AFTER YEAR. This is achieved through various techniques, some of which are discussed in the following sections.
2.1.1Short-term Financial Management in Practice
Means Managing Current Assets and Current Liabilities. It is one of the financial manager's most important and time-consuming activity. Short-term Financial Management is also generally referred to as...