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Working capital management

Decisions relating to working capital and short term financing are referred to as working capital management. These involve managing the relationship between a firm's short-term assets and its short-term liabilities.

As above, the goal of Corporate Finance is the maximization of firm value. In the context of long term, capital investment decisions, firm value is enhanced through appropriately selecting and funding NPV positive investments. These investments, in turn, have implications in terms of cash flow and cost of capital.

The goal of Working capital management is therefore to ensure that the firm is able to operate, and that it has sufficient cash flow to service long term debt, and to satisfy both maturing short-term debt and upcoming operational expenses. In so doing, firm value is enhanced when, and if, the return on capital exceeds the cost of capital See Economic value added (EVA).

Introduction to Working capital definition:

Working capital also called as net current assets or current capital measures how much in liquid assets, a company has available to build its business.

Numerically, working capital is defined as current assets minus current liabilities. Working capital can be positive or negative depending upon how much debt the company is carrying. In general companies having a lot of working capital will be more successful since they expand and improve their operations. Companies with negative working capital may lack the fund necessary for growth.

Working capital may also be defined as the cash available for running day to day operations of the business to buy assets or to pay for the obligations.Ample working capital allows management to avail of unexpected opportunities and to qualify for bank loans and favourable trade credit.

Sources of Working Capital and some Numericals:

Sources of working capital are as follows:  

    1. Net income

    2.long term loans

    3.sale of capital asset

   4.injection of funds by owner

Some practical numericals:

Q:1. Company ABC Ltd. has cash in hand as $1000, inventory worth $3000 and recievables as $1000. The company has to pay creditors an amount of $ 2000 and has short term obligations as $1000. What is the working capital available with the firm.

Sol:  Since the company has

current assets as cash in hand+ inventory+ recievables= $1000+$3000+$1000 = $ 5000

and current liabilities as creditors+ short term long = $2000+ $1000= $3000

so working capital requirements will be current assets - current liabilities = $5000 - $2000 = $3000.

Q:2 Firm XYZ has current assets as $30,000 and current liabilities as $ 35,000. What can you interpret about the health of the company?

sol: For Firm XYZ,

current assets= $30,000   and current liabilities= $ 35,000

so working capital = $30,000- $35,000 = -$5,000

Since the firm has negative working capital, we can interpret that health of the firm is not so good. Growth opportunities are less for the firm and firm would not be able to tap opportunities prevailing in the market.Thus management of the firm should lay special emphasis on managing the working capital requirements of the firm.

Self Practice Questions on Working Capital Definition:

The underlying questions are for self practice so as to have a better understanding of the term.

Q:1 Firm XYZ has working capital need of $40,000. Firm has short term obligations as $ 30,000.How much firm should have as current assets so as to run operations with above mentioned working capital requirement?

Q:2 Firm ABC wants to take working capital loan from the bank forcoming fiscal year. If projected balance sheet shows that current assets amounts to $50,000 and Current liabilities as $ 20,000, How much sanction does the firm needs from the bank?

Q:3 Comapany ABC ltd has working capital as $2500, what can be said about the health of the firm?


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