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Part Two: Working Capital Management

2. The Objectives and Structure of Working Capital Management

2.1. Introduction

In the previous Chapter, we observed that from an external user's analysis of periodic published financial statements:

Working capital is conventionally defined as a firm's current assets minus current liabilities on the date that a Balance Sheet is drawn up.

Respectively, current assets and current liabilities are assumed to represent those assets that are soon to be converted into cash and those liabilities that are soon to be repaid within the next financial period (usually a year).

However, from an internal financial management perspective, these accounting definitions were shown to be far too simplistic, a view supported by most contemporary writers and commentators on the subject (academic or otherwise).

For example, the popular "Guide to Financial Management" by John Tennent (2013) which is well worth reading, maintains that corporate management's skill is not simply how to record transactions, interpret the details of financial reporting and monitor any deviations in performance. It begins with a company's "mission" statement, namely knowledge of its long-term objectives, strategy and tactics at the highest level. To ensure that investment and financing decisions conform to the mission, management also need to be aware of the consequences of their actions from the outset, by creating a strategic plan incorporating the likely effects of any changes to its existing activity.

The following Exercises should clarify these issues from a working capital perspective.

2.2. Exercise 2.1: Financial Strategy: An Overview

If the normative objective of financial management is the maximization of shareholder wealth, a company requires a "long-term course of action" to satisfy this objective. And this is where "strategy" fits in.


1. Define Corporate Strategy

2. Explain the meaning of Financial Strategy?

3. How does strategy differ from "tactical" and "operational" planning?

An Indicative Outline Solution

1. Corporate Strategy

Strategy is a course of action that specifies the monetary, physical and human resources required to achieve a predetermined objective, or series of objectives, which satisfies the corporate mission statement.

Corporate Strategy is an over -arching, long-term "plan of action" that comprises a coordinated portfolio of functional business strategies (finance, marketing etc.) designed to meet the specified objective(s).

2. Financial Strategy

Financial Strategy is the portfolio constituent of the corporate strategic "plan" that embraces optimum investment and financing decisions required to attain an overall specified objective.

3. Strategic, tactical and operational planning.

- Strategy is a long-run macro course of action.

- Tactics are an intermediate plan designed to satisfy the objectives of the agreed strategy.

- Operational activities are short-term (even daily) functions, such as inventory control and cash management, required to satisfy the specified corporate objective(s) in accordance with tactical and strategic plans.

Needless to say, whilst senior management decide strategy, middle management focus on tactics and line management exercise operational control. None of these functions are independent of the other. All occupy a pivotal position in the decision-making process and naturally require co-ordination at the highest level.

2.3. Exercise 2.2: Financial Strategy and Working Capital

We have observed financial strategy as the area of managerial policy that determines macro investment and financial decisions, both of which are preconditions for shareholder wealth maximization. However, each decision can then be subdivided into two broad categories to satisfy a company's mission statement; longer term (strategic or tactical) and short-term (operational). The former is the province of capital budgeting (ideally based on ENPV analysis). The latter relates to working capital management. But obviously the two must be coordinated to satisfy the firm's overall objective(s).


1. Outline the contrasting features of capital budgeting and working capital management.

2. Explain how working capital fits into project appraisal using ENPV analysis.

T will then provide a Chapter summary.

An Indicative Outline Solution

1. Capital budgeting decisions are typically strategic, large scale and long-term, which may also be unique. Investment involves significant fixed asset expenditure but uncertain future gains. Financial prudence dictates the use of long-term sources of finance wherever possible, to ensure a project's liquidity before profits come on stream. Without sophisticated periodic forecasts of required outlays and associated returns that model the time value of money and an allowance for risk, the subsequent penalty for error can be severe. The decision itself may be irreversible, resulting in corporate failure.

Conversely, working capital management is operational. Investment decisions are short term, (measured in months rather than years) repetitious and divisible. So much so, that sometimes, current assets (notably inventory) may be acquired piecemeal. Such divisibility has the advantage that the average investment in current assets can be minimized, thereby reducing its associated costs and risk.

Unlike fixed asset formation, working capital investment may be supported by the long and short ends of the capital market. A proportion of, finance can therefore be acquired piecemeal, which provides greater scope for the minimization of capital costs associated with current asset investments.

Costs and returns are usually quantifiable from existing data with any weakness in forecasting easily remedied. Decisions themselves may be reversible, without any loss of goodwill.

2. Conventional accounting wisdom dictates that the more current assets "cover" current liabilities (particularly cash or near cash, rather than inventory) the more solvent the company. In other words, the greater the degree to which it can meet its short term obligations as they fall due.

From an internal financial management stance, however, these interpretations are too simplistic.

o Working capital represents a firm's net investment in current assets required to support its day to day activities.

o Working capital arises because of disparities between the cash inflows and outflows created by the supply and demand for the physical inputs and outputs of the firm.

For example, a company will usually pay for productive inputs before it receives cash from the subsequent sale of output. Similarly, a company is likely to hold precautionary stocks of inventory input and output to solve any problems of erratic supply and unanticipated demand.

For the technical purpose of investment appraisal, management therefore incorporate initial working capital into ENPV project analysis as a cash outflow in year zero. It is then adjusted in subsequent years for the net investment required to finance inventory, debtors and precautionary cash balances, less creditors, caused by the acceptance of a project. At the end of the project's life, funds still tied up in working capital are released for use, elsewhere in the business. This amount is treated as a cash inflow in the last year, or thereafter, when available.

The net effect of these adjustments is to charge the project with the interest foregone, i.e. the opportunity cost of the funds that were invested throughout its entire life. All of which is a significant departure from the conventional interpretation of published accounts by external users, based on the accrual concepts of Financial Accounting and generally accepted accounting principles (GAPP).

2.4. Summary and Conclusions

Despite the differences arising from the time horizons of capital budgeting and working capital management, it is important to realize that the two functions should never conflict. Remember that the unifying objective of financial management is the maximization of shareholders wealth, evidenced by an increase in a corporate share price.

Irrespective of the time horizon, the investment and financial decision functions of financial management (including working capital) should always involve a continual:

- Search for investment opportunities, consistent with the firm's business strategy.

- Selection of the most profitable investment opportunities (in absolute ENPV terms).

- Determination of an optimal mix of internal and external funds (long or short) that finances those opportunities.

- Application of a system of budgetary controls, using variance analysis, to govern the acquisition and disposition of funds.

- Analyses of financial result, using performance indicators as a guide to future investment.

None of these functions are independent of the other. All occupy a pivotal position in the decision-making process and naturally require co-ordination at the highest level.

2.5. Selected References

1. Tennent, J., The Economist Guide to Financial Management, Profile Books Ltd, 2013.

Text Books:

Working Capital and Strategic Debtor Management, 2013.

Business Texts:

Working Capital Management: Theory and Strategy, 2013.

Strategic Debtor Management and the Terms of Sale, 2013.

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