Financial management decisions are divided into the management of assets (investments) and liabilities (sources of financing), in the long term and in the short term. It is well known that the value of a company cannot be maximized in the long run unless it survives in the short run. Businesses fail most often because they cannot meet their working capital needs; therefore, good working capital management is a requirement for the survival of the company.
About 60 percent of a finance manager’s time is spent managing working capital, and many potential employees in finance-related fields will discover that their first job assignment will involve working capital. For these reasons, the policy and management of working capital is a fundamental subject of study. In many textbooks, working capital refers to current assets, and net working capital is defined as current assets minus current liabilities. Working capital policy refers to decisions related to the level of current assets and the way in which they are financed, while working capital management refers to all those decisions and activities that a company undertakes to manage efficiently the items of current assets.
The term working capital originated with the old Yankee peddler, who would load his cart with merchandise and then set out on his route to sell his wares. The merchandise was called working capital because it was what he actually sold, or “turned over,” to produce his profit. The cart and horse were his fixed assets. Usually he owned the horse and cart, so they were financed with “stock” capital, but he borrowed the funds to buy the merchandise. These loans were called working capital loans and had to be repaid after each trip to show the bank that credit was strong. If the peddler could repay the loan, then the bank would make another loan, and these were sound banking practices. The days of the Yankee peddler are long gone, but the importance of working capital remains. Working capital management and short-term financing remain the two staples of working capital and a daily headache for financial managers.
Working capital, sometimes called gross working capital, simply refers to the company’s total current assets (short-term assets), cash, marketable securities, accounts receivable, and inventory. While long-term financial analysis is primarily concerned with strategic planning, working capital management deals with day-to-day operations. By making sure production lines don’t stop due to lack of raw materials, inventories don’t build up because production continues flat when sales drop, customers pay on time, and there’s enough cash on hand to make payments when due. Obviously, without good working capital management, no company can be efficient and profitable.
Statements about the flexibility, cost, and risk of short-term versus long-term debt largely depend on the type of short-term credit actually used. Short-term credit is defined as any liability originally scheduled for payment within one year. There are numerous sources of short-term funds, such as accruals, accounts payable (trade credit), bank loans, and commercial paper. The main elements of current liabilities are trade payables and bank overdrafts, and these are discussed further.