Finance: Inventory and Working Capital Essay

Submitted By hrkeene
Words: 694
Pages: 3

Welcome to FIN 370, Working Capital Management. Working capital management entails short-term financial decision making. Short-term decisions involve cash inflows and outflows that occur within a year. What types of decisions need to be made? Here are some examples:

1. How much cash should be kept in order to pay bills?
2. How much cash needs to be borrowed in the short-term?
3. How much inventory should be kept on hand?

Working capital management is important for the following reasons. First, discussions with CFOs quickly lead to the conclusion that, as important as capital budgeting and capital structure decisions are, they are made less frequently, while the day-to-day complexities involving the management of net working capital (especially cash and inventory) consume tremendous amounts of management time. Second, it is clear that while poor long-term investment and financing decisions will adversely impact firm value, poor short-term financial decisions will impair the firm’s ability to continue operating. Finally, good working capital decisions can also have a major impact on firm value.

Working capital is composed of current assets and current liabilities. Cash is the most liquid current asset and, most likely, the most important. We will focus on how our decisions affect how much cash the firm has. We can define cash in terms of the other balance sheet accounts:

Net working capital + Fixed assets = Long-term debt + Equity

Net working capital = Cash + Other current assets – Current liabilities

Substituting NWC into the first equation and rearranging;

Cash = Long-term debt + Equity + Current Liabilities – Other current assets – Fixed assets

What activities affect the cash account?

Sources of Cash (Activities that increase cash)
Increase in long-term debt account (borrowed money)
Increase in equity accounts (sold stock)
Increase in current liability accounts (borrowed money)
Decrease in current asset accounts, other than cash (sold current assets)
Decrease in fixed assets (sold fixed assets)

Uses of Cash (Activities that decrease cash)
Decrease in long-term debt account (repaid loans)
Decrease in equity accounts (repurchased stock or paid dividends)
Decrease in current liability accounts (repaid suppliers or short-term creditors)
Increase in current asset accounts, other than cash (purchased current assets)
Increase in fixed assets (purchased fixed assets)

The Short-Term Financial Policy of the firm will show up in two ways:

.A The Size of the Firm’s Investment in Current Assets

If cash was collected from sales when the bills had to be paid, then cash balances and net working capital could be zero. The greater the mismatch between collections and payment, and the uncertainty surrounding collections, the greater the need to maintain some cash balances and to have positive net working capital.

Flexible (conservative) policy – high levels of current assets relative to sales, relatively more long-term financing

-Keep large cash