Chapter 13 • Management of working capital
not have to pay immediately on delivery but may be allowed to delay payment for a
period, say 30 days. The second is a source with which many of us are all too familiar
in our private lives, the bank overdraft.
Since the relationship between these short-term sources of finance (or current
liabilities) and the current assets tends to be very close, it seems logical to deal with
both of them in the same chapter, though there would also have been logic in dealing
with short-term sources of finance, alongside long-term ones, in Chapter 8.Particular features of the management of working capital
In the same way that it can be seen as illogical to discuss short-term finance separately
from long-term finance, it can also be argued that it is wrong to separate discussion
of current assets from discussion of the investment decision generally. The reason for
taking the present approach is simply that there are features of the management of
current assets and of current liabilities that particularly commend dealing with them
together, yet separate from the longer-term investment and financing decisions. These
features include the systematic nature of the management of the working capital
elements and the frequency with which decisions have to be taken in respect of most
of them.
Perhaps another reason for discussing current assets and current liabilities together
is that care needs to be taken by financial managers to maintain a reasonable balance
between them, so it is important not to lose sight of their interrelationship. In fact,
so closely related are these two that they are frequently netted against one another
and considered as a single factor, namely working capital (current assets less current
liabilities).
The objective of working capital management is the same as that for non-current
asset and long-term financing decisions. This is typically the maximisation, or at least
the enhancement, of the shareholders’ wealth. This will be achieved by optimising
positive cash flows through striking an appropriate balance between costs and re-
venues, on the one hand, and risk, on the other.13.2 The dynamics of working capital
The working capital cycle
The upper portion of Figure 13.1 depicts, in a highly simplified form, the chain of
events in a manufacturing business as regards working capital. The chain starts with
buying raw material inventories on credit. In due course these inventories will be used
in production, work will be carried out on the inventories, and it will become work in
progress (WIP). Work will continue on the WIP until it eventually emerges as the
finished product. As production progresses, labour costs and overheads will need to
be met. Of course, at some stage trade payables will need to be paid. When the
finished goods are sold on credit, trade receivables are increased. These will eventu-
ally be paid, so that cash will be injected into the business.
Each of the areas – inventories (raw materials, WIP and finished goods), trade
receivables, cash (positive or negative) and trade payables – can be viewed as tanks
into and from which funds flow. Most of this chapter will be devoted to questions
of why any of these ‘tanks’ need exist at all and, if they are necessary, what attitude