Chapter 13 • Management of working capital
The use of budgets
Control of working capital through the use of detailed plans in the form of budgets can
be very beneficial. The ability to assess in advance the calls that will be made on the
various elements of working capital enables managers to ensure that the ‘tanks’ are
always adequately full.
Few businesses have steady and regular working capital requirements from week
to week throughout the year. This is due, among other things, to seasonal factors.
Prior knowledge of what the demands are likely to be at various times is of enorm-
ous value.General attitude to working capital
Broadly, businesses should seek to minimise the level of each type of current asset
that they hold and to maximise the benefits of cheap short-term finance. This is,
of course, subject to the risks and costs involved with doing so to the extreme. For
example, granting credit to customers is expensive (in lost interest on the funds, if
nothing else), so, ideally, credit should not be offered. However, failing to offer credit
is very likely to mean that the business will be unable to make sales (perhaps because
competitors do offer credit). Clearly, the credit policy must seek to strike a balance
between the costs and risks of taking one extreme view and those of taking the other
extreme view.
Since working capital elements tend to be of high financial value, getting the
balance between the extremes wrong tends to be an expensive matter. Indeed, as we
shall shortly see, it can even be a fatal one.13.4 Working capital and liquidity
The need for liquidity
Not only do businesses need to strike a reasonable balance between the extremes
in respect of individual working capital elements, a balance should also be sought
between exploiting ‘cheap’ sources of short-term finance (current liabilities) to the
fullest possible extent, and the risks and possible costs involved with being heavily
reliant on suppliers of finance who can demand repayment at short notice. That is to
say, businesses need to maintain sufficient current assets to enable them to meet short-
term claims as they become due. They need to be able to do this since failure to meet
them would entitle the short-term claimants (of current liabilities) to take steps to put
the business into liquidation. This would normally involve the forced sale of some or
all of the business’s assets, including its non-current assets.
If bankruptcy costs were not significant and if the market for real assets were
efficient, from a shareholder wealth-maximisation perspective, the liquidation threat
would be unimportant. This is because shareholders could expect, on the liquidation
of the business, to receive an amount equal to the capital market price of the shares
immediately before the liquidation. In other words, liquidation would not affect
a shareholder’s wealth. In reality, of course, since bankruptcy costs are likely to be