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(^172) Financial Management
Net working capital concept also covers the question of judicious mix of long-term and
short-term funds for financing current assets. For every firm, there is a minimum
amount of net working capital which is permanent. Therefore, a portion of the working
capital should be financed with the permanent sorces of funds such as equity share
capital, debentures, long-term debt, preference share capital or retained earnings.
Management must, therefore, decide the extent to which current assets should be
financed with equity capital and/or borrowed capital.
In summary, it may be emphasised that both gross and net concepts of working capital
are equally important for the efficient management of working capital. There is no precise
way to determine the exact amount of gross, or net working capital for any firm. The data
and problems of each company should be analysed to determine the amount of working
capital. There is no specific rule as to how current assets should be financed. It is not
feasible in practice to finance current assets by short-term source only. ëKeeping in
view the constraints of the individual company, a judicious mix of long and short-term
finances should be invested in current assets. Since current assets involve cost of funds,
they should be put to productive use.
The common definition and its implications
The most common definition of net working capital is the difference between a firmís
current assets and current liabilities. As long as firmís current assets exceed its
current liabilities, it has net working capital. Most firm must operate with some amount
of net working capital; now much depends largely on the industry. Firms with very
predictable cash flows, such as electric utilities, can operate with negative net working
capital; however, most firms must maintain positive levels of net working capital.
The theoretical underpinning for the use of net working capital to measure a firmís
liquidity is the belief that the greater the margin by which a firmís current assets cover
its short-term obligations (current liabilities) the more able it will be to pay its bill as they
come due. However, a problem arises because each current asset and current liability
has a different degree of liquidity associated with it. Although the firmís current assets
may not be converted into cash at precisely the point in time when it is needed the
greater the amount of current assets present the more likely it is that some current
asset will be converted into cash in order to pay a debt that is due.
It is the nonsynchronous nature of a firmís cash flows that makes net working capital
necessary. The firmís cash outflows resulting from payment of current liabilities are
relatively predictable. It generally learns when bills are due when an obligation is
incurred. For instance, when merchandise is purchased on credit, the credit terms
extended to the firm require payment at a known point in time. The same predictability
is associated with notes payable and accruals, which have stated payment dates. What
is difficult to predict are the firmís cash inflows. Predicting when current assets other