CHAPTER 4

WORKING CAPITAL MANAGEMENT

WORKING CAPITAL
MANAGEMENT
INTRODUCTION
Working capital management (WCM) involves day
to day decisions regarding investment in current
assets and how the assets are to be financed i.e. it
is the management of both current assets and
current liabilities.

The study needs us to review alternative strategies

for investing in working capital for the purpose of
decision making which will affects the firm’s
riskiness and its expected rate of return
Objective Of Managing Working Capital
To achieve risk-return trade-off that
maximize the value of the firm
How? Current assets must be
available at all time to support the
firm’s operation. Current assets
holdings should be at minimum amount
to reduce investment and cost of
financing.
To achieve the objective firm’s can adopt 3 policies:

1. Relaxed Policy
This is a low risk policy.
Maintain large amount of current assets, as a result
there is high liquidity but low return from
investment.
2. Restricted Policy
– This is high risk policy.
– Reduce current assets holding to minimum, as a
result there will be low investment in current assets
which enable firm to increase investment in other
productive investment which can yields high
returns.
To achieve the objective firm’s can adopt 3 policies:
3. Moderate Policy
This is the middle road policy – it is between
relaxed and restricted policy.
Investment in current assets should be at minimum
level without sacrificing the liquidity requirements
– thus fund are available to invest in fixed assets
which are more productive.
Use short term financing to finance current assets
which is less expensive but do not use too
aggressively because it may lead to a decrease in
Net Working Capital, this could cause the risk of
Technical Insolvency – as a result moderate risk
and return could be achieved
Working Capital Strategies
 Current assets fluctuate overtime due to sales cycle and
business cycle, as such before we proceed to
understanding the strategies let us understand the terms
on how current assets being categorized and terms used in
financing the assets.

1. Permanent Assets
All assets fixed or current that are necessary for the firm
TO HOLD AT ALL TIME REGARDLESS OF FIRM’S
SALES LEVEL e.g. F.A- machinery, C.A – minimum
cash.

2) Temporary Assets
Part of current assets that FLUCTUATES DIRECTLY
WITH CHANGES IN SALES LEVEL.
(application preparation of Pro-forma Balance Sheet)
Working Capital Strategies
3) Permanent Liabilities (Financing)
Equity, long term debts are permanent in nature due
to their existence more than I year.

4) Temporary Liabilities (Financing)

Current liabilities used to support permanent current
assets e.g. short-term borrowings, notes payable,
commercial paper.

5) Spontaneous Financing
The type of financing arise from ordinary business
transactions – where no loan agreement or
negotiation is needed. E.g. trade credits- A/C
payable, Accruals – wages and taxes
 A) Hedging Approach
Ringgit Short- Term
or
Temporary
Fluctuating current assets Financing

Temporary Permanent +
Current Assets Spontaneous
financing

Permanent Current Assets

Fixed assets

Total Permanent Assets Time

Hedging Approach
Firms uses:
Temporary financing to finance temporary current assets
(TCA)
Permanent financing to finance permanent assets (FA +
PCA)
This approach is in line with traditional notion
where financing maturities should match the assets
requirement
Since this approach matches the financing duration
and the assets’ requirement, there is no need for
emergency funds
Results moderate risk with moderate returns
B) Aggressive Approach (Restricted Policy)

Short- Term or
Temporary
Financing
Fluctuating current assets

Temporary
Current assets

Permanent +
Permanent Level Of Current Assets Spontaneous
Financing

Fixed assets

Total Permanent Assets

Aggressive Approach
Involve more risk as it uses short-term/temporary
financing to support a relatively large portion of
current assets
Firm uses:
Long term financing to finance all fixed assets (FA) and
part of permanent current assets (PCA)
Short term financing to finance remaining permanent
current assets (PCA) and temporary current asset (TCA)
Current ratio low and may equal or less than 1
C) Conservative Approach ( Relaxed Policy)
Short- Term or
Temporary
Financing

Marketable
securities

r r e nt
Temporary cui n g Permanent +
tu a t
Current assets
Fl u c Spontaneous

s se ts financing
a
Permanent Level Of Current Assets

Fixed assets

Total Permanent Assets

Conservative Approach
Firm will prefer to have more cash in hand,
especially hard times
If there is excess funds, firms will invest in
marketable securities
Firm uses:
Permanent financing to finance the majority of its assets
that includes all permanent and part of temporary assets
Very safe policy
Lowest risk