Overall working capital policy considers both a firm’s level of working capital investment and its financing. In practice, the firm has to determine the joint impact of these two decisions upon its profitability and risk. However, to permit a better understanding of working capital policy, the working capital investment decision is discussed in this section, and the working capital financing decision is discussed in the following section. The two decisions are then considered together. The size and nature of a firm’s investment in current assets is a function of a number of different factors, including the following:
For the purposes of discussion and analysis, these factors are held constant for the remainder of this chapter. Instead of focusing on these factors, this section examines the risk–return trade-offs associated with alternative levels of working capital investment.
Profitability Versus Risk Trade-Off for Alternative Levels of Working Capital Investment
Before deciding on an appropriate level of working capital investment, a firm’s management has to evaluate the trade-off between expected profitability and the risk that it may be unable to meet its financial obligations. Profitability is measured by the rate of (operating) return on total assets; that is, EBIT/total assets. As mentioned earlier in this chapter, the risk that a firm will encounter financial difficulties is related to the firm’s net working capital position.
illustrates three alternative working capital policies.Each curve in the figure demonstrates the relationship between the firm’s investment in current assets and sales for that particular policy.
Policy C represents a conservative approach to working capital management. Under this policy, the company holds a relatively large proportion of its total assets in the form of current assets. Because the rate of return on current assets is normally assumed to be less than the rate of return on fixed assets,this policy results in a lower expected profitability as measured by the rate of return on the company’s total assets. Assuming that current liabilities remain constant, this type of policy also increases the company’s net working capital position, resulting in a lower risk that the firm will encounter financial difficulties.
In contrast to Policy C, Policy A represents an aggressive approach. Under this policy, the company holds a relatively small proportion of its total assets in the form of lower-yielding current assets and thus has relatively less net working capital. As a result, this policy yields a higher expected profitability and a higher risk that the company will encounter financial difficulties.
Finally, Policy M represents a moderate approach.With this policy, expected profitability and risk levels fall between those of Policy C and Policy A.
These three approaches may be illustrated with the following example. Suppose Burlington Resources has forecasted sales next year to be $100 million and EBIT to be $10 million. The company has fixed assets of $30 million and current liabilities totaling $20 million. Burlington Resources is considering three alternative working capital investment policies:
Assume that sales and EBIT remain constant under each policy contains the results of the three proposed policies. The aggressive policy would yield the highest expected rate of return on total assets, 15.38 percent, whereas the conservative policy would yield the lowest rate of return, 13.33 percent. The aggressive policy would also result in a lower net working capital position ($15 million) than would the conservative policy ($25 million). Using net working capital as a measure of risk, the aggressive policy is the riskiest and the conservative policy is the least risky. The current ratio is another measure of a firm’s ability to meet financial obligations as they come due. The aggressive policy would yield the lowest current ratio, and the conservative policy would yield the highest current ratio.
Optimal Level of Working Capital Investment
The optimal level of working capital investment is the level expected to maximize shareholder wealth. It is a function of several factors, including the variability of sales and cash flows and the degree of operating and financial leverage employed by the firm. Therefore, no single working capital investment policy is necessarily optimal for all firms.
Three Alternative Working Capital Investment Policies
In practice, however, this assumption may not be completely realistic because a firm’s sales are usually a function of its inventory and credit policies. Higher levels of finished goods inventories and a more liberal credit extension policy —both of which increase a firm’s investment in current assets—may also lead to higher sales. This effect can be incorporated into the analysis by modifying the sales and EBIT projections under the various alternative working capital policies. Although changing these projections would affect the numerical values contained in, it does not affect the general conclusions concerning the profitability versus risk trade-offs.
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Financial Management Tutorial
The Role And Objective Of Financial Management
The Domestic And International Financial Marketplace
Evaluation Of Financial Performance
Financial Planning And Forecasting
The Time Value Of Money
Risk And Return On At&t Common Stock
Fixed-income Securities: Characteristics And Valuation
Common Stock: Characteristics,valuation, And Issuance
Capital Budgeting And Cash Flow Analysis
Capital Budgeting: Decision Criteria And Real Option Considerations
Capital Budgeting And Risk
The Cost Of Capital
Capital Structure Concepts
Capital Structure Management In Practice
Working Capital Management
The Management Of Cash And Marketable Securities
Management Of Accounts Receivable And Inventories
Lease And Intermediate-term Financing
Financing With Derivatives
Internationan Financial Management
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