Working Capital Policy - Financial Management

Working capital policy involves decisions about a company’s current assets and current liabilities— what they consist of, how they are used, and how their mix affects the risk versus return characteristics of the company. Both the terms working capital and net working capital normally denote the difference between the company’s current assets and current liabilities. The two terms are often used interchangeably.

Working Capital Policy Notes

Working capital policies, through their effect on the firm’s expected future returns and the risk associated with these returns, ultimately have an impact on shareholder wealth. Effective working capital policies are crucial to a firm’s long-run growth and survival. If, for example, a company lacks the working capital needed to expand production and sales, it may lose revenues and profits.Working capital is used by firms to maintain liquidity, that is, the ability to meet their cash obligations as they come due. Otherwise, it may incur the costs associated with a deteriorating credit rating, a potential forced liquidation of assets, and possible bankruptcy.

Working capital management is a continuing process that involves a number of day-today operations and decisions that determine the following:

  • The firm’s level of current assets
  • The proportions of short-term and long-term debt the firm will use to finance its assets
  • The level of investment in each type of current asset
  • The specific sources and mix of short-term credit (current liabilities) the firm should employ

Working capital differs from fixed capital in terms of the time required to recover the investment in a given asset. In the case of fixed capital or long-term assets (such as land, buildings, and equipment), a company usually needs several years or more to recover the initial investment. In contrast, working capital is turned over, or circulated, at a relatively rapid rate. Investments in inventories and accounts receivable are usually recovered during a firm’s normal operating cycle, when inventories are sold and receivables are collected.

Importance of Working Capital

It has already been noted that a firm must have working capital to operate and survive. In many industries, working capital (current assets) constitutes a relatively large percentage of total assets. In the manufacturing sector, for example, current assets comprise about 40 percent of the total assets of all U.S. manufacturing corporations. Among the wholesaling and retailing sectors, the percentages are even higher—in the 50 to 60 percent range. shows the distribution of aggregate assets for several large companies. For the five companies shown, current assets as a percentage of total assets range from about 25 percent to over 50 percent. ExxonMobil, with its relatively high percentage of fixed assets, has a relatively low percentage of current assets.


In contrast,Walgreens, a retail pharmacy chain, has a relatively high percentage of current assets.Walgreens, with a large number of retail outlets, has almost 37 percent of its assets invested in inventories. IBM, which finances customer purchases of some of its products, has about 28 percent of its assets in receivables. Because current assets constitute a relatively high percentage of total assets in most businesses, it is important to have effective working capital policies. In a survey of large industrial corporations, it was found that about 30 percent of the companies have a formal policy for the management of their working capital and another 60 percent have an informal policy.

A significantly greater percentage of the larger companies within the sample have a formal policy than do the smaller companies. In almost onehalf of the companies that responded to the survey, the financial vice president has responsibility for establishing the company’s overall working capital policy. The president and treasurer are the next most frequently mentioned positions as having responsibility for working capital policy. There is considerable variation in the frequency with which companies review their working capital policy. Annual, quarterly, and monthly reviews are mentioned with about the same relative frequency (approximately 14 to 18 percent), whereas approximately one-half of the companies review working capital policy “whenever necessary.”

A firm’s net working capital position is not only important from an internal standpoint; it is also widely used as one measure of the firm’s risk. Risk, as used in this context, deals with the probability that a firm will encounter financial difficulties, such as the inability to pay bills on time. All other things being equal, the more net working capital a firm has, the more likely it is to be able to meet current financial obligations. Because net working capital is one measure of risk, a company’s net working capital position affects its ability to obtain debt financing. Many loan agreements with commercial banks and other lending institutions contain a provision requiring the firm to maintain a minimum net working capital position. Likewise, bond indentures also often contain such provisions.

Operating Cycle Analysis

A company’s operating cycle typically consists of three primary activities: purchasing resources, producing the product, and distributing (selling) the product. These activities create cash flows that are both unsynchronized and uncertain. They are unsynchronized because cash disbursements (for example, payments for resource purchases) usually take place before cash receipts (for example, collection of receivables). They are uncertain because future sales and costs, which generate the respective receipts and disbursements, cannot be forecasted with complete accuracy. If the firm is to maintain liquidity and function properly, it has to invest funds in various short-term assets (working capital) during this cycle.

It has to maintain a cash balance to pay the bills as they come due. In addition, the company must invest in inventories to fill customer orders promptly. And, finally, the company invests in accounts receivable to extend credit to its customers. Figure illustrates the operating cycle of a typical firm. The operating cycle is equal to the length of the inventory and receivables conversion periods:

Operating cycle = Inventory conversion period + Receivables conversion period

The inventory conversion period is the length of time required to produce and sell the product. It is defined as follows:

Inventory conversion period = Average inventory/Cost of sales/365

The receivables conversion period, or average collection period, represents the length of time required to collect the sales receipts. It is calculated as follows:

Receivables conversion period = Average accounts receivable/Annual credit sales/365

Operating Cycle of a Typical Company

The payables deferral period is the length of time the firm is able to defer payment on its various resource purchases (e.g., materials). The following equation is used to calculate the payables deferral period:

Operating Cycle of a Typical Company

Payable deferral period = Average accounts payable/Cost of sales/365

Finally, the cash conversion cycle represents the net time interval between the collection of cash receipts from product sales and the cash payments for the company’s various resource purchases. It is calculated as follows:

Cash conversion cycle = Operating cycle – Payables deferral period

The cash conversion cycle shows the time interval over which additional nonspontaneous sources of working capital financing must be obtained to carry out the firm’s activities. An increase in the length of the operating cycle, without a corresponding increase in the payables deferral period, lengthens the cash conversion cycle and creates further working capital financing needs for the company. Table shows an actual cash conversion cycle analysis for Walgreen Co., a drugstore retailer.Walgreen’s liquidity, as measured by the current and quick ratios, appears to have improved in 2002 compared to 2001.

The reduction of Walgreen’s cash conversion cycle from 44.9 days in 2001 to 43.6 days in 2002 indicates a more efficient utilization of its working capital. This was due primarily to over a 2-day reduction in its inventory conversion period, indicating that the company was turning over its inventory at a faster rate. Its receivables conversion period actually deteriorated slightly from 2001 to 2002 and its payables deferral period remained about the same.

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