Short Term Financing Bank Loans Trade Credit And Commercial Paper Working Capital Management

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Working Capital Management

Financial management decisions are divided into long-term and short-term management of assets (investments) and liabilities (financing resources). It is common knowledge that a firm’s value cannot be maximized in the long run unless it survives in the short run. Firms often fail because they are unable to meet their working capital requirements; Consequently, sound working capital management is essential for firm survival.

About 60 percent of a financial manager’s time is devoted to working capital management, and many prospective employees in finance-related fields will learn that their first job assignment will involve working capital. For these reasons, working capital is an essential subject of policy and management study. In many textbooks working capital refers to current assets, and net working capital is defined as current assets minus current liabilities. Working capital policy refers to decisions related to the level of current assets and how to finance them, while working capital management refers to all those decisions and activities that a firm undertakes to effectively manage the elements of current assets.

The term working capital originates from the old Yankee peddler, who would load his wagon with goods and then go on his way to peddle his goods. Merchandise was called working capital because it was actually sold by him, or “turned in” to produce his profit. A cart and a horse were his fixed assets. He usually owned horses and carriages, so they were financed with “equity” capital, but he borrowed funds to buy the business. These loans were called working capital loans, and they had to be repaid after each trip to show the bank that they had good credit. If the merchant was able to repay the loan, then the bank would issue another loan, and these were good banking practices. The days of the Yankee peddler are long gone, but the importance of working capital remains. Current asset management and short-term financing are still two fundamental elements of working capital and a daily headache for financial managers.

Working capital, sometimes called gross working capital, simply refers to a firm’s total current assets (short-term), cash, marketable securities, accounts receivable, and inventory. While long-term financial analysis is primarily concerned with strategic planning, working capital management is concerned with day-to-day operations. By ensuring that production lines do not shut down for lack of raw materials, that inventories do not build up because production remains unchanged when sales decline, that customers pay on time and that sufficient cash is on hand to pay when they are due. Obviously without good working capital management, no firm can be efficient and profitable.

Statements about the flexibility, cost, and risk of short-term credit versus long-term credit depend, to a large extent, on the type of short-term credit actually used. Short-term credit is defined as any obligation originally scheduled for payment within one year. There are many sources of short-term funding, such as accruals, accounts payable (trade credit), bank loans, and commercial paper. The major elements of current liabilities are trade creditors and bank overdrafts, and these are analyzed further.

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