The internal management of working capital can be distinguished from the capital budgeting decision that it underpins by:
The Production Cycle Unlike fixed asset investment, the working capital planning horizon, which defines the cyclical conversion of raw material inventory to the eventual receipt of cash from its sale, can be measured in months rather than years. Working capital can also be increased by smaller physical and monetary units. Such divisibility has the advantage that average investment in current assets can be minimised, thereby reducing its associated costs and risk.
The Financing Cycle Because the finance supporting working capital input (its conversion to output and the receipt of cash) can also be measured in months, management’s funding of inventory, debtors and precautionary cash balances is equally flexible. Unlike fixed asset formation, where financial prudence dictates the use of long-term finance wherever possible, working capital cycles may be supported by the long and short ends of the capital market. Finance can also be acquired piecemeal. Consequently, greater scope exists for the minimisation of capital costs associated with current asset investments.
Despite the disparity between capital budgeting and working capital time horizons, it is important to realise that the two functions should never conflict. Remember that the unifying objective of financial management is the maximisation of shareholders wealth, evidenced by an increase in corporate share price. This follows logically from a combination of:
- Investmentdecisions, which identify and select investment opportunities that maximiseanticipated net cash inflows in NPV terms,
- Financedecisions, which earmark potential funds sources required to sustain investments, evaluate the return expected by each and select the optimum mix which minimisestheir overall capital cost.
The relationships between investment and financing decisions are summarised in Figure 2.1.The diagram reveals that a company wishing to maximise its market price per share would not wish to employ funds unless their marginalyield at least matched the rate of return its investors can earn elsewhere. The efficientmanagement of current assets and current liabilities within this framework, therefore, poses two fundamental problems for financial management:
- Given sales and cost considerations, a firm’s optimuminvestments in inventory, debtors and cash balances must be specified.
- Given these amounts, a least-costcombination of finance must be obtained.