Theories of Working Capital Management Notes for the UGC-NET Exam (2024)

Firms must determine the optimal strategy for managing current assets like cash, receivables, stock, and current liabilities. Other theories guide working capital management. The conservative theory urges holding high levels of current assets to secure liquidity. Yet, this can tie up funds unproductively, falling profits. The bold theory means holding low current assets to maximize profitability. But there is a higher risk of illiquidity and inability to meet debts. The moderate theory balances the need for liquidity with profitability by targeting an optimal level of current assets. It tries to strike a balance among traditional and bold methods. The cash management theory focuses on efficiently driving cash balances. It suggests misjudging cash while ensuring enough for costs and random needs. Firms aim for just enough cash to operate smoothly. There is no single best approach to working capital management.

Theories of working capital management are vital for the UGC-NET Commerce Examination in detail.

In this article, the learners will be able to find out in detail about the theories of working capital management along with other relevant topics.

Read about Homan’s Theory.

Theories of Working Capital Management

Working capital involves driving a firm's current assets (like cash, stock and receivables) and liabilities. Several theories guide firms' approaches, as stated below.

• The conservative theory advises carrying high current assets to ensure liquidity. However, excess funds tied up can reduce profits.
• The aggressive theory suggests maintaining low current assets to maximize profitability. But there is a higher risk of illiquidity and inability to meet obligations.
• The moderate theory advocates an optimal level of current assets that balances liquidity needs with profitability. It tries to strike a balance among traditional and aggressive strategies.
• The cash management theory focuses on efficiently working cash balances. It means minimizing cash while ensuring enough for costs and random needs.

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In summary, there is no "one size fits all" approach to working capital management. Firms must determine the optimal strategy based on the following:

• Industry conventions
• Type of operations
• Growth plans
• Risk tolerance

Most firms adopt moderate or cash management systems, balancing liquidity and profits. Dynamic firms optimize working capital continually to respond quickly to shifts.

Limitations of existing theories include the following.

• They do not think about the blended nature of working capital decisions.
• They are largely static and do not factor in shifts in firm needs.
• They do not account for variations across drives and firm cases.

This has led to new theories that take a more dynamic, situational perspective on working capital management tailored to specific initiatives and firms.

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Principles of Working Capital Management Policy

A sound working capital management policy should follow several principles to ensure liquidity while maximizing profitability, as stated below.

• The optimum level - The policy should aim to keep an optimum level of current assets that balances liquidity needs with returns on current assets. Holding too much or too little working capital can be disadvantageous.
• Time horizon - The time horizon of the firm should be considered. Short-term solvency needs differ from long-term growth objectives.
• Industry norms - The policy should align with industry norms and best methods for current ratios, stock turns, receivables group periods, etc. However, a firm's unique case should also be factored in.
• Risk tolerance - The right risk tolerance for liquidity should be decided based on the firm's financial situation and stakeholder preferences. Higher risk patience may allow for lower working capital holdings.
• Flexibility - The policy should allow for adjustments to the working capital strategy as firm needs vary. Static policies may evolve ancient fast.
• Reporting framework - Clear metrics and key outcome indicators should be defined to watch working capital efficiency, risks and changes over time.
• Duty - Blame for enforcing and yielding with the working capital policy should be set to specific roles.

An effective working capital policy balances trade-offs among liquidity, profitability, risk and flexibility while setting a strategic direction, blame framework and control systems. Normal reviews and graces ensure the policy keeps pace with shifts in the trade climate.

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Working Capital Management Theories and Approaches

There are several views and strategies for driving a firm's working capital, as stated below.

• Traditional approach: Keeping high current assets like cash, receivables and stock to ensure fine liquidity. However, excess funds tied up can reduce profits.
• Bold method: Having low levels of current assets to maximize profitability from funded funds. But there is a higher risk of illiquidity and inability to meet short-term debts.
• Mild approach: Aim for an optimal level of current assets that balances liquidity needs with returns on current assets. Tries to strike a balance among traditional and feisty courses.
• Cash management approach: Focuses on efficiently driving cash balances by misjudging cash while ensuring enough for costs and unexpected needs. Firms aim for enough cash to operate smoothly.
• Theories: Various theories guide these methods, including cash conversion cycle theory, uneven cost of stock theory and liquidity versus profitability theory.
• Limitations: Current theories are often static and do not think shifts in firm needs or mix the interdependencies of working capital decisions.
• Newer approaches: More dynamic, situational perspectives tailored to specific industries and firms. These consider the integrated nature of working capital management.

In summary, there is no "one-size-fits-all" approach. Firms must select the optimal strategy based on their needs, considering risk appetite, industry norms, growth plans and time horizon. Most firms adopt moderate or cash management systems, balancing liquidity and returns while sometimes editing plans in response to shifts.

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Working Capital Policies in Financial Management

A working capital policy provides policies for managing a firm's current assets and current liabilities to achieve its short-term economic goals. Key elements of an effective working capital policy include the following.

• Optimal Level - The policy should specify an optimal level of working capital that hovers liquidity needs with profitability. Extreme or low working capital can both be disadvantageous.
• Time Horizons - The time horizon of the firm should be considered. Short-term needs differ from long-term goals. The policy should reflect these contrasts.
• Industry Norms - The policy should align with industry best practices for stock levels, receivables group periods, etc. However, a firm's unique case should also be reflected.
• Risk Tolerance - The right liquidity risk tolerance, based on financial position and stakeholder priorities, should be limited in the policy. Higher risk patience may allow for lower working capital targets.
• Flexibility - The policy should allow for adjustments to the active capital strategy as trade needs vary. Static policies can quickly evolve.
• Reporting - Clear metrics and key version hands should be set to track and report on working capital efficiency, risks and adjustments over time.
• Responsibility - Accountability for executing and yielding with the policy should be assigned to specific roles within the alliance.

An effective working capital policy balances trade-offs among liquidity, profitability, risk and flexibility while feeding clear policies, fault and control systems. Periodic reviews ensure it keeps pace with the evolving firm climate. The specific elements of a working capital policy should be tailored to a firm's unique needs and situation.

Read about situational theory.

Main Components of Working Capital Management

Working capital management is crucial for a company's short-term financial health and involves the management of a company's current assets and liabilities. The main components of working capital management include:

• Current Assets: a. Cash: The amount of money on hand and in bank accounts. b. Accounts Receivable: The money owed to the company by its customers for goods or services sold on credit. c. Inventory: The value of raw materials, work-in-progress, and finished goods held by the company. d. Marketable Securities: Short-term investments that can be easily converted into cash, such as Treasury bills or money market funds.
• Current Liabilities: a. Accounts Payable: The amount the company owes to its suppliers for goods or services purchased on credit. b. Short-Term Debt: Any debt that needs to be repaid within the next 12 months, such as short-term loans or lines of credit. c. Accrued Liabilities: Unpaid expenses that have been incurred but not yet paid, such as wages, utilities, and taxes. d. Deferred Revenue: Payments received in advance for goods or services that have not yet been provided.
• Working Capital Formula: Working capital is calculated as the difference between current assets and current liabilities. The formula is:
  Working Capital = Current Assets - Current Liabilities
  A positive working capital indicates that a company has more current assets than current liabilities, which is generally a sign of financial health. A negative working capital suggests potential liquidity issues.
• Working Capital Ratios: Various financial ratios are used to assess working capital management, including: a. Current Ratio: Current Assets divided by Current Liabilities. It measures short-term liquidity. b. Quick Ratio (or Acid-Test Ratio): (Current Assets - Inventory) divided by Current Liabilities. It measures liquidity without relying on slow-moving inventory. c. Cash Ratio: Cash and Marketable Securities divided by Current Liabilities. It assesses the company's ability to pay off short-term obligations with cash on hand.
• Working Capital Policies: Companies need to establish policies and guidelines for managing working capital effectively. This includes decisions related to credit terms offered to customers, inventory turnover, and supplier payment terms.
• Working Capital Financing: Determining how to finance working capital needs, whether through short-term loans, lines of credit, or other financing options.
• Monitoring and Control: Continuous monitoring of working capital components to ensure they are in line with the company's goals and policies. Regular adjustments and corrective actions may be necessary.

Effective working capital management helps a company maintain liquidity, meet short-term obligations, and support day-to-day operations without straining its financial resources. It is a critical aspect of financial management for both small businesses and large corporations.

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Types of Working Capital

Working capital can be categorized into two main types based on its nature and usage:

Gross Working Capital

• Gross working capital refers to the total current assets of a company, including cash, accounts receivable, inventory, and marketable securities.
• It represents the company's investment in short-term assets required to maintain day-to-day operations.
• Gross working capital provides a broad view of a company's liquidity and short-term financial health but does not consider short-term liabilities.

Net Working Capital

• Net working capital is the difference between a company's current assets and current liabilities.
• It reflects the company's ability to meet its short-term obligations after covering its short-term debts.
• A positive net working capital indicates that a company has more current assets than current liabilities, which is generally considered a sign of financial stability. Conversely, a negative net working capital suggests potential liquidity issues.

Both gross and net working capital are important for assessing a company's financial position and managing its short-term financial obligations.

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Conclusion

Other theories guide firms' policies to driving current assets and current liabilities. The optimal approach depends on a firm's specific needs and cases. Most firms adopt mild or cash management plans that balance liquidity and profits while periodically altering plans in reaction to shifts. Newer dynamic, situational views focus on integrated management in line with a firm's precise situation. Rigid loyalty to a single theory is unlikely to provide optimal results for working capital management. Firms need dynamic, adaptive routes that blend parts from multiple views in a situational way tailored to their clear needs and events. A balance of liquidity, returns, risk and flexibility optimized regularly in reply to shifts assures a firm can seize options and react nimbly to threats.

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