MANAGING NET WORKING CAPITAL BASIC INFORMATION AND TUTORIALS

Working capital is equal to current assets. Net working capital is equal to current assets less current liabilities.

EXAMPLE Ace Company has the following selected assets and liabilities:
Cash $10,000
Accounts receivable $30,000
Inventory $42,000
Machinery $90,000
Long-term investments $36,000
Patent $4,000
Accounts payable $12,000
Taxes payable $3,000
Accrued expenses payable $5,000
Bonds payable $50,000
Common stock $70,000
The net working capital is:

CURRENT ASSETS
Cash $10,000
Accounts receivable 30,000
Inventory 42,000 $82,000

CURRENT LIABILITIES
Accounts payable $12,000
Taxes payable 3,000
Accrued expenses payable 5,000 20,000
Net working capital $62,000

Management of net working capital involves regulating the various types of current assets and current liabilities. Management of net working capital also requires decisions about how current assets should be financed, for example, through short-term debt, long-term debt, or equity.

Net working capital is increased when current assets are financed through noncurrent sources. The liquidity of current assets will affect the terms and availability of short-term credit. The greater the liquidity, the easier it becomes, generally, to obtain a short-term loan at favorable terms. Short-term credit, in turn, affects the amount of cash balance held by a firm.



Working Capital Management and Risk-Return Trade-Off
The management of net working capital requires consideration for the trade-off between return and risk. Holding more current than fixed assets means a reduced liquidity risk. It also means greater flexibility, since current assets may be modified easily as sales volume changes.

However, the rate of return will be less with current assets than with fixed assets. Fixed assets typically earn a greater return than current assets. Long-term financing has less liquidity risk associated with it than short term debt, but it also carries a higher cost.


For example, when a company needs funds to purchase seasonal or cyclical inventory, it uses short term, not long-term financing. The short-term debt gives the firm flexibility to meet its seasonal needs within its ability to repay the loan.

On the other hand, the company’s permanent assets should be financed with long-term debt. Because the assets last longer, the financing can be spread over a longer time. Liquidity risk may be reduced by using the hedging approach to financing, in which assets are financed by liabilities with similar maturity