Essential Principles of Working Capital Management

Short-Term Financial Management

Short-term financial management: The management of current assets and current liabilities.

Working capital: Current assets which represent the portion of investment that circulates from one form to another in the ordinary conduct of business.

Net working capital: The difference between a firm’s current assets and current liabilities.

Profitability: The relationship between revenues and costs generated by using the firm's assets (current and fixed) in productive activities.

Operating Cycle and Funding

Operating cycle: The time from the beginning of the production process to the collection of cash from the sale of the finished product.

• Categories: Inventory and accounts receivable.

CCC (Cash Conversion Cycle): The amount of time a firm's resources are tied up.

Permanent funding requirements: Constant investment in operating assets resulting from constant sales over time.

Seasonal funding requirement: Investment in operating assets that varies over time as a result of cyclic sales.

Aggressive funding strategy: A funding strategy under which the firm funds its seasonal requirements with short-term debt and its permanent requirements with long-term debt.

Conservative funding strategy: A funding strategy under which the firm funds both its seasonal and its permanent requirements with long-term debt.

Inventory Management Systems

ABC inventory system: Divides inventory into 3 groups (A, B, C) in descending order of importance and level of monitoring, on the basis of the dollar investment in each.

Two-bin method: Typically applied to C group items and involves reordering inventory when one of two bins is empty.

Economic Order Quantity (EOQ) model: A technique for determining an item’s optimal order size, which minimizes the total of its order costs and carrying costs.

• Order costs: Fixed clerical costs of placing and receiving an inventory order.
• Carrying costs: Variable costs per unit of holding an item in inventory for a specific period of time.
• Total cost of inventory: The sum of order costs and carrying costs.

Reorder point: The point at which to reorder inventory, expressed as days of lead time × daily usage.

Safety stock: Extra inventory that is held to prevent stockouts of important items.

Advanced Planning Systems

Materials Requirement Planning (MRP) system: Applies EOQ concepts and a computer to compare production needs to available inventory balances and determine when orders should be placed for various items on a product’s bill of materials.

Manufacturing Resource Planning (MRPII): A sophisticated computerized system that integrates data from numerous areas such as finance, accounting, marketing, engineering, and manufacturing, and generates production plans as well as numerous financial and management reports.