Additional Paid In Capital On The Cash Flow Statement Working Capital Management

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Working Capital Management

Financial management decisions are divided into the management of assets (investments) and liabilities (sources of financing), long-term and short-term. It is common knowledge that a firm’s value cannot be increased in the long run unless it survives in the short run. Companies often fail because they cannot meet their working capital requirements; Consequently, strong 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 strategy and management is an essential subject of study. In most 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 methods of financing them, while working capital management refers to all the decisions and activities that a firm takes to efficiently manage current asset components.

The term working capital originates from the old Yankee peddler, who would load his wagon with goods and then go on his way to peddling his goods. A trader was called working capital because that was what he actually sold, or made his profit. A carriage and a horse were his fixed assets. He usually owned a horse and wagon, so they were financed with “equity” capital, but he borrowed funds to purchase merchandise. These loans were called working capital loans and had to be repaid after each trip to show the bank that they were creditworthy. If the peddler was able to repay the loan, the bank would issue another loan and this was good banking practice. 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 the two basic components 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 the production line does not shut down due to raw material shortages, inventories do not build up because production remains unchanged when sales decline, customers pay on time and sufficient cash is on hand to make payments when due. Of course no firm can be efficient and profitable without good working capital management.

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 deposits, accounts payable (trade credit), bank loans, and commercial paper. The major components of current liabilities are trade creditors and bank overdrafts, and these are analyzed next.

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