Working capital Theories and Approaches Working capital is a financial metric which represents operating liquidity available to a business,

organization or other entity, including governmental entity. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. Net working capital is calculated as current assets minus current liabilities. It is a derivation of working capital that is commonly used in valuation techniques such as DCFs. If current assets are less than current liabilities, an entity has a working capital deficiency, also called a working capital deficit. Decisions relating to working capital and short term financing are referred to as working capital management. These involve managing the relationship between a firm's short-term assets and its short-term liabilities. The goal of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses.

Calculation of working capital

Current assets and current liabilities include three accounts which are of special importance. These accounts represent the areas of the business where managers have the most direct impact:

accounts receivable (current asset) inventory (current assets), and accounts payable (current liability)

The current portion of debt (payable within 12 months) is critical, because it represents a shortterm claim to current assets and is often secured by long term assets. Common types of shortterm debt are bank loans and lines of credit.

An increase in working capital indicates that the business has either increased current assets (that it has increased its receivables, or other current assets) or has decreased current liabilitiesfor example has paid off some short-term creditors. Implications on M&A: The common commercial definition of working capital for the purpose of a working capital adjustment in an M&A transaction (i.e. for a working capital adjustment mechanism in a sale and purchase agreement) is equal to: Current Assets Current Liabilities excluding deferred tax assets/liabilities, excess cash, surplus assets and/or deposit balances. Cash balance items often attract a one-for-one, purchase-price adjustment. Dimensions of WCM In addition to long-term investment decisions viz. which project to take up for investment? What is the appropriate amount of debt financing? What is the best dividend policy for a firm? Agency management software can help a business to deal with many questions related with customer relationship management and sales force automation software. Companies face many decisions involving investment in current assets and their firm? What should be the level of investment in inventories and bills receivables? How much cash or marketable securities should be held? What should be the level of credit purchases and bills payable? To what extent should the current assets be financed through long-term funds? These questions relate to the current assets and current liabilities of a firm, and belong to the field of working capital management. Working capital management is thus concerned with all the aspects of managing current assets and current liabilities. Let us pinpoint its significant dimensions which require the attention of financial executives. Hedging principles of WCM

Basically, the hedging principle is one which guides a firms debt maturity financing decisions. The hedging principle states that the financing maturity should follow the cash flow characteristics of the assets being financed. For example, as asset that is expected to provide cash flows over a period of say, 5 years, then it should be finance with a debt having similar pattern of cash flow requirements. The hedging approach involves matching the cash flows generating characteristics of an asset with the maturity of the sources of financing used to finance it.

The hedging approach to working capital financing is based upon the concept of bifurcation of total working capital needs into permanent working capital and temporary working capital. As the name itself suggests, the life duration of current assets and the maturity period of the sources of funds are matched. The general rule is that the length of the finance should match with the life duration of the assets. That is why the fixed assets are always financed by long term sources only. So, the permanent working capital needs are financed by long term sources. On the other hand, the temporary working capital needs are financed by short term sources only. In other words, the core or fixed working capital is financed by long term sources of funds while the additional or fluctuating working capital needs the financed by the short term sources.

For example, a seasonal expansion in inventories should be financed with short term loan or liabilities. The rationale of the hedging principle is straight forward. Funds are needed for a limited period say for purchase of additional inventory, and when that period is over, the cash needed to repay the loan will be generated by the sale of extra inventory items. Obtaining the needed funds from a long terms source would mean that the firm would still have the fund after the inventories had already been sold. In this case, the firm would have excess liquidity, which it either holds in cash or marketable securities until the seasonal increase in inventories occurs again. The result of all this would be lowers the profits of the firm. The financing mix as suggested by the hedging approach is a desirable financing pattern. However, it may be noted that the exact match of maturity period of current assets and sources of finance is always not possible because of uncertainty involved.