The need for working capital and the management of...

10.2.3. Need for working capital and company value management

How to manage working capital? Why does the company need working capital if, figuratively speaking, it "selects" Does she have money? How to finance the need for working capital? Is the structure of financing this need relevant to the company? Is it possible to raise the question of the optimal correlation between own and borrowed sources of financing in relation to working capital? Current or long-term sources should be used to finance the need for working capital?

Inventory management has long been an organic part of operational management. Inventory management and accounts receivable are the most important elements of operational financial management. How does the management of working capital turn into an element of the overall strategy and a component of the company's financial strategy?

Seven factors of value growth. One of the founders of the theory of corporate shareholder value, Alfred Rappoport (see Chapter 8, § 8.3, pp. 466), distinguished seven factors of value growth for shareholders that any company creates. Among them is a decrease in the growth in the need for working capital. Practically oriented financial management assumes the existence of concrete measures that help to actually reduce the need for working capital. And yet it is necessary to decide the question, how realistic is it to calculate or rely on this reduction in its strategic plans and financial policy? Perhaps, on closer examination, after a fairly routine statement of the problem, there is nobody known "the country of the Looking Glass", where one has to move very fast to just stay in place, achieving stability?

Reducing the need for working capital in the most general case means only what is known to almost everyone today. Undoubtedly, we mean a reduction in inventories and accounts receivable. However, I would like to look at this problem from the perspective of the perspective and strategic vision of the future of the company. Our reasoning will change radically outwardly, because any strategic aspect of studying the problems of financial management inevitably leads us to cash flows. Reducing the need for working capital in terms of cash flow for the company will mean the following: cash outflows, i.e. investments in the growth of inventories and accounts receivable, will be less in comparison with cash inflows. Consequently, the amount of increment of funds sought by all managers turns out to be positive and will serve as a real source of growth in the value of the company. Both in the first and in the second case it is actually about the same thing - reducing the size of stocks and receivables.

Optimization of working capital requirements (TGSN) and sales growth. Opposite to this reduction is a very simple consideration. The growth in the scale of activities, which quantitatively manifests itself in the growth of sales volumes and the acceleration of their growth rates, inevitably leads to an increase in inventories and trade credit, and hence receivables. Thus, the problem of reducing the company's need for working capital, in the first approximation is obvious, on closer examination is not at all simple.

Of course, the growth of sales, which brings profit, is one of the most effective factors of value growth. Nevertheless, for many companies, the policy of reducing the need for working capital is more acceptable than the growth of sales and profits. Moreover, with the growth in sales, working capital also grows.

So, the first conclusion that arises in the formation of corporate financial policy is that it is easier to implement a policy of improvements in the management of working capital, thereby affecting its level and the need for investment, rather than developing a strategy for further growth in sales and profits .

The second conclusion is closer to reality. The policy of combining the optimal rates of development and reducing the need for working capital can bring the greatest effect to the company in terms of increment of its value. For the sake of justice it is worth noting: for a number of companies such a combination may be simply unacceptable. Examples include innovative or venture capital firms that are stagnant or operate in saturated food markets.

The need for working capital as an element of financial policy. The formation of the need for working capital is an organic element of financial policy. The increase in working capital requirements is an important component of free cash flow, which in investment decisions has to be calculated, forecasted, monitored and controlled. And all this to compare the present value of the expected cash flows with the initial investment and the implementation of the main rule of finance - the rules of net present value.

In addition, the need for working capital largely determines the structure of the invested capital, and it, in turn, forms the main criterion for profitability of operating activities. In this context, we mean the return on invested capital of any modern company engaged in determining its perspective or taking managerial decisions with an eye to strategic plans.

In order to get acquainted with the structure of free cash flow, making it in the name of strategic vision the subject of constant management care, we will use the management balance.

The balance schemes in the managerial format are developed by the listeners of the IBL and EMEP/ programs for many United States companies. In Table 10.8, the management balance of the company with the beautiful name "City of Masters" is given as an example. Practice has shown that their use has proven to be very useful, especially for companies that have actively begun to manage working capital on the basis of a balanced financial policy.

Free cash flow structure. Table 10.9 shows a diagram of the standard free cash flow, studying which it becomes clear that the role of the need for working capital in forecasting this type of cash flow can not be overestimated. This conclusion can easily be confirmed by statistics that graphically describe the relatively high proportion of working capital in the structure of the free cash flow of specific companies. A survey of a large number of United States companies differing in size, industry, and activities, showed fluctuations in the share of the need for working capital in the company's invested capital in the range from 40 to 55% or more.

TABLE 10.9. Free Cash Flow Scheme

Free Cash Flow Scheme

Managerial balance of the company "City of Masters", thousand rubles

Managerial balance of the company

However, despite the significant share of the need for working capital in the structure of free cash flow, its forecasting on closer examination is the least developed element of this cash flow. And the projected values ​​of working capital are most often either unreasonable, or reproduce the current trends.

Forecasting the need for working capital. The working capital requirement, which is the difference between current assets and current liabilities, less short-term loans, along with money and fixed assets, determines the amount of invested capital with which to build, and most importantly, quantify in essence any strategic alternatives. Of all the elements of invested capital, the least known for financial managers is the need for working capital. On the one hand, almost everyone knows about accounts receivable and accounts payable, a little less information about stocks. About working capital they write very many and very many years. On the other hand, the definition and the more the forecasting of the need for working capital for each company still remain problems unresolved, and for very many - unsolvable.

Working capital is designed to maintain the continuity of the operational cycle, and the need for it predetermines the amount of investment designed to finance this need. In fact, these investments represent the amount of inventories and receivables, net of accounts payable. If prepaid expenses are included in current assets (net of cash assets) and accrual costs are included in current liabilities, the company's investment in its working capital is measured by the difference between its current assets (without monetary assets) and current liabilities (net of short-term loans) . This difference determines the size of the company's need for working capital e:

where WCR (Working Capital Requirement) - the need for working capital; CA (Current Assets) - current assets; CASH - monetary assets; CL (Current Liabilities) - current liabilities; CD (Current Debt) - short-term loans.

For most companies, the need for working capital is positive; Current assets exceed current operating liabilities. Moreover, such excess is regulated and controlled by regulations. According to the current standard, current assets should be more than current liabilities exactly twice.

The need for working capital is sometimes negative. If you follow the traditional concepts of liquidity monitoring, the financial manager's reaction to this circumstance should be negative. But judiciously, it is easy to see: the negative value of the need for working capital, formed due to the fact that current liabilities in terms of accounts payable and accruals turned out to be larger than current assets without taking into account money, brings a lot of benefits to the financial manager.

In this case, the company's operational cycle becomes a source of money inflow, and the company ceases to play the role of a monster in the course of its operating activities, absorbing money without any reasonable restrictions. Companies that are likely to encounter negative working capital in the analysis are primarily companies operating in retail or in the service sector. This is often the case in construction. These companies collect money from their customers before they pay their suppliers. In addition, they contain relatively small stocks.

Net assets (or invested capital) are financed by two main sources of the company's capital - equity paid by the shareholders and borrowed capital from all kinds of creditors. The borrowed capital can be short-term or long-term. Accordingly, the invested capital as a cumulative source of financing invested capital can be classified in two ways: either as a sum of own and borrowed capital, or as a sum of sources of long-term financing (equity plus long-term borrowed capital) and short-term (short-term loans). In the first case, an approach is used that reveals the nature of the invested capital; The second approach reveals the length of funding sources.

Thus, when forming financial strategies that allow to finance investments in an effective way, apart from the usual optimization of the capital structure, it is necessary to determine a part of the borrowed capital that should be short-term or, alternatively, long-term within the chosen financial policy.

The company's profitability, risks and liquidity monitoring. The optimization of the capital structure is inextricably linked with the attempts of financial managers to balance the profitability of the company and its financial risks. This is how its financial stability is achieved. Unfortunately, the question of what kinds of loans (short-term or long-term) and in what ratio should be used in the implementation of a financial strategy are rarely discussed, and the answers to it are of a debatable nature. At the same time, this issue for strategic financial management of the company is no less important than the problems of financial stability. After all, it is inextricably linked to monitoring the liquidity of the company.

In the course of the study, the difference between financial stability and liquidity is not as obvious as it seems at first glance. If the company's liquidity demonstrates its ability to pay short-term current liabilities, then financial stability is, in fact, its liquidity from a long-term perspective.

Balanced financial strategy. When deciding which part of the investment should be financed from long-term sources and which - at the expense of short-term sources, most companies often resort to the so-called neutral, or balanced financial strategy. According to this strategy, long-term investments should be financed from long-term sources, and short-term investments should be financed from short-term ones. By balancing the life of the asset and the duration of its financial source, the company seeks to minimize the financial risk in which its fear is concentrated - the fear of losing its ability to finance the asset continuously, for the entire useful life of its life.

If you examine all three elements of invested capital, it becomes clear: a balanced financial strategy is used to finance a monetary asset: a short-term asset is financed by short-term obligations. Fixed assets are also financed from equity and long-term loans. Thus, in the case of fixed assets, a balanced financial strategy is most often implemented. The question remains open regarding the financing of the need for working capital.

In order to understand how the need for working capital should be financed, first of all it is necessary to establish the nature of the demand in it and only then decide what investments - long-term or short-term - this need should absorb? At first glance, it seems to everyone that the need for working capital is variable and is therefore financed by short-term investments. This point of view is explained very simply. Working capital consists of elements of current assets and current liabilities. And they are by definition short-term, reducing the company's cash balance for one year.

The constant nature of the need for working capital. However, a closer acquaintance with working capital shows that the nature of the sources of its financing is not so obvious. Although current assets and current liabilities are classified as current, they will be replaced by new current assets and liabilities as the new operating cycle resumes. And as long as the company remains in the business, the need for working capital will remain unchanged. In other words, the need for working capital refers to the category of permanent, and by nature closer to long-term investments. Thus, if a company seeks to follow a balanced (with minimal risk) financial strategy, it must finance its need for working capital from long-term sources. If the company is forced to finance the need for working capital at the expense of short-term funds, it must understand: its financial strategy is unbalanced, has, but in fact, an aggressive character in terms of risks that short-term loans can bring.

Let's explain what was said on a simple example.

Equipment with a useful life span of five years can be bought on credit. The loan can be of a long-term nature, say, the same five years. In this case, a neutral financial strategy will be implemented. The loan can be short-term and issued for a period of less than a year; in this case, a loan intended for the purchase of equipment must be replenished annually. The financial strategy in this situation is unbalanced. If we assume that the interest rate for a loan is the same in both cases, the unbalanced strategy appears to be more risky. The first reason for its imbalance lies in the interest rate. It and, accordingly, the cost of equipment financing can change over the next four years. The second reason is that the creditor can change his decision at any time and not resume crediting for the next year. These risks, interest and equity, are sharply reduced if a neutral balanced strategy is applied.

Without a doubt, the balance of the structure of assets and sources of their financing does not always mean for the company the optimal financial strategy. Most companies prefer to take on credit and stock risks. For example, in cases where it is certain that interest rates will decline, the above risks are justified. Nevertheless, there are many specific cases where companies prefer long-term financing. It seems to them that such a strategy, based on the use of long-term loans, will reduce their risks. Unfortunately, the third situation is known in United States practice: almost everywhere financial directors choose an unbalanced financial strategy, financing the need for working capital only at the expense of short-term sources. At the same time, they do not realize well what risks are placed on their company. One thing is clear: under conditions of continuously growing inflation, they can hardly rely on lowering interest rates in the foreseeable future, so it's legitimate to conclude that the financial risks of United States companies are unlikely to decline in the foreseeable future.

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