Tuesday, June 18, 2013

Capital Liquidity Management

Capital Management Issues

Working capital management refers to the administration of all components of working capital-cash, marketable securities, debtors (receivable) and stock (inventories) and creditors (payables). The financial manager must determine levels and composition of current assets. He must see that right sources are tapped to finance current asses, and that current liabilities are paid in time.

There are many aspects of working capital management which make it an important function of the financial manager.

1. Time: - Working capital management requires much of the financial manager’s time.
2. Investment: - Working capital represents a large portion of the total investment in assets.
3. Criticality: - Working capital management has great significance for all firms but it is very critical for small firms.
4. Growth: - The need for working capital is directly related to the firm’s growth.

Working capital management is critical for all firms, but particularly for small firms. A small firm may not have much investment in fixed assets, but it has to invest in current assets. Small firms in India face a severe problem if collecting their debtors (book debts or receivables). Further, the role of current liabilities in financing current assets is far more significant in case of small firms, as, unlike large firms, they face difficulties in raising long-term finances.

There is a direct relationship between a firm’s growth and its working capital needs. As sales grow, the firm needs to invest more in inventories and debtors. These needs become very frequent and fast when sales grow continuously. The financial manager should be aware of such needs and finance them quickly. Continuous growth in sales may also require additional investment in fixed assets.

It may thus be concluded that all precautions should be taken for the effective and efficient management of working capital. The finance manger should pay particular attention to the levels of current assets and the financing of current assets. To decide the levels and financing of current assets, the risk-return implications must be evaluated.

Liquidity Management

Net working capital is a qualitative concept. It indicates the liquidity position of the firm and suggests the extent to which working capital needs may be financed by permanent sources of funds. Current assets should be sufficiently in excess of current liabilities to constitute a margin or buffer for maturing obligations within the ordinary operating cycle of a business. In order to protect their interests, short-term creditors always like a company to maintain current assets at a higher level than current liabilities. It is a conventional rule to maintain the level of current assets twice the level of current liabilities. However, the quality of current assets should be considered in determining the level of current assets vis-à-vis current liabilities. A weak liquidity position poses a threat to the solvency of the company and makes it unsafe and unsound. A negative working capital means a negative liquidity, and may prove to be harmful for the company’s reputation. Excessive liquidity is also bad. It may be due to mismanagement of current assets. Therefore, prompt and timely actions should be taken by management to improve and correct the imbalances in the liquidity position of the firm.

Net working capital concept also covers the question of judicious max of long-term and short-term funds for financing current assets. For every firm, there is a minimum amount of net working capital which is permanent. Therefore, a portion of the working capital should be financed with the permanent sources of funds such as equity share capital, debentures, long-term debt, preference share capital or retained earnings, management must, therefore, decide the extent to which current assets should be financed with equity capital and/or borrowed capital.

In summary, it may be emphasized that both gross and net concepts of working capital are equally important for the efficient management of working capital. There is no precise way to determine the exact amount of gross or net working capital for any firm. The vote and problem of each company should be analyzed to determine the amount of working capital. There is no specific rule as to haw current assets should be financed. It is not feasible in practice to finance current assets by short-term sources only. Keeping in view the constraints, if the individual company having a judicious mix of long and short-term finances should be invested in current assets since when current assets involve cost of funds, they should be put to productive use.

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