Impact of aggressive working capital

“Impact of Aggressive

Working Capital

Management Policy on

Firms’ Profitability”

Ben10 Members: × Ben Jose× Christeena James× Deepa Rose Jacob× Indu Sukumaran× Jenita× Stephanie

The present study…• investigates the traditional relationship between

working capital management policies and a firm’s

profitability.

• Managers can create value if they adopt a

conservative approach towards working capital

investment and working capital financing policies.

The study also finds that investors give weight to

the stocks of those firms that adopt an aggressive

approach to managing their short-term liabilities.

What It Says…• Management of short-term assets and liabilities

need a careful investigation because the working

capital management plays an important role in a

firm’s profitability and risk as well as its value.

• Efficient management of working capital is a

fundamental part of the overall corporate

strategy in creating the shareholders’ value.

Definition of 'Working Capital'

Working Capital refers to that part of the firm’s capital, which

is required for financing short-term or current assets such a

cash marketable securities, debtors and inventories. Funds

thus, invested in current assets keep revolving fast and are

constantly converted into cash and this cash flow out again in

exchange for other current assets. Working Capital is also

known as revolving or circulating capital or short-term capital.

KINDS OF WORKING CAPITAL

WORKING CAPITAL

BASIS OF CONCEPT

BASIS OF TIME

Gross Working Capital

Net Working Capital

Permanent / Fixed

WC

Temporary / Variable

WC

Regular WC

Reserve WC

Special WC

Seasonal WC

Significance of Net Working Capital

Maintaining Liquidity position

For maintaining liquidity position there is a need to maintain

CA sufficiently in excess of CL.

Judge Financial Soundness of a firm

The Net working capital helps creditors and investors to

judge financial soundness of a firm.

Working Capital Financing Mix

Approaches to Financing Mix

The Conservative Approach

The AverageApproach

The Aggressive Approach

Aggressive and conservative levels of working

capital sit at the opposite ends of a spectrum.

This approach suggested that the entire estimated

investments in current asset should be finance

from long term source and short term should be

use only for emergency requirement.

Distinct features of this approach

• Liquidity is greater

• Risk is minimized

Conservative Approach

Companies in volatile or seasonal industries such as tourism, farming or construction might adopt conservative working capital policies to buffer against risk. 1. If you employ a conservative working capital policy:

there’s plenty of cash in the bank, 2. your warehouses are full of inventory and 3. your payables are all up to date.

If you compute the working capital ratio –

current assets/current liabilities a conservative

policy might yield a ratio above 2.0.

That is, you have more than $2 in current assets for

every dollar of short-term liabilities. Conservatively

managed working capital will help lower your risks of

short-term cash shortages but might hurt your long-

term profitability, because excess cash doesn’t earn

much of a return.

Aggressive approach

• The aggressive approach suggests that the entire

estimated requirement of current asset should be

financed from short-term sources and even a part

of fixed asset investment be financed from short -

term sources.This approach make the finance mix :• More Risky• Less costly • More Profitable

• An aggressive working capital policy is one in which

you try to squeeze by with a minimal investment in

current assets coupled with an extensive use of

short-term credit.

• Your goal is to put as much money to work as

possible to decrease the time needed to produce

products, turn over inventory or deliver services.

• Speeding up your business cycle grows your sales

and revenues. You keep little money on hand, cut

slow-moving inventory and unnecessary supplies

to the maximum and pay out your bills for as long

as possible.

Conservative  Use permanent capital for permanent assets and temporary assets.

Average   Match the maturity of the assets with the maturity of the financing.

 Aggressive   Use short-term financing to finance permanent assets.

In Simple Words…

So, the present study done by Mian Sajid Nazir and Talat Afza,

lecturer and professor of CIIT, Lahore, Pakistan, investigates the

relative relationship between the aggressive/conservative

working capital policies and profitability as well as risk of firms

for 208 public limited companies listed at Karachi Stock

Exchange for the period of 1998-2005. The empirical results,

which is in line with the study of Afza and Nazir (2007), found

the negative relationship between working capital policies and

profitability. It also says that there is no relationship between the

level of current assets and liabilities and risk of the firms.