09-07-2012, 02:36 PM
Working Capital Finance
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The Importance of Working Capital Finance
The term working capital has several meanings in business and economic
development finance. In accounting and financial statement analysis, working
capital is defined as the firm’s short-term or current assets and current
liabilities. Net working capital represents the excess of current assets over
current liabilities and is an indicator of the firm’s ability to meet its shortterm
financial obligations (Brealey & Myers, 2002).
Business Uses of Working Capital
Just as working capital has several meanings, firms use it in many
ways. Most fundamentally, working capital investment is the lifeblood of
a company. Without it, a firm cannot stay in business. Thus, the first, and
most critical, use of working capital is providing the ongoing investment
in short-term assets that a company needs to operate. A business requires
a minimum cash balance to meet basic day-to-day expenses and to provide
a reserve for unexpected costs. It also needs working capital for prepaid
business costs, such as licenses, insurance policies, or security deposits.
Furthermore, all businesses invest in some amount of inventory, from a law
firm’s stock of office supplies to the large inventories needed by retail and
wholesale enterprises.
Permanent and Cyclical Working Capital
Firms need both a long-term (or permanent) investment in working
capital and a short-term or cyclical one. The permanent working capital
investment provides an ongoing positive net working capital position, that is,
a level of current assets that exceeds current liabilities. This allows the firm to
operate with a comfortable financial margin since short-term assets exceed
short-term obligations and minimizes the risk of being unable to pay its
employees, vendors, lenders, or the government (for taxes). To have positive
net working capital, a company must finance part of its working capital on a
long-term basis. Since total assets equal total liabilities and owner’s equity,
when current assets exceed current liabilities, this excess is financed by the
long-term debt or equities (Brealey & Myers, 2002).
Line of Credit
A line of credit is an open-ended loan with a borrowing limit that the
business can draw against or repay at any time during the loan period. This
arrangement allows a company flexibility to borrow funds when the need
arises for the exact amount required. Interest is paid only on the amount
borrowed, typically on a monthly basis.
Operations
Crystal Clear Window Company operates in leased quarters and produces
aluminum windows and sliding glass doors of standard sizes. The operation
is primarily one of assembly. The firm purchases extruded window frames
from a national aluminum manufacturer. These frames are then sawed and
punched to size for assembly, and the prepared frames are assembled along
with the necessary glass and screens, which are also purchased to size. Screens
are purchased from the same firm that provides the aluminum frames. Glass,
imported in sizable lots from concerns in Belgium and Australia on a letter of
credit basis with draft terms at sight, comprises approximately 25% of the
cost of materials. The cutting and punching machines are relatively simple
and inexpensive.