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net working capital

Why do firms need to invest in net working capital?

Short-term financial planning is concerned with the management of the firm`s short-term, or current, assets and liabilities. The most important current assets are cash, marketable securities, inventory, and accounts receivable. The most important current liabilities are bank loans and accounts payable. The difference between current assets and current liabilities is called net working capital. Net working capital arises from lags between the time the firm obtains the raw materials for its product and the time it finally collects its bills from customers. The cash conversion cycle is the length of time between the firm`s payment for materials and the date that it gets paid by its customers. The cash conversion cycle is partly within management`s control. For example, it can choose to have a higher or lower level of inventories. Management needs to trade off the benefits and costs of investing in current assets. Higher investments in current assets entail higher carrying costs but lower expected shortage costs.

How does long-term financing policy affect short-term financing requirements?

The nature of the firm`s short-term financial planning problem is determined by the amount of long-term capital it raises. A firm that issues large amounts of long-term debt or common stock, or which retains a large part of its earnings, may find that it has permanent excess cash. Other firms raise relatively little long-term capital and end up as permanent short-term debtors. Most firms attempt to find a golden mean by financing all fixed assets and part of current assets with equity and long-term debt. Such firms may invest cash surpluses during part of the year and borrow during the rest of the year.

How does the firm`s sources and uses of cash relate to its need for short-term borrowing?

The starting point for short-term financial planning is an understanding of sources and uses of cash. Firms forecast their net cash requirement by forecasting collections on accounts receivable, adding other cash inflows, and subtracting all forecast cash outlays. If the forecast cash balance is insufficient to cover day-to-day operations and to provide a buffer against contingencies, you will need to find additional finance. For example, you may borrow from a bank on an unsecured line of credit, you may borrow by offering receivables or inventory as security, or you may issue your own short-term notes known as commercial paper.

How do firms develop a short-term financing plan that meets their need for cash?

The search for the best short-term financial plan inevitably proceeds by trial and error. The financial manager must explore the consequences of different assumptions about cash requirements, interest rates, limits on financing from particular sources, and so on. Firms are increasingly using computerized financial models to help in this process. Remember the key differences between the various sources of short-term financing for example, the differences between bank lines of credit and commercial paper. Remember too that firms often raise money on the strength of their current assets, especially accounts receivable and inventories.