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Working Capital: Benefits of the Money Market

In the Beginning: The Balance Sheet

It all starts, when a couple of entities decide to pool their resources together to generate more resources. They do so by creating a company; and they inject it with their pooled resources [known as equity] along with some long-term debt; the combination of equity and long-term debt consitutes the company’s capital strucutre. The company then converts this capital “into assets [and operates it] to earn economic returns by fulfilling customer needs” (Groth and Anderson, 1997).

Thus, we have established that a company has assets financed through equity and long-term debt. The company’s assets are made up of current assets [which are more liquid: in the sense that they can be converted into cash more readily] and fixed assets [which are more illiquid assets: such as factories]. Like wise,  part of the longer-term debt will be short-term (or current liabilities), to enable day to day financing operations. Therefore, we conclude that current and fixed assets are financed with current liabilities, long-term debt and equity; which are the constitutes of the balance sheet. This is captured in the below formula:

Current Assets + Fixed Assets = Current Liabilities + Long-term Debt + Equity   (equation 1)

Working Capital: What Is That?

In a nutshell, “working capital is the [difference] between current assets and current liabilities” (Pass and Pike, 1987). Current liabilities represents the debts or obligations that must be paid by the company within the duration of one year; whereas, current assets are those assets that will be converted into cash within one year. Therefore, working capital represents the supposed excess cash on hand “to continue business operations” (Needles and Powers, 2004, p.259). The importance of this quantity is that it gages a company’s liquidity; the availability of cash to continue operations and meeting debt obligations.

Ideal World View: Working Capital

In an ideal world, the management of a company would be able to identify all the debt obligations it shall incur in the upcoming year. By knowing such information, management would match the current liabilities with the same amount of current assets; effectively having a net working capital of zero. Referring back to (equation 1) from the previous section, since current assets and current liabilities are equal, they can be dropped from the equation. Therefore, in an ideal world, fixed assets (which have a longer nature of usability) would be financed by long-term debt and equity. So we notice that, there is a matching of the “maturity dates of the assets with the liabilities” (Pass and Pike, 1987). This ideal world view is best captured in the below diagram:


Real World View: Working Capital & Money Markets

Though the ideal world view conceptually makes sense, it is flawed for two reasons. The first of which is that it is very hard to predict with certainty the debt obligations for the upcoming year. The second, and more important issue, is that “current assets cannot be expected to drop to zero … [as] long-term rising level of sales will result in some permanent investment in current assets” (Ross et al., 2008, p.755). This permanent investment in current assets comes partially in the form of accounts receivables, inventories, accruals, etc. Therefore, the real world view diagram will look something like:

A company will want to maintain a working capital such that it would minimize the sum of the carrying and shortage costs; it would do so by “minimizing the amount of funds tied up in current assets” (Filbeck and Krueger, 2005). Why a company would do so, is because short-term debt is much cheaper than long-term debt &/or equity, especially since working capital is financed by their of the latter two.  But if a company wants to maintain a set working capital, its must be able to predict accurately future inflow/outflows of transactions (cash); which as previously discussed, not possible. Thus a company might have, at anytime, a bit more or less cash relative to the optimal capital structures, running costs up; as depicted in the below diagram:

(Pass and Pike, 1987)

That’s were the role of the Money Market (MM) comes in. If a company has excess cash, it would invest it in the MM. Likewise, if it requires additional money, it would obtain it from the MM; which is short-term in nature, meaning cheaper than long-term debt or equity. In that regards, the more developed the MM of a given country, the easier it is for companies to obtain short-term finances, and maintain a working capital that would result in the least amount of costs.

~ Youssef Aboul-Naja

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