Question 5 (a)
Working capital management: importance, contrast with capital budgeting, deficiency and excess
9 marks
- Time to write
- About 18 minutes
- Topic
- Working capital
Question
Question 5 (a) · 9 marksDiscuss what working capital management is and why it is important. How does it differ from capital budgeting? What possible effects follow for a firm that experiences (i) a deficiency of working capital (ii) an Excess of working capital
Reworded from the university paper; the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.
Before you write
Read off the question and its marks
Read from the question
- Discuss…How…?Two asks in one question: answer both. Where it asks why, give reasons, not a description.
- How does it differSet the differences out in a table, basis by basis, not as two separate essays.
Write it in this order
The parts stand alone: start with the one you are surest of.
- Read; underline the asks; jot your points 1 min
- 1 Meaning and importance 3 marks 5 min
- 2 Difference from capital budgeting 2 marks 4 min
- 3 (i) Deficiency of working capital 2 marks 4 min
- 4 (ii) Excess of working capital 2 marks 3 min
- Check: every ask answered, key terms underlined 1 min
Easy marks
- Step 1 opens with the meaning: a one-line definition, the quickest mark in it.
Short on time? A few lines on every part beat a full answer to one: each part is capped at its own marks.
Try it first. About 18 minutes for 9 marks. Write it out, then open the solution.
Solution
Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.
What it is. Working capital management is the management of the firm's current assets (cash, receivables, inventory) and current liabilities, and of how they are financed, so that the firm holds the right amount of working capital: neither too much nor too little.
- It keeps the business solvent and running from day to day: materials can be bought, wages paid and bills met.
- It decides the trade-off between liquidity and profitability: too little working capital risks being unable to pay; too much lowers the return on the funds employed.
- Current assets are a large part of total assets and fluctuate constantly, so they need continuous attention; a larger scale of operations generally needs more working capital.
How it differs from capital budgeting
| Basis | Working capital management | Capital budgeting |
|---|---|---|
| Assets | Current assets and liabilities | Long-term (fixed) assets |
| Time span | Short term; decisions recur continually | Long term; benefits over many years |
| Reversibility | Easily changed | Largely irreversible |
| Main concern | Liquidity versus profitability | Return versus cost of capital (NPV, IRR) |
| Time value of money | Usually not central | Central to the decision |
(i) Effects of a deficiency of working capital
- Short-term liabilities cannot be paid on time; the firm loses its reputation and credit.
- It cannot buy in bulk or take cash discounts.
- It cannot exploit favourable market conditions or undertake profitable projects.
- Its return on investment falls.
- Day-to-day expenses cannot be met, causing inefficiency, higher costs and lower profits.
(ii) Effects of an excess of working capital
- Idle funds earn nothing, so the firm earns a poor return.
- Unnecessary purchasing and accumulation of stocks, with more theft, waste and loss.
- Overall inefficiency in the organisation.
- The low return may depress the share price.
- Surplus funds may be used for speculative transactions.
Where the 9 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Meaning and importance | 3 |
| 2 | Difference from capital budgeting | 2 |
| 3 | (i) Deficiency of working capital | 2 |
| 4 | (ii) Excess of working capital | 2 |
| Total | 9 |
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