Principles of Working Capital Management

Working capital management is concerned with the problem that arises in attempting to manage the current assets, the current liabilities and the inter-relationship that exist between them. The goal of working capital management is to manage a firm’s current assets and current liabilities in such a way that a satisfactory level of working capital is maintained.

The financial manager must keep in mind the following principles of working capital management:

  1. Principle of Optimization:The level of working capital must be so kept that the rate of return on investment is optimized. In other words, the working capital should be maintained at an optimum level. This is the point at which the increase in cost due to decline in working capital is equal to the increase in the gain associated with it. According to the principle of optimization, the magnitude of working capital should be such that each rupee invested adds to its net value. In other words capital should be invested in each component of working capital as long as the equity position of firm increases.”
  2. Principle of Risk Variation: This principle is based on the assumption that the rate of return on investment is linked with degree of risk in the business. Risk here refers to the inability of firm to maintain sufficient current assets to pay its obligations. If working capital is varied relative to sales, the amount of risk that a firm assumes is also varied and the opportunity for gain or loss is increased. In other words, there is a definite relationship between the degree of risk and the rate of return. As a firm assumes more risk, the opportunity for gain or loss increases. As the level of working capital relative to sales decreases, the degree of risk increases. When the degree of risk increases, the opportunity for gain and loss also increases. Thus, if the level of working capital goes up, amount of risk goes down, and vice-versa, the opportunity for gain is like-wise adversely affected.
  3. Principle of Cost of Capital: Each source of working capital has different cost of capital. The degree of risk also differs from one source to another. The type of capital used to finance working capital directly affects the amount of risk that a firm assumes as well as the opportunity for gain or loss and cost of capital. A firm should raise capital in such a manner that a balance is maintained between risk and profit.
  4. Principle of Maturity of Payment: This principle states that the working capital should be so raised from different sources that the firm is able to repay them on maturity out of its inflows of funds.  Otherwise the firm would fail to repay on maturity and ultimately, it would find itself into liquidation though it is earning huge profits. This implies that the firm’s ability to repay its short-term debts depends not on its earnings but on the flow of cash into it.
  5. Principle of Equity Position: According to this principle, the amount of working capital invested in each component should be adequately justified by a firm’s equity position. Every rupee invested in the working capital should contribute to the net worth of the firm.

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