Investment in working capital involves determination of the total quantum of current assets, the size of individual items of current assets and the operating cycle. These may be planned, adopting any of the following approaches, viz. industry norm approach, economic mode approach and strategic choice approach.
- Under the Industry norm approach the size and composition of current assets are determined according to the convention or norms adopted by die firms in the industry. For instance, 2 months production requirements of raw materials, 1 months production needs of work-in-process, 3 months sales of finished stock, 2 months credit to customers, etc. may be norms and you follow the norms. When this approach is adopted, automatically total volume arid component size of currents assets become proportional with level of activity. But this approach is not scientific. It is a rule of thumb. But we cannot say it is a wrong course.
- Under the economic model approach, for each item of current assets the economic lot/order size is worked out. Economic lot size is that quantity of inventory where the sum of both the costs of carrying and costs of ordering is the least. When all the optimal quantities are added up you get the optimal size of investment in current assets. This approach is good for it satisfies one criterion of efficiency of working capital management. The level of working capital should be neither too much nor too low. If it is too much, more capital is locked up and the business loses interest, incurs loss on account of obsolescence, pilferage, pays more towards storage and insurance. Perhaps more bad debts could also result. If the size is too low, there is a hand-to-mouth living. There may result some lost sales, customer dissatisfaction and desertion, haste purchases, sub-optimal production runs, etc. So; an optimal investment in current assets is needed. The economic model approach helps in finding this optional size. But this approach is based on a set of assumptions, which may render the results of the approach subject to ‘ifs’ and ‘buts’.
- In the strategic choice approach which is more pragmatic, the management decides the level of investment in each type of current asset case by case taking into account the cost and benefits involved. No rule of thumb or predesigned plain models are used. Managerial consideration, competitors strategies, business exigencies and other relevant factors are used in deciding the size and components of working capital.