Relationship between Working Capital, Liquidity, and Short-term Funding Needs

Successful businesses aim to strike a balance between funds set aside for current assets and the risk of current asset shortages. Each company has different needs for working capital. Retail enterprises, for example, focus on inventory and receivables, whereas software companies might not do so.

Companies define their ideal levels of inventories, receivables, and payables as a function of sales to estimate their working capital needs.

After establishing its need for working capital, a business decides on the best combination of short- and long-term financing. The motivation for doing so is to buy the current assets it needs while maintaining enough financial flexibility during challenging times.

Depending on the company, working capital management strategies can range from conservative to aggressive.

With a conservative approach, a company bears greater holdings in cash, receivables, and inventory in relation to sales. This grants it the flexibility to react to unanticipated occurrences.

In an aggressive strategy, smaller investments in current assets are held. This limits a company’s short-term flexibility. It, however, may create greater returns for equity holders. The moderate approach holds a position between the aggressive and conservative approaches.

The financial impact of a company’s working capital strategy is assessed using the DuPont equation, where:

$$\begin{align} \text{Return on Equity (ROE)}&=\frac{\text{Net income}}{\text{Average shareholder’s equity}}\\ &=\text{Net income margin × Total asset turnover × Leverage}\\ &=\frac{\text{Net incomes}}{\text{Revenue}}\times \frac{\text{Revenue}}{\text{Average total assets}}\times \frac{\text{Average total assets}}{\text{Average shareholder equity}}\\ \end{align}$$

All things being equal, a company’s total asset turnover will rise when working capital investments are decreased, enhancing returns on equity. You may achieve this by:

• Using just-in-time inventory management lowers a company’s stock of inventory.
• Requesting quicker payments from clients.
• Accelerating cash collections.

Companies might utilize daily or monthly cash budgets to cover their short-term obligations.

A company’s working capital policies and marketing strategies could conflict with each other. While offering more lenient credit conditions might increase sales, it will also result in higher accounts receivable and, ultimately, uncollectible receivables.

Question

Which of the following is least likely a method companies use to increase total asset turnover and enhance returns on equity?

1. Offering lenient credit conditions.
2. Requesting quicker payments from clients.
3. The use of just-in-time inventory management.

The correct answer is A.

Offering lenient credit conditions to customers is a marketing strategy that increases sales and accounts for receivables. This will consequently increase working capital investments, reducing returns on equity.

B is incorrect. Requesting quicker payments from clients increases asset turnover, enhancing return on equity.

C is incorrect.  The just-in-time inventory management goal is to have the minimum amount of inventory on hand to meet demand. This reduces working capital investments and consequently enhances returns on equity.