Working Capital Management versus Capital Expenditure Management: An Empirical Study


By

Prof.  Sanjay Kumar Sadana
B.Com (Hons.), M. Com, PGDBA, LL.B (Professional), MBA Finance,
PGDPM&IR, M.A. (PM & IR), M.A. (MC& JR), M.Phil (Finance), PhD (Pursuing)
AMT (Accredited Management Teacher)- AIMA
Principal- Guru Gram Business School- Gurgaon & Faridabad campus
 


Abstract

The purpose of this research is to investigate the impact of firms' capital expenditure on their working capital management. Net Liquidity Balance and Working Capital Requirement for determination of working capital requirement and developed multiple regression models. The empirical research found that organisation's capital expenditure has a significant impact on working capital management. The study also found that the firms' operating cash flow, which was recognized as a control variable, has a significant relationship with working capital management.

Capital forecasting in a downturn environment where change is rapid. Incorporating dynamic forecasting to measure the impact of key uncertainties and risks on the portfolio of projects is crucial.

The findings increase the knowledge base of working capital management and will help companies manage working capital efficiently in growing conditions associated with capital expenditure.

[Keywords] Capital expenditure; working capital; firm

Working Capital Management versus Capital Expenditure Management: An Empirical Study

Background

Working capital is a way for accountants, investors and managers to view the short-term health of a company. Working capital equals current assets minus current liabilities. Current accounts are accounts that the company collects or are due in the next year. Making a capital expenditure will have several effects on the company's working capital, depending on the transaction. However, in certain cases, there may be no impact; it is important to understand why.

Corporate finance basically deals with three decisions:

A) capital structure decisions,

B) capital budgeting decisions, and

C) working capital management decisions.

Working capital management is a very important component of corporate finance since it affects the profitability and liquidity of a company. It deals with current assets and current liabilities.

Working capital management is recognized as an important concern of the financial manager due to many reasons. For one thing, a typical manufacturing firm's current assets account for over half of its total assets. For a distribution company, they account for even more. The maintenance of excessive levels of current assets can easily result in a substandard return on a firm's investment.

However, firms with inadequate levels of current assets may incur shortages and have difficulties in smoothly maintaining day-to-day operations. Efficient working capital management involves planning and controlling current assets and current liabilities in a manner that eliminates the risk of inability to meet due short term obligations on one hand and avoids excessive investment in these assets on the other hand.

Capital forecasting in a downturn environment where change is rapid. Incorporating dynamic forecasting to measure the impact of key uncertainties and risks on the portfolio of projects is crucial. Quantifying the impact of risks and delays atproject and portfolio level.Governance and control over capital expenditures, Portfolio prioritization.

Determining the optimal decision making level for capital allocation decision (corporate level vs business unit level vs hybrid model).

Capital expenditures

Whenever we make an expenditure that generates a cash flow benefit for more than one year, this is a capital expenditure. Examples include the purchase of new equipment, expansion of production facilities, buying another company, acquiring new technologies, launching a research & development program, etc., etc., etc. Capital expenditures often involve large cash outlays with major implications on the future values of the company. Additionally, once we commit to making a capital expenditure it is sometimes difficult to back-out.

It has been found that managers spend a considerable time on day-today working of capital decisions since current assets are short-lived investments that are continually being converted into other asset types (Rao, 1989). In the case of current liabilities, the firm is responsible for paying obligations mentioned under current liabilities on a timely basis. Liquidity for the on-going firm is reliant, rather, on the operating cash flows generated by the firm's assets. As a result, working capital management of a company is very critical area in the field of financial management (Joshi, 1994). It involves the decisions about the amount and composition of current assets and the financing of these assets.

The decision-making process on the level of different working capital components has become frequent, repetitive, and time-consuming.

Corporations are looking for new ways to stimulate growth, improve financial performance, and reduce risk in today's challenging economic climate. Funds tied up in working capital can be seen as hidden reserves that can be used to fund growth strategies, such as capital expansion. Cash flows locked in stock and receivables can be freed up by understanding the determinants of working capital. Many organizations that have earned profits over the years have shown the efficient management of working capital (WCM).

The successful management of working capital is essential for short-run corporate solvency or the survival of any organization. Especially, efficient WCM will lead a firm to react quickly and appropriately to unanticipated changes in market variables, such as interest rates and raw material prices, and gain competitive advantages over its rivals.

The way of managing working capital efficiently varies from firm to firm since it depends on industry, the nature of the business, business policy, strategy, etc. Thus, it is very important for an organization to understand the way to manage working capital efficiently.

Broadly, industry characteristics, firm-specific characteristics, and the financial environment are recognized as determining factors of working capital. However, still, there are firms that are struggling to manage working capital since they don't have a sufficient understanding of the determining factors of working capital. In addition to the growth, leverage, and the size of a company, type, and size of expenditures, such as finance and operating and capital expenditures, have different impacts on working capital.

Portfolio Approach in Capital Budgeting

Portfolio approach to achieve capital efficiency and organisational alignment can yield immediate positive cash-flow results for companies. Typically companies view capital expenditures through a cost and benefits filter that focuses largely on ROI and IRR type

measures. Whilst these measures are relevant, companies that do so often do not necessarily link these to the strategy of the company. They also do not prioritise capital expenditures in terms of their effect on strategy and shareholder value. We believe that by using a portfolio approach companies could:

* Increase returns on invested capital by understanding which projects contribute most to shareholder value and lie on the project efficiency frontier

* Have a holistic portfolio view of the return of the capital of the entire company

* Improve the strategic and organizational alignment of projects

* Make informed decisions on where to invest scarce cash resources.
 

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Source: E-mail December 25, 2010

          

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