Financial Management: Working Capital, Cash Flow, and Investment Appraisal
Working Capital Management
Working capital is the difference between current assets and current liabilities. Effective management ensures the business can meet short-term obligations. Key components include inventory, receivables, and payables. The cash conversion cycle measures how long cash is tied up: days inventory outstanding + days sales outstanding - days payables outstanding. A shorter cycle frees up cash.
Cash Flow
Cash flow is the lifeblood of a business. Profitable firms can fail if they run out of cash. Cash flow forecasting helps anticipate shortages. The statement of cash flows categorises cash flows into operating, investing, and financing activities. A common trap is confusing profit with cash: profit includes non-cash items (depreciation) and accruals.
Investment Appraisal
Investment appraisal techniques evaluate the viability of long-term projects. Payback period measures time to recover the initial investment; simple but ignores cash flows after payback and time value of money. Net present value (NPV) discounts future cash flows at the cost of capital; a positive NPV adds value. Internal rate of return (IRR) is the discount rate that makes NPV zero; accept if IRR > cost of capital. Accounting rate of return (ARR) uses accounting profit; ignores time value.
Traps
A frequent trap is using the wrong discount rate or mixing cash flows. Another is ignoring sunk costs (irrelevant) and opportunity costs (relevant). Also, beware of mutually exclusive projects: NPV is preferred over IRR for ranking because IRR can mislead with non-conventional cash flows.
Worked Example
A project costs £100,000 and generates £30,000 per year for 5 years. Cost of capital is 10%. NPV = -100,000 + 30,000 * annuity factor (10%, 5 years). Annuity factor = 3.791. NPV = -100,000 + 113,730 = £13,730. Since NPV > 0, accept the project. Payback period = 100,000 / 30,000 = 3.33 years.
Rule of Thumb
For investment appraisal, always use relevant cash flows (incremental, after-tax, excluding sunk costs and including opportunity costs). Prefer NPV for decision-making.