A quick PowerPoint presentation on Ernest Winfield Walker's four part theory.

1. Walkers 4 part theory
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2. About Ernest Winfield Walker
Ernest (Ernie) Winfield Walker was born in Mississippi in 1917. He grew up
on a small farm, paid his way through junior college, and enlisted in the army
upon the start of World War II. Upon his return home, he enrolled at the
University of Mississippi, where he received his bachelor’s and master’s
degrees. While at University of Mississippi he met Margaret Marshall, who he
married in 1949. Ernest received his doctorate in business administration
from Indiana University.
Dr. Walker made many contributions to the field of corporate finance and was
an expert in the financial management of small businesses. He excelled in
teaching, earning the Texas Exes Association’s Outstanding Educator Award
twice (1979 and 1998). In 1993, he was inducted into the McCombs Business
School’s Hall of Fame. He became the first recipient of the Gale Chair in
Small Business Management and Entrepreneurship in 1978.

3. Walkers 4 part theory
Early in 1964 Ernest W. Walker has developed a four-part theory of
working capital. He has laid down that a firm’s profitability is determined in
part by the way its working capital is managed. When the working capital
is varied relative to sales without a corresponding change in production,
the profit position is affected. If the flow of funds created by the movement
of working capital is Theories and Approaches interrupted, the turnover of
working capital is decreased, as is the rate of return on investment. In this
regard. Walker has laid down the following four principles with respect to
working capital investment.

4. First principle: This is concerned with the relation between the levels of working capital and
sales. His principle is that: 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. This implies that a
definite relation exists between the degree of risk that management assumes and the rate of
return. The more the risk that a firm assumes, the greater is the opportunity for gain or loss.
Consider the following data:
It can be seen from the data that the return on investment has increased from 7.6 percent to 16.6
per cent when working capital fell from Rs. 1,20,000 to Rs.50,000. Moreover, it is believed that
while the potential gain resulting from each decrease in working capital is greater in the beginning
than potential loss, exactly opposite occurs, if the management continues to decrease working
capital
Particulars 1 2 3
Level of working capital (Rs.) 50,000.00 90,000.00 1,20,000.00
Fixed capital (Rs.) 10,000.00 10,000.00 10,000.00
Liabilities 30,000.00 30,000.00 30,000.00
Net Worth 30,000.00 70,000.00 1,00,000.00
Sales 1,00,000.00 1,00,000.00 1,00,000.00
Fixed Capital Turnover 10 10 10
Working Capital Turnover 2 1.1 0.8333
Total Capital Turnover 1.66 1 0.761
Earnings (as Percent of Sales) 10 10 10
Rate of Return (Percent) 16.6 10 7.6

5. Second principle: Capital should be invested in each component of working capital as long as the equity
position of the firm increases. This principle is based on the concept that each rupee invested in fixed or
working capital should contribute to the net worth of the firm.
Third principle: 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. It is indisputable that
different types of capital possess varying degrees of risk. Investors relate the price for which they are
willing to sell their capital to this risk. They may charge less for debt than equity, since debt capital
possesses less risk. Thus risk is related to the return. Higher risk may imply a higher return too. Unlike
rate of return, cost of capital moves inversely with risk. As additional risk capital is employed by
management, cost of capital declines. This relationship prevails until the firm’s optimum capital structure
is achieved.
Fourth principle: The greater the disparity between the maturities of a firm’s short-term debt
instruments and its flow of internally generated funds, the greater the risk and vice-versa. This principle is
based on the analogy that the use of debt is recommended and the amount to be used is determined by
the level of risk, management wishes to assume. It should be noted that risk is not only associated with
the amount of debt used relative to equity, it is also related to the nature of the contracts negotiated by
the borrower. Some of the more important characteristics of debt contracts directly affecting a firm’s
operation are restrictive clauses of the contracts and dates of maturity.
Lenders of short-term funds are particularly conscious of this problem, and in an effort to protect them
selves by reducing the risk associated with improper maturity dates, they are requiring firms to produce
documents depicting cash flows. These documents when properly prepared, not only show the level of
loans necessary to support sales but also indicate when the loans can be repaid. In other words, lenders
realize that a firm’s ability to repay short-term loans is directly related to cash flow and not to earnings,
and therefore, a firm should make every effort to the maturities to its flow of internally generated funds.