Chapter Outline

• Working capital management

• Current assets- temporary and permanent
• Assets financing
• Long-term versus short-term financing
• Current assets financing plan- risk and profitability
• Expected value analysis in working capital
management
6-2
 Working Capital Management
• The financing and management of the current assets
of a firm
–Crucial to achieving long-term objectives of the firm
–Requires immediate action

6-3
 The Nature of Asset Growth
• Key to current asset planning – matching production
schedules with accurate sales forecast
• Differences in actual sales and forecasted sales can result
in:
– Unexpected buildup.
– Reduction in inventory, affecting receivables and cash flow
• Firm’s current assets could be:
– Self-liquidating
– ‘Permanent’ current assets.
6-4
The Nature of Asset Growth

6-5
Controlling Assets – Matching Sales and Production
• Fixed assets grow slowly with:
– Increase in productive capacity
– Replacement of old equipment
• Current assets fluctuate in the short run, depending on:
– Level of production versus the level of sales
• When production is higher than sales the inventory rises
• When sales are higher than production, inventory declines and
receivables increase

6-6
Controlling Assets – Matching Sales and
Production (cont’d)
• Cash budgeting process
– Level production method
• Smooth production schedules
• Use of manpower and equipment efficiently to lower cost
– Match sales and production as closely as possible in the short
run
• Allows current assets to increase or decrease with the level of sales
• Eliminates the large seasonal bulges or sharp reductions in current
assets
6-7
Matching Sales and Production-McGraw-Hill Companies,
Inc.
• A good example of seasonal sale
• Has significant share of sales and earnings in the third and
fourth quarters
• Due to seasonal nature of textbook publishing
– Lenders and financial managers need to plan inventory
– Lack of correct inventory planning can lead to lost sales

6-8
The Nature of Asset Growth.

6-9
 Seasonal Sales Pattern in Target and Limited Brands

• Like publishers, retail companies do not stock inventory for more

than a year
• Fourth quarter is the biggest quarter for retailers
• The retail firm Target is growing much faster than its
counterpart Limited Brands
• Even then, in the fourth quarter, peak earnings are almost equal
for both the companies

6-10
Quarterly Sales and Earnings Per Share, Target and
Limited Brands

6-11
 Computerized Inventory Control Systems

• Retail-oriented firms use new, computerized inventory control

systems linked to online point-of-sales terminals
– Allow either digital input or use of optical scanners to record the
inventory code numbers and the amount of each item sold.
• Use of Radio Frequency Identification (RFID) chips is the latest rage
in inventory/supply chain management

6-12
Temporary Assets under Level Production – An Example

• Yawakuzi Motorcycle Company

– Sales fluctuations: High sales demand during early spring and summer;
sales drop during October through March
– Decision: Apply level production method - 12-month sales forecast is
issued
– Result: Level production and seasonal sales combine to produce
fluctuating inventory

6-13
 Yawakuzi Sales Forecast (in units) Table-1

Table 6-1

6-14
Yawakuzi’s Production Schedule and Inventory
Table 6-2

6-15
 Sales Forecasts, Cash Receipts and Payments, and
Cash Budget
Table 6-3

6-16
 Sales Forecasts, Cash Receipts and Payments, and
Cash Budget (cont’d)
• Table 6-3 is created to examine the buildup in accounts receivable and
cash
– Sales forecast: Based on assumptions taken earlier (table 6-1)
– Cash receipts: 50% cash collected during the month of sale and 50% pertains to
the prior month
– Cash payments: Based on assumptions of level of production and cost per unit
plus payments for overhead, dividends, interest, and taxes
– Cash budget: a comparison of cash receipt and payment schedules to determine
cash flow

6-17
Total Current Assets, First Year
($ millions)

6-18
Cash Budget and Assets for II Year With No Growth
in Sales ($ millions)

6-19
 Yawakuzi’s Nature of Asset Growth
Graphic presentation of the current asset cycle assuming level of
production and no sales growth

6-20
 Patterns of Financing
• Selection of external sources to finance assets is an important
decision
• The appropriate financing pattern:
– Matching of asset buildup and length of financing terms

6-21
Matching Long-Term and Short-Term Needs

6-22
 Alternative Plans
• The challenge of constructing a financial plan is to categorize the
current assets into temporary and permanent
• Predicting the exact timing of asset liquidation is a difficult task
• It is also difficult to determine the amount of short-term and
long-term financing available

6-23
 Long-Term Financing
• Can assure adequate capital at all times
• May be used to cover part of the short-term needs in tight
money periods
• Can be used to finance:
• Fixed assets
• Permanent current assets
• Part of the temporary current assets

6-24
Using Long-Term Financing for Part of Short-Term
Needs

6-25
 Short- Term Financing
• Small businesses do not have total access to long-term financing
– They rely on short-term bank and trade credit
– Advantage: interest rates are lower
– Short-term finances are used to finance:
• Temporary current assets
• Part of the permanent working capital needs

6-26
Using Short-Term Financing for Part of Long-Term
Needs

6-27
 Term Structure of Interest Rates
• A yield curve – that shows the relative level of short-term and long-
term interest rates
– U.S. government securities are popular as they are free of default risks
– Corporate debt securities entail a higher interest rate due to more financial
risks
– Yield curves for both securities change daily to reflect:
• Current competitive conditions
• Expected inflation
• Changes in economic conditions

6-28
 Basic Theories - Yield Curve
• Liquidity premium theory
– Long-term rates should be higher than short-term rates
• Market segmentation theory
– Treasury securities are divided into market segments by the various
financial institutions investing in the market
• Expectations hypothesis
– Yields on long-term securities is a function of short-term rates

6-29
 Long- and Short-Term Annual Interest Rates
• Relative volatility and the historical level of short-term and long-
term rates

6-30
 Alternative Financing Plans
• A Decision Process: Comparing alternative financing plans for
working capital

6-31
Impact of Financing Plans on Earnings

6-32
 Varying Condition and its Impact
• Tight money periods
– Capital is scarce making short-term financing difficult to find or may
ensue very high rates
– Inadequate financing may mean loss of sales or financial
embarrassment

6-33
Expected Returns under Different Economic
Conditions
Expected value represents the sum of the
expected outcomes under both conditions

6-34
Expected Returns for High Risk Firms

6-35
 Shifts in Asset Structure
• During recession –
– Sales decline or stay even
– Cash, receivables, and inventory fall
– Short-term debt may rise,
• causing a large decline in the net working capital to sales ratio
• During upswing –
– cash, receivables, and inventory rise
– short-term debt may fall or be replaced by low-cost long-term debt.
• These two effects cause the firm’s profitability to increase and the net working capital to sales
ratio to rise.

6-36
Net Working Capital as a Percentage of Sales
and the Current Ratio

6-37
 Toward an Optimal Policy
• A firm should:
– Attempt to relate asset liquidity to financing patterns, and vice versa
– Decide how it wishes to combine asset liquidity and financing needs
• Risk-oriented firm - short-term borrowings and low degree of liquidity
• Conservative firm - long-term financing and high degree of liquidity

6-38
Asset Liquidity and Financing Assets

6-39