Financial Management

MBA 704

Overview of Working Capital

Management
Ferdinand Cueco
Adrian Olasiman
Rey Carrascal
Lisa Anne Villarico
Armeine Ataiza
 Contents
Introduction
• Working Capital Concepts
• Significance of Working Capital Management
• Profitability & Risk

Working Capital Issues

• Optimal amount (or level) of current assets
• Detour: Classification of Working Capital

Financing Current Assets: Short-Term and Long-Term Mix

• Hedging (Maturity Matching) Approach
• Short-Term versus Long-Term Financing

Combining Liability Structure and Current

Asset Decisions
• Uncertainty and the Margin of Safety
• Risk and Profitability
 Learning Objectives
1. Explain how the definition of "working capital" differs between financial analysts and accountants.

2. Understand the two fundamental decision issues in working capital management – and the trade-offs
involved in making these decisions.

3. Discuss how to determine the optimal level of current assets.

4. Describe the relationship between profitability, liquidity, and risk in the management of working capital.

5. Explain how to classify working capital according to its “components” and according to “time” (i.e., either
permanent or temporary).

5. Describe the hedging (maturity matching) approach to financing and the advantages/disadvantages of
short- versus long-term financing.

6. Explain how the financial manager combines the current asset decision with the liability structure decision.
Introduction
 Working Capital Concepts

Net Working Capital Gross Working Capital

Current assets – Current liabilities current assets like cash, marketable securities,
receivables and inventory

Current Assets

Cash
Account receivables
Inventory
Marketable securities –like stocks

Current Liabilities
Short term loans
Income tax payable
Dividends
 CURRENT RATIO CURRENT RATIO FORMULA

• Known as Working Capital Ratio

• measures the capability of a business to

meet its short-term obligations that are
due within a year. CURRENT
CURRENT ASSETS
LIABILITIES

• It indicates the financial health of a

company and how it can maximize the
liquidity of its current assets to settle
debt and payables.
Example:
If a business holds the following :
•Cash = $15 million
•Marketable securities = $20 million
•Inventory = $25 million
•Short-term debt = $15 million
•Accounts payables = $15 million
•Calculate the Current Ratio.
Solution:
Current assets = 15 + 20 + 25 = 60 million
Current liabilities = 15 + 15 = 30 million
Current ratio = 60 million / 30 million = 2.0x
The business currently has a current ratio of 2,
meaning it can easily settle each dollar on loan
or accounts payable twice. A rate of more than 1
suggests financial well-being for the company.
 Working Capital Management
The administration of the firms current assets and the financing needed to support the current
assets

• How the firm utilizes the current assets

• Handling the financing the current liabilities to support the current assets
Significance of Working Capital

• Continuity of Business Operations

• Increases Profitability and Productivity

• Dividend Payment

• Increases Goodwill

• Timely payments for long-term loans

• Increases credit worthiness

➢ Profitability and Risk

➢Profit risk -is a risk management tool that focuses on understanding concentrations within the
income statement and assessing the risk associated with those concentrations from a net income
perspective.

Types of Financial Risk

Also known as market risks, are risks that can affect an

entire economic market overall or a large percentage of
the total market. Market risks is the risk of losing
Systematic Risk investments due to factors, such as political risk and
macroenvironment risk, that affect the performance of
the overall market.

Also known as specific risk or idiosyncratic risk, a

Unsystematic Risk category of risk that only affects an industry or
particular company. It is a risk of losing an investment
due to company of industry – specific hazard.
Working capital management lie two fundamental decision issues for the firm. They are the
determination of:

• the optimal level of investment in current assets

• the appropriate mix of short-term and long-term financing used to support this invest-ment in
current assets.

Working Capital Management, Supply Chain Visibility

➢ Working capital refers to the cash a business requires for its day-to-day operations. Technically,
it's a measure of a company's efficiency and its short-term financial health. Often, it's the
company supply chain that is the first place that people look to for working capital reduction
opportunities.
Profit is a reward for risk taken in business. The higher the risk in
the business, the greater potential financial reward is for the
business owner.

-F.B Hawley
Working Capital Issues
Working Capital Issues
Optimal Amount [or Level] of Current Assets

The appropriate amount, or level, of current

assets, management must consider the
trade-off between profitability and risk.
Working Capital Issues
Optimal Amount [or Level] of Current Assets

Particulars Policy A Policy B Policy C

Annual Output 100,000 100,000 100,00
Level of Current Assets High Medium Low
Working Capital Issues
Optimal Amount [or Level] of Current Assets
Table 1: The relationship between output and current asset level
 Working Capital Issues
Optimal Amount [or Level] of Current Assets
Equating liquidity with conservativeness;
1. Policy A is the most conservative and most liquid,
2. Policy C is aggressive and least liquid.

The greater the level of current assets, the

greater the liquidity of the firm.
Working Capital Issues
Optimal Amount [or Level] of Current Assets

How about the expected profitability?

Return on Investment
• measures overall effectiveness in (ROI) generating profits
with available assets;
• it is the earning power of invested capital.
Working Capital Issues
Optimal Amount [or Level] of Current Assets

Particulars Policy A Policy B Policy C

Net Profit 10,000 10,000 10,000

Current Assets 200,000 150,000 100,000

ROI 5% 6.7% 10%

Working Capital Issues
Optimal Amount [or Level] of Current Assets

Two most basic principles in finance:

1. Profitability varies inversely with liquidity
2. Profitability moves together with risk (i.e., there is a trade-off between risk
and return).
Working Capital Issues
Optimal Amount [or Level] of Current Assets

The optimal level of each current asset (cash,

marketable securities, receivables, and inventory)
will be determined by management’s attitude to the
trade-off between profitability and risk.
Working Capital Issues
Classification of Working Capital

According to Component:
• Cash, According to Time:
• Marketable Securities, • Permanent, and
• Receivables, and • Temporary
• Inventory
Working Capital Issues
Classification of Working Capital
Financing Current Assets: Short-Term
and Long-Term Mix
 TOPICS FOR DISCUSSION

I. Financing Current Assets: Short-

Term and Long-Term Mix
II. Short Term Vs. Long Term
Financing
Financing Current Assets: Short-Term and
Long-Term Mix

Spontaneous Financing: Trade credit, and other

payables and accruals, that arise spontaneously in the
firm’s day-to-day operations.

• Based on policies regarding payment for purchases, labor,

taxes, and other expenses.
• We are concerned with managing non-spontaneous
financing of assets.
26
Hedging (or Maturity Matching) Approach
A method of financing where each asset would be offset with a financing instrument of the
same approximate maturity.

Short-term financing**
DOLLAR AMOUNT

Current assets*

Long-term financing
Fixed assets

TIME
27
Hedging (or Maturity Matching) Approach
* Less amount financed spontaneously by payables and accruals.
** In addition to spontaneous financing (payables and accruals).

Short-term financing**
DOLLAR AMOUNT

Current assets*

Long-term financing
Fixed assets

TIME
28
 Financing Needs and the Hedging Approach

• Fixed assets and the non-seasonal portion of current assets are

financed with long-term debt and equity (long-term profitability of
assets to cover the long-term financing costs of the firm).

• Seasonal needs are financed with short-term loans (under normal

operations sufficient cash flow is expected to cover the short-term
financing cost).

29
 Self-Liquidating Nature of Short-
Term Loans
• Seasonal orders require the purchase of inventory beyond current
levels.
• Increased inventory is used to meet the increased demand for the
final product.
• Sales become receivables.
• Receivables are collected and become cash.
• The resulting cash funds can be used to pay off the seasonal short-
term loan and cover associated long-term financing costs.

30
 Risks vs. Costs Trade-Off
(Conservative Approach)
• Long-Term Financing Benefits
• Less worry in refinancing short-term obligations
• Less uncertainty regarding future interest costs

• Long-Term Financing Risks

• Borrowing more than what is necessary
• Borrowing at a higher overall cost (usually)

• Result
• Manager accepts less expected profits in exchange for taking less risk.

31
Risks vs. Costs Trade-Off
(Conservative Approach)
Firm can reduce risks associated with short-term borrowing by using a larger
proportion of long-term financing.

Short-term financing
DOLLAR AMOUNT

Current assets

Long-term financing
Fixed assets

TIME
32
Comparison with an Aggressive Approach
• Short-Term Financing Benefits
• Financing long-term needs with a lower interest cost than
short-term debt
• Borrowing only what is necessary
• Short-Term Financing Risks
• Refinancing short-term obligations in the future
• Uncertain future interest costs
• Result
• Manager accepts greater expected profits in exchange for
taking greater risk.

33
Risks vs. Costs Trade-Off (Aggressive
Approach)
Firm increases risks associated with short-term borrowing by using a
larger proportion of short-term financing.
Short-term financing
DOLLAR AMOUNT

Current assets

Long-term financing
Fixed assets

TIME
Summary of Short- vs. Long-Term
Financing

Financing
Maturity
SHORT-TERM LONG-TERM
Asset
Maturity

SHORT-TERM Moderate Low

(Temporary)
Risk-Profitability Risk-Profitability

LONG-TERM High
Moderate
(Permanent) Risk-Profitability Risk-Profitability
35
Combining Liability Structure and
Current Asset Decision
Combining Liability Structure
and Current Asset Decisions

Two (2) Broad Aspects of Capital Management

1. What level of current asset to maintain

INTERDEPENDENT
2. How to finance current assets
 Combining Liability Structure and Current Asset Decisions

UNCERTAINTY vs. MARGIN OF SAFETY

Uncertainty
“the lack of certainty or sureness of an event”
-corporatefinanceinstitute.com-
Margin of Safety
“the difference between the amount of expected profitability
and the break-even point”
-corporatefinanceinstitute.com-
Current Sales Level-Breakeven Point
Margin of Safety = ------------------------------------------------------ X 100
Current Sales Level
 Combining Liability Structure and Current Asset Decisions

MARGIN OF SAFETY
-corporatefinanceinstitute.com-

BUDGETING INVESTING
-the gap between the estimated sales and -the difference between the
the breakeven point, which is the point of sales intrinsic value of a stock
can decrease before the company becomes unprofitable. against its prevailing market price.
 Combining Liability Structure and Current Asset Decisions

Finances its current assets entirely with Short Term

Borrowing
Finances its current assets
entirely with equity

Company A Company B
High Level of Current Assets Low Level of Current Assets
Company C
Combining Liability Structure and Current Asset Decisions

Company A
Projection Components are well
determined (i.e. future sales
demand, resulting receivable
collections, and production
schedule).

Company B
Projection Components are
uncertain
 Combining Liability Structure and Current Asset Decisions

IF FIRM CANNOT BORROW ON SHORT

NOTICE TO MEET UNEXPECTED ‘CASH
DRAINS’
…it can provide margin of safety only by:

1. increasing level of current assets

2. lengthening maturity schedule of financing
 Combining Liability Structure and Current Asset Decisions

RISK vs. PROFITABILITY

“The greater ability of the firm to borrow on short notice,
the less it needs to provide for a margin of safety…”

A decision on the appropriate margin of safety

will be governed by considerations of risk and
profitability and by management’s attitude
toward bearing risk.
 Keypoints
• There are two major concepts of working capital – net working capital (current assets
minus current liabilities) and gross working capital (current assets).

• In determining the appropriate amount, or level, of current assets, management must

consider the tradeoff between profitability and risk. The greater the level of current
assets, the greater the liquidity of the firm, all other things equal. With greater liquidity
comes less risk, but also less profitability. In the management
• of working capital, we see the two most basic principles of finance in operation:

1. Profitability varies inversely with liquidity.

2. Profitability moves together with risk.

• We can classify working capital by components – cash,marketable securities, receivables,

and inventory. In addition, working capital can be classified by time, as either permanent
or temporary. Permanent working capital is the amount of current assets required
tomeet a firm’s long-term minimum needs. Temporary working capital, on the other
hand, is the amount of current assets that varies with seasonal needs.
• If the firm adopts a hedging (maturity matching) approach to financing, each asset would be
offset with a financing instrument of the same approximate maturity. Short-term or seasonal
variations in current assets would be financed with short-term debt. The permanent component
of current assets and all fixed assets would be financed with long-term debt or equity.

• In general, the longer the composite maturity schedule of the financing used by the firm, the less
risky is that financing. However, the longer this maturity schedule, the more costly the financing is
likely to be. Consequently, we have yet another tradeoff between risk and profitability.

• The two key facets of working capital management – what level of current assets to maintain and
how to finance current assets – are interdependent. Because of their interdependence, these
two facets must be considered jointly.
REFERENCES

Van Horne James C. and Wachowickz, John Jr. M. 2008. Fundamentals of Financial Management (13th
ed.). Pearson Education Ltd.
 Q&A
PORTION