This action might not be possible to undo. Are you sure you want to continue?
Two major concept of WC – gross and net WC Gross WC – sometimes CA & CL collectively known as WC; [financial analysts mean
CA; focus on gross WC]
Net WC is CA – CL [accountants generally use term WC as referring to NWC] Net Operating WC (NOWC) – Operating CA less operating CL – Operating CA generally are cash, A/c Rec., and Inv., less A/c payable and accruals.[Marketable
securities and short term investments are generally not considered as operating CA.]
Working Capital Policy – firm‟s policies regarding (i) target levels of each category of CA, and (ii) how CA will be financed. Working Capital Management – mean administration of CA and financing needed to support CA (i.e., CL and external funding). It involves both setting WC policy and exercising that policy in day-to-day operation. A/c Rec. – unpaid bills from sales to other firms - known as Trade Credit, whereas sale of goods to final consumers - known as Consumer Credit. Marketable Securities – Principal marketable securities is Commercial Paper (shortterm unsecured debt sold by other firms). Other securities include Treasury Bills (shortterm debt sold by govt.)
Simple cycle operation is: _________________ Cash ______________________ ! ! Receivables Raw Material Inventory ! ! !________________ Finished Goods ______________! Inventory Finally firm takes out its profit and replenish cash balance for WC. Components of WC constantly change with cycle of operation, but amount of WC is fixed.
Management of all types of CA (except inventory) & CL is direct responsibility of financial manager . Short-term interest rates are generally less than long-tem debt rates.also requires day-to-day supervision. WC management is important. but sometimes it exceeds to long-term rates – possibly only temporary. Profitability assumptions suggest maintaining a low level of CA and high proportion of CL to total liabilities. running out of inventory) Trade-off b/w risk and profitability as it relates to level of financing of CA. . Fast growing but larger firm also makes use of CL financing. is likely to give higher profits because debt will be paid off during periods when not needed. Profitability and Risk Two fundamental decisions issues of sound WC management: Optimal level of investment in CA Appropriate mix of short & long-term financing used to support investments in CA. Greater the proportion of short-term debt to total debt. These decisions are influenced by trade-off b/w profitability and risk. but decisions related to WC matters can not be. More fundamental is the effect that WC decisions have on firm‟s risk..Significance of WC Management For small firms. return. higher is the profitability. Short-term borrowings are continually rolled over (refinanced) at maturity. and (ii) support proper level of sales (e. so a large proportion of financial manager‟s time must be devoted to it. Decisions on other matters like dividend and capital structure can be set aside for future time. Use of short-term debt as opposed to long-term. CLs are principal source of external financing – do not have access to longer-term capital market. Risk mean jeopardy to firm for not maintaining sufficient CA to: (i) meet its cash obligations as they occur.g. and share price.
so each dollar of CA is forced to “work harder” – low liquidity . it can be classified according to: Components – such cash. there is a trade-off b/w risk and return. (figure 8. securities. net profit/total assets is low. Moderate CA investment policy – in b/w these two extremes.2) Working Capital Investment and Financing Policies Up until we focused on management of CA or NOWC. inventories. as sales increase during the upswing. CA turned over more frequently. and where sales are stimulated by use of a credit policy that provides liberal financing to customers‟ and a corresponding high level of receivables – high liquidity – profitability (ROI) i. Profitability moves together with risk (i.) Ultimately..profitability (ROI) is high. but they then sell off inventories and reduce receivables when the economy slacks off. NOWC must be increased.e. and inventories are carried.relatively large amount of cash. Restricted CA investment (or “lean and mean”) policy – aggressive policy . whereas Temporary WC is the investment in CA that varies with seasonal requirements. Similarly. Two basic principles of finance emerged from above WC policies: 1. marketable securities. and receivables are minimized. Still NOWC rarely drops to zero – companies have some permanent NOWC.Optimal Amount (or Level) of CA . Time – permanent or temporary Permanent WC is the CA required to meet long-term minimum needs. all businesses must build up NOWC when economy is strong.e. receivables.holding amount of cash. now turn to decision involving shortterm investment and short-term financing.1) Relaxed CA investment (or “fat cat”) policy – or conservative policy . which is the on hand at the low point of the cycle Then.. and the additional NOWC is defined as . Most business experience seasonal and/or cyclical fluctuations. Initially consider three different CA policy alternatives – relationship b/w output and CA level (figure 8. 2. optimal level of CA will be determined by management‟s attitude to trade-off b/w profitability and risk Detour: Classification of WC Having defined WC as CA.Alternative CA Investment (or NOWC) Policies: In determining optimal level of CA – must consider trade-off b/w profitability and risk. marketable securities. Profitability varies inversely with liquidity. and inventory etc.
This strategy minimizes firm‟s risk of being unable to pay of its maturing obligations. extremely non-conservative positions. In practice. this would be a highly aggressive. and the firm would be very much subject to dangers from risking interest rates as well as to loan renewal problems – negative margin of safety. a machine expected to last 5 years could be financed with 5-year loan. could be financed with 30-day bank loan. while troughs below the dashed line represent short-term investing. academic studies do show that most firms tend to finance short-term assets from short-term sources and long-term assets from long-term sources. Cash flows from the plant (profits plus depreciation) would not be sufficient to pay off the loan at the end of only one year. . firm uses a small amount of short-term debt to meet its peak requirements. and problem of renewal would not have arisen. broad aspects of WC management: (i) what level of CA to maintain.temporary NOWC. In this situation. etc. Inventory expected to be sold in 30 days. however. a firm could attempt to match exactly the maturity structure of its assets and liabilities. The manner in which permanent and temporary NOPWC are financed is called firm‟s short-term financing policy.5 shows that long-term sources are being used to financed all permanent NOWC requirements and also meet some of the seasonal needs. then the company would have problems. If lender refuses to renew the loan. The humps above the dashed line represent short-term financing. 20 years building could be financed with 20-year loan. Had the plant been financed with long-term debt. suppose a company borrows on one-year basis and uses the funds to build and equip a plant. To illustrate.4 illustrates situation for a relatively aggressive firm that fiancés all of its fixed assets with long-term capital and part of its permanent NOWC with short-term debt. The term „relative‟ is used as there can be different degrees of aggressiveness. The fig. However. Hedging (Maturity Matching) or (“Self-Liquidating”) Approach A method of financing where each asset would be offset with a financing instrument of same approximate maturity . but it also meets a part of its seasonal needs by “strong liquidity” in the form of marketable securities. 8. firms don‟t actually finance each specific asset with a type of capital that has a maturity equal to the asset‟s life. However.8. Aggressive Approach Fig.3). short-term debt is often cheaper than long-term debt. At the limit. 8.asset and liability maturities are matched (as shown in fig. Combination of Liability Structure and CA Decisions In preceding sections. and some firms are willing to sacrifice safety for the chance of higher profits. If all of permanent NOPWC and part of fixed assets were financed with short-term credit. Conservative Approach Fig. These two facets are interdependent – so can be considered jointly. represents a very safe. So that loan would have to be renewed. required loan payments would have been better matched with cash flows. conservative current asset financing policy. and (ii) how to finance CA.
funds are committed to relatively low-yielding assets. or (ii) lengthening maturity schedule of financing. payment periods. thus. In first choice. plus some additional holdings. and so on. costs. interest payment on borrowing over periods of time when funds are not needed. Changing technology can lead to dramatic changes in optimal CA investment policy. would enable to hold inventories at optimal levels. computerized stocks. If firm cannot borrow on short notice to meet unexpected cash drains. Each solution will cost something in profit-making ability.Uncertainty and Margin of Safety Under conditions of certainty – where sales. firm requires some minimum amount of cash and inventories based on expected payments. Both of these actions affect profitability. but it entails greatest risk. If firm can borrow on short notice. or safety stocks. Certain firms can arrange for line of credit or revolving credits that enable them to borrow on short notice. Likewise. and value. firm holds minimal safety stocks of cash and inventory and it would have a tight credit policy. _______________ Any larger amounts would increase the need for external funding without a corresponding increase in profits. and greater the WC. greater the margin safety that management will wish to provide. hence lower the firm‟s operating risk. The moderate policy fall in b/w two extremes in terms of expected return and risk. expected order lead times. while reverse is true under relaxed policy. ******************** . In second. expected sales. Risk and Profitability Decision on appropriate margin of safety will be governed by consideration of risk and profitability and by management‟s attitude towards bearing risk. are known for sure – all firms hold only minimal levels of CA. thus profits will be maximized. to deal with deviation from expected values. Under conditions of uncertainty. A/c receivable levels are determined by credit terms. and so on. However. and tougher the credit terms. Such policy gives highest expected return on investment. lower the receivables. profits will be maximized. it can provide a margin of safety on by: (i) increasing level of CA (especially cash and marketable securities). if new technology makes it possible to speed up production from 10 days to 5 days. For example. lead times. Greater the dispersion of probability deviation of possible net cash flows. free cash. and automatically transmission of orders to suppliers’ computer. then its work-in-progress inventory can be cut in half. less needs to provide for margin of safety. holding WC is costly – it reduces firm‟s return on invested capital (ROIC). while any smaller holding would involve late payments to suppliers along with lost sales due to inventory shortages and an overly restrictive credit policy. even though this meant running the risk of losing sales. WC is necessary to conduct business. Following restricted CA policy. the smaller the danger of running short. Similarly. Cost of such credit line needs to be compared to cost of other solution.
This action might not be possible to undo. Are you sure you want to continue?
We've moved you to where you read on your other device.
Get the full title to continue reading from where you left off, or restart the preview.