You are on page 1of 40



Working Capital and the Financing Decision

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Outline
Working capital management Current asset management Asset financing Long-term versus short-term financing Risk and profitability vis--vis asset financing Expected value analysis may sometimes be employed


Working Capital Management

The financing and management of the current assets of a firm
Crucial to achieving long-term objectives of the firm or its failure Requires immediate action


The Nature of Asset Growth

Effective current assets management requires matching of the forecasted sales and production schedules Differences in actual sales and forecasted sales can result in:
Unexpected buildup. Reduction in inventory, affecting receivables and cash flow

Firms current assets could be:

Self-liquidating Permanent current assets.

The Nature of Asset Growth (contd)


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

Controlling Assets Matching Sales and Production (contd)

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

Matching Sales and ProductionMcGraw-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

Quarterly Sales and Earnings Per Share for McGraw Hill


Seasonal Sales Pattern in Target and Limited Brands

Like publishers, retail companies do not stock inventory for more then a year Fourth quarter is the biggest quarter for retailers As per the figure, the Target is growing much faster than the Limited Brands Even then, in the fourth quarter, peak earnings are almost equal for both the companies

Quarterly Sales and Earnings Per Share, Target and Limited Brands


Point-of-Sales Terminals
Retail-oriented firms use new, computerized inventory control systems linked online
Digital inputs or optical scanners
Helps adjust orders or production schedules

Radio Frequency Identification (RFID)


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 - 12month sales forecast is issued Result: Level production and seasonal sales combine to produce fluctuating inventory


Yawakuzi Sales Forecast (in units)


Yawakuzis Production Schedule and Inventory


Sales Forecasts, Cash Receipts, and Payments, and Cash Budget


Sales Forecasts, Cash Receipts, and Payments, and Cash Budget (contd)
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 budget: a comparison of cash receipt and payment schedules to determine cash flow

Total Current Assets, First Year ($millions)


Yawakuzis Nature of Asset Growth


Cash Budget and Assets for II Year With No Growth in Sales ($millions)
Graphic presentation of the current asset cycle.


11th Edition Problem 16 13th Edition Problem 19


Patterns of Financing
Selection of external sources to fund financial assets is an important decision The appropriate financing pattern:
Matching of asset buildup and length of financing pattern


Matching Long-Term and ShortTerm Needs


Alternative Plans
It is important to consider other alternatives
The challenge of constructing a financial plan is to prioritize the current assets into temporary and permanent The exact timing of asset liquidation, even in the light of ascertaining dollar amounts is onerous It is also difficult to judge the amount of shortterm and long-term financing available


Long-Term Financing
Firms can be assured of having adequate capital at all times:
Use long-term capital to cover part of the shortterm needs Long-term capital can be used to finance:
Fixed assets Permanent current assets Part of the temporary current assets


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


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


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


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

Basic Theories - Yield Curve

Liquidity premium theory
Long-term rates should be higher than shortterm 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

Long- and Short-Term Annual Interest Rates

Relative volatility and the historical level of short-term and long-term rates


Alternative Financing Plans

A Decision Process: Comparing alternative financing plans for working capital


Impact of Financing Plans on Earnings


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

Expected value
Represents the sum of the expected outcomes under both conditions


Expected Returns under Different Economic Conditions


Expected Returns for High Risk Firms


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


Net working capital as a percentage of salesS&P Industrials


Asset Liquidity and Financing Assets


Exercises: 11th Edition 1, 10, 20 13th Edition 1, 13, 17