The Importance of Managing and

Accumulating Working Capital

Working capital is the amount of the firms current
assets: cash, accounts receivable, marketable
securities, inventory and prepaid expenses.
Managing the level and financing of working capital is
necessary:
to keep costs under control (e.g. storage of inventory)
to keep risk levels at an appropriate level (e.g. liquidity)
1
Managing Current Assets & Liabilities
Net Working Capital
= Current Assets - Current Liabilities
Determining the Correct level of Working Capital
Balance Risk & Return
Benefits of Working Capital
Higher Liquidity (Lowers Risk)
Costs of Working Capital
Lower Returns - $$ invested in lower returning securities rather
than production.
2
Example: Risk-Return Trade-off
Compare the 2 following companies
3
Firm 1
ST Debt 100
LT Debt 400
Common Stock 500
Total Liabilities&Equity 1000
Firm 1
Marketable Securities 0
Other Current Assets 200
Fixed Assets 800
Total Assets 1000
Firm 1
Operating Earnings 150
Interest Earned 0
EBT 150
Taxes (40%) -60
Net Income 90


Current Assets
Current Liabilities
Current Ratio =
200
100
=
= 2
Current Ratio 2
Example: Risk-Return Trade-off
Compare the 2 following companies
4
Firm 1
ST Debt 100
LT Debt 400
Common Stock 500
Total Liabilities&Equity 1000
Firm 1
Marketable Securities 0
Other Current Assets 200
Fixed Assets 800
Total Assets 1000
Firm 1
Operating Earnings 150
Interest Earned 0
EBT 150
Taxes (40%) -60
Net Income 90

Current Ratio 2

Return on Assets =
Net Income
Assets
90
1000
=
=
.09 = 9%
ROA 9%
Example: Risk-Return Trade-off
Compare the 2 following companies
5
Firm 2:
$200 Marketable Securities
Financed with Common Stock

200 x 4% = $8 interest earned
Firm 1 Firm 2
Marketable Securities 0 200
Other Current Assets 200 200
Fixed Assets 800 800
Total Assets 1000 1200
Firm 1 Firm 2
ST Debt 100 100
LT Debt 400 400
Common Stock 500 700
Total Liabilities&Equity 1000 1200
Firm 1 Firm 2
Operating Earnings 150 150
Interest Earned 0 8
EBT 150 158
Taxes (40%) -60 -63
Net Income 90 95

Current Ratio 2
ROA 9%
Example: Risk-Return Trade-off
Compare the 2 following companies
6
Firm 1 Firm 2
Marketable Securities 0 200
Other Current Assets 200 200
Fixed Assets 800 800
Total Assets 1000 1200
Firm 1 Firm 2
ST Debt 100 100
LT Debt 400 400
Common Stock 500 700
Total Liabilities&Equity 1000 1200
Firm 1 Firm 2
Operating Earnings 150 150
Interest Earned 0 8
EBT 150 158
Taxes (40%) -60 -63
Net Income 90 95

Current Ratio 2
ROA 9%
400
100
=
Current Ratio =
CA
CL
= 4
4
Example: Risk-Return Trade-off
Compare the 2 following companies
7
Firm 1 Firm 2
Marketable Securities 0 200
Other Current Assets 200 200
Fixed Assets 800 800
Total Assets 1000 1200
Firm 1 Firm 2
ST Debt 100 100
LT Debt 400 400
Common Stock 500 700
Total Liabilities&Equity 1000 1200
Firm 1 Firm 2
Operating Earnings 150 150
Interest Earned 0 8
EBT 150 158
Taxes (40%) -60 -63
Net Income 90 95

Current Ratio 2 4
ROA 9%
95
1200
=
=.079 = 7.9%
7.9%
Return on Assets =
NI
Assets
Example: Risk-Return Trade-off
Compare the 2 following companies
8
Firm 1
Higher ROA
Less Liquid
Riskier
Firm 2
Lower ROA
More Liquid
Less Risky
Firm 1 Firm 2
Marketable Securities 0 200
Other Current Assets 200 200
Fixed Assets 800 800
Total Assets 1000 1200
Firm 1 Firm 2
ST Debt 100 100
LT Debt 400 400
Common Stock 500 700
Total Liabilities&Equity 1000 1200
Firm 1 Firm 2
Operating Earnings 150 150
Interest Earned 0 8
EBT 150 158
Taxes (40%) -60 -63
Net Income 90 95

Current Ratio 2 4
ROA 9% 7.9%
9
Time
Total Assets
Assume ZERO Long-term Growth
$5M
Variation in assets over time
Fixed
Assets
}
10
Time
Total Assets
Fixed
Assets
Permanent
Current Assets
}
}
$5M
$7M
Variation in assets over time
11
Temporary Current Assets
Variation in assets over time
Time
Total Assets
Fixed
Assets
Permanent
Current Assets
}
}
$5M
$7M
$10M
Different Approaches to Financing
Conservative Approach
Finance all fixed assets, permanent current assets,
and some temporary with LT debt or equity. ST
financing is used for the remaining temp. current
assets.
Lower risk, lower return

12
13
Financing Current Assets:
Conservative Approach
Temporary Current Assets
Time
Total Assets
Fixed
Assets
Permanent
Current Assets
}
}
$5M
$7M
$10M
Temporary Current Assets
Time
Total Assets
Fixed
Assets
Permanent
Current Assets
}
}
$5M
$7M
$10M
Short-term
Sources
L
o
n
g
-
t
e
r
m

S
o
u
r
c
e
s

Different Approaches to Financing
Conservative Approach
Finance all fixed assets, permanent current assets,
and some temporary with LT debt or equity. ST
financing is used for the remaining temp. current
assets.
Lower risk, lower return
Moderate Approach (Maturity Matching)
Finance fixed assets and permanent current assets
with LT funds and temporary current assets with ST
funds.
Moderate risk, moderate return
14
15
Financing Current Assets:
Moderate Approach
Temporary Current Assets
Time
Total Assets
Fixed
Assets
Permanent
Current Assets
}
}
$5M
$7M
$10M
Temporary Current Assets
Time
Total Assets
Fixed
Assets
Permanent
Current Assets
}
}
$5M
$7M
$10M
L
o
n
g
-
t
e
r
m

S
o
u
r
c
e
s

16
Financing Current Assets:
Moderate Approach
Short-term
Sources
Temporary Current Assets
Time
Total Assets
Fixed
Assets
Permanent
Current Assets
}
}
$5M
$7M
$10M
Temporary Current Assets
Time
Total Assets
Fixed
Assets
Permanent
Current Assets
}
}
$5M
$7M
$10M
L
o
n
g
-
t
e
r
m

S
o
u
r
c
e
s

Different Approaches to Financing
Conservative Approach
Finance all fixed assets, permanent current assets, and some
temporary with LT debt or equity. ST financing is used for the
remaining temp. current assets.
Lower risk, lower return
Moderate Approach (Maturity Matching)
Finance fixed assets and permanent current assets with LT
funds and temporary current assets with ST funds.
Moderate risk, moderate return
Aggressive Approach
Finance all temporary current assets, permanent current
assets, and some fixed assets with ST debt. LT financing is
used for the remaining fixed assets.
Higher risk, higher return

17
18
Long-term Sources
Financing Current Assets:
Aggressive Approach
Temporary Current Assets
Time
Total Assets
Fixed
Assets
Permanent
Current Assets
}
}
$5M
$7M
$10M
Temporary Current Assets
Time
Total Assets
Fixed
Assets
Permanent
Current Assets
}
}
$5M
$7M
$10M
Short-term
Sources