Working Capital

Management

8-1
 Working Capital
Management
Working Capital Concepts
Working Capital Issues
FinancingCurrent Assets: Short-Term
and Long-Term Mix
Combining Liability Structure and
Current Asset Decisions
8-2
 Working Capital Concepts
Net Working Capital
Current Assets - Current Liabilities.

Gross Working Capital

The firm’s investment in current assets.

Working Capital Management

The administration of the firm’s current assets and
the financing needed to support current assets.
8-3
 Fundamental Decision
Issues
1. What is the optimal level of
investment in current assets?
2. What is the appropriate mix of
short-term and long-term
financing to support investment
in current assets?
8-4
 Working Capital Issues
Optimal Amount (Level) of Current Assets

Assumptions
 50,000 maximum Policy A

ASSET LEVEL ($)

units of production Policy B
 Continuous Policy C
production
 Three different Current Assets
policies for current
asset levels are
possible 0 25,000 50,000
OUTPUT (units)
8-5
 Impact on Liquidity
Optimal Amount (Level) of Current Assets
Liquidity Analysis
Policy Liquidity Policy A

ASSET LEVEL ($)

A High Policy B
B Average Policy C
C Low
Greater current asset Current Assets
levels generate more
liquidity; all other
factors held constant. 0 25,000 50,000
OUTPUT (units)
8-6
 Impact on
Expected Profitability
Optimal Amount (Level) of Current Assets
Return on Investment =
Policy A
Net Profit

ASSET LEVEL ($)

Total Assets Policy B

Let Current Assets = Policy C

(Cash + Rec. + Inv.)
Current Assets
Return on Investment =
Net Profit
Current + Fixed Assets
0 25,000 50,000
OUTPUT (units)
8-7
 Impact on
Expected Profitability
Optimal Amount (Level) of Current Assets

Profitability Analysis
Policy Profitability Policy A

ASSET LEVEL ($)

A Low Policy B

B Average Policy C

C High
Current Assets
As current asset levels
decline, total assets will
decline and the ROI will
rise. 0 25,000 50,000
OUTPUT (units)
8-8
 Impact on Risk
Optimal Amount (Level) of Current Assets
 Decreasing cash
reduces the firm’s ability Policy A

ASSET LEVEL ($)

to meet its financial
obligations. More risk! Policy B
 Stricter credit policies Policy C
reduce receivables and
possibly lose sales and
customers. More risk! Current Assets
 Lower inventory levels
increase stockouts and
lost sales. More risk! 0 25,000 50,000
OUTPUT (units)
8-9
 Impact on Risk
Optimal Amount (Level) of Current Assets

Risk Analysis
Policy Risk Policy A

ASSET LEVEL ($)

A Low Policy B

B Average Policy C

C High
Current Assets
Risk increases as the
level of current assets
are reduced. 0 25,000 50,000
OUTPUT (units)
8-10
 Summary of the Optimal
Amount of Current Assets
SUMMARY OF OPTIMAL CURRENT ASSET ANALYSIS
Policy Liquidity Profitability Risk
A High Low Low
B Average Average Average
C Low High High

1. Profitability varies inversely with

liquidity.
2. Profitability moves together with risk.
(risk and return go hand in hand!)
8-11
 Classifications of
Working Capital
 Components

Cash, marketable securities,


receivables, and inventory
 Time

 Permanent
 Temporary
8-12
 Permanent
Working Capital
The amount of current assets required to
meet a firm’s long-term minimum needs.
DOLLAR AMOUNT

Permanent current assets

TIME
8-13
 Temporary
Working Capital
The amount of current assets that varies
with seasonal requirements.
DOLLAR AMOUNT

Temporary current assets

Permanent current assets

TIME
8-14
 Financing Current Assets:
Short-Term and Long-Term Mix

Short-Term Financing
 The shorter the maturity schedule of a
firm’s debt obligations, the greater the
risk that the firm will be unable to meet
principal and interest payments.
 The firm may not be able to roll over
(renew) the loan at maturity.

8-15
 Financing Current Assets….

Long-Term Financing
 The longer the maturity schedule of a
firm’s debt, the more costly the financing
is likely to be.

 Thefirm may well end up paying interest

on debt over periods of time when the
funds are not needed.
8-16
 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
8-17
 Financing Needs and
the Hedging Approach
 Fixed assets and the non-seasonal portion
of current assets are financed with long-
term debt and equity.
 Seasonal needs are financed with short-
term loans (under normal operations
sufficient cash flow is expected to cover the
short-term financing cost).

8-18
 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
8-19
 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
8-20
 Comparison with an
Aggressive Approach
 Short-Term Financing Benefits
 Financing long-term needs with a lower interest
cost than long-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.
8-21
 Combining Liability Structure
and Current Asset Decisions
 The level of current assets and the
method of financing those assets are
interdependent.
 A conservative method of financing
(all-equity) allows an aggressive policy
of “low” levels of current assets.
 A conservative policy of “high” levels of
current assets allows a more aggressive
method of financing current assets.
8-22
 Continued...

Uncertainty and the Margin of Safety

 If the firm knows with certainty its future sales
demand, resulting receivable collections, and
production schedule, it will be able to arrange its
debt maturity schedule to correspond exactly to the
schedule of future net cash flows and vice versa.

8-23
 Continued...
The greater the ability of the firm to
borrow on short notice, the less it
needs to provide for a margin of
safety.
Certain companies can arrange for
lines of credit or revolving credits
that enable them to borrow on short
notice.
8-24