Working Capital and The Financing Decision: Foundations of Financial Management

6
Working Capital and the

Financing Decision
Block, Hirt, and Danielsen
Foundations of Financial Management
17th edition
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 6-1
Learning Objectives
• Working capital management involves financing and controlling the
current assets of the firm.
• Management must distinguish between current assets that are
easily converted to cash and those that are more permanent.
• The financing of an asset should be tied to how long the asset is
likely to be on the balance sheet.
• Long-term financing is usually more expensive than short-term
financing based on the theory of the term structure of interest
rates.
• Risk, as well as profitability, determines the financing plan for
current assets.
• Expected value analysis may sometimes be employed in working
capital management.
Chapter Opening
• Working capital management
• Financing and management of current assets of
firm
• Current assets change constantly, requiring
decisions made by management
• Short-term decisions on working capital
determines whether a firms gets to long term
• Requires immediate action
The Nature of Asset Growth
• Key to current asset planning—matching production
schedules with accurate sales forecast
• Differences in actual sales and forecasted sales can
result in
• Unexpected buildup
• Reduction in inventory, affecting receivables and cash flow
• Firm’s current assets can be
• Self-liquidating assets
• “Permanent” current assets
Figure 6-1 The Nature of Asset Growth
Controlling Assets—Matching Sales and
Production
• Fixed assets grow slowly with
• Increase in productive capacity
• Replacement of old equipment
• Current assets fluctuate in short run,
depending on
• Level of production versus level of sales
• When production is higher than sales, inventory rises
• When sales are higher than production, inventory
declines and receivables increase
Controlling Assets—Matching Sales
and Production Continued 1
• Cash budgeting process
• Level production method
• Smooth production schedules
• Use manpower and equipment efficiently to lower cost
• Match sales and production as closely as possible
in short run
• Allows current assets to increase or decrease with level
of sales
• Eliminates large seasonal bulges or sharp reductions in
current assets
and Production Continued 2
• Briggs and Stratton Corporation example of
seasonal sale
• Sells most of their products early in the year to
other manufacturers
• Figure 6-2
• Sales are lowest in July to September quarter
• Peak sales are in January to March quarter
• First quarter of the year always generates negative
earnings per share
• Cost of production outweighs the revenue produced
Figure 6-2 Quarterly Sales and Earnings Per
Share for Briggs and Stratton
Controlling Assets—Matching Sales and
Production Continued 3
• Retail firms like Target and Macy’s also have
seasonal sales patterns
• Figure 6-3
• Sell products that are manufactured for them
• Involved in matching sales with inventory
• Selling seasons affected by weather and holidays,
therefore retailers cannot avoid inventory risk
• Fourth quarter (Nov.–Jan.) is their biggest quarter
and amounts to more than half of their sales
Figure 6-3 Quarterly Sales and Earnings Per
Share, Target and Macy's
and Production Concluded
• Retail-oriented firms use new, computerized
inventory control systems linked to online point-
of-sales terminals
• Allow either digital input or use of optical scanners to
record inventory code numbers and amount of each
item sold
• Managers can examine sales and inventory levels by
item and adjust orders or production schedules
• Predictability of the market will influence the speed of
manager’s response
• Complexity of production will dictate speed of production
changes
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
• 12-month sales forecast issued
• Result
• Level production and seasonal sales combine to
produce fluctuating inventory
Table 6-1 Yawakuzi Sales Forecast (in
Units)
Table 6-2 Yawakuzi’s Production
Schedule and Inventory
Table 6-3 Sales Forecasts, Cash Receipts
and Payments, and Cash Budget
Temporary Assets under Level
Production—an Example Continued
• Table 6-3 examines buildup in accounts receivable
and cash
• Sales forecast
• Based on assumptions taken earlier (Table 6-1)
• Cash receipts
• 50 percent represents cash collected during month of sale, and 50
percent pertains to prior month
• Cash payments
• Assumptions of level production plus payments for overhead,
dividends, interest, and taxes
• Cash budget
• Comparison of cash receipts and cash payments schedules to
determine cash flow
Table 6-4 Total Current Assets, First
Year ($ millions)
Table 6-5 Cash Budget and Assets for Second
Year with No Growth in Sales ($ millions)
Figure 6-4 The Nature of Asset Growth
(Yawakuzi)
Patterns of Financing
• Selecting of external sources to finance assets
is important
• Most appropriate financing pattern
• Matching asset buildup and financing terms length
• Figure 6-5
Figure 6-5 Matching Long-Term and Short-
Term Needs
Alternative Plans
• Challenge of constructing financial plan is
categorizing current assets into temporary and
permanent
• Predicting exact timing of asset liquidation is
difficult
• Difficult to determine amount of short-term
and long-term financing available
Long-Term Financing
• Can assure adequate capital at all times
• May rely on long-term funds to cover part of
short-term needs
• Can finance
• Fixed assets
• Permanent current assets
• Part of temporary current assets
Figure 6-6 Using Long-Term Financing for Part
of Short-Term Needs
Short-Term Financing
(Opposite Approach)
• Many small businesses do not have total

access to long-term financing
• Rely on short-term bank and trade credit
• Advantage: Interest rates are lower
• Short-term finances used for
• Temporary current assets
• Part of permanent working capital needs
Figure 6-7 Using Short-Term Financing
for Part of Long-Term Needs
Term Structure of Interest Rates
• Yield curve—shows relative level of short-term
and long-term interest rates
• U.S. government securities used; free of default risks
• Corporate debt securities move in same direction as
U.S. government securities
• Have higher interest rates due to more financial risk
• Yield curves for both securities change daily to reflect
• Current competitive conditions
• Expected inflation
• Changes in economic conditions
Term Structure of Interest Rates Continued
• Three basic theories describe shape of yield

curve
• Liquidity premium theory
• Long-term rates should be higher than short-term rates
• Incentive to hold less liquid and more price-sensitive
securities
• Market segmentation theory
• Treasury securities are divided into market segments by
various financial institutions investing in market
• Expectations hypothesis
• Yields on long-term securities are function of short-term
rates
• Over the time period long-term security is outstanding
Figure 6-9 Treasury Yield Curve
Figure 6-10 Long- and Short-Term
Annual Interest Rates
• Relative volatility and historical level of short-
term/long-term rates
Table 6-7 Alternative Financing Plans
• Decision Process—comparing alternative
working capital financing plans
Table 6-8 Impact of Financing Plans
on Earnings
Introducing Varying Conditions
• Tight money periods
• Capital is scarce
• Short-term financing may be difficult to find or
may have very high rates
• Inadequate financing may mean loss of sales or
financial embarrassment
Table 6-9 Expected Returns under Different
Economic Conditions
• Expected value represents sum of expected

outcomes under both conditions
Table 6-10 Expected Returns for
High-Risk Firm
Shifts in Asset Structure
• During recession
• Sales decline or stay even
• Cash, receivables, and inventory fall
• Short-term debt may rise
• Causes large decline in net working capital to sales ratio
• During upswing
• Cash, receivables, and inventory rise
• Short-term debt may fall or be replaced by low-
cost long-term debt
• These two effects cause a firm’s profitability to increase
and net working capital to sales ratio to rise
Figure 6-11 Net Working Capital as a
Percentage of Sales and the Current Ratio
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 will borrow short term and maintain
low level of liquidity
• Conservative firm will establish long-term financing and
maintain high degree of liquidity
Table 6-11 Asset Liquidity and Financing
Assets

Working Capital and The Financing Decision: Foundations of Financial Management

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Working Capital and the

• Many small businesses do not have total

• Three basic theories describe shape of yield

• Expected value represents sum of expected

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