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Chapter 8 : Overview Working Capital Management
Lecturer : Rizal Yaya, S.E., M.Sc., Ph.D., Ak, CA
 Overview of Working Capital Management

A. Working Capital Concepts

B. Working Capital Issues
C. Financing Current Assets: Short-Term and Long-
Term Mix
D. Combining Liability Structure and Current Asset
Decisions
 Working Capital Concepts
• Net Working Capital is current assets minus current liabilities

• Gross Working Capital is the firm’s investment in current

assets (like cash and marketable securities, receivables, and
inventory).

• Working Capital Management is the administration of the

firm’s current assets and the financing needed to support
current assets.
 Significance of Working Capital Management

• In a typical manufacturing firm, current assets exceed

one-half of total assets.
• Excessive levels can result in a substandard Return on
Investment (ROI).
• Current liabilities are the principal source of external
financing for small firms.
• Requires continuous, day-to-day managerial supervision.
• Working capital management affects the company’s risk,
return, and share price.
 Working Capital Issues

Optimal Amount (Level) of Current Assets

Assumptions
Policy A
• 100,000 maximum units

ASSET LEVEL ($)

of production Policy B

• Continuous production Policy C

• Three different policies

Current Assets
for current asset levels
are possible
0 50,000 100,000
OUTPUT (units)
 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
Current Assets
Greater current asset
levels generate more
liquidity; all other
0 50,000 100,000
factors held constant. OUTPUT (units)
 Impact on Expected Profitability
Optimal Amount (Level) of Current Assets

Return on Investment =
Net Profit Policy A
Total Assets

ASSET LEVEL ($)

Policy B
Current Assets = Policy C
(Cash + Rec. + Inv.)
Current Assets
Return on Investment =
Net Profit
Current + Fixed Assets 0 50,000 100,000
OUTPUT (units)
 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
0 50,000 100,000
rise. OUTPUT (units)
 Impact on Risk
Optimal Amount (Level) of Current Assets

• Decreasing cash reduces

the firm’s ability to meet
Policy A
its financial obligations.

ASSET LEVEL ($)

More risk! Policy B
• Stricter credit policies Policy C
reduce receivables and
possibly lose sales and
Current Assets
customers. More risk!
• Lower inventory levels
increase stockouts and lost
sales. More risk! 0 50,000 100,000
OUTPUT (units)
 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 50,000 100,000
OUTPUT (units)
Summary of the Optimal Amount of Current Assets

1. Profitability varies inversely with liquidity.

2. Profitability moves together with risk (there is a

trade-off between risk and return)
Classifications of Working Capital

Components Time

Cash,
Marketable
• Permanent
Securities,
Receivables, and • Temporary
Inventory
 Permanent and Temporary Working Capital

1. Permanent Working Capital is the amount of current assets required to

meet a firm’s long-term minimum needs.
2. Temporary Working Capital is the amount of current assets that varies with
seasonal requirements.
 Financing Current Assets:
Short-Term and Long-Term Mix

Spontaneous Financing is trade credit, and other payables

and accruals, that arise spontaneously in the firm’s day-to-
day operations. Based on policies regarding payment for
purchases, labor, taxes, and other expenses.
 Hedging (Maturity Matching) Approach

Hedging (maturity matching) approach is a method of financing where each asset

would be offset with a financing instrument of the same approximate maturity.
 Financing Needs and the Hedging Approach

• If the firm adopts a hedging (maturity matching) approach

to financing, each asset would be offset with a financing
instrument of the same approximate maturity.
• Short-term or seasonal variations in current assets would
be financed with short-term debt.
• The permanent component of current assets and all fixed
assets would be financed with long-term debt or equity.
 Self-Liquidating Nature of Short-Term Loans

• Seasonal orders require the purchase of inventory beyond

current levels.
• Increased inventory is used to meet the increased demand
for the final product.
• Sales become receivables.
• Receivables are collected and become cash.
• The cash needed to repay the loan would come from the
collection of these receivables.
 Risks vs. Coast Trade-Off
(Conservative Approach)
Long-Term Financing Benefits
• Less worry in refinancing short-term obligations
• Less uncertainty regarding future interest costs
Short-Term Financing Risks
• Borrowing more than what is necessary
• Borrowing at a higher overall cost (usually)
Result
• Manager accepts less expected profits in exchange for taking less risk.
 Risks vs. Coast Trade-Off
(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
 Comparison with an Aggressive Approach
Short-Term Financing Benefits
• Financing long-term needs with a lower interest cost than short-
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.
Comparison with an Aggressive Approach
Firm increases risks associated with short-term borrowing by
using a larger proportion of short-term financing.

DOLLAR AMOUNT Short-term financing

Current assets

Long-term financing
Fixed assets

TIME
Summary of Short- vs. Long-Term Financing
 Combining Liability Structure and
Current Asset Decisions

A Uncertainty and the Margin of Safety

B Risk and Profitability

 A Uncertainty and the Margin of Safety

Margin of safety provided for in working capital

management only by:
1. Increasing the level of current assets (especially cash and
marketable securities),
2. Lengthening the maturity schedule of financing. Both of
these actions affect profitability.
 A Risk and Profitability
• A decision on the appropriate margin of safety will be governed
by considerations of risk and profitability and by management’s
attitude toward bearing risk.
• For a given risk tolerance, management may determine which
solution is least costly and then implement that solution.
• Management could formulate risk tolerances on the basis of the
cost involved in providing a margin of safety.
• These tolerances would be in keeping with an objective of
maximizing shareholder wealth.
 Question
1. What does working capital management encompass? What functional decisions are
involved, and what underlying principle or trade-off influences the decision process?
2. A firm is currently employing an “aggressive” working capital policy with regard to the
level of current assets it maintains (relatively low levels of current assets for each possible
level of output). The firm has decided to switch to a more “conservative” working capital
policy. What effect will this decision probably have on the firm’s profitability and risk?
3. Utilities hold 10 percent of total assets in current assets; retail trade industries hold 60
percent of total assets in current assets. Explain how industry characteristics account for this
difference.
4. Distinguish between “temporary” and “permanent” working capital.
 Question
5. If the firm adopts a hedging (maturity matching) approach to financing, how would it
finance its current assets?
6. Some firms finance their permanent working capital with short-term liabilities
(commercial paper and short-term notes). Explain the impact of this decision on the
profitability and risk of these firms.
7. Suppose that a firm finances its seasonal (temporary) current assets with long-term funds.
What is the impact of this decision on the profitability and risk of this firm?
8. Risk associated with the amount of current assets is generally assumed to decrease with
increased levels of current assets. Is this assumption always correct for all levels of current
assets – in particular, for an excessively high level of current assets relative to the firm’s
needs? Explain.
 Question
9. At times, long-term interest rates are lower than short-term rates, yet the
discussion in the chapter suggests that long-term financing is more expensive. If
long-term rates are lower, should the firm finance itself entirely with long-term
debt?
10. How does shortening the maturity composition of outstanding debt increase the
firm’s risk? Why does increasing the liquidity of the firm’s assets reduce the risk?
11. What are the costs of maintaining too large a level of working capital? Too small
a level of working capital?
12. How is a margin of safety provided for in working capital management?