Chapter 8

Overview
Overview of
of
Working
Working Capital
Capital
Management
Management

1
 After studying Chapter 8,
you should be able to:
 Explain how the definition of "working capital" differs between
financial analysts and accountants.
 Understand the two fundamental decision issues in working
capital management -- and the trade-offs involved in making
these decisions.
 Discuss how to determine the optimal level of current assets.
 Describe the relationship between profitability, liquidity, and risk
in the management of working capital.
 Explain how to classify working capital according to its
“components” and according to “time” (i.e., either permanent or
temporary).
 Describe the hedging (maturity matching) approach to financing
and the advantages/disadvantages of short- versus long-term
financing.
 Explain how the financial manager combines the current asset
2 decision with the liability structure decision.
 Overview of Working
Capital Management
 Working Capital Concepts
 Working Capital Issues
 Financing Current Assets:
Short-Term and Long-Term Mix
 Combining Liability Structure
and Current Asset Decisions
3
 Working Capital Basics
What is Working Capital Management?
 Working capital management involves two
key issues:
1. What is the appropriate amount and mix of
current assets for the firm to hold?
2. How should these current assets be financed?

4
 Working Capital Basics
Basic Definitions of Working Capital Terminology
 Current assets are cash and other assets that the
firm expects to convert into cash in a year or less.

 Current liabilities (or short-term liabilities) are

obligations that the firm expects to pay off in
a year or less.
 Working capital is the funds invested in a
company’s cash account, account
receivables, inventory, and other current
assets (also called gross working capital).

5
 Working Capital Basics

Basic Definitions of Working Capital Terminology

 Net working capital (NWC) refers to the difference
between current assets and current liabilities. NWC
is important because it is a measure of liquidity and
represents the net short-term investment the firm
keeps in the business.

 Working capital management involves making

decisions regarding the use and sources of
current assets.
6
 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.
7
 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
 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 25,000 50,000
factors held constant. OUTPUT (units)
9
 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)
10
 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)
11
 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)
12
 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)
13
 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!)
14
 o u !
k Y
ha n
T
15