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The appropriate decision variable to examine on the asset side is the maturity
composition, liquidity, of the firm’s assets, that is the turnover into cash.Decisions
that affect liquidity of assets include the management of cash,and marketable
securities, credit policy and procedures, inventory management and control , and
the administration of fixed assets.
PROFITABILITY AND RISK
For current assets, the lower the proportion of current assets to total assets, the
greater is the firm’s rate of return, assuming that short term assets yield a return
that is less than the return on long term assets.
The profitability assumptions above suggest a lower proportion of current assets to total
assets and a high proportion of current liabilities to total liabilities.This will result in a low net
working capital, or negative working capital. Offsetting the profitability of this strategy is the
risk to the firm. In a legal sense , insolvency occurs whenever the assets of the firm are less
than its liabilities- a negative net worth.The risk associated with various levels of current
assets and current liabilities must be evaluated in relation to the profitability associated with
those levels.
A. EFFECTS OF CURRENT ASSET INVESTMENTS ON PROFITABILITY
C.2. Shortage costs: Shortage costs are involved when investment in current
assets is low. If a firm runs out of cash and can’t readily sell marketable securities ,
it may need to borrow or default on an obligation.( cash-out)
If a firm has no inventory ( stock-out) or if it can not extend credit to its customers,it
will lose customer goodwill. There are two types of shortage costs:
a. Trading or order costs-Order costs are the costs of placing an order for more
cash ( brokerage costs) or more inventory ( production set-up costs)
b. Costs related to safety reserves- There are costs of lost sales, lost customer
goodwill, and disruption of production schedule.
If carrying costs are low and/ or shortage costs are high,the optimal policy calls for substantial
current assets.If carrying costs are high and/or shortage costs are low, the optimal policy will
be a moderate investment in current assets.
II. MATURITY STRUCTURE OF DEBT
FINANCING POLICIES FOR CURRENT ASSETS
In an ideal economy, short-term assets can always be
financed with short-term debt , and long-term assets can be
financed with long-term debt and equity.In this economy, net
working capital is always zero.
Current assets can not be expected to drop to zero in the real world
because a long-term rise in sales will result in some permanent investment
in current assets.A growing firm can have both a permanent requirement
for current assets and one for long-term assets.The long –term asset
requirement will reflect:
Borrowing short-term and investing in fixed assets may be risky because the
company may not renew the loans. There is also interest rate uncertainty in short-
term borrowing.
A firm can reduce the risk of insolvency either by increasing the maturity schedule of
its debt or by increasing the relative maturity of its assets.
An exact synchronization of the schedule of expected future net cash flows and payment
schedule of debt is appropriate under conditions of certainty. Under uncertainty, the net cash
flows will deviate from expected cash flows in keeping with the business risk of the firm.The
margin of safety provided by the firm is the lag between the firm’s expected cash flow and its
contractual payments. The margin of safety will depend on the risk preferences of
management.
In general, the shorter the maturity of a firm’s debt obligations, the greater the risk that it will
be unable to meet the principal and interest payments.Committing the short –term funds to
long-term assets carries the risk that the firm may not be able to renew its borrowings.If the
company should fall on hard times, creditors may regard renewal as too risky and demand
immediate payment.This would cause the firm to go into bankruptcy. In addition, there is the
uncertainty associated with interest costs.When the firm finances with long-term debt it fixes
the interest rate over the maturity period of the funds. When short-term loans are used, there
is interest uncertainty upon refinancing( reinvestment rate risk) . Differences in risk between
short and long term financing must be balanced against differences in costs.When the yield
curve slopes upward, short-term debt is cheaper than long term debt.The longer the maturity
of a firm’s debt, the more costly the financing is likely to be. Financing short-term asset
fluctuations with long –term debt will require payment of interest on debt over periods of time
when the funds are not needed.
Short-term financing gives flexibility.If there is a probability that the firm’s need for funds will
decrease, the use of short-term debt permits debt to be paid off in keeping with the diminished
need for funds.
III.WORKING CAPITAL POLICIES
The firm’s decision on the level of investment in current assets and the
maturity composition of debt will determine the working capital policy
adopted by the firm.
A. CONSERVATIVE POLICY
In the aggressive policy, the level of current asset investment is low. There
is a negative margin of safety since current liabilities exceed current
assets.The company finances all fluctuating current assets, and a certain
portion of permanent current assets with short-term debt. The greater the
portion of permanent current assets financed with short-term debt, the
more aggressive the financing is said to be.
C. HEDGING POLICY
This is the zero net working capital situation with no margin of safety. Each
asset is matched with a financing instrument of the same approximate
maturity.Short-term or seasonal variations in current assets are financed
with short-term debt. Permanent current assets and fixed assets are
financed with long-term funds.A hedging approach to financing suggests
that as the firm has seasonal needs for funds , it borrows on a short-term
basis, paying off the loans as surplus cash is generated. In this case ,
financing is employed when it is needed. Fluctuating current assets are
expected to be financed with accounts payable and accruals that rise with sales.
Only the portion of fluctuating current assets that can not be financed by
spontaneous sources of finance is financed with short-term debt
IV. FACTORS THAT AFFECT THE NEED FOR WORKING CAPITAL
There are some factors that affect working capital requirement:
1. Uncertainty- The higher the uncertainty in the environment, the higher is the
need for margin of safety in working capital management.Thus there is higher
investment in current assets and more use of long-term funds.
2.Credit policy- Credit policy adopted by the firm involves discounts given in cash
sales, credit period, standards in extending credit and collection policy.
High cash discounts attracts new customers, and lowers DSO; shorter collection
period leads to reduction in receivables and tight credit standards reduce bad
debts.All of these policies lead to tight credit policy which reduces receivables but
may harm customer relations and discourage sales.
4.Inflation- A high inflation rate, holding all else constant, will increase working
capital investment required to maintain the operations of the firm.
5.Growth rate- A firm that has a high rate of growth in sales will have to increase
investments in current assets which implies a higher need for financing.
6.Cash conversion period- A long cash conversion implies that cash is tied up in
asset accounts for long periods and that the firm needs external financing to
maintain its operations.
V. CASH CONVERSION CYCLE
Net working capital= Cash+ Other current assets- Current liabilities (2)
Cash + Other current assets-Current Liabilities= Long-term debt+ Equity- Fixed assets (3)
Cash= Long-term debt+Equity- Net working capital(excluding cash)- Fixed assets (4)
Equation (4) shows that increasing long-term debt and equity and decreasing fixed
assets and net working capital (excluding cash) will increase the cash level of the
firm.
The short-term activities create patterns of cash inflows and outflows that are both
unsynchronized and uncertain. The operating cycle is the time interval between the
arrival of the inventory and the date when cash is collected from receivables.
The cash cycle begins when cash is paid for materials and ends when cash is
collected from receivables. The cash flow time line consists of an operating cycle
and a cash cycle. The need for short-term financial decision making is suggested
by the gap between the cash inflows and cash outflows.This is related to the
lengths of the operating cycle and the accounts payable period.This gap can be
filled either by borrowing or by holding reserve for marketable securities.The gap
can be shortened by reducing the inventory and receivables conversion period and
by increasing the payable period. The operating cycle is the sum of inventory
conversion period and receivable conversion period. The inventory conversion
period is the length of time required to order, produce and sell a product. The
accounts receivable conversion period is the length of time required to collect cash
receipts. The cash cycle is the time between cash payment for inventory
purchases and cash collections from receivables.
The accounts payable period is the length of time the firm is able to delay payments
on the purchase of various resources such as raw materials, wages.
The firm’s goal is to shorten the conversion period as much as possible.The longer the cash
conversion cycle,the greater the need for external financing.
VI. SHORT TERM FINANCING POLICY AND SOURCES OF FINANCE
1.Accruals include the firm’s estimated taxes, social security premiums, and witheld employee payrolls. Accruals increase
automatically as the firm’s operations expand.
2.Trade credit- Accounts payable generally represents 40% of current liabilities for an average nonfinancial corporation. This
percentage is lower for smaller firms. This is a spontaneous source of financing that arises from business transactions.
3.Short-term bank loans- The bulk of bank lending is on short-term basis. A line of credit is a formal or informal
understanding
between the bank and the borrower indicating the maximum credit the bank will extend to the borrower.
A revolving credit agreement is a formal line of credit often used by large firms.The bank has a legal obligation to honor a
revolving credit agreement and it receives a committment fee .Neither the obligation nor the fee exist under a less formal
line of credit.
4.Commercial paper is a type of unsecured promissory note issued by large, strong firms.Maturity ranges between one-to
nine months.The rates on commercial paper fluctuates with demand and supply conditions.
5.Secured short-term loans- Loans are secured using several kinds of collateral including marketable securities like bonds,
or
stocks , fixed assets like land and building, equipment, or assets like inventory or receivables. Buildings are generally
used
as a security for long-term loans.Most secured short-term loans use receivables ,or inventories as collateral.
6.Accounts receivable financing involves either the pledging of receivables or the selling of receivables ( factoring).The
pledging of accounts receivable is characterized by the fact that the lender not only has a claim against the receivables but
has a recourse to the borrower.If the buyer of the goods fails to pay, selling firm takes the loss. Factoring or selling
accounts receivable involves the purchase of accounts receivable by the lender without recourse to the borrower.Since the
factoring firm asumes default on bad accounts, it must do a credit check.So factors provide a credit department to the
borrower.
7.Asset based securities- ( VDMK) Institutions issue securities backed up by the receivables from their consumer credits,
mortgage agreements, financial leasing and other billed receivables. The amount issued can not exceed 90% of the value
of the receivables at the time of the issue.Eligible accounts receivable is defined as gross accounts receivable minus
discounts and other credits, slow paying accounts ( 0ver 60 days past due at the date of invoice), foreign receivables due
from affiliates and suppliers.
VII. EVA AND WORKING CAPITAL
Economic Value Added (EVA) is defined as:
EVA= (NOPAT - (k x TOC)
where
NOPAT= Net operating profits after taxes
k= Cost of funds
TOC= Total operating capital
If working capital or total assets can be reduced without adversely affecting sales,
this will increase profit margin ,and the total asset turnover, and increase ROE.
CASH CONVERSION PERIOD
( Speedy Maintenance Inc.)
DATA:
1.AVERAGE ACCOUNTS RECEIVABLE = 65,000+85,000/ 2
= $ 75,000
2.ACCOUNTS RECEIVABLE TURNOVER = 430,500/ 75,000
= 5.74X
3.A/R CONVERSION PERIOD = 365/ 5.74
= 64 days
4.AVERAGE INVENTORY OF SUPPLIES = 18,000+ 21,000/ 2
= 19,500
5.INVENTORY TURNOVER = COGS*/ INVENTORY
= 70,000/ 19,500
= 3.59 X
6.INV.CONVERSION PERIOD = 365/ 3.59
= 102 days
7.AVERAGE ACCOUNTS PAYABLE = 45,000+ 55,000/ 2
= $50,000
8.ACCOUNTS PAYABLE TURNOVER = COGS/ AV. A/P
= 360,000/ 50,000
= 7.2X
9.A/ P DEFERRAL PERIOD = 365 / 7.2
= 51 days
CASH CONVERSION PERIOD = 64+ 102 – 51
= 115 DAYS
This is COGS for supplies only.
FINANCING CASH FLOW CYCLE
Accounts
Receivable $ 75,000 64 days $1315 $1973 $ 2630
Accounts
Payable $ 50,000 ( 51 days) $(699) $(1048) $(1397)
An aggressive policy
A conservative policy
A moderate policy
The balance sheet will look as follows under the three policies:
BALANCE SHEET
Because its working capital policy would influence the firm’s ability to
respond to customers’ needs , sales are expected to vary under different
economic scenarios are as follows ( in thousands of dollars) :
SALES