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Working Capital Management

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Uses more short-term financing than the matching principle calls for. ... Financing of CA: Uses more short-term sources of financing. Benefit: Increased Profitability ... – PowerPoint PPT presentation

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Title: Working Capital Management


1
Working Capital Management
  • Working Capital refers to a companys Current
    Assets
  • Current Assets Cash and Equivalents, Accounts
    Receivable, and Inventory
  • Working Capital Management Applying Investment
    and Financing Decisions to Current Assets

2
Investment Decision Applied to Current Assets
  • What current assets to own?
  • We know which ones are needed - we need to know
    what level of each the firm should have.
  • How much cash does firm need?
  • How much accounts receivable should be carried
    (what is firms credit policy)?
  • How much inventory is needed?

3
Financing Decision Applied to Current Assets
  • How to finance current assets?
  • For most firms, CA exceed CL
  • Therefore, part of CA is being financed by
    long-term sources (debt or equity)
  • How is financing of CA split between short-term
    sources (CL) and long-term sources ( long-term
    debt and equity)?

4
Tradeoffs in Working Capital Management
  • In making the investment and financing decision
    for current assets, face tradeoff between
  • Liquidity Ability to pay bills, keep sales
    coming in, keep customers happy, play it safe
  • Profitability Size of earnings after taxes

5
Measuring Liquidity and Profitability
  • Liquidity NWC CA - CL
  • Liquidity Current Ratio CA/CL
  • Profitability Return on Total Assets
  • ROA EAT/TA
  • Also use Current Asset Turnover to see how
    efficiently current assets are used
  • CAT Sales/CA

6
Classifying Current Assets
  • Permanent Current Assets minimum level of cash,
    A/R, and inventory needed to stay in business
    (PCA)
  • Temporary Current Assets fluctuations in cash,
    A/R, and inventory corresponding to fluctuations
    in sales (TCA)

7
Matching Principle of WCM
  • Match the maturity of the sources of financing
    (CL, LTD, E) with the maturity of the uses (TCA,
    PCA, FA)
  • Use CL to finance TCA
  • Use LTD E to finance PCA and FA

8
Conservative Approach to WCM
  • Objective Improve Liquidity
  • Level of Current Assets
  • 1) Cash Maintains large cash balance.
  • Benefit Able to pay bills easily.
  • Cost Cash could be earning a higher rate of
    return if it was invested elsewhere.

9
  • 2) A/R Permits high level of accounts
    receivable Liberal Credit Policy (easy to get
    credit)
  • Benefit Keeps sales high, keeps customers happy.
  • Cost High bad debt expense.

10
  • 3) Inventory Maintains high level of inventory.
  • Benefit Keeps sales high, keeps customers happy.
  • Cost High carrying costs, funds could earn
    higher return invested elsewhere

11
  • Financing of Current Assets
  • Use more long-term financing than the matching
    principle calls for.
  • Benefit Have the money raised all at once and
    available to spend- no frequent refinancings.
  • Cost Long-term debt usually has higher interest
    rate than short-term debt, pay more interest
    expense.

12
Summary of Conservative Approach
  • Level of CA High cash, A/R, inventory
  • Financing of CA More long-term sources used
  • Benefit Increased liquidity
  • Cost Decreased profitability

13
Measures Indicating Conservative Approach
  • High Level of Net Working Capital
  • High Current Ratio
  • Low Return on Total Assets
  • Low Current Asset Turnover

14
Aggressive Approach to WCM
  • Objective Improve Profitability
  • Level of Current Assets
  • 1) Cash Keep minimum amount needed.
  • Benefit Cash is not in no or low interest
    accounts, invested elsewhere earning higher rate
    of return.
  • Cost May not be able to pay bills, no extra cash
    for emergencies.

15
  • 2) A/R Keeps receivables low, Tight Credit
    Policy (hard to get credit from them).
  • Benefit Low bad debt expense.
  • Cost Unhappy customers, sales drop.

16
  • 3) Inventory Minimum investment in inventory.
  • Benefit Low carrying costs, money invested
    elsewhere.
  • Cost Unhappy customers, sales drop.

17
  • Financing of Current Assets
  • Uses more short-term financing than the matching
    principle calls for.
  • Benefit Short-term debt usually carries lower
    interest rate than long-term debt, lower interest
    expense.
  • Cost Frequent refinancing, may have to borrow at
    higher rates in future, refinancing risk.

18
Summary of Aggressive Approach
  • Level of CA Low cash, A/R, inventory
  • Financing of CA Uses more short-term sources of
    financing
  • Benefit Increased Profitability
  • Cost Decreased Liquidity

19
Measures Indicating Aggressive Approach
  • Low level of Net Working Capital
  • Low Current Ratio
  • High Return on Total Assets
  • High Current Asset Turnover
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