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Chapter 8 -- Overview of Working Capital Management

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Title: Chapter 8 -- Overview of Working Capital Management


1
Chapter 8
Overview of Working Capital Management
2
After Studying Chapter 8, you should be able to
  1. Explain how the definition of "working capital"
    differs between financial analysts and
    accountants.
  2. Understand the two fundamental decision issues in
    working capital management and the trade-offs
    involved in making these decisions.
  3. Discuss how to determine the optimal level of
    current assets.
  4. Describe the relationship between profitability,
    liquidity, and risk in the management of working
    capital.
  5. Explain how to classify working capital according
    to its components and according to time
    (i.e., either permanent or temporary).
  6. Describe the hedging (maturity matching) approach
    to financing and the advantages/disadvantages of
    short- versus long-term financing.
  7. Explain how the financial manager combines the
    current asset decision with the liability
    structure decision.

3
Net Working Capital Fundamentals
  • Short Term Financial Management The management
    of current assets and current liabilities.
  • Working Capital Current assets, which represent
    the portion of investment that circulates from
    one form to another in the ordinary conduct of
    business.
  • Net Working Capital The portion of current
    assets financed with long term funds. Calculated
    by
  • NWC CA CL
  • Net Working Capital can be difficult to predict
    in some cases. However, the more predictable the
    firms cash flow the less net working capital a
    firm needs.

4
Working Capital Concepts
Net Working Capital Current Assets Current
Liabilities. Gross Working Capital The firms
investment in current assets. Working Capital
Management The administration of the firms
current assets and the financing needed to
support current assets.
5
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 companys
    risk, return, and share price.

6
The Tradeoff Between Profitability Risk
  • A tradeoff exists between profitability and
    risk.
  • Profitability The relationship between revenues
    and costs generated by using the firms assets
    (current and non current) in productive
    activities.
  • Risk The probability that the firm will become
    technically insolvent.
  • Generally, the greater the firms net working
    capital, the more liquid the firm is, and
    consequently the lower its risk.

7
Impact on Expected Profitability
Optimal Amount (Level) of Current Assets
Profitability Analysis Policy
Profitability A Low B Average
C High As current asset levels decline, total
assets will decline and the ROI will rise.
Policy A
Policy B
Policy C
ASSET LEVEL ()
Current Assets
0 25,000
50,000
OUTPUT (units)
8
Impact on Risk
Optimal Amount (Level) of Current Assets
Risk Analysis Policy Risk A Low
B Average C High Risk increases as the
level of current assets are reduced.
Policy A
Policy B
Policy C
ASSET LEVEL ()
Current Assets
0 25,000
50,000
OUTPUT (units)
9
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!)
10
Changes In Current Assets Current Liabilities
11
Classifications of Working Capital
  • Components
  • Cash, marketable securities, receivables, and
    inventory
  • Time
  • Permanent
  • Temporary

12
Permanent Working Capital
The amount of current assets required to meet a
firms long-term minimum needs.
DOLLAR AMOUNT
Permanent current assets
TIME
13
Temporary Working Capital
The amount of current assets that varies with
seasonal requirements.
Temporary current assets
DOLLAR AMOUNT
Permanent current assets
TIME
14
The Cash Conversion Cycle
  • Operating Cycle The time from the beginning of
    the production process to collection of cash from
    the sale of the finished product.
  • Calculated by
  • OC AAI ACP Equation 14.1
  • Where
  • AAI Average age of inventory
  • ACP Average collection period

15
The Cash Conversion Cycle
  • The amount of time the firms resources are tied
    up.
  • Calculated by
  • CCC OC APP Equation 14.2 OR
  • CCC AAI ACP APP Equation 14.3
  • Where
  • OC Operating cycle
  • APP Average payment period

16
The Cash Conversion Cycle
17
The Cash Conversion Cycle
18
Exercises
19
Strategies For Managing The Cash Conversion Cycle
  • Aim is to minimise the length of the cash
    conversion cycle.
  • Strategies to achieve this include
  • Turnover inventory as quickly as possible without
    stockouts.
  • Collect accounts receivable as quickly as
    possible.
  • Manage mail, processing and clearing time.
  • Pay accounts as slowly as possible without
    damaging the firms credit rating.

20
Funding Requirements Of The Cash Conversion Cycle
  • Permanent Funding Requirement The firms
    constant investment in operating assets resulting
    from constant sales over time.
  • Seasonal Funding Requirement The firms
    investment in operating assets that varies over
    time as a result of cyclic sales.

21
Funding Requirements Of The Cash Conversion Cycle
22
Funding Requirements Of The Cash Conversion Cycle
23
Funding Requirements Of The Cash Conversion Cycle
  • Aggressive Funding Strategy Where the firm funds
    its seasonal requirements with short term debt
    and its permanent requirements with long term
    debt.
  • 5. Amount of funding needed equals estimated
    funding requirements. Therefore there are no
    surplus balances

24
Funding Requirements Of The Cash Conversion Cycle
  • Conservative Funding Strategy Where the firm
    funds both its seasonal and its permanent
    requirements with long term debt.
  • 6. Peak seasonal needs permanent need average
    seasonal need
  • 1,125,000 135,000 101,250 888,750

25
Financing Current Assets Short-Term and
Long-Term Mix
  • Spontaneous Financing Trade credit, and other
    payables and accruals, that arise spontaneously
    in the firms day-to-day operations.
  • Based on policies regarding payment for
    purchases, labor, taxes, and other expenses.
  • We are concerned with managing non-spontaneous
    financing of assets.

26
Risks vs. Costs Trade-Off (Conservative Approach)
  • Long-Term Financing Benefits
  • Less worry in refinancing short-term obligations
  • Less uncertainty regarding future interest costs
  • Long-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.

27
Risks vs. Costs 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
Current assets
DOLLAR AMOUNT
Long-term financing
Fixed assets
TIME
28
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.

29
Risks vs. Costs Trade-Off (Aggressive Approach)
Firm increases risks associated with short-term
borrowing by using a larger proportion of
short-term financing.
Short-term financing
Current assets
DOLLAR AMOUNT
Long-term financing
Fixed assets
TIME
30
Summary of Short- vs. Long-Term Financing
Financing Maturity
SHORT-TERM
LONG-TERM
Asset Maturity
Low Risk-Profitability
Moderate Risk-Profitability
SHORT-TERM (Temporary)
High Risk-Profitability
Moderate Risk-Profitability
LONG-TERM (Permanent)
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