1. Working Capital Management FIN 340 Prof. David S. Allen Northern Arizona University

2. The Basic Questions What is the appropriate amount of current assets to carry, both in total and specific accounts? How should current assets be financed? These two questions constitute the firm’s working capital policy.

3. Terminology Working capital is defined as current assets. Net working capital is current asset minus current liabilities. The typical financial managers spends the majority of his/her time on working capital issues, rather than on long-term issues such as capital budgeting, capital structure, and dividend policy.

4. Additional Terminology Net operating working capital (NOWC)  =operating current assets – operating current liabilities  =cash + receivables + inventories – payables – accruals Working capital management  The process of setting the working capital policy, and implementing it on a day-to-day basis.

5. Alternative Net Operating Working Capital Policies Basic issue: How much current assets are needed to support the anticipated sales?

6. Alternative Current Asset Policies Basic issue: How much current assets are needed to support the anticipated sales?

7. Alternative Current Asset Policies Under conditions of certainty in sales, manufacturing time, and collections, firms would hold the least possible amount of current assets. Why?  All assets must be financed, and financing costs money, reducing profitability at any given level of sales.

8. Alternative Current Asset Policies Under conditions of uncertainty in sales, manufacturing time, and collections, firms would hold more than the minimum possible amount of current assets. Why?  Safety stocks are needed to meet unanticipated variations in demand and manufacturing time.

9. Alternative Current Asset Policies There is a risk-return tradeoff in determining the amount of current assets to hold:  Fewer current assets reduces financing costs, and so increases profits, but…  It increases the probability of losing sales due to stock outs and/or a restrictive credit policy. So, the firm has a balancing act to perform between profitability and risk.

10. Alternative Short-Term Financing Policies Net operating working capital = NOWC = operating current assets – operating current liabilities =(cash + receivables + inventories) – (payables + accruals) Virtually all firms experience changes in NOWC due to:  Seasonality in sales, or  Cyclicality in the economy NOWC has two components:  A permanent level, i.e. the minimum amount the firm always has, and  A temporary level which varies with seasonality and cyclicality. How the firm finances these components is known as the firm’s short-term financing policy.

11. Maturity Matching Approach The firm attempts to match the maturity of the financing with the expected life of the asset being financed.

12. Aggressive Approach Finance all fixed assets and a portion of permanent NOWC with long-term capital. Finance the remaining portion of permanent NOWC and all temporary NWC with short-term debt (which tends to be less expensive, thereby increasing profits).

13. Conservative Approach Finance all fixed assets, all permanent NOWC, and a portion of temporary NOWC with long-term capital. At times, the firm has more financing than needed, and “stores” the excess in marketable securities. Safer, but less profitable.

14. Short-Term Financing Advantages of short-term financing  Short-term loans can be obtained much faster than long- term credit.  If the financing need is seasonal, the firm may not want long- term funds since:  Floatation (issuance) costs are higher for long-term debt.  Long-term loans sometimes contain prepayment penalties.  Long-term loans always contain “restrictive covenants.”  The yield curve is normally upward sloping, i.e. long-term interest rates are higher than short-term interest rates.

15. Short-Term Financing Disadvantages of short-term financing  Short-term credit is more risky because:  Loans must be refinanced (rolled over) more often, and the rate on the new loan could increase substantially.  The lender may be unwilling to renew the loan if the firm’s financial condition has weakened or if the credit markets have become tighter.

16. Cash Conversion Cycle In a typical manufacturing firm, the cycle goes something like this:  The firm buys raw materials from its suppliers on credit, then applies labor (accrued wages) to convert it into the finished product.  The finished product is sold to customers on credit.  The firm pays its suppliers and employees.  The firm receives payment from its customers. So, cash is paid out before inflows are realized.

17. Cash Conversion Cycle Inventory conversion period = inventory / (COGS / 365)  Many published sources use sales in place of COGS. Receivables collection period = receivables / (annual sales / 365) Payables deferral period = payables / (COGS / 365)

18. Cash Conversion Cycle Cash conversion cycle = inventory conversion period + receivables collection period – payables deferral period Measures the number of days between paying out cash to suppliers and employees, and receiving cash from customers. The longer the CCC, the greater the amount of outside financing the firm will need. This increases financing costs and reduces profitability. Financing needed for purchases = CCC * (COGS/365)

19. Shortening the CCC Goal is to reduce the CCC as much as possible without hurting operations or alienating customers and/or suppliers.  Reduce inventory conversion period by processing and selling goods more quickly.  Reduce receivables collection period by speeding up collections.  Lengthen the payables deferral period by slowing down the firm’s own payments to suppliers.