8-1 Chapter 8 Overview of Working Capital Management © 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e Created by: Gregory A. Kuhlemeyer, Ph.D. Carroll College, Waukesha, WI

8-2 Overview of Working Capital Management u Working Capital Concepts u Working Capital Issues u Financing Current Assets: Short-Term and Long-Term Mix u Combining Liability Structure and Current Asset Decisions

8-3 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.

8-4 Significance of Working Capital Management u In a typical manufacturing firm, current assets exceed one-half of total assets. u Excessive levels can result in a substandard Return on Investment (ROI). u Current liabilities are the principal source of external financing for small firms. u Requires continuous, day-to-day managerial supervision. u Working capital management affects the company’s risk, return, and share price.

8-5 Working Capital Issues Assumptions u 50,000 maximum units of production u Continuous production u Three different policies for current asset levels are possible Optimal Amount (Level) of Current Assets 0 25,000 50,000 OUTPUT (units) ASSET LEVEL ($) Current Assets Policy C Policy A Policy B

8-6 Impact on Liquidity Liquidity Analysis PolicyLiquidity AHigh AHigh BAverage BAverage CLow CLow Greater current asset levels generate more liquidity; all other factors held constant. Optimal Amount (Level) of Current Assets 0 25,000 50,000 OUTPUT (units) ASSET LEVEL ($) Current Assets Policy C Policy A Policy B

8-7 Impact on Expected Profitability Return on Investment Return on Investment = Net Profit Total Assets Current Assets Let Current Assets = (Cash + Rec. + Inv.) Return on Investment Return on Investment = Net Profit Current Fixed Assets Current + Fixed Assets Optimal Amount (Level) of Current Assets 0 25,000 50,000 OUTPUT (units) ASSET LEVEL ($) Current Assets Policy C Policy A Policy B

8-8 Impact on Expected Profitability Profitability Analysis Policy Profitability ALow ALow BAverage BAverage CHigh CHigh As current asset levels decline, total assets will decline and the ROI will rise. Optimal Amount (Level) of Current Assets 0 25,000 50,000 OUTPUT (units) ASSET LEVEL ($) Current Assets Policy C Policy A Policy B

8-9 Impact on Risk More risk! u Decreasing cash reduces the firm’s ability to meet its financial obligations. More risk! More risk! u Stricter credit policies reduce receivables and possibly lose sales and customers. More risk! More risk! u Lower inventory levels increase stockouts and lost sales. More risk! Optimal Amount (Level) of Current Assets 0 25,000 50,000 OUTPUT (units) ASSET LEVEL ($) Current Assets Policy C Policy A Policy B

8-10 Impact on Risk Risk Analysis PolicyRisk ALow ALow BAverage BAverage CHigh CHigh Risk increases as the level of current assets are reduced. Optimal Amount (Level) of Current Assets 0 25,000 50,000 OUTPUT (units) ASSET LEVEL ($) Current Assets Policy C Policy A Policy B

8-11 Summary of the Optimal Amount of Current Assets S UMMARY O F O PTIMAL C URRENT A SSET A NALYSIS PolicyLiquidity Profitability Risk A High Low Low A High Low Low BAverage Average Average BAverage Average Average C Low High High C Low High High 1. Profitability varies inversely with liquidity. 2. Profitability moves together with risk. (risk and return go hand in hand!)

8-12 Classifications of Working Capital u Time u Permanent u Temporary u Components u Cash, marketable securities, receivables, and inventory

8-13 Permanent Working Capital The amount of current assets required to meet a firm’s long-term minimum needs. Permanent current assets TIME DOLLAR AMOUNT

8-14 Temporary Working Capital The amount of current assets that varies with seasonal requirements. Permanent current assets TIME DOLLAR AMOUNT Temporary current assets

8-15 Financing Current Assets: Short-Term and Long-Term Mix Spontaneous Financing: Spontaneous Financing: Trade credit, and other payables and accruals, that arise spontaneously in the firm’s day-to-day operations. u Based on policies regarding payment for purchases, labor, taxes, and other expenses. u We are concerned with managing non- spontaneous financing of assets.

8-16 Hedging (or Maturity Matching) Approach A method of financing where each asset would be offset with a financing instrument of the same approximate maturity. TIME DOLLAR AMOUNT Long-term financing Fixed assets Current assets* Short-term financing**

8-17 Hedging (or Maturity Matching) Approach * * Less amount financed spontaneously by payables and accruals. ** ** In addition to spontaneous financing (payables and accruals). TIME DOLLAR AMOUNT Long-term financing Fixed assets Current assets* Short-term financing**

8-18 Financing Needs and the Hedging Approach u Fixed assets and the non-seasonal portion of current assets are financed with long- term debt and equity (long-term profitability of assets to cover the long-term financing costs of the firm). u Seasonal needs are financed with short- term loans (under normal operations sufficient cash flow is expected to cover the short-term financing cost).

8-19 Self-Liquidating Nature of Short-Term Loans u Seasonal orders require the purchase of inventory beyond current levels. u Increased inventory is used to meet the increased demand for the final product. u Sales become receivables. u Receivables are collected and become cash. u The resulting cash funds can be used to pay off the seasonal short-term loan and cover associated long-term financing costs.

8-20 Risks vs. Costs Trade-Off (Conservative Approach) u Long-Term Financing Benefits u Less worry in refinancing short-term obligations u Less uncertainty regarding future interest costs u Short-Term Financing Risks u Borrowing more than what is necessary u Borrowing at a higher overall cost (usually) u Result u Manager accepts less expected profits in exchange for taking less risk.

8-21 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. TIME DOLLAR AMOUNT Long-term financing Fixed assets Current assets Short-term financing

8-22 Comparison with an Aggressive Approach u Short-Term Financing Benefits u Financing long-term needs with a lower interest cost than short-term debt u Borrowing only what is necessary u Short-Term Financing Risks u Refinancing short-term obligations in the future u Uncertain future interest costs u Result u Manager accepts greater expected profits in exchange for taking greater risk.

8-23 Firm increases risks associated with short-term borrowing by using a larger proportion of short-term financing. TIME DOLLAR AMOUNT Long-term financing Fixed assets Current assets Short-term financing Risks vs. Costs Trade-Off (Aggressive Approach)

8-24 Summary of Short- vs. Long-Term Financing Financing Maturity Asset Maturity SHORT-TERMLONG-TERM Low Risk-Profitability Moderate Risk-Profitability Moderate Risk-Profitability High Risk-Profitability SHORT-TERM Temporary (Temporary) LONG-TERM Permanent (Permanent)

8-25 Combining Liability Structure and Current Asset Decisions level of current assets method of financing those assets interdependent u The level of current assets and the method of financing those assets are interdependent. conservative policy aggressive u A conservative policy of “high” levels of current assets allows a more aggressive method of financing current assets. conservative u A conservative method of financing aggressive policy (all-equity) allows an aggressive policy of “low” levels of current assets.