Working Capital Management n Working Capital refers to a company’s Current Assets n Current Assets: Cash and Equivalents, Accounts Receivable, and Inventory n Working Capital Management: Applying Investment and Financing Decisions to Current Assets

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

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

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

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

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

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

Conservative Approach to WCM n Objective: Improve Liquidity n Level of Current Assets: n 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.

n 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.

n 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

Conservative Financing n Financing of Current Assets: n 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.

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

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

Aggressive Approach to WCM n Objective: Improve Profitability n Level of Current Assets: n 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.

n 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.

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

Aggressive Financing n Financing of Current Assets: n 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.

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

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