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

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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

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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)

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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

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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.

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• 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.

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• 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

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• 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.

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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

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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.

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• 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.

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

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• 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.

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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

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Measures Indicating Aggressive Approach

• Low level of Net Working Capital
• Low Current Ratio
• High Return on Total Assets
• High Current Asset Turnover