Your SlideShare is downloading. ×
Ch 08 - Overview of Working Capital Management
Upcoming SlideShare
Loading in...5
×

Thanks for flagging this SlideShare!

Oops! An error has occurred.

×

Introducing the official SlideShare app

Stunning, full-screen experience for iPhone and Android

Text the download link to your phone

Standard text messaging rates apply

Ch 08 - Overview of Working Capital Management

1,562
views

Published on

Financial Management by Van Horne …

Financial Management by Van Horne
Ch 08 - Overview of Working Capital Management

Published in: Economy & Finance, Business

0 Comments
5 Likes
Statistics
Notes
  • Be the first to comment

No Downloads
Views
Total Views
1,562
On Slideshare
0
From Embeds
0
Number of Embeds
0
Actions
Shares
0
Downloads
125
Comments
0
Likes
5
Embeds 0
No embeds

Report content
Flagged as inappropriate Flag as inappropriate
Flag as inappropriate

Select your reason for flagging this presentation as inappropriate.

Cancel
No notes for slide

Transcript

  • 1. 1Chapter 8Chapter 8Overview ofOverview ofWorking CapitalWorking CapitalManagementManagement© 2001 Prentice-Hall, Inc.Fundamentals of Financial Management, 11/eCreated by: Gregory A. Kuhlemeyer, Ph.D.Carroll College, Waukesha, WI
  • 2. 2Overview of WorkingOverview of WorkingCapital ManagementCapital ManagementWorking Capital ConceptsWorking Capital IssuesFinancing Current Assets:Short-Term and Long-Term MixCombining Liability Structureand Current Asset Decisions
  • 3. 3Working Capital ConceptsWorking Capital ConceptsNet Working CapitalNet Working CapitalCurrent Assets - Current Liabilities.Gross Working CapitalGross Working CapitalThe firm’s investment in current assets.Working Capital ManagementWorking Capital ManagementThe administration of the firm’s current assets andthe financing needed to support current assets.
  • 4. 4Significance of WorkingSignificance of WorkingCapital ManagementCapital ManagementIn a typical manufacturing firm, currentassets exceed one-half of total assets.Excessive levels can result in a substandardReturn on Investment (ROI).Current liabilities are the principal source ofexternal financing for small firms.Requires continuous, day-to-day managerialsupervision.Working capital management affects thecompany’s risk, return, and share price.
  • 5. 5Working Capital IssuesWorking Capital IssuesAssumptions50,000 maximumunits of productionContinuousproductionThree differentpolicies for currentasset levels arepossibleOptimal Amount (Level) of Current Assets0 25,000 50,000OUTPUT (units)ASSETLEVEL($)Current AssetsPolicy CPolicy CPolicy APolicy APolicy BPolicy B
  • 6. 6Impact on LiquidityImpact on LiquidityLiquidity AnalysisPolicyPolicy LiquidityLiquidityAA HighHighBB AverageAverageCC LowLowGreater current assetlevels generate moreliquidity; all otherfactors held constant.Optimal Amount (Level) of Current Assets0 25,000 50,000OUTPUT (units)ASSETLEVEL($)Current AssetsPolicy CPolicy CPolicy APolicy APolicy BPolicy B
  • 7. 7Impact onImpact onExpected ProfitabilityExpected ProfitabilityReturn on InvestmentReturn on Investment =Net ProfitNet ProfitTotal AssetsTotal AssetsLet Current AssetsCurrent Assets =(Cash + Rec. + Inv.)Return on InvestmentReturn on Investment =Net ProfitNet ProfitCurrentCurrent + Fixed AssetsFixed AssetsOptimal Amount (Level) of Current Assets0 25,000 50,000OUTPUT (units)ASSETLEVEL($)Current AssetsPolicy CPolicy CPolicy APolicy APolicy BPolicy B
  • 8. 8Impact onImpact onExpected ProfitabilityExpected ProfitabilityProfitability AnalysisPolicyPolicy ProfitabilityProfitabilityAA LowLowBB AverageAverageCC HighHighAs current asset levelsdecline, total assets willdecline and the ROI willrise.Optimal Amount (Level) of Current Assets0 25,000 50,000OUTPUT (units)ASSETLEVEL($)Current AssetsPolicy CPolicy CPolicy APolicy APolicy BPolicy B
  • 9. 9Impact on RiskImpact on RiskDecreasing cashreduces the firm’s abilityto meet its financialobligations. More risk!More risk!Stricter credit policiesreduce receivables andpossibly lose sales andcustomers. More risk!More risk!Lower inventory levelsincrease stockouts andlost sales. More risk!More risk!Optimal Amount (Level) of Current Assets0 25,000 50,000OUTPUT (units)ASSETLEVEL($)Current AssetsPolicy CPolicy CPolicy APolicy APolicy BPolicy B
  • 10. 10Impact on RiskImpact on RiskRisk AnalysisPolicyPolicy RiskRiskAA LowLowBB AverageAverageCC HighHighRisk increases as thelevel of current assetsare reduced.Optimal Amount (Level) of Current Assets0 25,000 50,000OUTPUT (units)ASSETLEVEL($)Current AssetsPolicy CPolicy CPolicy APolicy APolicy BPolicy B
  • 11. 11Summary of the OptimalSummary of the OptimalAmount of Current AssetsAmount of Current AssetsSSUMMARYUMMARY OOFF OOPTIMALPTIMAL CCURRENTURRENT AASSETSSET AANALYSISNALYSISPolicyPolicy LiquidityLiquidity ProfitabilityProfitability RiskRiskAA HighHigh LowLow LowLowBB AverageAverage AverageAverage AverageAverageCC LowLow HighHigh HighHigh1. Profitability varies inversely withliquidity.2. Profitability moves together with risk.(risk and return go hand in hand!)
  • 12. 12Classifications ofClassifications ofWorking CapitalWorking CapitalTimeTimePermanentTemporaryComponentsComponentsCash, marketable securities,receivables, and inventory
  • 13. 13PermanentPermanentWorking CapitalWorking CapitalThe amount of current assets required toThe amount of current assets required tomeet a firm’s long-term minimum needs.meet a firm’s long-term minimum needs.Permanent current assetsPermanent current assetsTIMEDOLLARAMOUNT
  • 14. 14TemporaryTemporaryWorking CapitalWorking CapitalThe amount of current assets that variesThe amount of current assets that varieswith seasonal requirements.with seasonal requirements.Permanent current assetsPermanent current assetsTIMEDOLLARAMOUNTTemporary current assetsTemporary current assets
  • 15. 15Financing Current Assets:Financing Current Assets:Short-Term and Long-Term MixShort-Term and Long-Term MixSpontaneous FinancingSpontaneous Financing:: Trade credit, andother payables and accruals, that arisespontaneously in the firm’s day-to-dayoperations.Based on policies regarding payment forpurchases, labor, taxes, and other expenses.We are concerned with managing non-spontaneous financing of assets.
  • 16. 16Hedging (or MaturityHedging (or MaturityMatching) ApproachMatching) ApproachA method of financing where each asset would be offset withA method of financing where each asset would be offset witha financing instrument of the same approximate maturity.a financing instrument of the same approximate maturity.TIMEDOLLARAMOUNTLong-term financingFixed assetsFixed assetsCurrent assets*Current assets*Short-term financing**
  • 17. 17Hedging (or MaturityHedging (or MaturityMatching) ApproachMatching) Approach** Less amount financed spontaneously by payables and accruals.**** In addition to spontaneous financing (payables and accruals).TIMEDOLLARAMOUNTLong-term financingFixed assetsFixed assetsCurrent assets*Current assets*Short-term financing**
  • 18. 18Financing Needs andFinancing Needs andthe Hedging Approachthe Hedging ApproachFixed assets and the non-seasonal portionof current assets are financed with long-term debt and equity (long-term profitabilityof assets to cover the long-term financingcosts of the firm).Seasonal needs are financed with short-term loans (under normal operationssufficient cash flow is expected to cover theshort-term financing cost).
  • 19. 19Self-Liquidating NatureSelf-Liquidating Natureof Short-Term Loansof Short-Term LoansSeasonal orders require the purchase ofinventory beyond current levels.Increased inventory is used to meet theincreased demand for the final product.Sales become receivables.Receivables are collected and become cash.The resulting cash funds can be used to payoff the seasonal short-term loan and coverassociated long-term financing costs.
  • 20. 20Risks vs. Costs Trade-OffRisks vs. Costs Trade-Off(Conservative Approach)(Conservative Approach)Long-Term Financing BenefitsLong-Term Financing BenefitsLess worry in refinancing short-term obligationsLess uncertainty regarding future interest costsShort-Term Financing RisksShort-Term Financing RisksBorrowing more than what is necessaryBorrowing at a higher overall cost (usually)ResultResultManager accepts less expected profits inexchange for taking less risk.
  • 21. 21Risks vs. Costs Trade-OffRisks vs. Costs Trade-Off(Conservative Approach)(Conservative Approach)Firm can reduce risks associated with short-term borrowingFirm can reduce risks associated with short-term borrowingby using a larger proportion of long-term financing.by using a larger proportion of long-term financing.TIMEDOLLARAMOUNTLong-term financingFixed assetsFixed assetsCurrent assetsCurrent assetsShort-term financingShort-term financing
  • 22. 22Comparison with anComparison with anAggressive ApproachAggressive ApproachShort-Term Financing BenefitsShort-Term Financing BenefitsFinancing long-term needs with a lower interestcost than short-term debtBorrowing only what is necessaryShort-Term Financing RisksShort-Term Financing RisksRefinancing short-term obligations in the futureUncertain future interest costsResultResultManager accepts greater expected profits inexchange for taking greater risk.
  • 23. 23Firm increases risks associated with short-term borrowing byFirm increases risks associated with short-term borrowing byusing a larger proportion of short-term financing.using a larger proportion of short-term financing.TIMEDOLLARAMOUNTLong-term financingFixed assetsFixed assetsCurrent assetsCurrent assetsShort-term financingRisks vs. Costs Trade-OffRisks vs. Costs Trade-Off(Aggressive Approach)(Aggressive Approach)
  • 24. 24Summary of Short- vs.Summary of Short- vs.Long-Term FinancingLong-Term FinancingFinancingMaturityAssetMaturitySHORT-TERM LONG-TERMLowRisk-ProfitabilityModerateRisk-ProfitabilityModerateRisk-ProfitabilityHighRisk-ProfitabilitySHORT-TERM(TemporaryTemporary)LONG-TERM(PermanentPermanent)
  • 25. 25Combining Liability StructureCombining Liability Structureand Current Asset Decisionsand Current Asset DecisionsThe level of current assetslevel of current assets and themethod of financing those assetsmethod of financing those assets areinterdependentinterdependent.A conservative policyconservative policy of “high” levels ofcurrent assets allows a more aggressiveaggressivemethod of financing current assets.A conservativeconservative method of financing(all-equity) allows an aggressive policyaggressive policyof “low” levels of current assets.