Capital

1. 8.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Overview of
Working Capital
Management

2. 8.2 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
1. Explain how the definition of "working capital" differs between
financial analysts and accountants.
2. Understand the two fundamental decision issues in working
capital management – and the trade-offs involved in making these
decisions.
3. Discuss how to determine the optimal level of current assets.
4. Describe the relationship between profitability, liquidity, and risk
in the management of working capital.
5. Explain how to classify working capital according to its
“components” and according to “time” (i.e., either permanent or
temporary).
6. Describe the hedging (maturity matching) approach to financing
and the advantages/disadvantages of short- versus long-term
financing.
7. Explain how the financial manager combines the current asset
decision with the liability structure decision.
After Studying lecture ,
you should be able to:

3. 8.3 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• Working Capital Concepts
• Working Capital Issues
• Financing Current Assets: Short-
Term and Long-Term Mix
• Combining Liability Structure
and Current Asset Decisions
Overview of Working
Capital Management

4. 8.4 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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.
Working Capital Concepts

5. 8.5 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• In a typical manufacturing firm, current
assets exceed one-half of total assets.
• Excessive levels can result in a substandard
Return on Investment (ROI).
• Current liabilities are the principal source of
external financing for small firms.
• Requires continuous, day-to-day managerial
supervision.
• Working capital management affects the
company’s risk, return, and share price.
Significance of Working
Capital Management

6. 8.6 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Assumptions
• 50,000 maximum
units of production
• Continuous
production
• 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
Working Capital Issues

7. 8.7 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Liquidity Analysis
Policy Liquidity
A High
B Average
C Low
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
Impact on Liquidity

8. 8.8 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Return on Investment =
Net Profit
Total Assets
Let Current Assets =
(Cash + Rec. + Inv.)
Return on Investment =
Net Profit
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
Impact on
Expected Profitability

9. 8.9 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Profitability Analysis
Policy Profitability
A Low
B Average
C High
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
Impact on
Expected Profitability

10. 8.10 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• Decreasing cash
reduces the firm’s ability
to meet its financial
obligations. More risk!
• Stricter credit policies
reduce receivables and
possibly lose sales and
customers. More risk!
• 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
Impact on Risk

11. 8.11 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Risk Analysis
Policy Risk
A Low
B Average
C High
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
Impact on Risk

12. 8.12 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
SUMMARY OF OPTIMAL CURRENT ASSET ANALYSIS
Policy Liquidity Profitability Risk
A High Low Low
B Average Average Average
C Low High High
1. Profitability varies inversely with
liquidity.
2. Profitability moves together with risk.
(risk and return go hand in hand!)
Summary of the Optimal
Amount of Current Assets

13. 8.13 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• Time
• Permanent
• Temporary
• Components
• Cash, marketable securities,
receivables, and inventory
Classifications of
Working Capital

14. 8.14 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
The amount of current assets required to
meet a firm’s long-term minimum needs.
Permanent current assets
TIME
DOLLAR
AMOUNT
Permanent
Working Capital

15. 8.15 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
The amount of current assets that varies
with seasonal requirements.
Permanent current assets
TIME
DOLLAR
AMOUNT
Temporary current assets
Temporary
Working Capital

16. 8.16 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Spontaneous Financing: Trade credit, and
other payables and accruals, that arise
spontaneously in the firm’s day-to-day
operations.
• Based on policies regarding payment for
purchases, labor, taxes, and other expenses.
• We are concerned with managing non-
spontaneous financing of assets.
Financing Current Assets:
Short-Term and Long-Term Mix

17. 8.17 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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**
Hedging (or Maturity
Matching) Approach

18. 8.18 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
* 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**
Hedging (or Maturity
Matching) Approach

19. 8.19 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• 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).
• Seasonal needs are financed with short-
term loans (under normal operations
sufficient cash flow is expected to cover the
short-term financing cost).
Financing Needs and
the Hedging Approach

20. 8.20 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• Seasonal orders require the purchase of
inventory beyond current levels.
• Increased inventory is used to meet the
increased demand for the final product.
• Sales become receivables.
• Receivables are collected and become cash.
• The resulting cash funds can be used to pay
off the seasonal short-term loan and cover
associated long-term financing costs.
Self-Liquidating Nature
of Short-Term Loans

21. 8.21 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• Long-Term Financing Benefits
• Less worry in refinancing short-term obligations
• Less uncertainty regarding future interest costs
• Long-Term Financing Risks
• Borrowing more than what is necessary
• Borrowing at a higher overall cost (usually)
• Result
• Manager accepts less expected profits in
exchange for taking less risk.
Risks vs. Costs Trade-Off
(Conservative Approach)

22. 8.22 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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
Risks vs. Costs Trade-Off
(Conservative Approach)

23. 8.23 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• Short-Term Financing Benefits
• Financing long-term needs with a lower interest
cost than short-term debt
• Borrowing only what is necessary
• Short-Term Financing Risks
• Refinancing short-term obligations in the future
• Uncertain future interest costs
• Result
• Manager accepts greater expected profits in
exchange for taking greater risk.
Comparison with an
Aggressive Approach

24. 8.24 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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)

25. 8.25 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Financing
Maturity
Asset
Maturity
SHORT-TERM LONG-TERM
Low
Risk-Profitability
Moderate
Risk-Profitability
Moderate
Risk-Profitability
High
Risk-Profitability
SHORT-TERM
(Temporary)
LONG-TERM
(Permanent)
Summary of Short- vs.
Long-Term Financing

26. 8.26 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• The level of current assets and the
method of financing those assets are
interdependent.
• A conservative policy of “high” levels of
current assets allows a more aggressive
method of financing current assets.
• A conservative method of financing
(all-equity) allows an aggressive policy
of “low” levels of current assets.
Combining Liability Structure
and Current Asset Decisions