Overview of Working Capital Management, financial analysts and accountants, Current Assets, Current Liabilities, Capital Management, profit, risk,

1. 1
Chapter 8Chapter 8
Overview ofOverview of
Working CapitalWorking Capital
ManagementManagement

2. 2
After studying Chapter 8,After studying Chapter 8,
you should be able to:you should be able to:
Explain how the definition of "working capital" differs between
financial analysts and accountants.
Understand the two fundamental decision issues in working
capital management -- and the trade-offs involved in making
these decisions.
Discuss how to determine the optimal level of current assets.
Describe the relationship between profitability, liquidity, and risk
in the management of working capital.
Explain how to classify working capital according to its
“components” and according to “time” (i.e., either permanent or
temporary).
Describe the hedging (maturity matching) approach to financing
and the advantages/disadvantages of short- versus long-term
financing.
Explain how the financial manager combines the current asset
decision with the liability structure decision.

3. 3
Overview of WorkingOverview of Working
Capital ManagementCapital Management
Working Capital Concepts
Working Capital Issues
Financing Current Assets:
Short-Term and Long-Term Mix
Combining Liability Structure
and Current Asset Decisions

4. 4
Working Capital ConceptsWorking Capital Concepts
Net Working CapitalNet Working Capital
Current Assets - Current Liabilities.
Gross Working CapitalGross Working Capital
The firm’s investment in current assets.
Working Capital ManagementWorking Capital Management
The administration of the firm’s current assets and
the financing needed to support current assets.

5. 5
Significance of WorkingSignificance of Working
Capital ManagementCapital Management
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.

6. 6
Working Capital IssuesWorking Capital Issues
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)
ASSETLEVEL($)
Current Assets
Policy CPolicy C
Policy APolicy A
Policy BPolicy B

7. 7
Impact on LiquidityImpact on Liquidity
Liquidity Analysis
PolicyPolicy LiquidityLiquidity
AA HighHigh
BB AverageAverage
CC LowLow
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)
ASSETLEVEL($)
Current Assets
Policy CPolicy C
Policy APolicy A
Policy BPolicy B

8. 8
Impact onImpact on
Expected ProfitabilityExpected Profitability
Return on InvestmentReturn on Investment =
Net ProfitNet Profit
Total AssetsTotal Assets
Let Current AssetsCurrent Assets =
(Cash + Rec. + Inv.)
Return on InvestmentReturn on Investment =
Net ProfitNet Profit
CurrentCurrent + Fixed AssetsFixed Assets
Optimal Amount (Level) of Current Assets
0 25,000 50,000
OUTPUT (units)
ASSETLEVEL($)
Current Assets
Policy CPolicy C
Policy APolicy A
Policy BPolicy B

9. 9
Impact onImpact on
Expected ProfitabilityExpected Profitability
Profitability Analysis
PolicyPolicy ProfitabilityProfitability
AA LowLow
BB AverageAverage
CC HighHigh
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)
ASSETLEVEL($)
Current Assets
Policy CPolicy C
Policy APolicy A
Policy BPolicy B

10. 10
Impact on RiskImpact on Risk
Decreasing cash
reduces the firm’s ability
to meet its financial
obligations. More risk!More risk!
Stricter credit policies
reduce receivables and
possibly lose sales and
customers. More risk!More risk!
Lower inventory levels
increase stockouts and
lost sales. More risk!More risk!
Optimal Amount (Level) of Current Assets
0 25,000 50,000
OUTPUT (units)
ASSETLEVEL($)
Current Assets
Policy CPolicy C
Policy APolicy A
Policy BPolicy B

11. 11
Impact on RiskImpact on Risk
Risk Analysis
PolicyPolicy RiskRisk
AA LowLow
BB AverageAverage
CC HighHigh
Risk increases as the
level of current assets
are reduced.
Optimal Amount (Level) of Current Assets
0 25,000 50,000
OUTPUT (units)
ASSETLEVEL($)
Current Assets
Policy CPolicy C
Policy APolicy A
Policy BPolicy B

12. 12
Summary of the OptimalSummary of the Optimal
Amount of Current AssetsAmount of Current Assets
SSUMMARYUMMARY OOFF OOPTIMALPTIMAL CCURRENTURRENT AASSETSSET AANALYSISNALYSIS
PolicyPolicy LiquidityLiquidity ProfitabilityProfitability RiskRisk
AA HighHigh LowLow LowLow
BB AverageAverage AverageAverage AverageAverage
CC LowLow HighHigh HighHigh
1. Profitability varies inversely with
liquidity.
2. Profitability moves together with risk.
(risk and return go hand in hand!)

13. 13
Classifications ofClassifications of
Working CapitalWorking Capital
TimeTime
Permanent
Temporary
ComponentsComponents
Cash, marketable securities,
receivables, and inventory

14. 14
PermanentPermanent
Working CapitalWorking Capital
The amount of current assets required toThe amount of current assets required to
meet a firm’s long-term minimum needs.meet a firm’s long-term minimum needs.
Permanent current assetsPermanent current assets
TIME
DOLLARAMOUNT

15. 15
TemporaryTemporary
Working CapitalWorking Capital
The amount of current assets that variesThe amount of current assets that varies
with seasonal requirements.with seasonal requirements.
Permanent current assetsPermanent current assets
TIME
DOLLARAMOUNT
Temporary current assetsTemporary current assets

16. 16
Financing Current Assets:Financing Current Assets:
Short-Term and Long-Term MixShort-Term and Long-Term Mix
Spontaneous FinancingSpontaneous 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.

17. 17
Hedging (or MaturityHedging (or Maturity
Matching) ApproachMatching) Approach
A method of financing where each asset would be offset withA method of financing where each asset would be offset with
a financing instrument of the same approximate maturity.a financing instrument of the same approximate maturity.
TIME
DOLLARAMOUNT
Long-term financing
Fixed assetsFixed assets
Current assets*Current assets*
Short-term financing**

18. 18
Hedging (or MaturityHedging (or Maturity
Matching) ApproachMatching) Approach
** Less amount financed spontaneously by payables and accruals.
**** In addition to spontaneous financing (payables and accruals).
TIME
DOLLARAMOUNT
Long-term financing
Fixed assetsFixed assets
Current assets*Current assets*
Short-term financing**

19. 19
Financing Needs andFinancing Needs and
the Hedging Approachthe Hedging Approach
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).

20. 20
Self-Liquidating NatureSelf-Liquidating Nature
of Short-Term Loansof Short-Term Loans
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.

21. 21
Risks vs. Costs Trade-OffRisks vs. Costs Trade-Off
(Conservative Approach)(Conservative Approach)
Long-Term Financing BenefitsLong-Term Financing Benefits
Less worry in refinancing short-term obligations
Less uncertainty regarding future interest costs
Long-Term Financing RisksLong-Term Financing Risks
Borrowing more than what is necessary
Borrowing at a higher overall cost (usually)
ResultResult
Manager accepts less expected profits in
exchange for taking less risk.

22. 22
Risks 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 borrowing
by using a larger proportion of long-term financing.by using a larger proportion of long-term financing.
TIME
DOLLARAMOUNT
Long-term financing
Fixed assetsFixed assets
Current assetsCurrent assets
Short-term financingShort-term financing

23. 23
Comparison with anComparison with an
Aggressive ApproachAggressive Approach
Short-Term Financing BenefitsShort-Term Financing Benefits
Financing long-term needs with a lower interest
cost than short-term debt
Borrowing only what is necessary
Short-Term Financing RisksShort-Term Financing Risks
Refinancing short-term obligations in the future
Uncertain future interest costs
ResultResult
Manager accepts greater expected profits in
exchange for taking greater risk.

24. 24
Firm increases risks associated with short-term borrowing byFirm increases risks associated with short-term borrowing by
using a larger proportion of short-term financing.using a larger proportion of short-term financing.
TIME
DOLLARAMOUNT
Long-term financing
Fixed assetsFixed assets
Current assetsCurrent assets
Short-term financing
Risks vs. Costs Trade-OffRisks vs. Costs Trade-Off
(Aggressive Approach)(Aggressive Approach)

25. 25
Summary of Short- vs.Summary of Short- vs.
Long-Term FinancingLong-Term Financing
Financing
Maturity
Asset
Maturity
SHORT-TERM LONG-TERM
Low
Risk-Profitability
Moderate
Risk-Profitability
Moderate
Risk-Profitability
High
Risk-Profitability
SHORT-TERM
(TemporaryTemporary)
LONG-TERM
(PermanentPermanent)

26. 26
Combining Liability StructureCombining Liability Structure
and Current Asset Decisionsand Current Asset Decisions
The level of current assetslevel of current assets and the
method of financing those assetsmethod of financing those assets are
interdependentinterdependent.
A conservative policyconservative policy of “high” levels of
current assets allows a more aggressiveaggressive
method of financing current assets.
A conservativeconservative method of financing
(all-equity) allows an aggressive policyaggressive policy
of “low” levels of current assets.