This document outlines key concepts around working capital management and financing decisions. It discusses matching a firm's current asset levels with forecasted sales and production schedules. It also covers controlling assets by matching sales and production levels. Additionally, it examines using long-term versus short-term financing to fund different types of current assets, as well as how financing decisions impact risk and profitability. Overall, the document provides an overview of effective working capital management strategies.

1. Chapter 06
• Working Capital and the Financing Decision
6-1

2. Chapter Outline
• Working capital management
• Current asset management
• Asset financing
• Long-term versus short-term financing
• Risk and profitability vis-à-vis asset
financing
• Expected value analysis may sometimes be
employed
6-2

3. Working Capital Management
• The financing and management of the
current assets of a firm
– Crucial to achieving long-term objectives of the
firm or its failure
– Requires immediate action
6-3

4. The Nature of Asset Growth
• Effective current assets management
requires matching of the forecasted sales
and production schedules
• Differences in actual sales and forecasted
sales can result in:
– Unexpected buildup.
– Reduction in inventory, affecting receivables and
cash flow
• Firm’s current assets could be:
– Self-liquidating
– ‘Permanent’ current assets.
6-4

5. The Nature of Asset Growth (cont’d)
6-5

6. Controlling Assets – Matching Sales
and Production
• Fixed assets grow slowly with:
– Increase in productive capacity
– Replacement of old equipment
• Current assets fluctuate in the short run,
depending on:
– Level of production versus the level of sales
• When production is higher than sales the inventory
rises
• When sales are higher than production, inventory
declines and receivables increase
6-6

7. Controlling Assets – Matching Sales
and Production (cont’d)
• Cash budgeting process
– Level production method
• Smooth production schedules
• Use of manpower and equipment efficiently to lower
cost
– Match sales and production as closely as
possible in the short run
• Allows current assets to increase or decrease with the
level of sales
• Eliminates the large seasonal bulges or sharp
reductions in current assets
6-7

8. Matching Sales and Production-
McGraw-Hill Companies, Inc.
• A good example of seasonal sale
• Has significant share of sales and earnings
in the third and fourth quarters
• Due to seasonal nature of textbook
publishing
– Lenders and financial managers need to plan
inventory
– Lack of correct inventory planning can lead to
lost sales
6-8

9. Quarterly Sales and Earnings Per
Share for McGraw Hill
6-9

10. Seasonal Sales Pattern in Target and
Limited Brands
• Like publishers, retail companies do not
stock inventory for more then a year
• Fourth quarter is the biggest quarter for
retailers
• As per the figure, the Target is growing
much faster than the Limited Brands
• Even then, in the fourth quarter, peak
earnings are almost equal for both the
companies
6-10

11. Quarterly Sales and Earnings Per
Share, Target and Limited Brands
6-11

12. Point-of-Sales Terminals
• Retail-oriented firms use new, computerized
inventory control systems linked online
– Digital inputs or optical scanners
• Helps adjust orders or production schedules
– Radio Frequency Identification (RFID)
6-12

13. Temporary Assets under Level
Production – An Example
• Yawakuzi Motorcycle Company
– Sales fluctuations: High sales demand during
early spring and summer; sales drop during
October through March
– Decision: Apply level production method - 12-
month sales forecast is issued
– Result: Level production and seasonal sales
combine to produce fluctuating inventory
6-13

14. Yawakuzi Sales Forecast (in units)
6-14

15. Yawakuzi’s Production Schedule
and Inventory
6-15

16. Sales Forecasts, Cash Receipts, and
Payments, and Cash Budget
6-16

17. Sales Forecasts, Cash Receipts, and
Payments, and Cash Budget (cont’d)
• Table 6-3 is created to examine the buildup
in accounts receivable and cash
– Sales forecast: Based on assumptions taken
earlier (table 6-1)
– Cash receipts: 50% cash collected during the
month of sale and 50% pertains to the prior
month
– Cash budget: a comparison of cash receipt and
payment schedules to determine cash flow
6-17

18. Total Current Assets, First Year
($millions)
6-18

19. Yawakuzi’s Nature of Asset Growth
6-19

20. Cash Budget and Assets for II Year
With No Growth in Sales ($millions)
• Graphic presentation of the current asset
cycle.
6-20

21. Patterns of Financing
• Selection of external sources to fund
financial assets is an important decision
• The appropriate financing pattern:
– Matching of asset buildup and length of
financing pattern
6-21

22. Matching Long-Term and Short-
Term Needs
6-22

23. Alternative Plans
• It is important to consider other alternatives
– The challenge of constructing a financial plan is
to prioritize the current assets into temporary
and permanent
– The exact timing of asset liquidation, even in the
light of ascertaining dollar amounts is onerous
– It is also difficult to judge the amount of short-
term and long-term financing available
6-23

24. Long-Term Financing
• Firms can be assured of having adequate
capital at all times:
– Use long-term capital to cover part of the short-
term needs
– Long-term capital can be used to finance:
• Fixed assets
• Permanent current assets
• Part of the temporary current assets
6-24

25. Using Long-Term Financing for Part
of Short-Term Needs
6-25

26. Short- Term Financing
• Small businesses do not have total access
to long-term financing
– They rely on short-term bank and trade credit
– Advantage: interest rates are lower
– Short-term finances are used finance:
• Temporary current assets
• Part of the permanent working capital needs
6-26

27. Using Short-Term Financing for Part
of Long-Term Needs
6-27

28. Term Structure of Interest Rates
• A yield curve – that shows the relative level
of short-term and long-term interest rates
– U.S. government securities are popular as they
are free of default risks
– Corporate debt securities entail a higher interest
rate due to more financial risks
– Yield curves for both securities change daily to
reflect:
• Current competitive conditions
• Expected inflation
• Changes in economic conditions
6-28

29. Basic Theories - Yield Curve
• Liquidity premium theory
– Long-term rates should be higher than short-
term rates
• Market segmentation theory
– Treasury securities are divided into market
segments by the various financial institutions
investing in the market
• Expectations hypothesis
– Yields on long-term securities is a function of
short-term rates
6-29

30. Long- and Short-Term Annual
Interest Rates
• Relative volatility and the historical level of
short-term and long-term rates
6-30

31. Alternative Financing Plans
• A Decision Process: Comparing alternative
financing plans for working capital
6-31

32. Impact of Financing Plans on
Earnings
6-32

33. Varying Condition and its Impact
• Tight money periods
– Capital is scarce making short-term financing
difficult to find or may ensue very high rates
– Inadequate financing may mean loss of sales or
financial embarrassment
• Expected value
– Represents the sum of the expected outcomes
under both conditions
6-33

34. Expected Returns under Different
Economic Conditions
6-34

35. Expected Returns for High Risk
Firms
6-35

36. Toward an Optimal Policy
• A firm should:
– Attempt to relate asset liquidity to financing
patterns, and vice versa
– Decide how it wishes to combine asset liquidity
and financing needs
• Risk-oriented firm - short-term borrowings and low
degree of liquidity
• Conservative firm - long-term financing and high
degree of liquidity
6-36

37. Net working capital as a percentage of
sales—S&P Industrials
6-37

38. Asset Liquidity and Financing
Assets
6-38

39. End
Q
6-39

40. Q&A
6-40

41. Thank You.
6-41