Chapter_7.Working_Capital_Management
Chapter_7.Working_Capital_Management
101
Financial Management
Working Capital
Management
S-1
Undergraduate Program Of
Management
Contents
Inventories
Account Receivables
Account Payable
Objectives
• Explain how different amounts of current assets and current liabilities affect firms’
profitability and thus their stock prices.
• Explain how companies decide on the proper amount of each current asset— cash,
marketable securities, accounts receivable, and inventory.
• Discuss how companies set their credit policies and explain the effect of credit policy
on sales and profits.
• Describe how the costs of trade credit, bank loans, and commercial paper are
determined and how that information impacts decisions for financing working capital.
• Explain how companies use security to lower their costs of short-term credit
Background on Working
Capital
Background on Working Capital
Working capital.
Current assets are often called working capital because these
assets “turn over” (i.e., are used and then replaced all during the
year)
Net working capital.
When a firm buys inventory on credit, its suppliers in effect lend it
the money used to finance the inventory
Investments in current assets must be financed; and the primary sources of funds include bank loans, credit
from suppliers (accounts payable), accrued liabilities, long-term debt, and common equity
To begin, note that most businesses experience seasonal and/or cyclical fluctuations
For example
construction firms tend to peak in the summer, retailers peak around Christmas, and the manufacturers
who supply both construction companies and retailers follow related patterns
The sales of virtually all businesses increase when the economy is strong
they build up current assets at those times but let inventories and receivables fall when the economy
weakens.
that current assets rarely drop to zero—companies maintain some permanent current assets, which are the
current assets needed at the low point of the business cycle.
Then as sales increase during an upswing, current assets are increased, and these extra current assets are
defined as temporary current assets as opposed to permanent current assets
Current Asset Financing Policies
• Maturity Matching, or “Self-Liquidating,” Approach
• A financing policy that matches asset and liability maturities. This is a moderate policy
• The maturity matching, or “self-liquidating,” approach calls for matching asset and liability
maturities
• shown in Panel a of Figure
• All of the fixed assets plus the permanent current
assets are financed with long-term capital, but
temporary current assets are financed with short-
term debt.
• Inventory expected to be sold in 30 days would be
financed with a 30-day bank loan, a machine
expected to last for 5 years would be financed with
a 5-year loan, a 20-year building would be financed
with a 20-year mortgage bond, and so forth
Current Asset Financing Policies
• Some common equity must be used, and common equity has no maturity.
• when a firm attempts to match asset and liability maturities, this is defined as
a moderate current asset financing policy.
Current Asset Financing Policies
• Aggressive Approach
• Aggressive firm that finances some of its permanent assets with short-term debt
• indicating that all of the current assets— both permanent and temporary—and
part of the fixed assets were financed with short-term credit
• This policy would be a highly aggressive, extremely non conservative position;
and the firm would be subject to dangers from loan renewal as well as problems
with rising interest rates
• The reason for adopting the aggressive policy is to take advantage of the fact
that the yield curve is generally upward-sloping; hence, short-term rates are
generally lower than long-term rates.
Current Asset Financing Policies
• Conservative Approach
• long-term capital is used to finance all the permanent assets
and to meet some of the seasonal needs
• the firm uses a small amount of short-term credit to meet its
peak requirements, but it also meets part of its seasonal
needs by “storing liquidity” in the form of marketable
securities
• This is a very safe, conservative financing policy.
The Cash Budget
The Cash Budget
• Cash budget
• The monthly cash budget begins with a forecast of sales for each month and a
projection of when actual collections will occur.
• Then there is a forecast of materials purchases, followed by forecasted payments
for materials, labor, leases, new equipment, taxes, and other expenses.
• When the forecasted payments are subtracted from the forecasted collections,
the result is the expected net cash gain or loss for each month.
• This gain or loss is added to or subtracted from the beginning cash balance, and
the result is the amount of cash the firm would have on hand at the end of the
month if it neither borrowed nor invested.
The Cash Budget
• Cash Planning
• Cash Planning
• Baumol’s Model–Assumptions:
• The firm is able to forecast its cash needs with certainty.
• The firm’s cash payments occur uniformly over a period of
time.
• The opportunity cost of holding cash is known and it does not
change over time.
• The firm will incur the same transaction cost whenever it
converts securities to cash.
The Cash Budget
• Baumol’s Model:
• The firm incurs a holding cost for keeping the cash balance. It is an
opportunity cost; that is, the return foregone on the marketable
securities. If the opportunity cost is k, then the firm’s holding cost for
maintaining an average cash balance is as follows:
• Holding Cost = k(C/2)
• The firm incurs a transaction cost whenever it converts its
marketable securities to cash. Total number of transactions during
the year will be total funds requirement, T, divided by the cash
balance, C, i.e., T/C. The per transaction cost is assumed to be
constant. If per transaction cost is c, then the total transaction cost
will be:
• Transaction Cost = c(T/C)
• The total annual cost of the demand for cash will be:
• Total cost = k(C/2) + c(T/C)
• The optimum cash balance, C*, is obtained when the total2cT cost is minimum. The
*
formula for the optimum cash balance is as follows: C
k
The Cash Budget
• Cash Planning
• The Miller–Orr Model
• The MO model provides for two control limits–the upper control limit
and the lower control limit as well as a return point.
• If the firm’s cash flows fluctuate randomly and hit the upper limit, then
it buys sufficient marketable securities to come back to a normal level
of cash balance (the return point).
• Similarly, when the firm’s cash flows wander and hit the lower limit, it
sells sufficient marketable securities to bring the cash balance back to
the normal level (the return point).
The Cash Budget
• Cash Planning
• The Miller–Orr Model
• The difference between the upper limit and the lower limit depends on the
following factors:
• The transaction cost (c)
• The interest rate, (i)
• The standard deviation (s) of net cash flows.
• The formula for determining the distance between upper and lower control
(Upper Limit
limits – Lower
(called Z)Limit) (3/ 4 × Transaction Cost × Cash Flow Variance / Interest Rate)1 / 3
is as=follows:
Upper Limit = Lower Limit + 3Z
Return Point = Lower Limit + Z
The net effect is that the firms hold the average the cash balance equal to:
Average Cash Balance = Lower Limit + 4/3Z
Inventories
Inventories
• ABC System
• A firm using the ABC inventory system divides its inventory into three groups: A, B,
and C.
• The A group items receive the most intense monitoring because of the high dollar
investment.
• Collection policy refers to the procedures used to collect past due accounts, including the
toughness or laxity used in the process.
• At one extreme, the firm might write a series of polite letters after a fairly long delay
• at the other extreme, delinquent accounts may be turned over to a collection agency relatively
quickly
Accounts Payable
Accounts Payable
• Firms generally make purchases from other firms on credit and record the debt
as an account payable.
• Accounts payable, or trade credit, is the largest single category of short-term
debt, representing about 40% of the average corporation’s current liabilities.
• This credit is a spontaneous source of financing in the sense that it arises
spontaneously from ordinary business transactions
• For example
• If a firm makes a purchase of $1,000 on terms of net 30, it must pay for goods 30
days after the invoice date. This instantly and spontaneously provides $1,000 of
credit for 30 days
Accounts Payable
• If the seller does not offer discounts, the credit is free in the sense that there is no cost for using
it.
• Illustrated
• PCC Inc. buys 20 microchips each day with a list price of $100 per chip on terms of 2/10, net 30.
• because the chips can be purchased for only $98 by paying within 10 days
• If PCC decides to take the discount, it will pay at the end of Day 10 and show
Accounts Payable
• Illustrated
• If it decides to delay payment until the 30th day, its trade credit
will be