Chapter 9
Working Capital Policy
Importance of Working Capital Policy
• “Working capital”: a firm’s investment in
current assets
• Net working capital: the excess of current
assets over current liabilities; circulating
capital of a business
Importance of Working Capital Policy
• Why working capital management (effective
control of circulating capital) is important:
1. Working capital decisions are urgent
•
Growth in current assets (specifically, receivables) occurs
spontaneously with increases in sales, which must be
financed from current liabilities, or external sources of
capital, or reinvested earnings in order to maintain control
of firm’s asset structure
2. Current assets (accounts receivable and inventory)
often represent largest single category of asset
investment
•
Particularly true for small and rapidly growing businesses
Importance of Working Capital Policy
•
Why working capital management is important
(continued):
3. Working capital management represents firm’s first line
of defense against sales decline
•
•
•
In face of “credit crunch,” firm can reduce inventory or tighten up
accounts receivable to provide increased liquidity
Accounts payable payments may be slowed to provide additional
source of financing
Cannot do much about fixed asset commitments or long-term
debt arrangements
4. Inability to control growth of working capital accounts is
a major cause of business failures
•
Since current assets grow spontaneously with growth in sales,
control is important, especially for small, rapidly growing firms
Importance of Working Capital Policy
• Working capital policy issues
1. Short-term versus long-term financing
2. Relative magnitude of working capital
investment
3. Inventory control policy
4. Credit policy
5. Accounts payable policy
Short-term versus Long-term Financing
• Very definite risk-return tradeoff:
– Short-term financing is a riskier form of financing
than long-term financing, but it is less costly
• Lower cost of short-term financing: short-term interest
rates are generally lower than long-term interest rates
• Rate risk: future short-term interest rates cannot be
known with certainty, whereas cost of long-term debt is
fixed in advance for life of loan
• Renewal risk: always possibility that firm may not be
able to renew short-term debt obligation when it
comes due
Short-term versus Long-term Financing
• To add to the trade-off between short-term
financing and long-term financing:
– Added flexibility
• Once long-term loan is negotiated or bond issue is sold,
firm is locked in to terms of note over its life span
(unless note is callable)
• If firm has cyclical needs for funds (i.e. need to finance
seasonal inventory buildup), long-term obligation is
highly undesirable or may be inappropriate
Short-term versus Long-term Financing
• Firms strive to match their loan maturities with their asset
maturities.
• Short-term fund requirements (i.e. seasonal buildups of inventory,
growth of accounts receivable) should be financed with short-term
financing sources (i.e. accounts payable, short-term loans).
• Long-term fund requirements (new plant and equipment) should be
financed from long-term financing sources (i.e. long-term loans,
leases, equity capital)
• “Borrow short and invest long”: using short-term financing sources
to fund long-term needs can lead to financial insolvency because
when short-term note comes due, funds are still needed and
therefore unavailable to repay note. Borrower therefore becomes
dependant on forbearance or “rollover” by lender.
Short-term versus Long-term Financing
• Listing an asset as “current” on balance sheet does
not necessarily mean the need to finance this asset is
short-term.
– As current assets grow with sales, the overall level of
currents assets will increase permanently.
• This increase is financed by permanent increase in level of
accounts payable, other permanent increases in short-term
liabilities, and permanent sources of capital (i.e. long-term debt,
reinvested earnings, and new equity capital).
– As firm grows, current assets will grow faster than current
liabilities.
– Difference between current assets and current liabilities
(net working capital) will grow permanently, which
requires a source of permanent financing.
Short-term versus Long-term Financing
• Term Structure of Interest Rates
– Interest rates are measured by yield to maturity of
debt agreement.
• Yield to maturity: average annual compound rate of return
earned by lender
– For short-term loans, debt agreement is evidenced by
written loan agreement between borrower and bank
or other source of funds.
– For long-term loans, agreement is publicly or privately
placed bond issue or long-term loan agreement
between borrower and bank or other supplier of longterm capital
Short-term versus Long-term Financing
• Term Structure of Interest Rates
– Term of maturity of the debt: number of years
over which debt is to be repaid
– Structure of interest rates: relationship between
yield to maturity and term to maturity of debt
issues
– Yield curve: graph that shows yield to maturity as
a function of term to maturity
• Each category of debt will have its own yield curve
relationships; base curve uses the Treasury market
Short-term versus Long-term Financing
• Term Structure of Interest Rates
– Normal yield curve: (see exhibit 9.1) upwardsloping, or “positive,” yield curve where long-term
rates are higher than short-term rates
• Represents normal condition of capital markets
• Short-term debt is less costly than long-term debt, but
riskier due to interest rate risk and renewal risk.
– Negative yield curve: (see exhibit 9.2) downward
sloping, or “negative,” yield curve where shortterm rates are higher than long-term rates
• Occurs during periods of “tight” monetary policy
Short-term versus Long-term Financing
• Term Structure of Interest Rates
– Liquidity preference theory: long-term interest rates should be
higher than short-term interest rates due to liquidity
preferences of lenders and borrowers
– Lenders’ and investors’ side:
• Prefer to lend short-term rather than long-term because of greater
liquidity of short-term debt.
• May get locked in to long-term debt agreements during periods of rising
interest rates, suffering losses as their cost of funds rises but their loan
portfolios continue to provide relatively low rates of return.
• Short-term debt is subject to less fluctuation in principal value as interest
rates fluctuate. Thus, long-term debt is riskier than short-term debt.
• Suppliers of long-term debt demand higher interest rates on long-term
debt than on short-term debt.
• Additional interest charged on long-term debt is a premium for lack of
liquidity.
Short-term versus Long-term Financing
• Term Structure of Interest Rates
– Liquidity preference theory (continued)
– Borrowers’ side:
• Prefer to avoid renewal and interest-rate risk and therefore prefer
to borrow long-term rather than short-term.
• Willing to pay higher interest rates for long-term debt than for
short-term debt.
– Interaction of borrowers’ and lenders’ liquidity preferences
normally results in an upward-sloping yield curve.
– But the yield curve is not always positive! There must be
forces other than liquidity preference at work.
Short-term versus Long-term Financing
• Term Structure of Interest Rates
– Expectations hypothesis: capital market competition
forces long-term rates to be equal to average annual
compound rate of return that participants expect to earn
on short-term debt over life of long-term issue
– Ex. Yield to maturity on ten-year bond should be equal to
yield investors expect to earn by continually investing and
reinvesting in one-year bonds over each of next ten years
• Positive yield curve: current long-term (ten-year) rate would be
higher than current short-term (one-year) rate
– If investors expect future one-year interest rates to rise (during
periods of low interest rates), they would expect to reinvest in oneyear bonds at higher and higher rates over next ten years.
Short-term versus Long-term Financing
• Term Structure of Interest Rates
– Expectations hypothesis (continued)
– Ex. (continued)
• Negative yield curve: current long-term rates would be lower than
short-term rates
– If investors expect to see future one-year rates decline (during
periods of high interest rates), they would expect to reinvest in oneyear bonds at lower and lower interest rates over next ten years.
– They would except long-term rates to decline in future and anxious
to lock in current high rates available on long-term bonds.
• If investors expect stable future interest rates, then yield curve will
be flat.
• If investors expect to see future interest rates rising and then
falling (or falling and then rising), then yield curve will have one or
more “humps.”
Short-term and Long-term Financing
• Term Structure of Interest Rates
– Market-segmentation theory (or institutional or
hedging-pressure theory): various market
participants have distinct maturity preferences
• Interest rates are determined by the supply and
demand for money in each market segment, where a
market segment is defined by debt maturities
• Yield curve may assume any shape, depending on
supply and demand conditions
Short-term and Long-term Financing
• Term Structure of Interest Rates
– Market-segmentation theory (continued)
• Pension funds and insurance companies prefer to invest
in long-term securities.
• Federal government, through Federal Reserve, may
seek to purchase long-term bonds to put downward
pressure on long-term interest rates.
• Commercial banks prefer to invest in short-term loans
• Borrowers have distinct maturity preferences according
to needs they are attempting to finance.
Short-term and Long-term Financing
• Term Structure of Interest Rates
– The term structure of interest rates is affected by
liquidity preferences, future expectations, and
supply and demand conditions.
– The shape of the yield curve is the result of the
interaction of all three forces, any one of which
may be primary at any given time.
Relative Magnitude of Working Capital
Investment
• Aggressive working capital policy: firm
maintains relatively low levels of current
assets and relatively high levels of current
liabilities
– Attempts to minimize cash balances, maximize
inventory turnover, and minimize level of
investment in accounts receivable
– Net effect: minimizes firm’s overall investment in
investment in working capital
Relative Magnitude of Working Capital
Investment
• Aggressive working capital policy has implications for
sales and profitability:
– By minimizing investment in net working capital:
• Sales may be lost
– To customers who find competitor's credit terms more agreeable
– Because aggressive firm is more selective in granting credit than its
competitors
– Because desired items are out of stock due to high level of inventory
turnover
• Extensive use of trade credit may result in missed discounts
(discounts from face amount of invoice are commonly allowed for
prompt payment)
• Extensive use of short-term credit may result in incurring relatively
high interest costs
– Also subjects firm to renewal and interest rate risks
Relative Magnitude of Working Capital
Investment
• Cost of aggressive working capital policy has
two major benefits:
1. Firm’s investment in current assets is minimized
•
If net income levels can be maintained, return on
assets can be increased through reduction in firm’s
total asset base
2. Overall financing costs are reduced:
1. Lower level of assets requires less financing to begin
with
2. Cost of short-term debt may be lower than long-term
debt (when yield curve is positive)
Relative Magnitude of Working Capital
Investment
• Conservative working capital policy: firm is less aggressive in
minimizing current assets and employing short-term debt
• Ex. Kyle Manufacturing Company follows conservative policy
–
–
–
–
–
–
Total assets: $2,700,000
Sales: $5,000,000
Net income (after-tax): $425,000
ROA: 15.7% ($425,000/$2,700,000)
Return on sales: 8.5% ($425,000/$5,000,000)
Tom Kyle is considering shifting to more aggressive policy.
• Total assets: $2,200,000
• Sales: $4,500,000
• Net income (after-tax): $391,500 (8.7% x $4,500,000)
• ROA: 17.8%
• Savings in interest expenses to increase return on sales: 8.7%
• If assets freed up by shift can be employed elsewhere at comparable
Relative Magnitude of Working Capital
Investment
• There are uncertainties and questions to be considered in
switching policies:
1. How accurate are revised sales, earnings, and asset estimates?
2. What is the probable impact of the shift to more short-term financing
on the riskiness of the firm?
3. What is the likely impact of this shift on the long term growth and
profitability of the company?
4. Can the assets freed up by this change be employed elsewhere at a
comparable ROA?
• Analytical techniques and “what if” exercises can turn
expectations and speculations into dollars and percentages,
but answers to these questions are ultimately a matter of
judgment.
Inventory Control Policy
• Each item in inventory normally is assigned:
– High limit: maximum quantity that should be held
– Low limit: minimum quantity that should be held
– Reorder point: quantity at which a replenishment order
should be placed
– Reorder quantity: quantity that should be ordered when
reorder point is reached
• Economic order quantity model (EOQ): determines
optimal average inventory level that should be
carried and the optimal quantity that should be
ordered each time an order is placed
Credit Policy
• Credit policy: requires establishment of major
policy variables within which accounts
receivable will be managed
– Variables include:
• Deciding to whom credit should be extended
• Length of time to be allowed for payment of invoices
• Whether discounts will be offered for prompt payment
Credit Policy
• Aspects of accounts receivable management:
1. Firm must establish terms under which credit will be
granted and to whom credit will be offered.
•
Requires an analysis of potential impact of credit policy
terms on sales and profits.
2. Firm must consider relationship of accounts receivable to
short-term liability structure.
•
•
Possible to use accounts receivable as collateral for shortterm loans.
Factoring: possible to sell accounts receivable at discount
to commercial bank or commercial factor
–
No need to make additional credit policy decisions because
once policy of factoring is established, factor dictates credit
terms.
Accounts Payable Payment Policy
• Suppliers commonly offer discounts on
accounts payable to prompt payment by
customers.
• Ex. “2/10, net 60”: 2% discount off face amount of
invoice is allowed if payment is made within 10 days
of receipt of invoice. If discount is not taken, then
total amount is due within 60 days.
Accounts Payable Payment Policy
• Two concerns in establishing payment policy:
1. Cost and availability of money
2. Impact of policy on firm’s credit rating
Accounts Payable Payment Policy
1. Cost and availability of money
1. Cost of missing discount can be translated easily into
approximate annual percentage rate of interest
–
Ex. (see previous slide)

Discount terms allows 2% reduction in amount payable if
payment is made within 10 days, but require full amount to
be paid if payment is not made until 60 days have passed.

Missing discount results in 50-day loan from supplier to
purchaser.

Cost of loan is 2% per period for 7.3 periods per year (365
days/50 days)

Approximate annual percentage rate, or imputed interest rate
on missed discounts, is approximately 14.6% (2% x 7.3 period,
ignoring compounding)

If firm’s cost of money is less than 14.6%, then discount terms
are financially attractive.
Accounts Payable Payment Policy
1. Cost and availability of money (continued)
2. Availability
•
•
•
If cash flow or credit capacity is strained, it may not be
possible to take advantage of discounts even if terms
are financially attractive.
If firm is unable to obtain funds necessary to take
discounts, cost of money is infinite (money is
unavailable at any cost).
If funds can be obtained only at relatively high cost,
discount terms are unattractive.
Accounts Payable Payment Policy
1. Cost and availability of money (continued)
–
The shorter the lending period, the higher the cost of
missed discounts.
•
–
Ex. “2/10, net 30”: terms increase cost of missed discounts to 36.5% per
year (2% times 365/20)
High short-term financing costs dictate that, once
discount is missed, payment should be delayed until
latest allowable payment date.
– General rule: Firm should not make an early
payment after discount is missed or if no discount
is allowed.
Accounts Payable Payment Policy
2. Impact of policy on firm’s credit rating
– Some firms pay their payables promptly and take
discounts even though discounts are not
particularly attractive strictly on cost basis
because record of prompt payments may
enhance credit reputation of firm.
– Though not necessarily economically rational at
the moment, maintenance of good credit rating
improves firm’s future access to and cost of
external financing.