Chapter 14
Working Capital Policy
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Learning Outcomes
Chapter 14
Discuss why working capital is needed and how working
capital accounts are related.
Describe the cash conversion cycle and how it can be
used to better manage working capital activities.
Describe the policies that a firm might follow
(a) when investing in current assets and
(b) when financing current assets.
Discuss the advantages and disadvantages of using shortterm financing rather than long-term financing.
Describe how working capital management in
multinational firms is different from working capital
management in purely domestic firms.
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Working Capital Terminology
Working Capital Management
 The management of short-term (ST) assets
(investments) and short-term (ST)liabilities
(financing sources)
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Working Capital Terminology
Working Capital
 A firm’s investment in ST assets:
• Cash
• Marketable securities
• Inventory
• Accounts receivable
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Working Capital Terminology
Net Working Capital =
 Current assets - current liabilities
 Amount of current assets financed by long-term
liabilities
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Working Capital Terminology
Working Capital Policy
 Target levels for each current asset account
 How current assets will be financed
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Working Capital Terminology
Working capital only includes current liabilities that
are specifically used to finance current assets.
Working capital does not include current liabilities
that might be due in the current period if they are
due from long-term capital decisions, even though
these must be considered when assessing the firm’s
ability to meet its current obligations.
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Working Capital Terminology
Not Working Capital (Liabilities)
 Current maturities of long-term debt
 Financing associated with a construction program that will
be funded with the proceeds of a long-term security issue
after the project is completed
 Use of short-term debt to finance fixed assets
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The Requirement for External Working
Capital Financing
Seasonal Variations
Business Cycles
Expansion requires more working capital
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The Relationships of Working Capital
Accounts
A decision affecting one working capital
account (e.g. inventory) will impact other
working capital accounts (e.g. receivables
and payables)
If a firm’s operations are stable, the balance
in accounts receivable and accounts payable
can be computed using this equation
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The Cash Conversion Cycle
The length of time from the payment for
purchases of raw materials used to
manufacture a product until the collection of
accounts receivable associated with the sale
of the product
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The Inventory Conversion Period
Length of time required to convert materials into finished
goods and then to sell those goods
The amount of time the product remains in inventory in
various stages of completion
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The Receivables Collection Period
Average length of time required to convert the firm’s
receivables into cash; also called days sales outstanding (DSO)
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The Payables Deferral Period
Average length of time between the purchase of raw
materials and labor and the payment of cash for them
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The Cash Conversion Cycle
Average length of time a dollar is tied up in
current assets
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The Cash Conversion Cycle for Unilate Textiles
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Working Capital Investment and Financing
Policies
Two Basic Questions
 What is the appropriate level for current assets,
both in total and by specific accounts?
 How should current assets be financed?
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Alternative Current Asset Investment
Policies
Relaxed Current Asset Investment Policy
 Relatively large amounts of cash and marketable securities
and inventories are carried and sales are stimulated by a
liberal credit policy that results in a high level of receivables
Restricted Current Asset Investment Policy
 Holdings of cash and marketable securities and inventories
are minimized
Moderate Current Asset Investment Policy
 A policy that is between relaxed and restricted policies
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Alternative Current Asset Investment Policies
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Alternative Current Asset Financing
Policies
Maturity matching (“self-liquidating”) approach
 Match asset and liability maturities
Aggressive approach
 Finance all temporary assets with short-term, spontaneous
debt, and finance all fixed assets and some permanent
assets with long-term, non-spontaneous funds
Conservative approach
 Use permanent capital to finance all permanent assets and
some seasonal, temporary needs; use spontaneous, shortterm debt to finance the rest of the seasonal needs
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Maturity Matching, or “Self-Liquidating” Approach
A financing policy that matches asset and liability maturities
This would be considered a moderate current asset financing policy.
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Aggressive Approach
A policy in which all of the fixed assets of a firm are financed with
long-term capital, but some of the firm’s permanent current assets
are financed with short-term non-spontaneous sources of funds
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Conservative Approach
A policy in which all of the fixed assets, all of the permanent current
assets, and some of the temporary current assets of a firm are
financed with long-term capital
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Advantages of Short-Term Financing
Speed
 A short-term loan can be obtained much faster
than long-term credit.
Flexibility
 For cyclical needs, avoid long-term debt
• Cost of issuing long-term debt is higher.
• Penalties for payoff prior to maturity
• Restrictive covenants
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Advantages of Short-Term Financing
Cost of Long-Term versus
Short-Term Debt
 Yield curve is generally upward sloping.
 Short term interest rates are generally lower than
long-term rates.
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Disadvantages of
Short-Term Financing
Risk of Long-Term versus Short-Term Debt
 Short-Term Debt subjects the firm to more risk
than long-term debt does.
• Short-term interest expenses fluctuate.
• Firm may not be able to repay short-term debt
and be forced into bankruptcy.
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Multinational Working Capital Management
How Working Capital Policies of U.S. Firms
Differ from European Firms:
 Average cash conversion cycle of European firms
more than twice that of U.S. firms.
 U.S. firms follow more conservative working
capital policies than European firms do.
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