Chapter
6
McGraw-Hill/Irwin
Working Capital
and the Financing
Decision
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Outline
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Working capital management
Current assets- temporary and permanent
Assets financing
Long-term versus short-term financing
Current assets financing plan- risk and
profitability
• Expected value analysis in working capital
management
6-2
Working Capital Management
• The financing and management of the
current assets of a firm
– Crucial to achieving long-term objectives of the
firm
– Requires immediate action
6-3
The Nature of Asset Growth
• Key to current asset planning – matching
production schedules with accurate sales forecast
• 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
The Nature of Asset Growth
6-5
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
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
Matching Sales and ProductionMcGraw-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
The Nature of Asset Growth.
6-9
Seasonal Sales Pattern in Target and
Limited Brands
• Like publishers, retail companies do not
stock inventory for more than a year
• Fourth quarter is the biggest quarter for
retailers
• The retail firm Target is growing much faster
than its counterpart Limited Brands
• Even then, in the fourth quarter, peak
earnings are almost equal for both the
companies
6-10
Quarterly Sales and Earnings Per
Share, Target and Limited Brands
6-11
Computerized Inventory Control
Systems
• Retail-oriented firms use new, computerized
inventory control systems linked to online
point-of-sales terminals
– Allow either digital input or use of optical
scanners to record the inventory code numbers
and the amount of each item sold.
• Use of Radio Frequency Identification
(RFID) chips is the latest rage in
inventory/supply chain management
6-12
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 - 12month sales forecast is issued
– Result: Level production and seasonal sales
combine to produce fluctuating inventory
6-13
Yawakuzi Sales Forecast (in units)
Table-1
Table 6-1
6-14
Yawakuzi’s Production Schedule and
Inventory
Table 6-2
6-15
Sales Forecasts, Cash Receipts and
Payments, and Cash Budget
Table 6-3
6-16
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 payments: Based on assumptions of level of
production and cost per unit plus payments for
overhead, dividends, interest, and taxes
– Cash budget: a comparison of cash receipt and payment
schedules to determine cash flow
6-17
Total Current Assets, First Year
($ millions)
6-18
Cash Budget and Assets for II Year
With No Growth in Sales ($ millions)
6-19
Yawakuzi’s Nature of Asset Growth
Graphic presentation of the current asset cycle assuming level of
production and no sales growth
6-20
Patterns of Financing
• Selection of external sources to finance
assets is an important decision
• The appropriate financing pattern:
– Matching of asset buildup and length of
financing terms
6-21
Matching Long-Term and ShortTerm Needs
6-22
Alternative Plans
• The challenge of constructing a financial
plan is to categorize the current assets into
temporary and permanent
• Predicting the exact timing of asset
liquidation is a difficult task
• It is also difficult to determine the amount of
short-term and long-term financing available
6-23
Long-Term Financing
• Can assure adequate capital at all times
• May be used to cover part of the short-term
needs in tight money periods
• Can be used to finance:
• Fixed assets
• Permanent current assets
• Part of the temporary current assets
6-24
Using Long-Term Financing for Part
of Short-Term Needs
6-25
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 to finance:
• Temporary current assets
• Part of the permanent working capital needs
6-26
Using Short-Term Financing for Part
of Long-Term Needs
6-27
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
Basic Theories - Yield Curve
• Liquidity premium theory
– Long-term rates should be higher than shortterm 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
Long- and Short-Term Annual
Interest Rates
• Relative volatility and the historical level of
short-term and long-term rates
6-30
Alternative Financing Plans
• A Decision Process: Comparing alternative
financing plans for working capital
6-31
Impact of Financing Plans on
Earnings
6-32
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
6-33
Expected Returns under Different
Economic Conditions
Expected value represents the sum of the
expected outcomes under both conditions
6-34
Expected Returns for High Risk
Firms
6-35
Shifts in Asset Structure
• During recession –
– Sales decline or stay even
– Cash, receivables, and inventory fall
– Short-term debt may rise,
• causing a large decline in the net working capital to sales ratio
• During upswing –
– cash, receivables, and inventory rise
– short-term debt may fall or be replaced by low-cost longterm debt.
• These two effects cause the firm’s profitability to increase and
the net working capital to sales ratio to rise.
6-36
Net Working Capital as a Percentage
of Sales and the Current Ratio
6-37
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
6-38
Asset Liquidity and Financing Assets
6-39