Lecture 5 - cda college

Prepared by:
Chara Charalambous
Working Capital and the
Financing Decision
Chapter 8 – Agenda
 What
is Working Capital
 Short-Term vs. Long-Term Financing
 Approaches to Working Capital Financing
 Summary and Conclusions
Statement of Financial Position (Balance Sheet) as at 31st December 20YY
Fixed Assets
Land and Buildings
Furniture and Fittings
Motor Vechicles
Add Net ProfitX
Less DrawingsX
Long-term Liabilities
(repayable later than one year)
Long-term Loan
Current Assets
Current Liabilities
(amounts due within a year)
Bank Overdraft
Short Term Loan
Balance Sheet as at 31 December Year 20XX
Fixed Assets
Land and Buildings
Furniture and fittings
Motor Vehicles
Current Assets
Closing Inventory
Capital Account
Add Net Profit
Less Drawings
Long-trrm Liabilities
Long term loan
Current Liabilities
Bank Overdraft
Short term loan
Current assets are cash and other assets that the firm
expects to convert into cash in a year or less.
Current liabilities (or short-term liabilities) are
obligations that the firm expects to pay off in a year or
Working capital, also called gross working capital,
includes the funds invested in a company’s cash account,
account receivables, inventory, and other current assets.
Net working capital (NWC) refers to the difference
between current assets and current liabilities.
Liquidity is the ability of a company to convert assets—
real or financial—into cash quickly without suffering a
financial loss.
NWC is important because it is a measure
of liquidity and represents the net shortterm investment the firm keeps in the
Working Capital Accounts
The various working capital accounts are:
 Cash: This account includes cash and marketable securities
like Treasury securities.
The higher the cash balance, the better the ability of the firm to
meet its short-term financial obligations.
Receivables: These represent the amount owed by
customers who have taken advantage of the firm’s trade
credit policy.
Inventory: Firms maintain inventory of raw materials and
work in process and finished goods.
Payables: The payables balance represents the amount owed to the
firm’s vendors and suppliers on materials purchased on credit. The
accrual accounts are liabilities incurred but not yet paid, such as
accrued wages or taxes.
Working Capital
The most common meaning for the term working capital is
the difference between current assets and current liabilities:
In this usage, working capital is the dollar amount of
current assets left over after the remaining current assets
are allocated to pay the company's current liabilities. These
“extra” current assets can be used to finance the ongoing
work of the business, hence they represent the firm's
“working capital.”
Fixed assets
Fixed assets are long-term, tangible assets such as land,
equipment, buildings, furniture and vehicles. Fixed assets are
parts of the company that help with production and are
components that last over time in the company. They are
physical assets that can be seen. They are not used for
liquidation purposes or cashed out in any way to aid a
business financially , they contribute to the company's
Working Capital
Working capital management: The administration of the
firm’s current assets( cash and marketable securities,
receivables, and inventory) and the financing (current
liabilities) needed to support current assets.
Marketable securities is short term investments: Any equity or debt
instrument that it easily saleable and can be converted into cash, or
exchanged with ease. Stocks, bonds, and certificates of deposit are all
considered marketable securities because there is a public demand for
them and because they can be easily converted into cash.
A security is a tradable asset of any kind. Securities are broadly
categorized into:
Debt securities (such as banknotes, bonds and debentures),
Equity securities, e.g., common stocks
Excessive levels of current assets can easily result in a firm realizing unsatisfactory
return on investment. If the current ratio is too high (much more than 2), then the
company may not be using its current assets or its short-term financing facilities
efficiently. This may also indicate problems in working capital management.
However, firms with too few current assets may incur shortages and difficulties in
maintaining smooth operations. All other things being equal, creditors consider a
high current ratio to be better than a low current ratio, because a high current ratio
means that the company is more likely to meet its liabilities which are due over the
next 12 months.
For small companies, current liabilities are the principal source of external financing.
These firms do not have access to the longer-term capital markets, other than to
acquire a mortgage on a building. The fast-growing but larger company also makes
use of current liability financing. For these reasons, the financial manager and staff
devote a considerable portion of their time to working capital matters. The
management of cash, marketable securities, accounts receivable, accounts payable,
accruals, and other means of short-term financing is the direct responsibility of the
financial manager; only the management of inventories is not. Moreover, these
management responsibilities require continuous, day-to-day supervision. Unlike
dividend and capital structure decisions, you cannot study the issue, reach a decision, and
set the matter aside for many months to come. Thus working capital management is
important, if for no other reason than the proportion of the financial manager’s time that
must be devoted to it. More fundamental, however, is the effect that working capital
decisions have on the company’s risk, return, and share price.
Working Capital Basics
Working capital management involves two key issues.
What is the appropriate amount of current assets for the firm
to hold? –optimal level of investment.
How should these current assets be financed – mix of short
term and long term financing used to support current assets ?
These issues are affected by the trade-off that must be made
between profitability and risk:
Lowering the level of investment in current assets while still being able to support sales
To the extent that the costs of short term financing are less than those of long term
financing, the greater the proportion of short term debt to total debt, the higher is the
profitability of the firm.
Although short-term interest rates sometimes exceed long-term rates,
generally they are less. Even when short-term rates are higher, the
situation is likely to be only temporary. Over an extended period of
time, we would expect to pay more in interest cost with long-term
debt than we would with short-term borrowings. These profitability
assumptions suggest maintaining a low level of current assets and a
high proportion of current liabilities to total liabilities. This strategy
will result in a low, or possibly negative, level of net working capital.
On the one hand this strategy gives us high profitability and on the
other hand contains a risk , an increased risk, which has to do with
maintaining sufficient current assets to:
meet its cash obligations as they occur
support the proper level of sales (e.g., running out of inventory).
Working Capital Management
capital management is about financing and
controlling the investment in the current assets of a firm
growth often leads to a buildup in inventory and
accounts receivable (Debtors). Firm may require additional
external financing
is to achieve a balance between liquidity and
profitability that contributes positively to the firm’s value.
To answer this question, we need to use the return on investment (ROI)
equation as follows:
ROI = Net profit =
Net profit
Total assets
(Cash + Receivables + Inventory) + Fixed assets
Current assets
From the equation above we can see that decreasing the amounts of current
assets held will increase our potential profitability. If we can reduce the firm’s
investment in current assets while still being able to properly support output and
sales, ROI will increase. Lower levels of cash, receivables, and inventory would
reduce the denominator in the equation; and net profits, our numerator, would
remain roughly the same or perhaps even increase. So if the policy follow is this
with low liquidity it will provide the highest profitability possible as measured
by ROI.
However decreasing cash reduces the firm’s ability to meet
financial obligations as they come due. Decreasing receivables,
by adopting stricter credit terms and a tougher enforcement
policy, may result in some lost customers and sales. Decreasing
inventory may also result in lost sales due to products being out
of stock. Therefore more aggressive working capital policies
lead to increased risk. Clearly, the previous policy discussed is
the most risky working capital policy. It is also a policy that
emphasizes profitability over liquidity. In short, we can now
make the following generalizations: regarding Liquidity,
Profitability and Risk !!!
Profitability varies inversely with liquidity.. Increased liquidity
generally comes at the expense of reduced profitability.
Profitability moves together with risk (i.e., there is a trade-off
between risk and return). In search of higher profitability, we
must expect to take greater risks. You might say that risk and
return walk hand in hand.
In the end, the optimal level of each company’s current assets
(cash, marketable securities, receivables, and inventory) will be
determined by management’s attitude to the trade-off between
profitability and risk.
Hedging (Maturity Matching) Approach
A method of financing where each asset would be offset with
a financing instrument of the same approximate maturity.
Short-term or seasonal variations in current assets would be
financed with short-term debt and all fixed assets would be
financed with long-term debt or with equity. The rationale for
this is that if long-term debt is used to finance short-term needs,
the firm will be paying interest for the use of funds during times
when these funds are not needed. It is obvious that financing
would be working and be engaged in periods of seasonal quiet
periods – when it is not needed. With a hedging approach to
financing, the borrowing and payment schedule for short-term
financing would be arranged to correspond to the expected
swings in current assets.
For example, a seasonal expansion in inventory (and receivables) for
the Christmas selling season would be financed with a short-term loan.
As the inventory was reduced through sales, receivables would be built
up. The cash needed to repay the loan would come from the collection
of these receivables. All of this would occur within a matter of a few
months. In this way, financing would be employed only when it was
needed. This loan to support a seasonal need would be following a
self-liquidating principle. That is, the loan is for a purpose that will
generate the funds necessary for repayment in the normal course of
Permanent asset requirements would be financed with long-term
debt and equity. In this situation, it would be the long-term
profitability of the financed assets that would be counted on to
cover the long-term financing costs. In a growth situation,
permanent financing would be increased in keeping with
increases in permanent asset requirements.
Hedged (Balanced) Approach to
Match liquidity (life) of your assets to the maturity (term) of
your financing
Means your assets will be generating cash when your
liabilities come due (this reduces risk)
Balanced Financing
Temporary (seasonal) build-up in inventory and accounts
finance with trade credit, short-term bank loans, short-term
notes payable
Property and equipment, long-term investments
finance with long-term loans, leases, bonds, capital stock,
retained earnings
Short-Term vs. Long-Term Financing
Although the Hedging (Maturity Matching) Approach is appropriate under
conditions of certainty, it is usually not appropriate when uncertainty exists:
Net cash flows will deviate from expected flows and so there is a business
risk. As a result, the schedule of maturities of the debt is very significant in
assessing the risk-profitability trade-off. The question is: What margin of
safety should be built into the maturity schedule to allow for adverse
fluctuations in cash flows? This depends on management’s attitude to the
trade-off between risk and profitability.
The Relative Risks Involved. In general, the shorter the maturity schedule of
a firm’s debt obligations, the greater the risk that the firm will be unable to
meet principal and interest payments.
Financing Current Assets:
Short-Term vs. Long-Term Financing
 Short-term
financing is less expensive but riskier
lower interest rates (usually)
 short-term rates are volatile
 risk of default if sales slow down
 risk that bank may not extend / renew loans
 Long-term
financing is more expensive but less risky
usually higher interest rates,
 you may pay interest on funds you don’t always need
 you have capital at all times
 Firm
must decide the appropriate “mix”
Working Capital Financing Plans
A conservative (safe or cautious) firm:
L/T financing and high liquidity
A moderate (balanced) firm:
S/T financing and high liquidity OR
 L/T financing and low liquidity
An aggressive (risky) firm:
S/T financing and low liquidity
 Appropriate
strategy is determined based on
company’s tolerance for risk
Current asset liquidity and asset financing
Asset Liquidity
Financing Plan Low Liquidity
High Liquidity
High profit
High risk
Moderate profit
Moderate risk
Moderate profit
Moderate risk
Low profit
Low risk
Working Capital Ratios
 Ratios
to determine the operating cycle
Although there is a ratio for Operating Working Capital, operating working
capital is usually broken down into its main components:
Accounts Payable
Accounts Receivable
As always, ratios need to be understood and interpreted in relation to a firm's
 Working
capital liquidity ratios
Ratios to determine the operating cycle
Working Capital Turnover = Sales / Working Capital
Indicates how efficiently working capital is being used to generate sales. The
higher the number the better.
Accounts Payable Turnover = Purchases / Accounts Payable
Indicates how quickly payables are being paid. Since accounts payable often
times is similar to cost-free financing, to a point, usually a slower rate is
preferred. That is, when financing is cheap or free, repayment of the debt
should be extended for as long as possible. "Cost of Goods Sold" might be
substituted for "Purchases."
Day's Payables = 365 Days / Accounts Payable Turnover
To calculate Day's payables, simply take the number calculated by the
"Accounts Payable Turnover, and divide it by 365 days. This will indicate the
average number of days the firm is taking to pay its accounts payables. e.g. If
the terms of accounts payable are such that outstanding accounts payable are
to be paid in 60 days, then the day's payables should also be close to 60 days.
Accounts Receivable Turnover = Credit Sales / Accounts Receivable
Indicates how quickly customers are paying on their accounts. Accounts
receivable is a big use of cash and so a rapid turnover is good. i.e. The bigger the
number, the better. (usually). "Sales" might be substituted for "Credit Sales.“
Day's Receivables = 365 Days / Accounts Receivable Turnover
Indicates the number of days on average customers are taking to pay on their
Inventory Turnover = Cost of Goods Sold / Inventory
Indicates how rapidly inventory is being sold. Usually, the faster inventory is
sold, the more profitable the firm will be. Firms with rapid turnover might
include grocery stores, donut shops, etc. A larger inventory turnover number is
usually preferred over a smaller number.
Day's Inventory =365 Days / Inventory Turnover
Indicates on average how long inventory sits on a firm's shelves
The Operating and Cash Conversion
The cash conversion cycle begins when the firm invests cash to
purchase the raw materials that would be used to produce the goods
that the firm manufactures and ends with the finished goods being
sold to customers and the cash collected on the sales, also taking into
account the time taken by the firm to pay for its purchases.
 Two tools to measure the working capital management efficiency
are the operating cycle and the cash conversion cycle.
 The operating cycle begins when the firm receives the raw materials
it purchased and ends when the firm collects cash payments on its
credit sales. = Day's Receivables + Day's Inventory
Cash conversion cycle=?
'Asset Turnover Ratio'
The amount of sales or revenues generated per dollar of
assets. The Asset Turnover ratio is an indicator of the
efficiency with which a company is deploying its assets.
Asset Turnover = Sales or Revenues/Total Assets
In running a business, you must determine the efficiency of using your
assets relative to generating sales by calculating the financial ratio of
your total assets and net sales which is referred to as the total asset
Generally speaking, the higher the ratio, the better it is, since it implies
the company is generating more revenues per dollar of assets. But since
this ratio varies widely from one industry to the next, comparisons are
only meaningful when they are made for different companies in the same
Asset Turnover is typically calculated over an annual basis – either fiscal or
calendar year – with the “Total Assets” figure used in the denominator
calculated as the average of assets at the beginning and end of the year.
For example, company X may have an asset base of $400 million at the
beginning of a given year and $500 million at year-end, with revenues of
$900 million generated in that year. The asset turnover ratio for company X is
The asset turnover ratio tends to be higher for companies in a sector like
consumer staples, which has a relatively small asset base but high sales
volume. Conversely, firms in sectors like utilities and telecommunications,
For a specific company, the trend in the asset turnover ratio
over a period of time should also be reviewed to check
whether asset usage is improving or deteriorating.
Working Capital Ratios (liquidity)
The “liquidity position” of a business refers to its ability to
pay its debts – i.e. does it have enough cash to pay the bills?
 The balance sheet of a business provides a “snapshot” of the
working capital position at a particular point in time
 There are two key ratios that can be calculated to provide a
guide to the liquidity position of a business:
– Current ratio
– Acid test (“quick”) ratio
Current Ratio
Calculation Formula= Current Assets
Current Liabilities
Example Calculation:
Trade Debtors
Cash Balances
Current Assets
Trade Creditors
Other Long Term Liabilities
Current Liabilities
= 2.8
Acid Test (“Quick”) Ratio
Calculation Formula= Current Assets less Stocks
Current Liabilities
Example Calculation:
Trade Debtors
Cash Balances
Current Assets
Trade Creditors
Other Long Term Liabilities
Current Liabilities
3525-1125 = 1.9
Interpreting the Ratios
A business needs to have enough cash (or “cash to come”) to be able to
pay its debts.
Obviously, a current ratio comfortably in excess of 1 should be expected –
but what is comfortable depends on the kind of business
Some businesses find it hard to turn stock and debtors into cash – so need
a high current ratio.
Some businesses (e.g. supermarkets) turn stock into cash very rapidly
and have low debtors – so they can happily exist with a current ratio of
less than 1.
The acid test ratio is often considered to be a better test of liquidity for
businesses with a low stock turnover.
Limitations of Liquidity Ratios
Liquidity ratios should be used with care
Balance sheet values at a particular moment in time may not
be typical
Balances used for a seasonal business will not represent
average values
Ratios can be subject to “window dressing” or manipulation
(e.g. a big push to get customers to pay outstanding balances
by the year end)
Ratios concern the past (historic) not the future
Working capital management is very much about ensuring
the business has sufficient cash in the future
Ways to Improve Liquidity
Reduce the stock holding period for
finished goods and raw materials
May result in production delays or shortages if
demand increases unexpectedly
Improve the efficiency of the production
process (e.g. shorten by using better
production methods)
Costly to reorganise
production – but may be worth it in the
medium term
Reduce the credit period offered to trade
debtors and chase amounts due more
May upset customers – or cause them to
reduce the amount they buy
Extend the time taken to pay creditors
A dangerous option – suppliers may refuse to
supply or may charge interest if their payment
terms are exceeded
Use invoice discounting or debt factoring
to obtain cash from trade debtors
A good way to obtain cash quickly – but
usually costly (e.g.factoring firm charges a
high commission on debts paid)
Sale and leaseback of assets
Another good way of releasing cash from fixed
assets – but leaves the business with higher
costs and payment obligations
Summary and Conclusions
Working capital management involves the financing and
management of current assets, such as cash, accounts receivable,
and inventory
As sales increase, a business requires additional current assets to
support the higher sales volume
In a hedged approach to financing, the financial manager tries to
time the due dates of liabilities to the receipt of cash from sales
Carrying more long-term debt increases the financing available,
but involves a higher interest rate
Carrying more short-term debt may reduces interest costs, but
increases the risk of capital shortages
Carrying more liquid current assets improves bill-paying
capability, but may reduce potential profits