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Introduction to Working Capital > Overview of the Working Capital Financing Decision
Overview of the Working Capital Financing Decision
• Evaluating Interest Rates
• Decision Criteria
• Identifying Varying Conditions
• Calculating Expected Value
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Introduction to Working Capital > Overview of the Working Capital Financing Decision
Evaluating Interest Rates
• The interest rate most commonly used in working capital management is the cost
of capital.
• Firm value is enhanced when, and if, the return on capital, which results from
working-capital management, exceeds the cost of capital, which results from
capital investment decisions.
• Working capital decision criteria that focus on interest rates include debtors
management and short-term financing.
• The discount rates typically applied to different types of companies show
significant differences.
Interest
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Introduction to Working Capital > Overview of the Working Capital Financing Decision
Decision Criteria
• The decisions relating to working capital are always current (i.e., short-term
decisions.
• The most useful measure of profitability is return on capital (ROC).
• One measure of cash flow is provided by the cash conversion cycle (CCC)–the
net number of days from the outlay of cash for raw material to receiving payment
from the customer.
• The most useful measure of profitability is return on capital (ROC).
Cash cycle
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Introduction to Working Capital > Overview of the Working Capital Financing Decision
Identifying Varying Conditions
• The goal of working capital management is to ensure that the firm is able to
continue its operations and that it has sufficient cash flow to satisfy both maturing
short-term debt and upcoming operational expenses.
• Identify the cash balance which allows for the business to meet day to day
expenses, but reduces cash holding costs.
• Identify the level of inventory which allows for uninterrupted production but
reduces the investment in raw materials - and minimizes reordering costs - and
hence increases cash flow.
• Identify the appropriate credit policy and the appropriate source of financing,
given the cash conversion cycle.
Inventory
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Introduction to Working Capital > Overview of the Working Capital Financing Decision
Calculating Expected Value
• Positive working capital is required to ensure that a firm is able to continue its
operations and that it has sufficient funds to satisfy both maturing short-term debt
and upcoming operational expenses.
• The management of working capital involves managing inventories, accounts
receivable and payable, and cash.
• Current assets and current liabilities include three accounts which are of special
importance: accounts receivable, inventory, and accounts payable.
• Working capital is equal to accounts receivable plus the value of inventory, minus
accounts payable.
Working Capital Equation
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Appendix
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Introduction to Working Capital
Key terms
• balance sheet A summary of a person's or organization's assets, liabilities and equity as of a specific date.
• cash conversion cycle how long a firm will be deprived of cash if it increases its investment in resources in order to expand
customer sales.
• cost of capital The rate of return that capital could be expected to earn in an alternative investment of equivalent risk.
• credit rating An estimate, based on a company or person's history of borrowing and repayment and/or available financial
resources, that is used by creditors to determine the maximum amount of credit it can extend to a without undue risk.
• Finished good Finished goods are goods that have completed the manufacturing process but have not yet been sold or
distributed to the end user.
• liquidity Availability of cash over short term: ability to service short-term debt.
• M&A Mergers and acquisitions (M&A) are aspects of corporate strategy, corporate finance, and management dealing with the
buying, selling, dividing, and combining of different companies and similar entities that can help an enterprise grow rapidly in its
sector or location of origin, or a new field or new location, without creating a subsidiary, other child entity or using a joint
venture.
• Work in process Work in process (WIP) or in-process inventory includes the set at large of unfinished items for products in a
production process. These items are not yet completed but either just being fabricated or waiting in a queue for further
processing or in a buffer storage.
• working capital A financial metric that is a measure of current assets of a business that exceeds its liabilities and can be applied
to its operation.
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Introduction to Working Capital
Interest
Interest rates of working capital financing can be largely affected by discount rate, WACC and cost of capital.
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Introduction to Working Capital
Inventory
Identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials and minimizes reordering costs and,
hence, increases cash flow.
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Introduction to Working Capital
Working Capital Equation
Working capital is equal to accounts receivable, plus current inventory, minus accounts payable.
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Introduction to Working Capital
Cash cycle
Cash conversion cycle is a main criteria for working capital management.
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Introduction to Working Capital
A company is a late stage startup. What should be its target rate
of return for its equity?
A) 50%-100%
B) 30%-50%
C) 40%-60%
D) 10%-25%
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Introduction to Working Capital
A company is a late stage startup. What should be its target rate
of return for its equity?
A) 50%-100%
B) 30%-50%
C) 40%-60%
D) 10%-25%
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Introduction to Working Capital
Which of the following correctly defines a factor that influences a
company's working capital financing decisions?
A) All of these answers.
B) A CCC is the number of days from the purchase of materials until the
customer pays for the product.
C) A company's return on capital is income divided by the capital used to
earn that revenue.
D) Credit policy is how a company uses credit to make purchases and
whether it allows sales on credit.
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Introduction to Working Capital
Which of the following correctly defines a factor that influences a
company's working capital financing decisions?
A) All of these answers.
B) A CCC is the number of days from the purchase of materials until the
customer pays for the product.
C) A company's return on capital is income divided by the capital used to
earn that revenue.
D) Credit policy is how a company uses credit to make purchases and
whether it allows sales on credit.
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Introduction to Working Capital
Which of the following correctly defines one of the four main areas
of variability that must be considered during working capital
management?
A) All of these answers.
B) Cash management balances having enough cash for expenses while
minimizing cash holding costs.
C) Inventory management ensures uninterrupted production while
minimizing investment in raw materials.
D) Debtors management finds the appropriate credit policy.
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Introduction to Working Capital
Which of the following correctly defines one of the four main areas
of variability that must be considered during working capital
management?
A) All of these answers.
B) Cash management balances having enough cash for expenses while
minimizing cash holding costs.
C) Inventory management ensures uninterrupted production while
minimizing investment in raw materials.
D) Debtors management finds the appropriate credit policy.
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Introduction to Working Capital
A company has $350,000 in accounts receivable, $100,000 in
current inventory, and $125,000 in accounts payable. What is its
working capital?
A) $375,000
B) $225,000
C) $325,000
D) $450,000
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Introduction to Working Capital
A company has $350,000 in accounts receivable, $100,000 in
current inventory, and $125,000 in accounts payable. What is its
working capital?
A) $375,000
B) $225,000
C) $325,000
D) $450,000
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Introduction to Working Capital
Attribution
• Wikipedia. "Working capital." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Working_capital
• Wikipedia. "Discounting." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Discounting
• Wikipedia. "cash conversion cycle." CC BY-SA 3.0 http://en.wikipedia.org/wiki/cash%20conversion%20cycle
• Wikipedia. "cost of capital." CC BY-SA 3.0 http://en.wikipedia.org/wiki/cost%20of%20capital
• Wiktionary. "credit rating." CC BY-SA 3.0 http://en.wiktionary.org/wiki/credit+rating
• Wikipedia. "M&A." CC BY-SA 3.0 http://en.wikipedia.org/wiki/M&A
• Wikipedia. "Working capital." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Working_capital
• Wiktionary. "balance sheet." CC BY-SA 3.0 http://en.wiktionary.org/wiki/balance+sheet
• Wikipedia. "Working capital." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Working_capital
• Wikipedia. "Working capital." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Working_capital
• Boundless Learning. "Boundless." CC BY-SA 3.0 http://www.boundless.com//business/definition/work-in-process
• Wikipedia. "Finished good." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Finished%20good
• Wikipedia. "Corporate finance." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Corporate_finance#Working_capital_management
• Wikipedia. "Working capital." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Working_capital
• Wiktionary. "liquidity." CC BY-SA 3.0 http://en.wiktionary.org/wiki/liquidity
• Wiktionary. "working capital." CC BY-SA 3.0 http://en.wiktionary.org/wiki/working+capital
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