Topic 4: Working capital finance and AFN
Topic Learning Outcomes
After this topic, you should be able to:
1. Understand the concepts of working capital management and its application
2. Discuss the trade-off between profitability and risk
Let’s Discuss
1. Concepts and significance of working capital management
2. Trade-Off between Profitability and Risk
3. Working capital investment and financing policies (conservative vs. aggressive)
4. Apply the additional funds needed (AFN) equation in determining the amount of external
funding.
Working Capital Finance
Working capital
• “Current assets” because these assets “turn over” and are used and then replaced during the year
Net working capital
• Current assets less current liabilities
Net operating working capital
• Working capital that is used for operating purposes.
• Excludes interest bearing notes payable
𝑁𝑒𝑡 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 (𝑁𝑂𝑊𝐶)
= 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − (𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 − 𝑁𝑜𝑡𝑒𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒)
Working Capital Management
•
Administration of company’s working capital with primary objective of balance between risk and
return
Temporary Current Assets
• Current assets that fluctuate with the firm’s operations, or with seasonal or cyclical variations in
sales
•
Permanent Current Assets
• These are required to maintain daily operations
• Current assets that firm must carry even at the through of its cycle
Working Capital Investment Policies
a. Relaxed Investment Policy
b. Restricted Investment Policy
c. Moderate Investment Policy
Working Capital Financing Policy
a. Conservative (Relaxed) Policy
o Operations with too much working capital; financing almost all assets with long-term capital
b. Aggressive (Restricted) Policy
o Operations with minimal amount of working capital; uses short-term liabilities to finance not
only temporary, but also part or all the permanent current asset requirement.
c. Matching Policy (or Self-Liquidating Policy or Hedging Policy)
o Short-term Assets: Short-Term Liabilities
o Long-term Assets: Long-Term Liabilities
Sample Problem
Wakanda Corp. has a total fixed asset of 200,000.
Cash
Accounts Receivable
Inventories
P
1st
Quarter
40,000
76,000
40,000
2nd
Quarter
20,000
35,000
85,000
3rd
Quarter
25,000
67,000
89,000
4th
Quarter
30,000
108,000
30,000
1. If Wakanda Corp.’s policy is to finance all fixed asset and half the permanent current assets with longterm financing and the rest with short-term financing, what is the level of long-term financing?
2. Describe the type of financing of the company’s working capital in (1).
3. If Wakanda Corp.’s policy in financing its working capital is describe as moderate, what is the level of
long-term financing?
4. If Wakanda Corp.’s policy is to finance all the fixed and permanent assets and half the seasonal assets
with long-term financing and the rest with short-term financing, describe the financing it employs.
Answer
Current Asset
1st Quarter
156,000
2nd Quarter
140,000
3rd Quarter
181,000
4th Quarter
168,000
Notes:
o Fixed Assets remain constant throughout the quarters at a level of 200,000.
o On the illustration above, everything above 200,000 mark is the current asset.
o Current assets that are not affected by seasonal cycles are considered to be a permanent current asset.
o On the problem, the 2nd quarter current assets amounting to 140,000 is the minimum amount of current
asset that is needed to sustain the operation throughout the year (i.e. 140,000 amounts of current asset
must stay or be permanent all throughout the quarters).
o Permanent Current Asset, although classified under financial reporting as current asset, acts “somehow”
as a fixed asset since it must be constant to sustain the operation of the firm.
o Any excess above the level of permanent current asset each quarter are called Seasonal or Temporary
Current Asset. These Current assets exist specifically to support the operation of the firm whose service
or product are affected by seasonality trends (e.g. school supplies have high seasonality trend during
months when school commences).
Answers:
1. • fixed asset + half of permanent current assets
• 200,000 + (140,000/2) = 270,000
2.
The type of financing of the Wakanda Corp.'s working capital in (1) is aggressive because
short-term liabilities is used to finance not only the temporary but also part of the
permanent current asset.
3.
•
Under Moderate Investment Policy or Matching Policy, Short-Term and Long-Term
Assets and Liabilities are appropriately Matched.
••
•
4.
Moderate Investment Policy or Matching Policy: Long-Term Financing = Fixed Assets
(or Non-current Assets) + Permanent Current Assets
Long-Term Financing = 200,000 + 140,000 = 340,000
Wakanda Corp. employs Conservative (or Relaxed) Policy since it finances almost all
assets with long-term capital.
Financial forecasting using Additional Funds Needed (AFN)
Firm’s Primary Capital Sources
a. Spontaneously generated funds
• Spontaneous Increase in Accounts Payable and Accruals
• Fund that rise out of normal business operations
b. Additions to Retain Earnings
• Depending on the firm’s profit margin and its retention ratio
• Retention Ratio (PBR) is the portion of the income reinvested in the firm
c. Additional Funds Needed (AFN)
• Amount of external capital necessary to acquire the required assets
• May be interest-bearing debt or preferred or common stock
Additional Funds Needed (AFN) Equation
𝐴𝐹𝑁 = 𝐴𝑠𝑠𝑒𝑡𝑠0 ∗ 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 − 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠0 ∗ 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒
− (𝑆𝑎𝑙𝑒𝑠1 )(𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛)(𝑃𝑙𝑜𝑤 𝐵𝑎𝑐𝑘 𝑅𝑎𝑡𝑖𝑜)
Capital Intensity Ratio
• The ratio of Assets required per dollar of sales
Excess Capacity Adjustment
• Changes Made to the existing asset forecast because the firm is not operating at full capacity
Sample Problem
Problem 1 – Asset requirement
Blue Corp. forecasted its sales to be 5,000,000, gross profit margin to be 30% and its return on sales to be
10%. Accounts receivable is expected to be 10% of sales while inventory is expected to be 20% of cost of sales.
Blue has a minimum cash balance of 250,000 and fixed assets of 3,500,000. How much is the total asset
requirement?
Problem 2 – AFN
Jelly Inc. uses Additional Funds Needed as a plug item. It has a new capital budget of 2,000,000, a profit of
3,000,000 and a payout ratio of 60%, how much must be raised in external funds?
Problem 3 – AFN (operation not in full capacity)
Airline Enterprise’s Balance sheet as of December 31, 2019 is as follows:
Current Assets
P
600,000
Accounts Payable
Accruals
Notes Payable
Long-term Liabilities
Fixed Assets
400,000
Equity
P
1,000,000
P
P
100,000
100,000
100,000
300,000
400,000
1,000,000
In 2019, the company reported sales of 5,000,000, net income of 100,000, and dividends of 60,00. Sales are
projected to increase by 20% next year. Both profit Margin and the dividend pay-out ratio will remain the
same. Operations are at full capacity. Assume external fund will be raised through issuances of long-term
debt.
a. How much long-term will the company have to issue next year?
b. If the operations are not in full capacity, what will be your answer?
Problem 1
Asset Requirement
Cash
250,000.00
AR
500,000.00
Inventory
700,000.00
Fixed Asset
3,500,000.00
4,950,000.00
Problem 2
AFN = 2,000,000 – [3,000,000 * (100% - 60%)]
AFN = 800,000
Problem 3
a. AFN = 𝐴𝑠𝑠𝑒𝑡𝑠0 ∗ 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 – 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠0 ∗ 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 − (𝑆𝑎𝑙𝑒𝑠1)(𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛)(𝑃𝑙𝑜𝑤 𝐵𝑎𝑐𝑘
𝑅𝑎𝑡𝑖𝑜)
100,000
100,000−60,000
AFN = (1,000,000 * 20%) – (200,000 * 20%) – (5,000,000 *1.2) (5,000,000) ( 100,000 )
AFN = 112,000
100,000
b. AFN = (600,000 * 20%) – (200,000 * 20%) – (5,000,000 *1.2) (5,000,000) (
100,000−60,000
100,000
)
AFN = 32,000
Note: Assets are only 600,000 in (b) since the company does not operate at full capacity. It needs to utilize first
the fixed asset before it must be included in the asset that need to be increased
References
Gitman, L. J., & Zutter, C. J. (2015). Principles of Managerial Finance. Pearson Education Limited.
Brigham, E. F., & Houston, J. F. (2019). Fundamentals of Financial Management. Cengege.
Roque, R. S. (2013). Reviewer in Management Advisory Services.
Other online resources
https://www.fundingoptions.com/knowledge/working-capital-finance/
https://www.investopedia.com/terms/w/workingcapital.asp
https://www.youtube.com/watch?v=bHK77lbdyWA