Chapter
6
Working Capital and the
Financing Decision
Prepared by:
Terry Fegarty
Seneca College
Revised by:
P Chua
McGraw-Hill Ryerson
2003 McGraw-Hill
RyersonLimited
Limited
©2003©McGraw-Hill
Ryerson
PPT 6-2
Chapter 6 - Outline
 What
is Working Capital
Management?
 The Nature of Asset Growth
 Term Structure of Interest Rates
 Short-Term vs. Long-Term Financing
 Approaches to Working Capital Financing
 Summary and Conclusions
© 2003 McGraw-Hill Ryerson Limited
PPT 6-3
Working Capital Management
Working
capital management is financing and controlling
the investment in the current assets of a firm
Sales
growth often leads to a buildup in inventory and
accounts receivable. Firm may require additional external
financing
Goal
is to achieve a balance between liquidity and
profitability that contributes positively to the firm’s value.
Crucial
to short-term success or failure of a business
© 2003 McGraw-Hill Ryerson Limited
Cash Conversion Cycle
 Operating
Cycle (OC) consists of that period of time
measured by the Inventory Holding Period (IHP) or
Average Age of Inventory (AAI) and the Average
Collection Period (ACP) of accounts receivable.
 Cash
Conversion Cycle (CCC) completes the flow of
the OC by subtracting the Accounts Payable Period
(APP) or Average Payment Period (APP) of
accounts payable.
CCC = AAI + ACP - APP
© 2003 McGraw-Hill Ryerson Limited
Cash Conversion Timeline
© 2003 McGraw-Hill Ryerson Limited
Strategies for Managing Cycle
 Turn
over inventory as quickly as possible
(minimizing IHP).
 Collect accounts receivable as quickly as possible
(minimizing ACP).
 Pay accounts payable as slowly as possible
(maximizing APP).
© 2003 McGraw-Hill Ryerson Limited
PPT 6-5
Figure 6-1b
The nature of asset growth
Dollars
Temporary current assets
Permanent
current assets
Capital assets
Time period
© 2003 McGraw-Hill Ryerson Limited
Figure 6-12
PPT 6-23
Yield curves showing Term Structure of Interest Rates
© 2003 McGraw-Hill Ryerson Limited
Figure 6-13
Long-term and short-term interest rates
PPT 6-24
© 2003 McGraw-Hill Ryerson Limited
Short-Term vs. Long-Term Financing
 Short-term
PPT 6-21
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”
© 2003 McGraw-Hill Ryerson Limited
PPT 6-18
Figure 6-8
Matching long-term and short-term
needs (Balanced Approach)
Dollars
Temporary current assets
Short-term
financing
Permanent
current assets
Long-term
financing
(debt & equity)
Capital assets
Time period
© 2003 McGraw-Hill Ryerson Limited
PPT 6-17
Hedged (Balanced) Approach to
Financing


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
receivable


finance with trade credit, short-term bank loans, short-term
notes payable
Permanent (minimum) levels of inventory, receivables +
Property and equipment, long-term investments

finance with long-term loans, leases, bonds, capital stock,
retained earnings
© 2003 McGraw-Hill Ryerson Limited
PPT 6-19
Figure 6-9
Using long-term financing for part of
short-term needs (Conservative)
Dollars
Temporary current assets
Short-term
financing
Permanent
current assets
Long-term
financing
(debt & equity)
Capital assets
Time period
© 2003 McGraw-Hill Ryerson Limited
PPT 6-20
Figure 6-10
Using short-term financing for part of
long-term needs (Aggressive)
Dollars
Temporary current assets
Short-term
financing
Permanent
current assets
Capital assets
Long-term
financing
(debt & equity)
Time period
© 2003 McGraw-Hill Ryerson Limited
PPT 6-25
Table 6-7
Alternative financing plans
EDWARDS CORPORATION
Plan A
Part 1. Current assets
Plan B
Temporary . . . . . . .
Permanent . . . . . . .
Total current assets . . .
$250,000
250,000
500,000
$250,000
250,000
500,000
Short-term financing (6%). .
Long-term financing (10%) .
125,000
375,000
$500,000
375,000
125,000
$500,000
Part 2. Capital assets
Plant and equipment . . . .
Long-term financing (10%) .
$100,000
$100,000
$100,000
$100,000
Part 3. Total financing (summary of parts 1 & 2)
Short-term (6%) . . . . .
Long-term (10% . . . . .
$125,000
475,000
$600,000
$375,000
225,000
$600,000
© 2003 McGraw-Hill Ryerson Limited
PPT 6-26
Table 6-8
Impact of financing plans on earnings
EDWARDS CORPORATION
Plan A
Earnings before interest and taxes
Interest (short-term), 6%  $125,000
Interest (long-term), 10%  $475,000
Earnings before taxes
Taxes (50%)
Earnings aftertaxes
$200,000
– 7,500
– 47,500
145,000
72,500
$ 72,500
Plan B
Earnings before interest and taxes
Interest (short-term), 6%  $375,000
Interest (long-term), 10%  $225,000
Earnings before taxes
Taxes (50%)
Earnings aftertaxes
$200,000
– 22,500
– 22,500
155,000
77,500
$ 77,500
© 2003 McGraw-Hill Ryerson Limited
PPT 6-29
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
© 2003 McGraw-Hill Ryerson Limited
PPT 6-30
Table 6-11
Current asset liquidity and asset financing
plan
Asset Liquidity
Financing Plan Low Liquidity
High Liquidity
Short-term
1
High profit
High risk
2
Moderate profit
Moderate risk
Long-term
3
Moderate profit
Moderate risk
4
Low profit
Low risk
© 2003 McGraw-Hill Ryerson Limited
PPT 6-31
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
© 2003 McGraw-Hill Ryerson Limited