Lecture 8
Working Capital Definition
firm’s investment in short-term
assets-cash, marketable securities,
inventory and accounts receivable.
 Current assets, which represent the
portion of investment that circulates
from one form to another in the
ordinary conduct of business.
Working Capital Terminology
Working Capital Management: The
management of short-term assets
(investments) and liabilities (financing
 Net Working Capital: The difference
between the firm’s current assets and its
current liabilities, or, the portion of current
assets financed with long-term funds; can
be positive or negative.
Working Capital Terminology
Working Capital Policy: Decisions regarding The optimal level of investment in current assets
 The appropriate mix of short-term and long-term
financing used to support this investment in
current assets.
 Profitability: The relationship between
revenues and costs generated by using the
firm’s assets- both current and fixed- in
productive activities.
Importance of Working Capital
The largest portion of most financial managers’
time is involved to the day-to-day internal
operations of the firm, which fall under the
heading of working capital management.
 Working capital management particularly
important for small firms. Its possible for them
to minimize fixed cost but they cannot avoid
investment in cash, receivable, and
inventories. They rely heavily on trade credit
and short term bank loans, both of which affect
working capital by increasing current liabilities.
Importance of Working Capital
Current assets represent a large proportion of
total assets, generally 40 percent. Moreover,
current assets fluctuate with sales, and sales
vary over time.
 The relationship between sales growth and the
need to invest in current assets is close and
direct. As sales grow, the firm must increase
receivables and inventories and it may need to
increase its cash balance as well.
Trade-off Between Profitability
& Risk
A firm’s profits can be increased by (1)
increasing revenues or (2) decreasing costs.
In the context of short-term financial
management, risk is the probability that the firm
will be unable to pay its bills as they come due.
A firm that cannot pay its bills as they come due
is said to be technically insolvent. The greater
the firm’s net working capital, the lower its risk
because of more liquidity and low risk of
becoming technically insolvent.
How changing the level of the
firm’s current assets affects its
profitability-risk trade-off?
It is explained by using the ratio of current assets
to total assets which indicates the percentage of
total assets that is current. Here we assume that
the level of total assets remains unchanged.
When the ratio increases- that is, when current
assts increase-profitability decreases. Because
current assets are less profitable than fixed
assets. Fixed assets are more profitable because
they add more value compared to the product
than provided by current assets. Without fixed
assets, the firm could not produce the product.
How changing the level of the
firm’s current assets affects its
profitability-risk trade-off?........
The risk effect, however, decreases as the
ratio of current assets to total assets
increases. Because net working capital
increases here, thereby reducing the risk of
technical insolvency.
The Firm’s Financing Need
Firm’s financing requirements can be separated
into a permanent and a seasonal need.
Permanent Need- Financing requirements for the
firm’s fixed assets plus the permanent portion of
the firm’s current assets; these requirements
remain unchanged over the year.
Seasonal Need- Financing requirements for the
temporary portion of current assets, which vary
over the year.
Net Working Capital Strategies
Aggressive Approach: Strategy by which the firm
finances at least its seasonal requirements, and
possibly some of its permanents requirements,
with short-term funds and the balance of its
permanent requirements with long-term funds.
Cost Consideration
Risk Consideration
Net Working Capital Strategies
Conservative Approach: Strategy by which the
firm finances all projects funds requirements with
long term funds and uses short-term financing only
for emergencies or unexpected outflows.
Cost consideration
Risk consideration
Spontaneous Sources of ShortTerm Financing
Spontaneous Financing- Financing that arises
from the normal operations of the firm. Major
sources here:
 Accounts Payable (trade credit from
# Open accounts
# Notes Payables
# Trade Acceptances
 Accrued Expenses/ Accruals
Open Accounts
The most common type of arrangement
where the seller ships goods to the buyer
and send an invoice that specifies the goods
shipped, the total amount due, and the term
of the sale. Open account credit derives its
name from the fact that the buyers does not
sign a formal debt instrument evidencing the
amount owed to the seller. It appears on the
buyer’s balance sheet as accounts payable.
Notes Payable
Here the buyer signs a note that
evidence a debt to the seller. The note
calls for the payment of the obligation at
some specified future date. This
arrangement is employed when the
seller wants the buyer to acknowledge
the debt formally.
Trade Acceptances
Under this arrangement, the seller draws a draft
on the buyer, ordering the buyer to pay the draft
at some future date. The seller will not release
the goods until the buyer accepts the time draft.
Accepting the draft, the buyer designates a
bank at which the draft will be paid when it
comes due. At that time, the draft becomes a
trade acceptance, and depending on the
buyer’s credit worthiness, it may posses some
degree of marketability.
Advantages of Trade Credit
 Ready
availability- because the
accounts payable of the most firms
represent a continuous form of credit.
 There is no need to formally arrange
financing- it is already there. As old
bills are paid and new credit purchase
made, new accounts payable replaces
the old ones.
Advantages of Trade Credit (cont.)
 There
is no need to negotiate with
the supplier, the decision is entirely
up to the firm.
 More flexible means of financing
because the firm does not have to
sign a note and, pledge collateral, or
adhere to a strict payment schedule
on a note.
Suggested Questions
Define working capital and net working capital.
Why proper managing of working capital is
How changing the level of the firm’s current assets
affects its profitability-risk trade-off? Explain.
Explain two forms of net working capital strategies.
Identify and explain the spontaneous sources of
short-term financing.
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