Lecture 8 WORKING CAPITAL & SHORT-TERM FINANCING Working Capital Definition A firm’s investment in short-term assets-cash, marketable securities, inventory and accounts receivable. Or, 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 sources). 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 Management 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 Management 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 suppliers) # 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 important? 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.