Working Capital Management:
Current Asset Management
and Short-Term Financing
Corporate Finance
Dr. A. DeMaskey
Learning Objectives
• Questions to be answered:
– What is working capital management?
– What is the appropriate amount of current assets for the
firm to carry, both in total and for each specific
account?
– How should current assets be financed?
– What are the major sources of short-term financing?
– What are the costs associated with each type of
financing?
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Working Capital Terminology
• Gross working capital
– Total current assets
• Net operating working capital
– Current assets - Current liabilities
• Working capital policy:
– The level of each current asset.
– How current assets are financed.
(More…)
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Working Capital Terminology
• Working capital management:
– Includes both establishing working capital
policy and then the day-to-day control of:
•
•
•
•
Cash
Inventories
Receivables
Short-term liabilities
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Alternative Current Asset
Investment Policies
Current Assets ($)
Relaxed
Moderate
Restricted
Sales ($)
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Cash Conversion Cycle
• The cash conversion cycle focuses on the
time between payments made for materials
and labor and payments received from
sales:
– Inventory conversion period
– Receivables collection period
– Payables deferral period
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Goal of Cash Management
• Cash is a non-earning asset.
• To minimize the amount of cash in order to
conduct normal business activities.
• To have sufficient cash in order to:
– Take trade discounts.
– Maintain credit rating.
– Meet unexpected cash needs.
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Reasons for Holding Cash
• Transactions balances
Primary reasons
• Compensating balances
• Precautionary balances
Secondary reasons
• Speculative balances
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Cash Budget: The Primary
Cash Management Tool
• Purpose: Uses forecasts of cash inflows,
outflows, and ending cash balances to
predict loan needs and funds available for
temporary investment.
• Timing: Daily, weekly, or monthly,
depending upon budget’s purpose. Monthly
for annual planning, daily for actual cash
management.
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Data Required for Cash Budget
1. Sales forecast.
2. Information on collections delay.
3. Forecast of purchases and payment terms.
4. Forecast of cash expenses: wages, taxes,
utilities, and so on.
5. Initial cash on hand.
6. Target cash balance.
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Ways to Minimize Cash
Holdings
•
•
•
•
•
Use lockboxes.
Insist on wire transfers from customers.
Synchronize inflows and outflows.
Use a remote disbursement account.
Increase forecast accuracy to reduce the need for a
cash “safety stock.”
• Hold marketable securities instead of a cash
“safety stock.”
• Negotiate a line of credit (also reduces need for a
“safety stock”).
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Working Capital Financing
Policies
• Maturity Matching: Matches the maturity
of the assets with the maturity of the
financing.
• Aggressive: Uses short-term (temporary)
capital to finance some permanent assets.
• Conservative: Uses long-term (permanent)
capital to finance some temporary assets.
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Maturity Matching Financing
Policy
$
Temp. C.A.
S-T
Loans
Perm C.A.
L-T Fin:
Stock,
Bonds,
Spon. C.L.
Fixed Assets
Years
What are “permanent” assets?
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Aggressive Financing Policy
$
Temp. C.A.
S-T
Loans
Perm C.A.
L-T Fin:
Stock,
Bonds,
Spon. C.L.
Fixed Assets
Years
More aggressive the lower the dashed line.
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Conservative Financing Policy
$
Marketable Securities
Zero S-T
debt
Perm C.A.
L-T Fin:
Stock,
Bonds,
Spon. C.L.
Fixed Assets
Years
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Working Capital Policy
• The choice of working capital policy is a
classic risk/return tradeoff.
• The aggressive policy promises the highest
return but carries the greatest risk.
• The conservative policy has the least risk
but also the lowest expected return.
• The moderate (maturity matching) policy
falls between the two extremes.
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Marketable Securities
• Interest-bearing short-term securities
• Level of liquid assets held
– Interest rate
– Transaction costs
– Variability in cash flows
• Choosing marketable securities
–
–
–
–
–
Default risk
Marketability or liquidity
Maturity
Purchasing power risk
Rate of return
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Short-Term Financing
• Short-term debt is riskier than long-term debt for
the borrower.
– Short-term rates may rise.
– May have trouble rolling debt over.
• Advantages of short-term debt.
– Typically lower cost.
– Can get funds relatively quickly with low transactions
costs.
– Can repay without penalty.
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Major Sources of Short-Term
Financing
• Short-term credit: Debt requiring
repayment within one year.
• Major sources:
–
–
–
–
Accruals
Accounts payable (trade credit)
Bank loans
Commercial paper
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Trade Credit
• Trade credit is credit furnished by a firm’s
suppliers.
– Free trade credit
– Costly trade credit
• Trade credit is often the largest source of
short-term credit for small firms.
• Trade credit is spontaneous and relatively
easy to get, but the cost can be high.
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Bank Loans
• Mature in one year or less.
• Compensating balance requirement
• Types of bank loans:
– Line of credit
– Revolving credit agreement
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Interest Cost of Bank Loans
•
•
•
•
•
Regular, or simple, interest
Discount interest
Add-on interest
Annual percentage rate
Interest rate with compensating balance
requirement
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Effective Annual Percentage
Rate
• To be able to compare loan cost rates and
choose the alternative with the lowest cost.
• Because the loans have different terms, we
must make the comparison on the basis of
EARs.
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Commercial Paper
•
•
•
•
Unsecured promissory note
Issued by large, financially sound firms
Average maturity of five months
Interest rate is less than prime rate but
slightly more than T-Bill rate
• Commercial paper market is impersonal
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