6 Working Capital and the Financing Decision Chapter McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter Outline • • • • • Working capital management. Current asset management. Asset financing. Long-term versus short-term financing. Risk and profitability vis-à-vis asset financing. 6-2 Working Capital Management • The financing and management of the current assets of a firm. – Crucial to achieving long-term objectives of the firm or its failure. – Requires immediate action. 6-3 The Nature of Asset Growth • Effective current assets management requires matching of the forecasted sales and production schedules. • Differences in actual sales and forecasted sales can result in: – Unexpected buildups. – Reduction in inventory, affecting receivables and cash flow. • Firm’s current assets could be: – Self-liquidating. – ‘Permanent’ current assets. 6-4 Controlling Assets – Matching Sales and Production • Fixed assets grow slowly with: – Increase in productive capacity. – Replacement of old equipment. • Current assets fluctuate in the short run, depending on: – Level of production versus the level of sales. • When production is higher than sales the inventory rises. • When sales are higher than production, inventory declines and receivables increase. 6-5 Controlling Assets – Matching Sales and Production (cont’d) • Cash budgeting process – Level production method • Smooth production schedules • Use of manpower and equipment efficiently to lower cost – Match sales and production as closely as possible in the short run. • Allows current assets to increase or decrease with the level of sales. • Eliminates the large seasonal bulges or sharp reductions in current assets. 6-6 Temporary Assets under Level Production – An Example • Yawakuzi Motorcycle Company – Sales fluctuations: High sales demand during early spring and summer; sales drop during October through March. – Decision: Apply level production method - 12month sales forecast is issued. – Result: Level production and seasonal sales combine to produce fluctuating inventory. 6-7 Yawakuzi Sales Forecast (in units) 6-8 Yawakuzi’s Production Schedule and Inventory 6-9 Sales Forecasts, Cash Receipts, and Payments, and Cash Budget 6-10 Sales Forecasts, Cash Receipts, and Payments, and Cash Budget (cont’d) • Table 6-3 is created to examine the buildup in accounts receivable and cash. – Sales forecast: Based on assumptions taken earlier (table 6-1). – Cash receipts: 50% cash collected during the month of sale and 50% pertains to the prior month. – Cash budget: a comparison of cash receipt and payment schedules to determine cash flow. 6-11 Total Current Assets, First Year ($millions) 6-12 Cash Budget and Assets for II Year With No Growth in Sales ($millions) • Graphic presentation of the current asset cycle. 6-13 Patterns of Financing • Selection of external sources to fund financial assets is an important decision. • The appropriate financing pattern: – Matching of asset buildup and length of financing pattern. 6-14 Matching Long-Term and ShortTerm Needs 6-15 Long-Term Financing • Firms can be assured of having adequate capital at all times: – Use long-term capital to cover part of the shortterm needs. – Long-term capital can be used to finance: • Fixed assets. • Permanent current assets. • Part of the temporary current assets. 6-16 Short- Term Financing • Small businesses do not have total access to long-term financing. – They rely on short-term bank and trade credit. – Advantage: interest rates are lower. – Short-term finances are used finance: • Temporary current assets. • Part of the permanent working capital needs. 6-17 The Financing Decision • Corporations usually have multiple financial alternatives to reduce their costs of funds. – Achieved through the use of a combination of financing methods. – Aim to strike a balance between short-term versus long-term considerations against: • The composition of the firm’s assets • The willingness to accept risk. – Influenced by the term structure of interest rates. 6-18 Alternative Financing Plans • A Decision Process: Comparing alternative financing plans for working capital. 6-19 Impact of Financing Plans on Earnings 6-20 Varying Condition and its Impact • Tight money periods – Capital is scarce making short-term financing difficult to find or may ensue very high rates. – Inadequate financing may mean loss of sales or financial embarrassment. • Expected value – Represents the sum of the expected outcomes under both conditions. 6-21 Expected Returns under Different Economic Conditions 6-22 Expected Returns for High Risk Firms 6-23 Toward an Optimal Policy • A firm should: – Attempt to relate asset liquidity to financing patterns, and vice versa. – Decide how it wishes to combine asset liquidity and financing needs. • Risk-oriented firm - short-term borrowings and low degree of liquidity. • Conservative firm - long-term financing and high degree of liquidity. 6-24 Asset Liquidity and Financing Assets 6-25 Toward an Optimal Policy • Company needs must be met by structuring: – Working capital position – The associated risk-return trade-off • The ultimate concern: – Maximize the overall valuation of the firm. – Use astute analysis of risk-return options. 6-26 6-27