Working Capital Management
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Working Capital refers to a company’s
Current Assets
Current Assets: Cash and Equivalents,
Accounts Receivable, and Inventory
Working Capital Management: Applying
Investment and Financing Decisions
to Current Assets
Investment Decision Applied to
Current Assets
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What current assets to own?
We know which ones are needed - we
need to know what level of each the firm
should have.
How much cash does firm need?
How much accounts receivable should
be carried (what is firm’s credit policy)?
How much inventory is needed?
Financing Decision Applied to
Current Assets
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How to finance current assets?
For most firms, CA exceed CL
Therefore, part of CA is being financed
by long-term sources (debt or equity)
How is financing of CA split between
short-term sources (CL) and long-term
sources ( long-term debt and equity)?
Tradeoffs in Working Capital
Management
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In making the investment and financing
decision for current assets, face tradeoff
between
Liquidity: Ability to pay bills, keep sales
coming in, keep customers happy, play
it safe
Profitability: Size of earnings after taxes
Measuring Liquidity and
Profitability
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Liquidity: NWC = CA - CL
Liquidity: Current Ratio = CA/CL
Profitability: Return on Total Assets
ROA = EAT/TA
Also use Current Asset Turnover to see
how efficiently current assets are used
CAT = Sales/CA
Classifying Current Assets
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Permanent Current Assets = minimum
level of cash, A/R, and inventory
needed to stay in business (PCA)
Temporary Current Assets =
fluctuations in cash, A/R, and inventory
corresponding to fluctuations in sales
(TCA)
Matching Principle of WCM
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Match the maturity of the sources of
financing (CL, LTD, E) with the maturity
of the uses (TCA, PCA, FA)
Use CL to finance TCA
Use LTD & E to finance PCA and FA
Conservative Approach to WCM
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Objective: Improve Liquidity
Level of Current Assets:
1) Cash: Maintains large cash balance.
– Benefit: Able to pay bills easily.
– Cost: Cash could be earning a higher rate
of return if it was invested elsewhere.
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2) A/R: Permits high level of accounts
receivable: Liberal Credit Policy (easy to
get credit)
– Benefit: Keeps sales high, keeps
customers happy.
– Cost: High bad debt expense.
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3) Inventory: Maintains high level of
inventory.
– Benefit: Keeps sales high, keeps
customers happy.
– Cost: High carrying costs, funds could earn
higher return invested elsewhere
Conservative Financing
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Financing of Current Assets:
Use more long-term financing than the
matching principle calls for.
– Benefit: Have the money raised all at once
and available to spend- no frequent
refinancings.
– Cost: Long-term debt usually has higher
interest rate than short-term debt, pay
more interest expense.
Summary of Conservative
Approach
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Level of CA: High cash, A/R, inventory
Financing of CA: More long-term
sources used
Benefit: Increased liquidity
Cost: Decreased profitability
Measures Indicating
Conservative Approach
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High Level of Net Working Capital
High Current Ratio
Low Return on Total Assets
Low Current Asset Turnover
Aggressive Approach to WCM
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Objective: Improve Profitability
Level of Current Assets:
1) Cash: Keep minimum amount
needed.
– Benefit: Cash is not in no or low interest
accounts, invested elsewhere earning
higher rate of return.
– Cost: May not be able to pay bills, no extra
cash for emergencies.
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2) A/R: Keeps receivables low, Tight
Credit Policy (hard to get credit from
them).
– Benefit: Low bad debt expense.
– Cost: Unhappy customers, sales drop.
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3) Inventory: Minimum investment in
inventory.
– Benefit: Low carrying costs, money
invested elsewhere.
– Cost: Unhappy customers, sales drop.
Aggressive Financing
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Financing of Current Assets:
Uses more short-term financing than the
matching principle calls for.
– Benefit: Short-term debt usually carries
lower interest rate than long-term debt,
lower interest expense.
– Cost: Frequent refinancing, may have to
borrow at higher rates in future, refinancing
risk.
Summary of Aggressive
Approach
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Level of CA: Low cash, A/R, inventory
Financing of CA: Uses more short-term
sources of financing
Benefit: Increased Profitability
Cost: Decreased Liquidity
Measures Indicating Aggressive
Approach
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Low level of Net Working Capital
Low Current Ratio
High Return on Total Assets
High Current Asset Turnover