Chapter 8 Overview of Working Capital Management 8

Chapter 8 Overview of Working Capital Management 8. 1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

After Studying Chapter 8, you should be able to: 1. 2. 3. 4. 5. 6. 7. 8. 2 Explain how the definition of "working capital" differs between financial analysts and accountants. Understand the two fundamental decision issues in working capital management – and the trade-offs involved in making these decisions. Discuss how to determine the optimal level of current assets. Describe the relationship between profitability, liquidity, and risk in the management of working capital. Explain how to classify working capital according to its “components” and according to “time” (i. e. , either permanent or temporary). Describe the hedging (maturity matching) approach to financing and the advantages/disadvantages of short- versus long-term financing. Explain how the financial manager combines the current asset decision with the liability structure decision. Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Corporate Value & Required investment in Operations 8. 3 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Working Capital Concepts Net Working Capital Current Assets – Current Liabilities. Gross Working Capital The firm’s investment in current assets. Working Capital Management The management of the firm’s current assets and the financing needed to support current assets. 8. 4 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Significance of Working Capital Management • • • 8. 5 In a typical manufacturing firm, current assets exceed one-half of total assets. Excessive levels can result in a substandard Return on Investment (ROI). Current liabilities are the principal source of external financing for small firms. Requires continuous, day-to-day managerial supervision. Working capital management affects the company’s risk, return, and share price. Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

The Tradeoff Between Profitability & Risk A ‘tradeoff’ exists between profitability and risk. Profitability: The relationship between revenues and costs generated by using the firm’s assets (current and non current) in productive activities. Risk: The probability that the firm will become technically insolvent. Generally, the greater the firm’s net working capital, the more liquid the firm is, and consequently the lower its risk. 8. 6 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Summary of the Optimal Amount of Current Assets SUMMARY OF OPTIMAL CURRENT ASSET ANALYSIS Policy A B C Liquidity High Average Low Profitability Low Average High Risk Low Average High 1. Profitability varies inversely with liquidity. 2. Profitability moves together with risk. (risk and return go hand in hand!) 8. 7 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Changes In Current Assets & Current Liabilities 8. 8 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Classifications of Working Capital • Components • Cash, marketable securities, receivables, and inventory Time • 8. 9 • Permanent • Temporary Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Permanent Working Capital DOLLAR AMOUNT The amount of current assets required to meet a firm’s long-term minimum needs. Permanent current assets TIME 8. 10 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Temporary Working Capital DOLLAR AMOUNT The amount of current assets that varies with seasonal requirements. Temporary current assets Permanent current assets TIME 8. 11 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

The Cash Conversion Cycle Slides 12 -21 are based on the Gitman handout. See also Van Horne pp 146 -148 Operating Cycle: The time from the beginning of the production process to collection of cash from the sale of the finished product. Calculated by: OC = AAI + ACP [Equation 14. 1] 8. 12 Where: AAI = Average of inventory ACP = Average collection period Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

The Cash Conversion Cycle The amount of time the firm’s resources are tied up. Calculated by: CCC = OC – APP [Equation 14. 2] OR CCC = AAI + ACP – APP [Equation 14. 3] 8. 13 Where: OC = Operating cycle APP = Average payment period Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

The Cash Conversion Cycle 8. 14 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

The Cash Conversion Cycle 8. 15 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Strategies For Managing The Cash Conversion Cycle 8. 16 Aim is to minimise the length of the cash conversion cycle. Strategies to achieve this include: Turnover inventory as quickly as possible without stockouts. Collect accounts receivable as quickly as possible. Manage mail, processing and clearing time. Pay accounts as slowly as possible without damaging the firm’s credit rating. Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Funding Requirements Of The Cash Conversion Cycle Permanent Funding Requirement: The firm’s constant investment in operating assets resulting from constant sales over time. Seasonal Funding Requirement: The firm’s investment in operating assets that varies over time as a result of cyclic sales. 8. 17 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Funding Requirements Of The Cash Conversion Cycle 8. 18 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Funding Requirements Of The Cash Conversion Cycle 8. 19 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Funding Requirements Of The Cash Conversion Cycle 8. 20 Aggressive Funding Strategy: Where the firm funds its seasonal requirements with short term debt and its permanent requirements with long term debt. 5. Amount of funding needed equals estimated funding requirements. Therefore there are no surplus balances Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Funding Requirements Of The Cash Conversion Cycle Conservative Funding Strategy: Where the firm funds both its seasonal and its permanent requirements with long term debt. 6. 8. 21 Peak seasonal needs – permanent need – average seasonal need 1, 125, 000 – 135, 000 – 101, 250 = 888, 750 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Financing Current Assets: Short. Term and Long-Term Mix Spontaneous Financing: Trade credit, and other payables and accruals, that arise spontaneously in the firm’s day-to-day operations. 8. 22 • Based on policies regarding payment for purchases, labor, taxes, and other expenses. • We are concerned with managing nonspontaneous financing of assets. Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Risks vs. Costs Trade-Off (Conservative Approach) • Long-Term Financing Benefits • • • Long-Term Financing Risks • • • Borrowing more than what is necessary Borrowing at a higher overall cost (usually) Result • 8. 23 Less worry in refinancing short-term obligations Less uncertainty regarding future interest costs Manager accepts less expected profits in exchange for taking less risk. Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Risks vs. Costs Trade-Off (Conservative Approach) Firm can reduce risks associated with short-term borrowing by using a larger proportion of long-term financing. DOLLAR AMOUNT Short-term financing Current assets Long-term financing Fixed assets TIME 8. 24 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Comparison with an Aggressive Approach • Short-Term Financing Benefits • • • Short-Term Financing Risks • • • Refinancing short-term obligations in the future Uncertain future interest costs Result • 8. 25 Financing long-term needs with a lower interest cost than short-term debt Borrowing only what is necessary Manager accepts greater expected profits in exchange for taking greater risk. Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Risks vs. Costs Trade-Off (Aggressive Approach) Firm increases risks associated with short-term borrowing by using a larger proportion of short-term financing. DOLLAR AMOUNT Short-term financing Current assets Long-term financing Fixed assets TIME 8. 26 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Summary of Short- vs. Long-Term Financing Maturity Asset Maturity SHORT-TERM LONG-TERM SHORT-TERM (Temporary) Temporary Moderate Risk-Profitability Low Risk-Profitability LONG-TERM (Permanent) Permanent 8. 27 High Risk-Profitability Moderate Risk-Profitability Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.