Working capital management
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Working Capital Management. 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.

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Working Capital Management

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Working capital management

Working Capital Management

  • 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

Investment Decision Applied to Current Assets

  • 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

Financing Decision Applied to Current Assets

  • 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

Tradeoffs in Working Capital Management

  • 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

Measuring Liquidity and Profitability

  • 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

Classifying Current Assets

  • 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

Matching Principle of WCM

  • 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

Conservative Approach to WCM

  • Objective: ImproveLiquidity

  • 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.


Working capital management

  • 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.


Working capital management

  • 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

Conservative Financing

  • 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

Summary of Conservative Approach

  • 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

Measures Indicating Conservative Approach

  • High Level of Net Working Capital

  • High Current Ratio

  • Low Return on Total Assets

  • Low Current Asset Turnover


Aggressive approach to wcm

Aggressive Approach to WCM

  • 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.


Working capital management

  • 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.


Working capital management

  • 3) Inventory: Minimum investment in inventory.

    • Benefit: Low carrying costs, money invested elsewhere.

    • Cost: Unhappy customers, sales drop.


Aggressive financing

Aggressive Financing

  • 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

Summary of Aggressive Approach

  • 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

Measures Indicating Aggressive Approach

  • Low level of Net Working Capital

  • Low Current Ratio

  • High Return on Total Assets

  • High Current Asset Turnover


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