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Chapter 14 Working Capital Management. Key Sections (pages 441 - 446) Risk/return trade-offs in Working Capital Management Hedging principle. Introduction. Net WC – current assets less current liabilities

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Chapter 14 working capital management
Chapter 14Working Capital Management

  • Key Sections (pages 441 - 446)

    Risk/return trade-offs in Working Capital Management

    Hedging principle


Introduction
Introduction

  • Net WC – current assets less current liabilities

  • Liquidity management – establish current asset and liability levels so firm can meet its obligations

  • Short-term – under one year. How much and from what sources?

  • On average, 15% of sales in working capital


Current liabilities
Current Liabilities

Advantages

  • Flexibility

  • Lower interest cost on short-term debt

    Disadvantages

    - Causes increase in risk of illiquidity especially

    if financial condition deteriorates

    - Uncertain interest costs year to year


Risk return trade off liquidity versus profitability
Risk/Return Trade-offLiquidity versus Profitability

  • Large current assets reduce risk of production stoppages, lost sales and inability to pay bills

  • But as WC  , no increase in returns

    • With no increase in profits, ROI drops

  • Greater reliance on current liabilities, greater risk of illiquidity


Short term long term trade offs
Short-term, Long-termTrade-offs

  • Risk of illiquidity

    • What happens if can’t obtain or roll over S-T debt?

    • Xerox, GM, Ford, etc as ratings deteriorated

  • S-T less costly than L-T and more flexible

  • Uncertainty of interest costs from year to year

  • Trade-off – increased risk of illiquidity versus increased profitability


Sources of financing
Sources of Financing

Assets – temporary (seasonal) or permanent

Spontaneous sources – arise in normal course of business

Trade credit – accounts payable

Other payables and accruals

Discretionary sources – from an explicit decision by management, both short and long-term borrowings


Hedging principle
Hedging Principle

  • Maturity should follow cash flows of asset being financed

    - S-T Financing should be self-liquidating

  • After spontaneous sources used, finance

    - Temporary assets with current liabilities.

    - Permanent assets with permanent financing, including permanent part of working capital



Working capital management need for integrative approach
Working Capital ManagementNeed for Integrative Approach

  • People are expensive so automate!

    • Requires external and internal teamwork to integrate systems for paperless environment

  • Customers, suppliers, banks, company

  • MSIS, Finance and Production


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