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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
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.
slide9
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.
slide10
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.
slide15
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.
slide16
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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