© 2003 McGraw-Hill Ryerson Limited

66Chapt

er

Chapt

er Working Capital and the

Financing DecisionWorking Capital and the

Financing Decision

McGraw-Hill Ryerson ©2003 McGraw-Hill Ryerson Limited

Prepared by:Terry FegartySeneca College

Revised by:P Chua

© 2003 McGraw-Hill Ryerson Limited

Chapter 6 - Outline

What is Working Capital

Management?The Nature of Asset GrowthTerm Structure of Interest RatesShort-Term vs. Long-Term FinancingApproaches to Working Capital Financing Summary and Conclusions

PPT 6-2

© 2003 McGraw-Hill Ryerson Limited

Working Capital Management

Working capital management is financing and controlling the investment in the current assets of a firm

Sales growth often leads to a buildup in inventory and accounts receivable. Firm may require additional external financing

Goal is to achieve a balance between liquidity and profitability that contributes positively to the firm’s value.

Crucial to short-term success or failure of a business

PPT 6-3

© 2003 McGraw-Hill Ryerson Limited

Cash Conversion Cycle

Operating Cycle (OC) consists of that period of time measured by the Inventory Holding Period (IHP) or Average Age of Inventory (AAI) and the Average Collection Period (ACP) of accounts receivable.

Cash Conversion Cycle (CCC) completes the flow of the OC by subtracting the Accounts Payable Period (APP) or Average Payment Period (APP) of accounts payable.

CCC = AAI + ACP - APP

© 2003 McGraw-Hill Ryerson Limited

Cash Conversion Timeline

© 2003 McGraw-Hill Ryerson Limited

Strategies for Managing Cycle

Turn over inventory as quickly as possible (minimizing IHP).

Collect accounts receivable as quickly as possible (minimizing ACP).

Pay accounts payable as slowly as possible (maximizing APP).

© 2003 McGraw-Hill Ryerson Limited

Figure 6-1bThe nature of asset growth

Dollars

Temporary current assets

Capital assets

Time period

Permanentcurrent assets

PPT 6-5

© 2003 McGraw-Hill Ryerson Limited

Figure 6-12Yield curves showing Term Structure of Interest Rates

PPT 6-23

© 2003 McGraw-Hill Ryerson Limited

Figure 6-13Long-term and short-term interest rates

PPT 6-24

© 2003 McGraw-Hill Ryerson Limited

Short-Term vs. Long-Term Financing

Short-term financing is less expensive but riskier lower interest rates (usually) short-term rates are volatile risk of default if sales slow down risk that bank may not extend / renew loans

Long-term financing is more expensive but less risky usually higher interest rates, you may pay interest on funds you don’t always need you have capital at all times

Firm must decide the appropriate “mix”

PPT 6-21

© 2003 McGraw-Hill Ryerson Limited

Figure 6-8Matching long-term and short-term needs (Balanced Approach)

Dollars

Temporary current assets

Capital assets

Time period

Permanentcurrent assets

Short-termfinancing

Long-termfinancing

(debt & equity)

PPT 6-18

© 2003 McGraw-Hill Ryerson Limited

Hedged (Balanced) Approach to Financing Match liquidity (life) of your assets to the maturity (term) of

your financing Means your assets will be generating cash when your

liabilities come due (this reduces risk)

Balanced Financing Temporary (seasonal) build-up in inventory and accounts

receivable finance with trade credit, short-term bank loans, short-term

notes payable Permanent (minimum) levels of inventory, receivables + Property and equipment, long-term investments

finance with long-term loans, leases, bonds, capital stock, retained earnings

PPT 6-17

© 2003 McGraw-Hill Ryerson Limited

Figure 6-9Using long-term financing for part of short-term needs (Conservative)

Dollars

Temporary current assets

Capital assets

Time period

Permanentcurrent assets

PPT 6-19

Short-termfinancing

Long-termfinancing

(debt & equity)

© 2003 McGraw-Hill Ryerson Limited

Dollars

Temporary current assets

Capital assets

Time period

Permanentcurrent assets

PPT 6-20

Short-termfinancing

Long-termfinancing

(debt & equity)

Figure 6-10Using short-term financing for part of long-term needs (Aggressive)

© 2003 McGraw-Hill Ryerson Limited

Plan A Plan B Part 1. Current assets

Temporary . . . . . . . $250,000 $250,000Permanent . . . . . . . 250,000 250,000 Total current assets . . . 500,000 500,000

Short-term financing (6%). . 125,000 375,000Long-term financing (10%) . 375,000 125,000

$500,000 $500,000Part 2. Capital assets

Plant and equipment . . . . $100,000 $100,000Long-term financing (10%) . $100,000 $100,000

Part 3. Total financing (summary of parts 1 & 2)Short-term (6%) . . . . . $125,000 $375,000Long-term (10% . . . . . 475,000 225,000

$600,000 $600,000

Table 6-7Alternative financing plans

EDWARDS CORPORATION

PPT 6-25

© 2003 McGraw-Hill Ryerson Limited

Plan A

Table 6-8Impact of financing plans on earnings

Earnings before interest and taxes $200,000Interest (short-term), 6% $125,000 – 7,500Interest (long-term), 10% $475,000 – 47,500

Earnings before taxes 145,000Taxes (50%) 72,500

Earnings aftertaxes $ 72,500

Earnings before interest and taxes $200,000Interest (short-term), 6% $375,000 – 22,500Interest (long-term), 10% $225,000 – 22,500

Earnings before taxes 155,000Taxes (50%) 77,500

Earnings aftertaxes $ 77,500

Plan B

PPT 6-26

EDWARDS CORPORATION

© 2003 McGraw-Hill Ryerson Limited

Working Capital Financing Plans

A conservative (safe or cautious) firm: L/T financing and high liquidity

A moderate (balanced) firm: S/T financing and high liquidity OR L/T financing and low liquidity

An aggressive (risky) firm: S/T financing and low liquidity

Appropriate strategy is determined based on company’s tolerance for risk

PPT 6-29

© 2003 McGraw-Hill Ryerson Limited

Asset Liquidity

Financing Plan Low Liquidity High Liquidity

1 2Short-term High profit Moderate profit

High risk Moderate risk

3 4Long-term Moderate profit Low profit

Moderate risk Low risk

PPT 6-30Table 6-11Current asset liquidity and asset financing plan

© 2003 McGraw-Hill Ryerson Limited

Summary and Conclusions Working capital management involves the financing and

management of current assets, such as cash, accounts receivable, and inventory

As sales increase, a business requires additional current assets to support the higher sales volume

In a hedged approach to financing, the financial manager tries to time the due dates of liabilities to the receipt of cash from sales

Carrying more long-term debt increases the financing available, but involves a higher interest rate

Carrying more short-term debt may reduces interest costs, but increases the risk of capital shortages

Carrying more liquid current assets improves bill-paying capability, but may reduce potential profits

PPT 6-31