88Chapt

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Chapt

er Working Capital and the

Financing DecisionWorking Capital and the

Financing Decision

Prepared by:Chara CharalambousCDA COLLEGE

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Chapter 8 – Agenda

What is Working Capital

Management?Short-Term vs. Long-Term FinancingApproaches to Working Capital Financing Summary and Conclusions

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Statement of Financial Position (Balance Sheet) as at 31st December 20YY

FixedFixed AssetsAssets

Land and BuildingsLand and BuildingsFurniture and FittingsFurniture and Fittings

Motor VechiclesMotor Vechicles

GoodwillGoodwill

€

X

XXX

CurrentCurrent AssetsAssets

StocStockk

DDebtorsebtors

BankBank

Cash Cash

X

X

X

X

Capital Capital

Add Net ProfitAdd Net ProfitLess DrawingsLess Drawings

XX

€

X X

Current LiabilitiesCurrent Liabilities

(amounts due within a year)(amounts due within a year)

CreditorsCreditorsBank OverdraftBank OverdraftShort Term LoanShort Term Loan

XX

X

Long-term Loan

X

X X

Long-term Liabilities Long-term Liabilities (repayable later than one year)(repayable later than one year)

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Balance Sheet as at 31 December Year 20XX

Fixed Assets € €

Land and BuildingsFurniture and fittings xMotor Vehicles x xGoodwil

Current Assets

Closing Inventory xDebtors xPrepayments xBank xCash x x

xxxxxxCapital Account xAdd Net Profit xLess Drawings x x

Long-trrm LiabilitiesLong term loan

Current Liabilities

Creditors xAccruals xBank Overdraft xShort term loan x X

xxxxxx4

Definitions

Current assets are cash and other assets that the firm expects to convert into cash in a year or less.

Current liabilities (or short-term liabilities) are obligations that the firm expects to pay off in a year or less.

Working capital, also called gross working capital, includes the funds invested in a company’s cash account, account receivables, inventory, and other current assets.

Net working capital (NWC) refers to the difference between current assets and current liabilities.

Liquidity is the ability of a company to convert assets—real or financial—into cash quickly without suffering a financial loss.

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NWC is important because it is a measure of liquidity and represents the net short-term investment the firm keeps in the business.

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Working Capital Accounts

The various working capital accounts are: Cash: This account includes cash and marketable securities

like Treasury securities. The higher the cash balance, the better the ability of the firm to

meet its short-term financial obligations.

Receivables: These represent the amount owed by customers who have taken advantage of the firm’s trade credit policy.

Inventory: Firms maintain inventory of raw materials and work in process and finished goods. Payables: The payables balance represents the amount owed to the

firm’s vendors and suppliers on materials purchased on credit. The accrual accounts are liabilities incurred but not yet paid, such as accrued wages or taxes.

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Working CapitalThe most common meaning for the term working capital is the difference between current assets and current liabilities:

In this usage, working capital is the dollar amount of current assets left over after the remaining current assets are allocated to pay the company's current liabilities. These “extra” current assets can be used to finance the ongoing work of the business, hence they represent the firm's “working capital.”

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Fixed assets

Fixed assets are long-term, tangible assets such as land, equipment, buildings, furniture and vehicles. Fixed assets are parts of the company that help with production and are components that last over time in the company. They are physical assets that can be seen. They are not used for liquidation purposes or cashed out in any way to aid a business financially , they contribute to the company's income.

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Working Capital

Working capital management: The administration of the firm’s current assets( cash and marketable securities, receivables, and inventory) and the financing (current liabilities) needed to support current assets.

Marketable securities is short term investments: Any equity or debt instrument that it easily saleable and can be converted into cash, or exchanged with ease. Stocks, bonds, and certificates of deposit are all considered marketable securities because there is a public demand for them and because they can be easily converted into cash.

A security is a tradable asset of any kind. Securities are broadly categorized into:

Debt securities (such as banknotes, bonds and debentures), Equity securities, e.g., common stocks

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Excessive levels of current assets can easily result in a firm realizing unsatisfactory return on investment. If the current ratio is too high (much more than 2), then the company may not be using its current assets or its short-term financing facilities efficiently. This may also indicate problems in working capital management.

However, firms with too few current assets may incur shortages and difficulties in maintaining smooth operations. All other things being equal, creditors consider a high current ratio to be better than a low current ratio, because a high current ratio means that the company is more likely to meet its liabilities which are due over the next 12 months.

For small companies, current liabilities are the principal source of external financing. These firms do not have access to the longer-term capital markets, other than to acquire a mortgage on a building. The fast-growing but larger company also makes use of current liability financing. For these reasons, the financial manager and staff devote a considerable portion of their time to working capital matters. The management of cash, marketable securities, accounts receivable, accounts payable, accruals, and other means of short-term financing is the direct responsibility of the financial manager; only the management of inventories is not. Moreover, these management responsibilities require continuous, day-to-day supervision. Unlike dividend and capital structure decisions, you cannot study the issue, reach a decision, and set the matter aside for many months to come. Thus working capital management is important, if for no other reason than the proportion of the financial manager’s time that must be devoted to it. More fundamental, however, is the effect that working capital decisions have on the company’s risk, return, and share price.

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Working Capital Basics

Working capital management involves two key issues.

What is the appropriate amount of current assets for the firm to hold? –optimal level of investment.

How should these current assets be financed – mix of short term and long term financing used to support current assets ?

These issues are affected by the trade-off that must be made between profitability and risk:

Lowering the level of investment in current assets while still being able to support sales To the extent that the costs of short term financing are less than those of long term

financing, the greater the proportion of short term debt to total debt, the higher is the profitability of the firm. 12

Although short-term interest rates sometimes exceed long-term rates, generally they are less. Even when short-term rates are higher, the situation is likely to be only temporary. Over an extended period of time, we would expect to pay more in interest cost with long-term debt than we would with short-term borrowings. These profitability assumptions suggest maintaining a low level of current assets and a high proportion of current liabilities to total liabilities. This strategy will result in a low, or possibly negative, level of net working capital. On the one hand this strategy gives us high profitability and on the other hand contains a risk , an increased risk, which has to do with maintaining sufficient current assets to:

meet its cash obligations as they occur support the proper level of sales (e.g., running out of inventory).

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Working Capital Management

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

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

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

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OPTIMAL LEVEL OF CURRENT ASSETS

To answer this question, we need to use the return on investment (ROI) equation as follows:

ROI = Net profit = Net profit

Total assets (Cash + Receivables + Inventory) + Fixed assets

From the equation above we can see that decreasing the amounts of current assets held will increase our potential profitability. If we can reduce the firm’s investment in current assets while still being able to properly support output and sales, ROI will increase. Lower levels of cash, receivables, and inventory would reduce the denominator in the equation; and net profits, our numerator, would remain roughly the same or perhaps even increase. So if the policy follow is this with low liquidity it will provide the highest profitability possible as measured by ROI.

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Current assets

However decreasing cash reduces the firm’s ability to meet financial obligations as they come due. Decreasing receivables, by adopting stricter credit terms and a tougher enforcement policy, may result in some lost customers and sales. Decreasing inventory may also result in lost sales due to products being out of stock. Therefore more aggressive working capital policies lead to increased risk. Clearly, the previous policy discussed is the most risky working capital policy. It is also a policy that emphasizes profitability over liquidity. In short, we can now make the following generalizations: regarding Liquidity, Profitability and Risk !!!

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Profitability varies inversely with liquidity.. Increased liquidity generally comes at the expense of reduced profitability.

Profitability moves together with risk (i.e., there is a trade-off between risk and return). In search of higher profitability, we must expect to take greater risks. You might say that risk and return walk hand in hand.

In the end, the optimal level of each company’s current assets (cash, marketable securities, receivables, and inventory) will be determined by management’s attitude to the trade-off between profitability and risk.

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Hedging (Maturity Matching) Approach A method of financing where each asset would be offset with

a financing instrument of the same approximate maturity. Short-term or seasonal variations in current assets would be

financed with short-term debt and all fixed assets would be financed with long-term debt or with equity. The rationale for this is that if long-term debt is used to finance short-term needs, the firm will be paying interest for the use of funds during times when these funds are not needed. It is obvious that financing would be working and be engaged in periods of seasonal quiet periods – when it is not needed. With a hedging approach to financing, the borrowing and payment schedule for short-term financing would be arranged to correspond to the expected swings in current assets. 18

For example, a seasonal expansion in inventory (and receivables) for the Christmas selling season would be financed with a short-term loan. As the inventory was reduced through sales, receivables would be built up. The cash needed to repay the loan would come from the collection of these receivables. All of this would occur within a matter of a few months. In this way, financing would be employed only when it was needed. This loan to support a seasonal need would be following a self-liquidating principle. That is, the loan is for a purpose that will generate the funds necessary for repayment in the normal course of operations.

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Permanent asset requirements would be financed with long-term debt and equity. In this situation, it would be the long-term profitability of the financed assets that would be counted on to cover the long-term financing costs. In a growth situation, permanent financing would be increased in keeping with increases in permanent asset requirements.

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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

Property and equipment, long-term investments finance with long-term loans, leases, bonds, capital stock,

retained earnings21

Short-Term vs. Long-Term Financing Although the Hedging (Maturity Matching) Approach is appropriate under

conditions of certainty, it is usually not appropriate when uncertainty exists: Net cash flows will deviate from expected flows and so there is a business risk. As a result, the schedule of maturities of the debt is very significant in assessing the risk-profitability trade-off. The question is: What margin of safety should be built into the maturity schedule to allow for adverse fluctuations in cash flows? This depends on management’s attitude to the trade-off between risk and profitability.

The Relative Risks Involved. In general, the shorter the maturity schedule of a firm’s debt obligations, the greater the risk that the firm will be unable to meet principal and interest payments.

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Financing Current Assets: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”23

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 24

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

Current asset liquidity and asset financing plan

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Working Capital Ratios

Ratios to determine the operating cycle Although there is a ratio for Operating Working Capital, operating working

capital is usually broken down into its main components:  Accounts Payable Inventory Accounts Receivable 

As always, ratios need to be understood and interpreted in relation to a firm's strategy.

Working capital liquidity ratios

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Ratios to determine the operating cycle Working Capital Turnover = Sales / Working Capital

Indicates how efficiently working capital is being used to generate sales.  The higher the number the better.

Accounts Payable Turnover = Purchases / Accounts Payable

Indicates how quickly payables are being paid.  Since accounts payable often times is similar to cost-free financing, to a point, usually a slower rate is preferred.  That is, when financing is cheap or free, repayment of the debt should be extended for as long as possible.  "Cost of Goods Sold" might be substituted for "Purchases."

Day's Payables = 365 Days / Accounts Payable Turnover

To calculate Day's payables, simply take the number calculated by the "Accounts Payable Turnover, and divide it by 365 days.  This will indicate the average number of days the firm is taking to pay its accounts payables.  e.g. If the terms of accounts payable are such that outstanding accounts payable are to be paid in 60 days, then the day's payables should also be close to 60 days. 

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Accounts Receivable Turnover = Credit Sales / Accounts Receivable

Indicates how quickly customers are paying on their accounts.  Accounts receivable is a big use of cash and so a rapid turnover is good.  i.e. The bigger the number, the better. (usually).  "Sales" might be substituted for "Credit Sales.“

Day's Receivables = 365 Days / Accounts Receivable Turnover

Indicates the number of days on average customers are taking to pay on their accounts.

Inventory Turnover = Cost of Goods Sold / Inventory

Indicates how rapidly inventory is being sold.  Usually, the faster inventory is sold, the more profitable the firm will be.  Firms with rapid turnover might include grocery stores, donut shops, etc.  A larger inventory turnover number is usually preferred over a smaller number.

Day's Inventory =365 Days / Inventory Turnover

Indicates on average how long inventory sits on a firm's shelves28

The Operating and Cash Conversion Cycles

The cash conversion cycle begins when the firm invests cash to purchase the raw materials that would be used to produce the goods that the firm manufactures and ends with the finished goods being sold to customers and the cash collected on the sales, also taking into account the time taken by the firm to pay for its purchases.

Two tools to measure the working capital management efficiency are the operating cycle and the cash conversion cycle.

The operating cycle begins when the firm receives the raw materials it purchased and ends when the firm collects cash payments on its credit sales. = Day's Receivables + Day's Inventory

Cash conversion cycle=?

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'Asset Turnover Ratio'

The amount of sales or revenues generated per dollar of assets. The Asset Turnover ratio is an indicator of the efficiency with which a company is deploying its assets.

Asset Turnover = Sales or Revenues/Total Assets In running a business, you must determine the efficiency of using your

assets relative to generating sales by calculating the financial ratio of your total assets and net sales which is referred to as the total asset turnover .

Generally speaking, the higher the ratio, the better it is, since it implies the company is generating more revenues per dollar of assets.  But since this ratio varies widely from one industry to the next, comparisons are only meaningful when they are made for different companies in the same sector

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Asset Turnover is typically calculated over an annual basis – either fiscal or calendar year – with the “Total Assets” figure used in the denominator calculated as the average of assets at the beginning and end of the year.

For example, company X may have an asset base of $400 million at the beginning of a given year and $500 million at year-end, with revenues of $900 million generated in that year. The asset turnover ratio for company X is therefore ($900 million / $450 million) = 2.

The asset turnover ratio tends to be higher for companies in a sector like consumer staples, which has a relatively small asset base but high sales volume. Conversely, firms in sectors like utilities and telecommunications, which have large asset bases, will have lower asset turnover.

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For a specific company, the trend in the asset turnover ratio over a period of time should also be reviewed to check whether asset usage is improving or deteriorating.

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Working Capital Ratios (liquidity)

The “liquidity position” of a business refers to its ability to pay its debts – i.e. does it have enough cash to pay the bills?

The balance sheet of a business provides a “snapshot” of the working capital position at a particular point in time

There are two key ratios that can be calculated to provide a guide to the liquidity position of a business:

– Current ratio

– Acid test (“quick”) ratio

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Current Ratio

Calculation Formula= Current Assets

Current Liabilities

Example Calculation:

Stocks 1125

Trade Debtors 1750

Cash Balances 650

Current Assets 3525

Trade Creditors 1025

Other Long Term Liabilities 235

Current Liabilities 1260

3525

1260= 2.8

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Acid Test (“Quick”) Ratio

Calculation Formula= Current Assets less Stocks

Current Liabilities

Example Calculation:

Stocks 1125

Trade Debtors 1750

Cash Balances 650

Current Assets 3525

Trade Creditors 1025

Other Long Term Liabilities 235

Current Liabilities 1260

3525-1125

1260= 1.9

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Interpreting the Ratios

A business needs to have enough cash (or “cash to come”) to be able to pay its debts.

Obviously, a current ratio comfortably in excess of 1 should be expected – but what is comfortable depends on the kind of business

Some businesses find it hard to turn stock and debtors into cash – so need a high current ratio.

Some businesses (e.g. supermarkets) turn stock into cash very rapidly and have low debtors – so they can happily exist with a current ratio of less than 1.

The acid test ratio is often considered to be a better test of liquidity for businesses with a low stock turnover.

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Limitations of Liquidity Ratios

Liquidity ratios should be used with care Balance sheet values at a particular moment in time may not

be typical Balances used for a seasonal business will not represent

average values Ratios can be subject to “window dressing” or manipulation

(e.g. a big push to get customers to pay outstanding balances by the year end)

Ratios concern the past (historic) not the future Working capital management is very much about ensuring

the business has sufficient cash in the future

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Ways to Improve LiquidityOption Pitfalls

Reduce the stock holding period forfinished goods and raw materials

May result in production delays or shortages if demand increases unexpectedly

Improve the efficiency of the productionprocess (e.g. shorten by using betterproduction methods)

Costly to reorganiseproduction – but may be worth it in the medium term

Reduce the credit period offered to tradedebtors and chase amounts due moreaggressively

May upset customers – or cause them to reduce the amount they buy

Extend the time taken to pay creditors A dangerous option – suppliers may refuse to supply or may charge interest if their payment terms are exceeded

Use invoice discounting or debt factoringto obtain cash from trade debtors

A good way to obtain cash quickly – but usually costly (e.g.factoring firm charges a high commission on debts paid)

Sale and leaseback of assets Another good way of releasing cash from fixed assets – but leaves the business with higher costs and payment obligations 38

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

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