working-capital management chapter 14

Working-Capital Management

Chapter 14

Keown Martin Petty - Chapter 15 2

What is Working Capital?What is Working Capital? The firm’s investment in current The firm’s investment in current

assetsassets



Net Working CapitalNet Working Capital The difference between the firm’s The difference between the firm’s

current assets and current current assets and current liabilitiesliabilities




Current AssetsCurrent Assets cash, marketable securities, inventory, cash, marketable securities, inventory,

accounts receivableaccounts receivable Long-Term AssetsLong-Term Assets

equipment, buildings, landequipment, buildings, land Which earn Which earn higher rates of returnhigher rates of return??

Long-term assetsLong-term assets Which help avoid risk of Which help avoid risk of illiquidityilliquidity??

Current AssetsCurrent Assets



CurrentCurrent AssetsAssets cash, marketable securities, inventory, cash, marketable securities, inventory,

accounts receivableaccounts receivable Long-TermLong-Term AssetsAssets

equipment, buildings, landequipment, buildings, land

Risk-Return Trade-off:Risk-Return Trade-off:

Current assets earn low returns, but Current assets earn low returns, but help reduce thehelp reduce the risk of illiquidity. risk of illiquidity.



Current LiabilitiesCurrent Liabilities short-term notes, accrued expenses, short-term notes, accrued expenses,

accounts payableaccounts payable Long-Term Debt and EquityLong-Term Debt and Equity

bonds, preferred stock, common stockbonds, preferred stock, common stock

Which are more Which are more expensiveexpensive for the firm? for the firm? Which help avoid risk of Which help avoid risk of illiquidityilliquidity??



CurrentCurrent LiabilitiesLiabilities short-term notes, accrued expenses, short-term notes, accrued expenses,

accounts payableaccounts payable Long-Term Debt and EquityLong-Term Debt and Equity

bonds, preferred stock, common stockbonds, preferred stock, common stock

Risk-Return Trade-off:Risk-Return Trade-off:

Current liabilities are less expensive, Current liabilities are less expensive, but increase thebut increase the risk of illiquidity. risk of illiquidity.


Balance SheetBalance Sheet

Current Assets Current LiabilitiesCurrent Assets Current Liabilities

Fixed AssetsFixed Assets Long-Term Debt Long-Term Debt

Preferred StockPreferred Stock

Common StockCommon Stock

To illustrate, let’s finance all To illustrate, let’s finance all current assetscurrent assets with with current liabilitiescurrent liabilities, and , and finance all finance all fixed assets with long-term financingfixed assets with long-term financing..



Current Assets Current LiabilitiesCurrent Assets Current Liabilities




Suppose we use Suppose we use long-termlong-term financing to financing to finance some of our finance some of our current assetscurrent assets. .

This strategy would be This strategy would be less riskyless risky, but , but more more expensive!expensive!



Current Assets Current Assets Current LiabilitiesCurrent Liabilities




Suppose we use Suppose we use current liabilitiescurrent liabilities to to finance some of our finance some of our fixed assetsfixed assets. .

This strategy would be This strategy would be less expensiveless expensive, but , but more riskymore risky!!


The Hedging Principle

PermanentPermanent AssetsAssets (those held (those held >> 1 year) 1 year) should be financed with permanent and should be financed with permanent and

spontaneous sources of financing.spontaneous sources of financing. TemporaryTemporary AssetsAssets (those held (those held << 1 year) 1 year)

should be financed with temporary should be financed with temporary sources of financing.sources of financing.



TemporaryTemporary Temporary Temporary

Current Assets Current Assets Short-term financing Short-term financing

PermanentPermanent PermanentPermanent

Fixed AssetsFixed Assets FinancingFinancing

andand

SpontaneousSpontaneous

FinancingFinancing


The Hedging Principle

Permanent FinancingPermanent Financing intermediate-term loans, long-term debt, intermediate-term loans, long-term debt,

preferred stock, common stockpreferred stock, common stock Spontaneous FinancingSpontaneous Financing

accounts payable that arise spontaneously accounts payable that arise spontaneously in day-to-day operations (trade credit, in day-to-day operations (trade credit, wages payable, accrued interest and taxes)wages payable, accrued interest and taxes)

Short-term financingShort-term financing unsecured bank loans, commercial paper, unsecured bank loans, commercial paper,

loans secured by A/R or inventoryloans secured by A/R or inventory


Sources of Short-term Credit

UnsecuredUnsecured accrued wages and taxesaccrued wages and taxes trade credittrade credit bank creditbank credit commercial papercommercial paper

SecuredSecured accounts receivable loansaccounts receivable loans inventory loansinventory loans

Working Capital

Keown Martin Petty - Chapter 15

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Working Capital Working capital – The firm’s total

investment in current assets.

Net working capital – The difference between the firm’s current assets and its current liabilities.

This chapter focuses on net working capital.


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Managing Net Working Capital

Managing net working capital is concerned with managing the firm’s liquidity. This entails managing two related aspects of the firm’s operations:

1. Investment in current assets

2. Use of short-term or current liabilities


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Risk-Return Trade-off


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Use of Current versus Fixed Assets

Holding more current assets will reduce the risk of illiquidity.

However, liquid assets like cash and marketable securities earn relatively less compared to other assets. Thus larger amount liquid investments will reduce overall rate of return

The Trade-off: Increased liquidity must be traded-off against the firm’s reduction in return on investment.


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Use of Current versus Long-term Debt

Other things remaining the same, the greater the firm’s reliance on short-term debt or current liabilities in financing its assets, the greater the risk of illiquidity.

Trade-off: A firm can reduce its risk of illiquidity through the use of long-term debt at the expense of a reduction in its return on invested funds. Trade-off involves an increased risk of illiquidity versus increased profitability.


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Advantages of Current Liabilities: Return

Flexibility

Current liabilities can be used to match the timing of a firm’s needs for short-term financing. Example: Obtaining seasonal financing versus long-term financing for short-term needs.

Interest Cost

Interest rates on short-term debt are lower than on long-term debt.


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Disadvantages of Current Liabilities: Risk

Risk of illiquidity increases due to:

Short-term debt must be repaid or rolled over more often

Uncertainty of interest costs from year to year

The Appropriate Level of Working Capital


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Appropriate Level of Working Capital

Managing working capital involves interrelated decisions regarding investments in current assets and use of current liabilities.

Hedging Principle or Principle of Self-Liquidating Debt provides a guide to the maintenance of appropriate level of liquidity.


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Hedging Principle

Involves matching the cash flow generating characteristics of an asset with the maturity of the source of financing used to finance its acquisition.

Thus a seasonal need for inventories should be financed with a short-term loan or current liability.

On the other hand, investment in equipment expected to last for a long time should be financed with long-term debt.


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Permanent and Temporary Assets

Permanent investments

Investments that the firm expects to hold for a period longer than one year

Temporary Investments

Current assets that will be liquidated and not replaced within the current year


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Sources of Financing

Total assets will equal the sum of temporary, permanent and spontaneous sources of financing.


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Temporary & Permanent Source

Temporary sources of financing consist of current liabilities such as short-term secured and unsecured notes payable.

Permanent sources of financing include: intermediate-term loans, long-term debt, preferred stock common equity


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Spontaneous Sources of Financing

Spontaneous sources of financing arise spontaneously in the firm’s day-to-day operations. Trade credit is often made available

spontaneously or on demand from the firm’s supplies when the firm orders its supplies or more inventory of products to sell.

Trade credit appears on a balance sheet as accounts payable.

Wages and salaries payable, accrued interest and accrued taxes also provide valuable sources of spontaneous financing.


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Also see table 15-1


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Hedging Principle Summary

Asset needs of the firm not financed by spontaneous sources should be financed in accordance with this rule:

Permanent-asset investments are financed with permanent sources, and temporary investments are financed with temporary sources.

Cash Conversion Cycle


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Cash Conversion Cycle A firm can minimize its working capital by

speeding up collection on sales, increasing inventory turns, and slowing down the disbursement of cash.

Cash Conversion cycle (CCC) captures the above.

CCC = days of sales outstanding + days of sales in inventory – days of payables outstanding.


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Short-term credit sources can be classified into two basic groups:

Unsecured

Secured


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Unsecured Loans

Unsecured loans include all of those sources that have as their security only the lender’s faith in the ability of the borrower to repay the funds when due.

Major sources:

Accrued wages and taxes, trade credit, unsecured bank loans, and commercial paper


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Secured Loans Involve the pledge of specific assets as

collateral in the event that the borrower defaults in payment of principal or interest.

Primary Suppliers: Commercial banks, finance companies, and

factors

Principal sources of collateral: Accounts receivable and inventories


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Unsecured Source:Trade Credit Trade credit arises spontaneously with

the firm’s purchases. Often, the credit terms offered with trade credit involve a cash discount for early payment.

Terms such as 2/10 net 30 means a 2% discount is offered for payment within 10 days, or the full amount is due in 30 days

A 2% penalty is involved for not paying within 10 days.


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Effective Cost of Passing Up a Discount

Terms 2/10 net 30The equivalent APR of this discount is:APR = $.02/$.98 X [1/(20/360)]

= .3673 or 36.73%

The effective cost of delaying payment for 20 days is 36.73%

working-capital management chapter 14

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