11
Chapter 9 Working Capital Policy

Chapter 9 Working Capital Policy. Importance of Working Capital Management Net working capital = current assets – current liabilities Net working capital

Embed Size (px)

Citation preview

Page 1: Chapter 9 Working Capital Policy. Importance of Working Capital Management Net working capital = current assets – current liabilities Net working capital

Chapter 9

Working Capital Policy

Page 2: Chapter 9 Working Capital Policy. Importance of Working Capital Management Net working capital = current assets – current liabilities Net working capital

Importance of Working Capital Management

• Net working capital = current assets – current liabilities

• Net working capital = “circulating capital”

• There is urgency to working capital decisions because of close relationship between sales growth and growth of working capital

Page 3: Chapter 9 Working Capital Policy. Importance of Working Capital Management Net working capital = current assets – current liabilities Net working capital

Importance of Working Capital Management

• Large size of working capital accounts makes working capital policy important

• First line of defense in response to revenue downturn is good working capital management

• Effective working capital management is important for survival

Page 4: Chapter 9 Working Capital Policy. Importance of Working Capital Management Net working capital = current assets – current liabilities Net working capital

Short-term versus Long-term Financing

• Short-term debt is riskier than long-term debt due to interest-rate risk and renewal risk

• Short-term debt generally is less expensive and more flexible

• Match loan maturities with asset maturities• Classic rule for going broke is to “borrow short

and invest long”• Permanent growth in level of net working capital

requires a source of permanent financing

Page 5: Chapter 9 Working Capital Policy. Importance of Working Capital Management Net working capital = current assets – current liabilities Net working capital

Term Structure of Interest Rates

• Yield to maturity = average annual compound rate of return by lender

• Term structure of interest rates shows relationship between yield to maturity and term to maturity

• In a “normal” yield curve, short-term debt yield is less than long-term

(see Exhibit 9.1)

Page 6: Chapter 9 Working Capital Policy. Importance of Working Capital Management Net working capital = current assets – current liabilities Net working capital

Term Structure of Interest Rates

• Yield curve is not always “normal”

(see Exhibit 9.2)

• Liquidity preference: long-term rates should be higher than short-term rates due to borrowers’ preference to borrow long and lenders’ preference to lend short

Page 7: Chapter 9 Working Capital Policy. Importance of Working Capital Management Net working capital = current assets – current liabilities Net working capital

Term Structure of Interest Rates

• Expectations hypothesis: yield curve is the result of market participants’ future expectations about the term structure; the average annual compound rates of return expected on short-term investments over the term of the long-term investment

• Market segmentation theory: term structure results from supply of and demand for money in each market segment

Page 8: Chapter 9 Working Capital Policy. Importance of Working Capital Management Net working capital = current assets – current liabilities Net working capital

Relative Magnitude of Working Capital Investment

• Aggressive policy maintains low level of current assets and high levels of current liabilities

• Two major benefits to an aggressive policy:– Minimizing current assets increases ROI– Short-term debt is less expensive than long-term debt

• Conservative policy maintains higher levels of current assets and is less aggressive in employing short-term debt

Page 9: Chapter 9 Working Capital Policy. Importance of Working Capital Management Net working capital = current assets – current liabilities Net working capital

Inventory Control Policy

• Aggressive policy minimizes inventory investment, leading to increased ROI

• Aggressive policy increases possibility of production shortages due to inventory shortages and lost sales due to stockouts

• Economic order quantity model is detailed in chapter 10

Page 10: Chapter 9 Working Capital Policy. Importance of Working Capital Management Net working capital = current assets – current liabilities Net working capital

Credit Policy

• Policy variables for management of accounts receivable need to be established

• Terms under which credit will be offered need to be set up

• To whom credit will be offered also must be decided

• There is a relationship between accounts receivable and short-term liability structure

Page 11: Chapter 9 Working Capital Policy. Importance of Working Capital Management Net working capital = current assets – current liabilities Net working capital

Accounts Payable Payment Policy

• Determine payment terms and whether or not to take discounts

• Assess cost and availability of money versus imputed interest rate of missed discounts

• Payment policy has an impact on credit rating