Chapter 3.Working Capital Management.ppt

Working Capital Management

Section 1General Outlines of Working

Capital Management

2

Financial Decisions Revisited

3

Working Capital Expressed as difference between current assets and current

liabilities;

Can be interpreted as money available to a company for day-to-day operations;

It’s a common measure of a company's liquidity, efficiency, and overall health;

Includes inventory accounts receivable, accounts payable, accruals and short-term debts;

4

Why It Matters? Positive working capital

generally indicates that a company is able to pay off its short-term liabilities almost immediately;

It means that company is able to maintain or grow sales, pay bills slowly, or collect receivables quickly;

5

Problems with Working Capital Formula

The formula assumes that a company really would liquidate its current assets to pay current liabilities, which is not always realistic;

a. the timing of receivables collection and payables due may not overlap all the times;

b. some cash is always needed to meet payroll obligations and maintain operations;

c. accounts receivable are not always readily available for collection, and some of

them may be treated as bad debts;6

Measuring of Working CapitalCurrent Ratio

Current Ratio=Current Assets/Current Liabilities

Shows the ability of a business to pay for its current liabilities with its current assets;

A working capital ratio of less than 1.0 is a strong indicator that there will be liquidity problems in the future, while a ratio in the

vicinity of 2.0 is considered to represent good short-term liquidity;

ExampleYear 1 Year 2 Year 3

Current Assets $4,000,000 $8,200,000 $11,700,000

Current Liabilities $2,000,000 $4,825,000 $9,000,000

Current Ratio 2:1 1.7:1 1.3:1

Current ratio formula may be misleading by yielding higher results:

a)when current assets are built on the account of inventories(they are hard to liquidate in short term basis

especially when inventory turnover ratio is low); b) the same pitfalls are valid in the case of receivables;

8

Measuring of Working CapitalQuick Ratio

Indicates company’s ability to meet its short-term obligations with its most liquid assets. For this reason, the ratio exclude inventories as it takes some time to convert them into cash. The higher the quick ratio, the better the

company's liquidity position.

Quick Ratio=(Current Assets-Inventories)/Current Liabilities

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Working Capital Management

Focuses on two specific issues; a)administration of the firm’s current assets;

b)the financing needed to support current assets;

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Significance of Working Capital Management

In a typical manufacturing firm, current assets exceed one-half of total assets;

Excessive levels can result in a substandard Return on Investment (ROI);

Low current asset level may lead shortages and difficulties in maintaining smooth operations;

Working capital management affects the company’s risk, return, and share price;

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Working Capital Management Policy

A conservative approach aims to reduce the risk of system breakdown by holding high levels of gross workingcapital;

An aggressive approach aims to reduce financing costs and increaseprofitability by cutting inventories, speeding up collections from customersand delaying payments to suppliers;

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Working Capital Policy Illustrations

Assumptions• 50,000 maximum

units of production• Continuous

production• Three different

policies for current asset levels are possible

Optimal Amount (Level) of Current Assets

0 25,000 50,000OUTPUT (units)

AS

SE

T LE

VE

L ($

)

Current Assets

Policy CPolicy C

Policy APolicy A

Policy BPolicy B

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Impact on Liquidity

Liquidity AnalysisPolicyPolicy LiquidityLiquidity AA HighHigh BB AverageAverage CC LowLow

Greater current asset levels generate more

liquidity; all other factors held constant.


0 25,000 50,000OUTPUT (units)

AS

SE

T LE

VE

L ($

)

Current Assets

Policy CPolicy C

Policy APolicy A

Policy BPolicy B

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Impact on Expected Profitability

Return on Investment Return on Investment =

Net ProfitNet ProfitTotal AssetsTotal Assets

Let Current Assets Current Assets = (Cash + Rec. + Inv.)

Return on Investment Return on Investment =

Net ProfitNet ProfitCurrent Current + Fixed AssetsFixed Assets


0 25,000 50,000OUTPUT (units)

AS

SE

T LE

VE

L ($

)

Current Assets

Policy CPolicy C

Policy APolicy A

Policy BPolicy B

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Impact on Expected Profitability

Profitability AnalysisPolicyPolicy ProfitabilityProfitability AA LowLow BB AverageAverage CC HighHigh

As current asset levels decline, total assets will decline and the ROI will

rise.


0 25,000 50,000OUTPUT (units)

AS

SE

T LE

VE

L ($

)

Current Assets

Policy CPolicy C

Policy APolicy A

Policy BPolicy B

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Impact on Risk

• Decreasing cash reduces the firm’s ability to meet its financial obligations. More More risk!risk!

• Stricter credit policies reduce receivables and possibly lose sales and customers. More risk!More risk!

• Lower inventory levels increase stockouts and lost sales. More risk!More risk!


0 25,000 50,000OUTPUT (units)

AS

SE

T LE

VE

L ($

)

Current Assets

Policy CPolicy C

Policy APolicy A

Policy BPolicy B

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Impact on Risk

Risk AnalysisPolicyPolicy RiskRisk AA LowLow BB AverageAverage CC HighHigh

Risk increases as the level of current assets are

reduced.


0 25,000 50,000OUTPUT (units)

AS

SE

T LE

VE

L ($

)

Current Assets

Policy CPolicy C

Policy APolicy A

Policy BPolicy B

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Summary of the Optimal Amount of Current AssetsSSUMMARYUMMARY O OFF O OPTIMALPTIMAL C CURRENTURRENT A ASSETSSET A ANALYSISNALYSIS

PolicyPolicy LiquidityLiquidity ProfitabilityProfitability RiskRisk AA High High Low Low Low Low BB AverageAverage Average Average Average Average CC Low Low High High High High

1. Profitability varies inversely with liquidity. 2. Profitability moves together with risk.

(risk and return go hand in hand!)

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Section 2Financing of Current Assets

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Hedging (or Maturity Matching) Approach

A method of financing where each asset would be offset with a A method of financing where each asset would be offset with a financing instrument of the same approximate maturity.financing instrument of the same approximate maturity.

If long-term debt is used for financing short-term needs, the firm If long-term debt is used for financing short-term needs, the firm will be paying interest for the use of funds during times when those will be paying interest for the use of funds during times when those

funds are not neededfunds are not needed

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Self-Liquidating Nature of Short-Term Loans

Seasonal orders require the purchase of inventory beyond current levels;

Increased inventory is used to meet the increased demand for the final product.

Sales become receivables; Receivables are collected and become cash; The resulting cash funds can be usedto pay off the seasonal short-term loan and

cover associated long-term financing costs;

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Risks vs. Costs Trade-Off

Long-Term Financing BenefitsLong-Term Financing Benefits– Less worry in refinancing short-term obligations– Less uncertainty regarding future interest costs

Long-Term Financing RisksLong-Term Financing Risks– Borrowing more than what is necessary– Borrowing at a higher overall cost (usually)

ResultResult– Manager accepts less expected profits in exchange

for taking less risk.

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Risks vs. Costs Trade-Off

Short-Term Financing BenefitsShort-Term Financing Benefits– Financing long-term needs with a lower interest cost

than short-term debt– Borrowing only what is necessary

Short-Term Financing RisksShort-Term Financing Risks– Refinancing short-term obligations in the future– Uncertain future interest costs

ResultResult– Manager accepts greater expected profits in

exchange for taking greater risk.24

Section 3Cash and Marketable

Securities Management

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Motives for Holding Cash Transactions MotiveTransactions Motive -to meet payments

arising in the ordinary course of business; Speculative MotiveSpeculative Motive -to take advantage of

temporary opportunities; Precautionary MotivePrecautionary Motive -to maintain a

cushion or buffer to meet unexpected cash needs;

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Cash Management System

Collections Disbursements

Marketable securitiesinvestment

Control through information reporting

= Funds Flow = Information Flow 27

Cash Management Involves the efficient

collection,disbursement and temporary investment of cash;

The general idea is the firm will benefit by speeding up cash receipts and slowing down cash payments;

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Cash Flow Problems

Making losses-if a business is continually making losses, it will eventually have cash flow problems;

Growth-when a business is growing, it needs to acquire more non-current assets, and to support higher

amounts of inventories and accounts receivable;

Seasonal business-when a business has seasonal or cyclical sales, it may have cash flow difficulties at certain times;

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Methods of Easing Cash Shortages

Postponing capital expenditure;

Accelerating cash inflows which would otherwise be expected

in a later period;

Reversing past investment decisions by selling assets previously acquired;

Negotiating a reduction in cash outflows,

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Possible Cash PositionsCash Position Actions Taken

Short-term surplus Pay accounts payable early to obtain discount

Attempt to increase sales by increasing accounts receivable and inventories

Make short-term investments

Short-term deficit Increase accounts payableReduce accounts receivable

Arrange an overdraft

Long-term surplus Make long-term investmentsExpandDiversify

Replace/update non-current assets

Long-term deficit Raise long-term finance (such as via issue of share capital)

Consider shutdown/disinvestment opportunities

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Investment in Marketable SecuritiesMarketable Securities are shown on the Marketable Securities are shown on the

balance sheet as:balance sheet as:

1.1. Cash equivalents if maturities are less Cash equivalents if maturities are less than three (3) months at the time of than three (3) months at the time of acquisition.acquisition.

2.2. Short-term investments if remaining Short-term investments if remaining maturities are less than one (1) year.maturities are less than one (1) year.

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The Marketable Securities Portfolio

Ready Cash Ready Cash Segment (R$)Segment (R$)

Optimal balance of Optimal balance of marketable securities marketable securities held to take care of held to take care of

probable deficiencies probable deficiencies in the firmin the firm’’s cash s cash

account.account.

R$F$

C$

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Controllable Cash Controllable Cash Segment (C$)Segment (C$)

Marketable securities Marketable securities held for meeting held for meeting

controllable (knowable) controllable (knowable) outflows, such as taxes outflows, such as taxes

and dividends.and dividends.


R$F$

C$

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Free Cash Segment Free Cash Segment (F$)(F$)

““FreeFree”” marketable marketable securities (that is, securities (that is, available for as yet available for as yet

unassigned purposes).unassigned purposes).


R$F$

C$

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Variables in Marketable Securities Selection

Marketability (or Liquidity)Marketability (or Liquidity)The ability to sell a significant volume of securities in a short period of time in the

secondary market without significant price concession.

SafetySafetyRefers to the likelihood of getting back the

same number of dollars you originally invested (principal).

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Variables in Marketable Securities Selection

MaturityMaturityRefers to the remaining life of the security.

Interest Rate (or Yield) RiskInterest Rate (or Yield) RiskThe variability in the market price of a security caused by changes in interest

rates.

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Common Money Market Instruments

Treasury Bills (T-bills)Treasury Bills (T-bills): : Short-term, non-interest bearing obligations of the U.S. Treasury issued at a discount and redeemed at maturity for full face value. Minimum $1,000 amount and $1,000 increments thereafter.

Money Market InstrumentsMoney Market InstrumentsAll government securities and short-term corporate obligations. (Broadly defined)

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BankersBankers’’ Acceptances (BAs) Acceptances (BAs): : Short-term promissory trade notes for which a bank (by having “accepted” them) promises to pay the holder the face amount at maturity;

Repurchase Agreements (RPs; repos)Repurchase Agreements (RPs; repos): : Agreements to buy securities (usually Treasury bills) and resell them at a higher price at a later date;

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Commercial PaperCommercial Paper:: Short-term, unsecured promissory notes, generally issued by large corporations (unsecured IOUs). The largest dollar-volume instrument.

Negotiable Certificate of DepositNegotiable Certificate of Deposit: : A large-denomination investment in a negotiable time deposit at a commercial bank or savings institution paying a fixed or variable rate of interest for a specified period of time.

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.

EurodollarsEurodollars: : A U.S. dollar-denominated deposit -- generally in a bank located outside the United States -- not subject to U.S. banking regulations

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Selecting Securities for the Portfolio Segments

Ready Cash Ready Cash Segment (R$)Segment (R$)

Safety and ability to Safety and ability to convert to cash is most convert to cash is most

important.important.

Select Select U.S. TreasuriesU.S. Treasuries for this segment.for this segment.

R$F$

C$

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Controllable Cash Controllable Cash Segment (C$)Segment (C$)

Marketability less Marketability less important. Possibly important. Possibly match time needs.match time needs.

May select May select CDs, repos,CDs, repos, BAs,BAs, euroseuros for this for this

segment.segment.

R$F$

C$


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Free Cash Segment Free Cash Segment (F$)(F$)

Base choice on yield Base choice on yield subject to risk-return subject to risk-return

trade-offs.trade-offs.

Any money market Any money market instrumentinstrument may be may be

selected for this segment.selected for this segment.

R$F$

C$


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Thank You

Economy & Finance

Chapter 3.Working Capital Management.ppt