Chapter 06

• Working Capital and the Financing Decision

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Chapter Outline

• Working capital management

• Current asset management

• Asset financing

• Long-term versus short-term financing

• Risk and profitability vis-à-vis asset financing

• Expected value analysis may sometimes be employed

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Working Capital Management

• The financing and management of the current assets of a firm– Crucial to achieving long-term objectives of the

firm or its failure– Requires immediate action

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The Nature of Asset Growth

• Effective current assets management requires matching of the forecasted sales and production schedules

• Differences in actual sales and forecasted sales can result in:– Unexpected buildup.– Reduction in inventory, affecting receivables and

cash flow• Firm’s current assets could be:

– Self-liquidating– ‘Permanent’ current assets.

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The Nature of Asset Growth (cont’d)

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Controlling Assets – Matching Sales and Production

• Fixed assets grow slowly with:– Increase in productive capacity– Replacement of old equipment

• Current assets fluctuate in the short run, depending on:– Level of production versus the level of sales

• When production is higher than sales the inventory rises

• When sales are higher than production, inventory declines and receivables increase

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Controlling Assets – Matching Sales and Production (cont’d)

• Cash budgeting process– Level production method

• Smooth production schedules• Use of manpower and equipment efficiently to lower

cost

– Match sales and production as closely as possible in the short run

• Allows current assets to increase or decrease with the level of sales

• Eliminates the large seasonal bulges or sharp reductions in current assets

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Matching Sales and Production-McGraw-Hill Companies, Inc.

• A good example of seasonal sale

• Has significant share of sales and earnings in the third and fourth quarters

• Due to seasonal nature of textbook publishing– Lenders and financial managers need to plan

inventory – Lack of correct inventory planning can lead to

lost sales

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Quarterly Sales and Earnings Per Share for McGraw Hill

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Seasonal Sales Pattern in Target and Limited Brands

• Like publishers, retail companies do not stock inventory for more then a year

• Fourth quarter is the biggest quarter for retailers

• As per the figure, the Target is growing much faster than the Limited Brands

• Even then, in the fourth quarter, peak earnings are almost equal for both the companies

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Quarterly Sales and Earnings Per Share, Target and Limited Brands

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Point-of-Sales Terminals

• Retail-oriented firms use new, computerized inventory control systems linked online– Digital inputs or optical scanners

• Helps adjust orders or production schedules

– Radio Frequency Identification (RFID)

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Temporary Assets under Level Production – An Example

• Yawakuzi Motorcycle Company – Sales fluctuations: High sales demand during

early spring and summer; sales drop during October through March

– Decision: Apply level production method - 12-month sales forecast is issued

– Result: Level production and seasonal sales combine to produce fluctuating inventory

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Yawakuzi Sales Forecast (in units)

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Yawakuzi’s Production Schedule and Inventory

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Sales Forecasts, Cash Receipts, and Payments, and Cash Budget

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Sales Forecasts, Cash Receipts, and Payments, and Cash Budget (cont’d)• Table 6-3 is created to examine the buildup

in accounts receivable and cash– Sales forecast: Based on assumptions taken

earlier (table 6-1)– Cash receipts: 50% cash collected during the

month of sale and 50% pertains to the prior month

– Cash budget: a comparison of cash receipt and payment schedules to determine cash flow

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Total Current Assets, First Year ($millions)

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Yawakuzi’s Nature of Asset Growth

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Cash Budget and Assets for II Year With No Growth in Sales ($millions)• Graphic presentation of the current asset

cycle.

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Patterns of Financing

• Selection of external sources to fund financial assets is an important decision

• The appropriate financing pattern:– Matching of asset buildup and length of

financing pattern

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Matching Long-Term and Short-Term Needs

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Alternative Plans

• It is important to consider other alternatives– The challenge of constructing a financial plan is

to prioritize the current assets into temporary and permanent

– The exact timing of asset liquidation, even in the light of ascertaining dollar amounts is onerous

– It is also difficult to judge the amount of short-term and long-term financing available

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Long-Term Financing

• Firms can be assured of having adequate capital at all times:– Use long-term capital to cover part of the short-

term needs– Long-term capital can be used to finance:

• Fixed assets• Permanent current assets• Part of the temporary current assets

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Using Long-Term Financing for Part of Short-Term Needs

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Short- Term Financing

• Small businesses do not have total access to long-term financing– They rely on short-term bank and trade credit– Advantage: interest rates are lower– Short-term finances are used finance:

• Temporary current assets• Part of the permanent working capital needs

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Using Short-Term Financing for Part of Long-Term Needs

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Term Structure of Interest Rates

• A yield curve – that shows the relative level of short-term and long-term interest rates – U.S. government securities are popular as they

are free of default risks– Corporate debt securities entail a higher interest

rate due to more financial risks– Yield curves for both securities change daily to

reflect:• Current competitive conditions• Expected inflation• Changes in economic conditions

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Basic Theories - Yield Curve

• Liquidity premium theory– Long-term rates should be higher than short-

term rates

• Market segmentation theory– Treasury securities are divided into market

segments by the various financial institutions investing in the market

• Expectations hypothesis– Yields on long-term securities is a function of

short-term rates

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Long- and Short-Term Annual Interest Rates

• Relative volatility and the historical level of short-term and long-term rates

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Alternative Financing Plans

• A Decision Process: Comparing alternative financing plans for working capital

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Impact of Financing Plans on Earnings

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Varying Condition and its Impact

• Tight money periods– Capital is scarce making short-term financing

difficult to find or may ensue very high rates– Inadequate financing may mean loss of sales or

financial embarrassment

• Expected value– Represents the sum of the expected outcomes

under both conditions

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Expected Returns under Different Economic Conditions

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Expected Returns for High Risk Firms

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Toward an Optimal Policy

• A firm should:– Attempt to relate asset liquidity to financing

patterns, and vice versa– Decide how it wishes to combine asset liquidity

and financing needs• Risk-oriented firm - short-term borrowings and low

degree of liquidity• Conservative firm - long-term financing and high

degree of liquidity

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Net working capital as a percentage of sales—S&P Industrials

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Asset Liquidity and Financing Assets

Q

End

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Q & A

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Thank You.

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