Chapter

Working Capital and the Financing Decision

Prepared by: Terry Fegarty Seneca College Revised by: P Chua

McGraw-Hill Ryerson

2003 2003 McGraw-Hill RyersonLimited McGraw-Hill Ryerson Limited

PPT 6-2

Chapter 6 - Outline
What

is Working Capital Management? The Nature of Asset Growth Term Structure of Interest Rates Short-Term vs. Long-Term Financing Approaches to Working Capital Financing Summary and Conclusions

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PPT 6-3

Working Capital Management

Working

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

growth often leads to a buildup in inventory and accounts receivable. Firm may require additional external financing
Goal

is to achieve a balance between liquidity and profitability that contributes positively to the firms value.
Crucial

to short-term success or failure of a business

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Cash Conversion Cycle

Operating

Cycle (OC) consists of that period of time measured by the Inventory Holding Period (IHP) or Average Age of Inventory (AAI) and the Average Collection Period (ACP) of accounts receivable.

Cash

Conversion Cycle (CCC) completes the flow of the OC by subtracting the Accounts Payable Period (APP) or Average Payment Period (APP) of accounts payable.

CCC = AAI + ACP - APP

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Cash Conversion Timeline

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Strategies for Managing Cycle

Turn

over inventory as quickly as possible (minimizing IHP). Collect accounts receivable as quickly as possible (minimizing ACP). Pay accounts payable as slowly as possible (maximizing APP).

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PPT 6-5

Figure 6-1b

The nature of asset growth

Dollars

Temporary current assets

Permanent current assets

Capital assets
Time period
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Figure 6-12

PPT 6-23

Yield curves showing Term Structure of Interest Rates

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Figure 6-13

Long-term and short-term interest rates

PPT 6-24

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Short-Term vs. Long-Term Financing

Short-term

PPT 6-21

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 dont always need you have capital at all times
Firm

must decide the appropriate mix

2003 McGraw-Hill Ryerson Limited

Figure 6-8

PPT 6-18

Matching long-term and short-term needs (Balanced Approach)

Dollars Temporary current assets
Short-term financing

Permanent current assets Capital assets

Time period

Long-term financing (debt & equity)

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Hedged (Balanced) Approach to Financing

PPT 6-17

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

Permanent (minimum) levels of inventory, receivables + Property and equipment, long-term investments

finance with long-term loans, leases, bonds, capital stock, retained earnings
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Figure 6-9

PPT 6-19

Using long-term financing for part of short-term needs (Conservative)

Dollars Temporary current assets
Short-term financing

Permanent current assets Capital assets

Time period

Long-term financing (debt & equity)

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Figure 6-10

PPT 6-20

Using short-term financing for part of long-term needs (Aggressive)

Dollars

Temporary current assets

Short-term financing

Permanent current assets

Long-term financing (debt & equity)

Capital assets
Time period

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PPT 6-25

Table 6-7

Alternative financing plans

EDWARDS CORPORATION
Plan A Part 1. Current assets
Temporary . . . . . . . Permanent . . . . . . . Total current assets . . . Short-term financing (6%). . Long-term financing (10%) . $250,000 250,000 500,000 125,000 375,000 $500,000 $100,000 $100,000 $125,000 475,000 $600,000

Plan B
$250,000 250,000 500,000 375,000 125,000 $500,000 $100,000 $100,000 $375,000 225,000 $600,000
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Part 2. Capital assets

Plant and equipment . . . . Long-term financing (10%) . Short-term (6%) . . . . . Long-term (10% . . . . .

Part 3. Total financing (summary of parts 1 & 2)

PPT 6-26

Table 6-8

Impact of financing plans on earnings

EDWARDS CORPORATION Plan A Earnings before interest and taxes Interest (short-term), 6% $125,000 Interest (long-term), 10% $475,000 Earnings before taxes Taxes (50%) Earnings aftertaxes Plan B Earnings before interest and taxes Interest (short-term), 6% $375,000 Interest (long-term), 10% $225,000 Earnings before taxes Taxes (50%) Earnings aftertaxes

$200,000 7,500 47,500 145,000 72,500 $ 72,500

$200,000 22,500 22,500 155,000 77,500 $ 77,500
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PPT 6-29

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 companys tolerance for risk

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Table 6-11

PPT 6-30

Current asset liquidity and asset financing plan

Asset Liquidity Financing Plan Low Liquidity Short-term 1 High profit High risk 3 Moderate profit Moderate risk High Liquidity 2 Moderate profit Moderate risk 4 Low profit Low risk

Long-term

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PPT 6-31

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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