Chapter 2 Principles of Working Capital Management
Chapter 2 Principles of Working Capital Management
Chapter 2 Principles of Working Capital Management
FINANCIAL MANAGEMENT II
CHAPTER 2 PRINCIPLES OF WORKING CAPITAL
MANAGEMENT
WORKING CAPITAL MANAGEMENT
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Cash manager Collection, concentration, disbursement; Cash, marketable short-term investments; short-term
borrowing; securities, short-term loans
banking relations
Credit manager Monitoring and control of accounts Accounts receivable
receivable; credit policy decisions
Marketing manager Credit policy decisions Accounts receivable
Purchasing manager Decisions on purchases, suppliers; may Inventory, accounts payable
negotiate payment terms
Production manager Setting of production schedules and Inventory, accounts payable
materials requirements
Payables manager Decisions on payment policies and on Accounts payable
whether to take discounts
Controller Accounting information on cash flows; Accounts receivable, reconciliation of accounts payable;
application accounts payable
of payments to accounts receivable
OBJECTIVE OF WORKING CAPITAL
9 MANAGEMENT
The goal of working capital management is to manage the
current assets and liabilities in such a way that an acceptable
level of net working capital is maintained. There are two
issues that are dealt under working capital.
1) Determining the level of working capital to be maintained.
2) Decision regarding financing of current assets.
OBJECTIVE OF WORKING CAPITAL
MANAGEMENT
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short-term assets
Benefit of low working capital
Money otherwise tied up in current assets can be invested
in activities that generate higher payoff
Reduces need for costly financing
Cost of low working capital
Risk of shortages in cash, inventory
WORKING CAPITAL TRADE-OFFS
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Inventory
HIGH LEVELS LOW LEVELS
Benefit: Cost:
Happy customers • Shortages
Few production delays (always have needed parts on • Dissatisfied customers
hand)
Cost: Benefit:
• Expensive • Low storage costs
• High storage costs • Less risk of obsolescence
• Risk of obsolescence
Cash
HIGH LEVELS LOW LEVELS
Benefit: Benefit:
• Reduces risk • Reduces financing costs
Cost: Cost:
• Increases financing costs • Increases risk
WORKING CAPITAL TRADE-OFFS
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Accounts Receivable
High Levels (favorable credit terms) Low Levels (unfavorable terms)
Benefit: Cost:
• Happy customers • Dissatisfied customers
• High sales • Lower Sales
Cost: Benefit:
• Expensive • Less expensive
• High collection costs
• Increases financing costs
Accounts Payable and Accruals
High Levels Low Levels
Benefit: Benefit:
• Reduces need for external finance--using a • Happy suppliers/employees
spontaneous financing source Cost:
Cost: • Not using a spontaneous financing
• Unhappy suppliers source
THE TRADEOFF BETWEEN
PROFITABILITY AND RISK
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low cost
Current Current
low
Assets Liabilities
return Net Working
Capital > 0
high cost
Long-Term
Debt
high
return Fixed
Assets Equity highest
cost
THE TRADEOFF BETWEEN
PROFITABILITY AND RISK (CONT.)
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low
Current Current
return Assets Liabilities low cost
Net Working
Capital < 0
Long-Term
high Debt high cost
return
Fixed
Assets Equity
highest
cost
WORKING CAPITAL TRADE-OFFS
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THE TRADEOFF BETWEEN
PROFITABILITY AND RISK (CONT.)
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Assumptions
50,000 maximum units of Policy A
0 25,000 50,000
OUTPUT (units)
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IMPACT ON LIQUIDITY
Liquidity Analysis
Policy Liquidity Policy A
B Average Policy C
C Low
Greater current asset levels Current Assets
generate more liquidity; all
other factors held constant.
0 25,000 50,000
OUTPUT (units)
IMPACT ON EXPECTED
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PROFITABILITY
Net Profit
Current + Fixed Assets
0 25,000 50,000
OUTPUT (units)
IMPACT ON EXPECTED
PROFITABILITY
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Profitability Analysis
Policy Profitability Policy A
B Average Policy C
C High
As current asset levels decline, Current Assets
total assets will decline and the
ROI will rise.
0 25,000 50,000
OUTPUT (units)
IMPACT ON RISK
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Risk Analysis
Policy Risk Policy A
B Average Policy C
C High
Current Assets
Risk increases as the level of
current assets are reduced.
0 25,000 50,000
OUTPUT (units)
SUMMARY OF THE OPTIMAL
AMOUNT OF CURRENT ASSETS
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TIME
TEMPORARY WORKING CAPITAL
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TIME
DISTINCTION –
PERMANENT AND TEMPORARY/VAIABLE
WORKING CAPITAL
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Spontaneous Financing
Firm will also always have minimum level of Accounts Payable—in
effect, money you have borrowed
Accounts Payable (and Accruals) are generated spontaneously
Arise automatically with inventory and expenses
Offset the funding required to support current assets
DECISION REGARDING
FINANCING OF CURRENT ASSETS:
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of finance
DECISION REGARDING
FINANCING OF CURRENT ASSETS:
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Long-term financing
Safe but expensive
Safe—you can secure the required capital
Expensive—long-term rates generally higher than short-term rates
WORKING CAPITAL FINANCING POLICY:
CONSERVATIVE FINANCING POLICY
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Use more of bank borrowings and public deposits and less of long-
term sources of finance for financing its current assets.
Useful for companies that have a fluctuating need for current assets
because usually the bank borrowings are geared to move in tandem
with the fluctuating level of current assets so that the total interest
charge for the company is likely to be low.
An aggressive financing policy involves higher risk of “technical
insolvency.”
Hence, depending upon the attitude of management towards risk
and keeping in view the constraints imposed by banking sector with
respect to short-term credit, the firm should choose the appropriate
financing policy.
SUMMARY OF SHORT- TERM VS.
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LONG-TERM FINANCING
Financing
Maturity
SHORT-TERM LONG-TERM
Asset
FINANCING FINANCING
Maturity
High
LONG-TERM Moderate
Risk-Profitability
(Permanent) Risk-Profitability
STATIC VIEW OF WORKING CAPITAL
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As per the static view, working capital can be defined in two
ways:
Gross working capital: It is equal to the total current assets
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are shown under the category of unsecured loans and are not
included in current liabilities.
Short-term marketable securities that are held for the purpose
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OPERATING/ WORKING CAPITAL CYCLE
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fuel etc.
Manufacture of the product which includes conversion of raw
Raw material
Cash
purchased Finished goods sold
received
Order Stock
Placed Arrives
Time
Accounts payable period
Operating cycle
Cash cycle
ACTIVITIES OF WORKING CAPITAL MANAGEMENT
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Seasonality of demand.
Conversion Period
65 The average work-in-process inventory period can be
computed as:
=
Average Payment Period:
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