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Chapter

McGraw-Hill/IrwinCopyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Working Capital

and the Financing

Decision6

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Chapter Outline

Working capital management

Current asset management

Asset financing Long-term versus short-term financing

Risk and profitability vis--vis asset financing

Expected value analysis may sometimes beemployed

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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 thefirm or its failure

Requires immediate action

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The Nature of Asset Growth

Effective current assets managementrequires matching of the forecasted salesand production schedules

Differences in actual sales and forecastedsales can result in: Unexpected buildup.

Reduction in inventory, affecting receivables and

cash flow Firms current assets could be:

Self-liquidating

Permanent current assets.

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The Nature of Asset Growth (contd)

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Controlling Assets Matching Sales

and Production Fixed assets grow slowly with:

Increase in productive capacity

Replacement ofold 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 (contd) 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 planinventory

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 forretailers

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 oroptical scanners Helps adjust orders or production schedules

RadioFrequency 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 salescombine to produce fluctuating inventory

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Yawakuzi Sales Forecast (in units)

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Yawakuzis 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 (contd) Table 6-3 is created to examine the buildup

in accounts receivable and cash

Sales forecast: Based on assumptions takenearlier (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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Yawakuzis 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 considerother 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-T

erm 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-T

erm Needs

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Term Structure of Interest Rates

A yield curve that shows the relative levelof 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 institutionsinvesting in the market

Expectations hypothesis

Yields on long-term securities is a function ofshort-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

ADecision Process: Comparing alternative

financing plans forworking 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 outcomesunder 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

salesS&P Industrials

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Asset Liquidity and Financing

Assets