Practical financial management lasher 7th ed chapter 016

Chapter 16 Working Capital


Working Capital Basics
Working Capital
– Assets and liabilities required to operate a business on
a day-to-day basis

Assets:
– Cash
– Accounts Receivable
– Inventory

Liabilities:
– Accounts Payable
– Accruals
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Working Capital, Funding Requirements, and
the Current Accounts
Gross Working Capital represents an
investment in assets
– Capital – funds committed to support
assets
– Working – short term, day-to-day
operations
Working Capital Requires Funds
– Maintaining a working capital balance
requires a permanent funds commitment
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The Short-Term Liabilities
Spontaneous Financing
Operating activities automatically
create payables & accruals essentially debts
– These liabilities spontaneously offset the
funding required to support current
assets

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Working Capital and the Current
Accounts
Net Working Capital – the difference
between gross working capital and
spontaneous financing
Generally:
– Gross working capital = current assets
– Net working capital =
current assets – current liabilities
People often say working capital when they
actually mean net working capital
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Objective of Working
Capital Management
To run the firm with as little money tied up

in the current accounts as possible
Working capital elements
– Inventory
– Receivables
– Cash
– Payables
– Accruals
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Objective of Working Capital Management
Inventory
High Levels

Low Levels

Benefit:
Happy customers – supplied quickly
Few production delays (parts always on hand)
Cost:
High financing costs
High storage costs
Shrinkage (theft)
Risk of obsolescence

Cost:
Shortages
Dissatisfied customers –
product not available
Benefit:

Low financing and storage
costs
Less risk of obsolescence

Cash
High Levels
Benefit:
Reduces risk of being unable to pay bills
Cost:
Increases financing costs

Low Levels
Benefit:
Reduces financing costs
Cost:
Increases transaction risk
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Objective of Working Capital Management
Accounts Receivable
High Levels
Benefit:
Happy customers –can pay slowly
High credit sales
Cost:
More bad debts
High collection costs
Increased financing costs

Low Levels
Cost:
Customers unhappy with
payment terms
Lower Credit Sales
Benefit:
Less financing cost

Payables and Accruals
High Levels
Benefit:
Spontaneous financing reduces need to borrow
Cost:
Unhappy suppliers because paid slowly

Low Levels
Benefit:
Happy suppliers/employees
Cost:
Not using spontaneous financing

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Figure 16-1 Cash Conversion Cycle

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Figure 16-2 Timeline Representation of Cash Conversion

Cycle

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Permanent and Temporary
Working Capital
Need for working capital varies with
sales level
Temporary working capital supports
seasonal peaks in business
Working capital is permanent to the
extent that it supports a constant,
minimum level of sales
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Figure 16-3 Working Capital Needs of
Different Firms

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Financing Net Working Capital
Short-term working capital should be
financed with short-term sources
Maturity Matching Principle – the
term of financing should match the
term or duration of the project or
item supported

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Short-Term vs. Long-Term Financing in
Support of Working Capital
Long-term financing
Safe but expensive
– Safe – funds are
committed and can’t
be withdrawn
– Expensive - longterm rates are
generally higher

Short-term financing
Cheap but risky
– Cheap - short-term
interest rates are
generally lower
– Risky - must
continually renew
borrowing
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Alternative Financing Policies
The mix of short/long-term financing
supporting working capital
– Heavier use of longer term funds is
conservative

– Using more short-term funding is
aggressive

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Figure 16-4a Working Capital
Financing Policies

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Figure 16-4b Working Capital
Financing Policies

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Working Capital Policy
A firm’s Working Capital Policy refers
to its handling the following issues:
– How much working capital is used
– Extent supported by short or long term
financing
– The nature and source of any short-term
financing used
– How each component is managed
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Sources of Short-term Financing
Spontaneous financing
– payables and accruals

Unsecured bank loans
Commercial paper
Secured loans

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Spontaneous Financing
Accruals

Accounts Payable

– Interest–free loans – Effectively loans from
suppliers selling on credit
from whoever
provides services – Credit Terms:
deferring payment
Specify details of payment
– Wage Accrual
Money owed to
employees for
work performed
but not yet paid

E.g. 2/10, net 30
2% discount if pay within 10

days, otherwise entire
amount due in 30 days

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Prompt Payment Discount
Passing up prompt payment
discounts is an expensive source of
financing
If terms are 2/10, net 30, and don’t pay by the 10th day,
essentially paying 2% for 20 days’ use of money
The implied annual rate is

(365 / 20) x 2% = 36.5%

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Abuses of Trade Credit Terms
Trade credit, originally a service to
customers, is now expected
– Paying beyond the due date is a common
abuse of trade credit
Called “stretching” payables or “leaning on
the trade”
Slow paying companies receive poor credit
ratings
– May lose the ability to buy on credit in future

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Unsecured Bank Loans
Represent the primary source of
short-term financing for most
companies
Unsecured  Repayment is not
guaranteed by the pledge of a specific
asset
Promissory Note – Written promise
to repay amount borrowed plus
interest
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Unsecured Bank Loans
Line of credit
– Informal, non-binding agreement
between a bank and a borrowing firm
specifying the maximum amount that
can be borrowed during a period

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Revolving Credit Agreement
Similar to a line of credit except bank
guarantees availability of funds up to
a maximum amount

– Borrower pays a commitment fee on the
unborrowed balance

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