1. Chapter 06
• Working Capital and the Financing Decision
6-1

2. 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
6-2

3. 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
6-3

4. 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.
6-4

5. The Nature of Asset Growth (cont’d)
6-5

6. 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
6-6

7. 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
6-7

8. 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
6-8

9. Quarterly Sales and Earnings Per
Share for McGraw Hill
6-9

10. 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
6-10

11. Quarterly Sales and Earnings Per
Share, Target and Limited Brands
6-11

12. 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)
6-12

13. 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
6-13

14. Yawakuzi Sales Forecast (in units)
6-14

15. Yawakuzi’s Production Schedule
and Inventory
6-15

16. Sales Forecasts, Cash Receipts, and
Payments, and Cash Budget
6-16

17. 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
6-17

18. Total Current Assets, First Year
($millions)
6-18

19. Yawakuzi’s Nature of Asset Growth
6-19

20. Cash Budget and Assets for II Year
With No Growth in Sales ($millions)
• Graphic presentation of the current asset
cycle.
6-20

21. 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
6-21

22. Matching Long-Term and Short-
Term Needs
6-22

23. 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
6-23

24. 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
6-24

25. Using Long-Term Financing for Part
of Short-Term Needs
6-25

26. 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
6-26

27. Using Short-Term Financing for Part
of Long-Term Needs
6-27

28. 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
6-28

29. 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
6-29

30. Long- and Short-Term Annual
Interest Rates
• Relative volatility and the historical level of
short-term and long-term rates
6-30

31. Alternative Financing Plans
• A Decision Process: Comparing alternative
financing plans for working capital
6-31

32. Impact of Financing Plans on
Earnings
6-32

33. 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
6-33

34. Expected Returns under Different
Economic Conditions
6-34

35. Expected Returns for High Risk
Firms
6-35

36. 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
6-36

37. Net working capital as a percentage of
sales—S&P Industrials
6-37

38. Asset Liquidity and Financing
Assets
6-38

39. End
Q
6-39

40. Q&A
6-40

41. Thank You.
6-41