Working Capital Management

1. Working
Capital
Management

2. Section 1
General Outlines of
Working Capital
Management
2

3. Financial Decisions
Revisited
3

4. Working Capital
 Expressed as difference between current assets and current
liabilities;
 Can be interpreted as money available to a company for day-to-day
operations;
 It’s a common measure of a company's liquidity, efficiency, and
overall health;
 Includes inventory accounts receivable, accounts payable, accruals
and short-term debts;
4

5. Why It Matters?
 Positive working capital
generally indicates that a
company is able to pay
off its short-term liabilities
almost immediately;
 It means that company is
able to maintain or grow
sales, pay bills slowly, or
collect receivables
quickly;
5

6. Problems with Working
Capital Formula
 The formula assumes that a company
really would liquidate its current assets to
pay current liabilities, which is not always
realistic;
a. the timing of receivables collection and
payables due may not overlap all the
times;
b. some cash is always needed to meet
payroll obligations and maintain
operations;
c. accounts receivable are not always
readily available for collection, and some of
them may be treated as bad debts;
6

7. Measuring of Working Capital
Current Ratio
Current Ratio=
Current Assets/Current Liabilities
 Shows the ability of a business to pay for its current liabilities
with its current assets;
 A working capital ratio of less than 1.0 is a strong indicator that
there will be liquidity problems in the future, while a ratio in the
vicinity of 2.0 is considered to represent good short-term
liquidity;

8. Example
Year 1 Year 2 Year 3
Current Assets $4,000,000 $8,200,000 $11,700,000
Current Liabilities $2,000,000 $4,825,000 $9,000,000
Current Ratio 2:1 1.7:1 1.3:1
Current ratio formula may be misleading by yielding higher
results:
a)when current assets are built on the account of
inventories(they are hard to liquidate in short term basis
especially when inventory turnover ratio is low);
b) the same pitfalls are valid in the case of receivables;
8

9. Measuring of Working Capital
Quick Ratio
Indicates company’s ability to meet its short-term
obligations with its most liquid assets. For this reason, the
ratio exclude inventories as it takes some time to convert
them into cash. The higher the quick ratio, the better the
company's liquidity position.
Quick Ratio=
(Current Assets-Inventories)/Current
Liabilities
9

10. Working Capital
Management
Focuses on two specific issues;
a)administration of the firm’s
current assets;
b)the financing needed to
support current assets;
10

11. Significance of Working
Capital Management
 In a typical manufacturing firm, current assets exceed one-
half of total assets;
 Excessive levels can result in a substandard Return on
Investment (ROI);
 Low current asset level may lead shortages and difficulties
in maintaining smooth operations;
 Working capital management affects the company’s risk,
return, and share price;
11

12. Working Capital
Management Policy
 A conservative approach aims to
reduce the risk of system breakdown
by holding high levels of gross working
capital;
 An aggressive approach aims
to reduce financing costs and increase
profitability by cutting inventories,
speeding up collections from customers
and delaying payments to suppliers; 12

13. Working Capital Policy
Illustrations
Assumptions
• 50,000 maximum
units of production
• Continuous
production
• Three different
policies for current
asset levels are
possible
Optimal Amount (Level) of Current Assets
0 25,000 50,000
OUTPUT (units)
ASSETLEVEL($)
Current Assets
Policy CPolicy C
Policy APolicy A
Policy BPolicy B
13

14. Impact on Liquidity
Liquidity Analysis
PolicyPolicy LiquidityLiquidity
AA HighHigh
BB AverageAverage
CC LowLow
Greater current asset
levels generate more
liquidity; all other factors
held constant.
Optimal Amount (Level) of Current Assets
0 25,000 50,000
OUTPUT (units)
ASSETLEVEL($)
Current Assets
Policy CPolicy C
Policy APolicy A
Policy BPolicy B
14

15. Impact on
Expected Profitability
Return on InvestmentReturn on Investment =
Net ProfitNet Profit
Total AssetsTotal Assets
Let Current AssetsCurrent Assets =
(Cash + Rec. + Inv.)
Return on InvestmentReturn on Investment =
Net ProfitNet Profit
CurrentCurrent + Fixed AssetsFixed Assets
Optimal Amount (Level) of Current Assets
0 25,000 50,000
OUTPUT (units)
ASSETLEVEL($)
Current Assets
Policy CPolicy C
Policy APolicy A
Policy BPolicy B
15

16. Impact on
Expected Profitability
Profitability Analysis
PolicyPolicy ProfitabilityProfitability
AA LowLow
BB AverageAverage
CC HighHigh
As current asset levels
decline, total assets will
decline and the ROI will
rise.
Optimal Amount (Level) of Current Assets
0 25,000 50,000
OUTPUT (units)
ASSETLEVEL($)
Current Assets
Policy CPolicy C
Policy APolicy A
Policy BPolicy B
16

17. Impact on Risk
• Decreasing cash reduces
the firm’s ability to meet its
financial obligations. MoreMore
risk!risk!
• Stricter credit policies
reduce receivables and
possibly lose sales and
customers. More risk!More risk!
• Lower inventory levels
increase stockouts and
lost sales. More risk!More risk!
Optimal Amount (Level) of Current Assets
0 25,000 50,000
OUTPUT (units)
ASSETLEVEL($)
Current Assets
Policy CPolicy C
Policy APolicy A
Policy BPolicy B
17

18. Impact on Risk
Risk Analysis
PolicyPolicy RiskRisk
AA LowLow
BB AverageAverage
CC HighHigh
Risk increases as the
level of current assets are
reduced.
Optimal Amount (Level) of Current Assets
0 25,000 50,000
OUTPUT (units)
ASSETLEVEL($)
Current Assets
Policy CPolicy C
Policy APolicy A
Policy BPolicy B
18

19. Summary of the Optimal
Amount of Current Assets
SSUMMARYUMMARY OOFF OOPTIMALPTIMAL CCURRENTURRENT AASSETSSET AANALYSISNALYSIS
PolicyPolicy LiquidityLiquidity ProfitabilityProfitability RiskRisk
AA HighHigh LowLow LowLow
BB AverageAverage AverageAverage AverageAverage
CC LowLow HighHigh HighHigh
1. Profitability varies inversely with liquidity.
2. Profitability moves together with risk.
(risk and return go hand in hand!)
19

20. Section 2
Financing of Current
Assets
20

21. Hedging (or Maturity
Matching) Approach
A method of financing where each asset would be offset with aA method of financing where each asset would be offset with a
financing instrument of the same approximate maturity.financing instrument of the same approximate maturity.
If long-term debt is used for financing short-term needs, the firmIf long-term debt is used for financing short-term needs, the firm
will be paying interest for the use of funds during times when thosewill be paying interest for the use of funds during times when those
funds are not neededfunds are not needed
21

22. Self-Liquidating Nature
of Short-Term Loans
 Seasonal orders require the purchase of
inventory beyond current levels;
 Increased inventory is used to meet the
increased demand for the final product.
 Sales become receivables;
 Receivables are collected and
become cash;
 The resulting cash funds can be used
to pay off the seasonal short-term loan and
cover associated long-term financing costs;
22

23. Risks vs. Costs Trade-
Off
 Long-Term Financing BenefitsLong-Term Financing Benefits
– Less worry in refinancing short-term obligations
– Less uncertainty regarding future interest costs
 Long-Term Financing RisksLong-Term Financing Risks
– Borrowing more than what is necessary
– Borrowing at a higher overall cost (usually)
 ResultResult
– Manager accepts less expected profits in exchange
for taking less risk.
23

24. Risks vs. Costs Trade-
Off
 Short-Term Financing BenefitsShort-Term Financing Benefits
– Financing long-term needs with a lower interest cost
than short-term debt
– Borrowing only what is necessary
 Short-Term Financing RisksShort-Term Financing Risks
– Refinancing short-term obligations in the future
– Uncertain future interest costs
 ResultResult
– Manager accepts greater expected profits in
exchange for taking greater risk.
24

25. Section 3
Cash and Marketable
Securities Management
25

26. Motives for Holding Cash
 Transactions MotiveTransactions Motive -to meet payments
arising in the ordinary course of business;
 Speculative MotiveSpeculative Motive -to take advantage of
temporary opportunities;
 Precautionary MotivePrecautionary Motive -to maintain a
cushion or buffer to meet unexpected
cash needs;
26

27. Cash Management
System
Collections Disbursements
Marketable securities
investment
Control through information reporting
= Funds Flow = Information Flow 27

28. Cash Management
 Involves the efficient
collection,disbursement and temporary
investment of cash;
 The general idea is the firm will benefit
by speeding up cash receipts and slowing
down cash payments;
28

29. Cash Flow Problems
 Making losses-if a business is continually making losses,
it will eventually have cash flow problems;
 Growth-when a business is growing, it needs to acquire
more non-current assets, and to support higher
amounts of inventories and accounts receivable;
 Seasonal business-when a business has seasonal or
cyclical sales, it may have cash flow difficulties at certain
times;
29

30. Methods of Easing Cash
Shortages
 Postponing capital expenditure;
 Accelerating cash inflows which
would otherwise be expected
in a later period;
 Reversing past investment
decisions by selling assets
previously acquired;
 Negotiating a reduction in cash
outflows, 30

31. Possible Cash Positions
Cash Position Actions Taken
Short-term surplus Pay accounts payable early to obtain
discount
Attempt to increase sales by increasing
accounts receivable and inventories
Make short-term investments
Short-term deficit Increase accounts payable
Reduce accounts receivable
Arrange an overdraft
Long-term surplus Make long-term investments
Expand
Diversify
Replace/update non-current assets
Long-term deficit Raise long-term finance (such as via issue
of share capital)
Consider shutdown/disinvestment
opportunities
31

32. Investment in
Marketable Securities
Marketable Securities are shown on theMarketable Securities are shown on the
balance sheet as:balance sheet as:
1.1. Cash equivalents if maturities are lessCash equivalents if maturities are less
than three (3) months at the time ofthan three (3) months at the time of
acquisition.acquisition.
2.2. Short-term investments if remainingShort-term investments if remaining
maturities are less than one (1) year.maturities are less than one (1) year.
32

33. The Marketable
Securities Portfolio
Ready CashReady Cash
Segment (R$)Segment (R$)
Optimal balance ofOptimal balance of
marketable securitiesmarketable securities
held to take care ofheld to take care of
probable deficienciesprobable deficiencies
in the firmin the firm’s cash’s cash
account.account.
R$
F$
C$
33

34. Controllable CashControllable Cash
Segment (C$)Segment (C$)
Marketable securitiesMarketable securities
held for meetingheld for meeting
controllable (knowable)controllable (knowable)
outflows, such asoutflows, such as
taxes and dividends.taxes and dividends.
The Marketable
Securities Portfolio
R$
F$
C$
34

35. Free Cash SegmentFree Cash Segment
(F$)(F$)
““Free” marketableFree” marketable
securities (that is,securities (that is,
available for as yetavailable for as yet
unassigned purposes).unassigned purposes).
The Marketable
Securities Portfolio
R$
F$
C$
35

36. Variables in
Marketable Securities
Selection
Marketability (or Liquidity)Marketability (or Liquidity)
The ability to sell a significant volume of
securities in a short period of time in the
secondary market without significant price
concession.
SafetySafety
Refers to the likelihood of getting back the
same number of dollars you originally invested
(principal).
36

37. Variables in
Marketable Securities
Selection
MaturityMaturity
Refers to the remaining life of the security.
Interest Rate (or Yield) RiskInterest Rate (or Yield) Risk
The variability in the market price of a
security caused by changes in interest
rates.
37

38. Common Money Market
Instruments
Treasury Bills (T-bills)Treasury Bills (T-bills):: Short-term, non-
interest bearing obligations of the U.S.
Treasury issued at a discount and redeemed
at maturity for full face value. Minimum
$1,000 amount and $1,000 increments
thereafter.
Money Market InstrumentsMoney Market Instruments
All government securities and short-term
corporate obligations. (Broadly defined)
38

39. Common Money Market
Instruments
BankersBankers’ Acceptances (BAs)’ Acceptances (BAs):: Short-term
promissory trade notes for which a bank (by
having “accepted” them) promises to pay the
holder the face amount at maturity;
Repurchase Agreements (RPs; repos)Repurchase Agreements (RPs; repos)::
Agreements to buy securities (usually
Treasury bills) and resell them at a higher
price at a later date;
39

40. Common Money Market
Instruments
Commercial PaperCommercial Paper:: Short-term, unsecured
promissory notes, generally issued by large
corporations (unsecured IOUs). The largest dollar-
volume instrument.
Negotiable Certificate of DepositNegotiable Certificate of Deposit:: A large-
denomination investment in a negotiable time
deposit at a commercial bank or savings
institution paying a fixed or variable rate of
interest for a specified period of time.
40

41. Common Money
Market Instruments
.
EurodollarsEurodollars:: A U.S. dollar-denominated
deposit -- generally in a bank located outside
the United States -- not subject to U.S.
banking regulations
41

42. Selecting Securities for
the Portfolio Segments
Ready CashReady Cash
Segment (R$)Segment (R$)
Safety and ability toSafety and ability to
convert to cash is mostconvert to cash is most
important.important.
SelectSelect U.S. TreasuriesU.S. Treasuries
for this segment.for this segment.
R$
F$
C$
42

43. Controllable CashControllable Cash
Segment (C$)Segment (C$)
Marketability lessMarketability less
important. Possiblyimportant. Possibly
match time needs.match time needs.
May selectMay select CDs,CDs,
repos,repos, BAs,BAs, euroseuros forfor
this segment.this segment.
R$
F$
C$
Selecting Securities for
the Portfolio Segments
43

44. Free Cash SegmentFree Cash Segment
(F$)(F$)
Base choice on yieldBase choice on yield
subject to risk-returnsubject to risk-return
trade-offs.trade-offs.
Any money marketAny money market
instrumentinstrument may bemay be
selected for this segment.selected for this segment.
R$
F$
C$
Selecting Securities for
the Portfolio Segments
44

45. Thank You