Working Capital and the Financing Decision Chapter 6 McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Outline Working capital management Current assets- temporary and permanent Assets financing Long-term versus short-term financing Current assets financing plan- risk and profitability Expected value analysis in working capital management

Working Capital Management The financing and management of the current assets of a firm Crucial to achieving long-term objectives of the firm Requires immediate action

The Nature of Asset Growth Key to current asset planning – matching production schedules with accurate sales forecast 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.

The Nature of Asset Growth

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

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

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

The Nature of Asset Growth.

Seasonal Sales Pattern in Target and Limited Brands Like publishers, retail companies do not stock inventory for more than a year Fourth quarter is the biggest quarter for retailers The retail firm Target is growing much faster than its counterpart Limited Brands Even then, in the fourth quarter, peak earnings are almost equal for both the companies

Quarterly Sales and Earnings Per Share, Target and Limited Brands

Computerized Inventory Control Systems Retail-oriented firms use new, computerized inventory control systems linked to online point-of-sales terminals Allow either digital input or use of optical scanners to record the inventory code numbers and the amount of each item sold. Use of Radio Frequency Identification (RFID) chips is the latest rage in inventory/supply chain management

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

Yawakuzi Sales Forecast (in units) Table-1

Yawakuzi’s Production Schedule and Inventory Table 6-2

Sales Forecasts, Cash Receipts and Payments, and Cash Budget Table 6-3

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 payments: Based on assumptions of level of production and cost per unit plus payments for overhead, dividends, interest, and taxes Cash budget: a comparison of cash receipt and payment schedules to determine cash flow

Total Current Assets, First Year ($ millions)

Cash Budget and Assets for II Year With No Growth in Sales ($ millions)

Yawakuzi’s Nature of Asset Growth Graphic presentation of the current asset cycle assuming level of production and no sales growth

Patterns of Financing Selection of external sources to finance assets is an important decision The appropriate financing pattern: Matching of asset buildup and length of financing terms

Matching Long-Term and Short-Term Needs

Alternative Plans The challenge of constructing a financial plan is to categorize the current assets into temporary and permanent Predicting the exact timing of asset liquidation is a difficult task It is also difficult to determine the amount of short-term and long-term financing available

Long-Term Financing Can assure adequate capital at all times May be used to cover part of the short-term needs in tight money periods Can be used to finance: Fixed assets Permanent current assets Part of the temporary current assets

Using Long-Term Financing for Part of Short-Term Needs

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 to finance: Temporary current assets Part of the permanent working capital needs

Using Short-Term Financing for Part of Long-Term Needs

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

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

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

Alternative Financing Plans A Decision Process: Comparing alternative financing plans for working capital

Impact of Financing Plans on Earnings

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 Returns under Different Economic Conditions Expected value represents the sum of the expected outcomes under both conditions

Expected Returns for High Risk Firms

Shifts in Asset Structure During recession – Sales decline or stay even Cash, receivables, and inventory fall Short-term debt may rise, causing a large decline in the net working capital to sales ratio During upswing – cash, receivables, and inventory rise short-term debt may fall or be replaced by low-cost long-term debt. These two effects cause the firm’s profitability to increase and the net working capital to sales ratio to rise.

Net Working Capital as a Percentage of Sales and the Current Ratio

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

Asset Liquidity and Financing Assets