6 Chapter Working Capital and the Financing Decision Prepared by: Terry Fegarty Seneca College Revised by: P Chua McGraw-Hill Ryerson ©2003 McGraw-Hill Ryerson Limited

Chapter 6 - Outline What is Working Capital Management? PPT 6-2 Chapter 6 - Outline What is Working Capital Management? The Nature of Asset Growth Term Structure of Interest Rates Short-Term vs. Long-Term Financing Approaches to Working Capital Financing Summary and Conclusions

Working Capital Management PPT 6-3 Working Capital Management Working capital management is financing and controlling the investment in the current assets of a firm Sales growth often leads to a buildup in inventory and accounts receivable. Firm may require additional external financing Goal is to achieve a balance between liquidity and profitability that contributes positively to the firm’s value. Crucial to short-term success or failure of a business

Cash Conversion Cycle Operating Cycle (OC) consists of that period of time measured by the Inventory Holding Period (IHP) or Average Age of Inventory (AAI) and the Average Collection Period (ACP) of accounts receivable. Cash Conversion Cycle (CCC) completes the flow of the OC by subtracting the Accounts Payable Period (APP) or Average Payment Period (APP) of accounts payable. CCC = AAI + ACP - APP

Cash Conversion Timeline

Strategies for Managing Cycle Turn over inventory as quickly as possible (minimizing IHP). Collect accounts receivable as quickly as possible (minimizing ACP). Pay accounts payable as slowly as possible (maximizing APP).

Figure 6-1b The nature of asset growth PPT 6-5 Figure 6-1b The nature of asset growth Dollars Temporary current assets Permanent current assets Capital assets Time period

Figure 6-12 Yield curves showing Term Structure of Interest Rates PPT 6-23 Figure 6-12 Yield curves showing Term Structure of Interest Rates

Figure 6-13 Long-term and short-term interest rates PPT 6-24 Figure 6-13 Long-term and short-term interest rates

Short-Term vs. Long-Term Financing PPT 6-21 Short-Term vs. Long-Term Financing Short-term financing is less expensive but riskier lower interest rates (usually) short-term rates are volatile risk of default if sales slow down risk that bank may not extend / renew loans Long-term financing is more expensive but less risky usually higher interest rates, you may pay interest on funds you don’t always need you have capital at all times Firm must decide the appropriate “mix”

Figure 6-8 Matching long-term and short-term needs (Balanced Approach) PPT 6-18 Figure 6-8 Matching long-term and short-term needs (Balanced Approach) Dollars Temporary current assets Short-term financing Permanent current assets Long-term financing (debt & equity) Capital assets Time period

Hedged (Balanced) Approach to Financing PPT 6-17 Hedged (Balanced) Approach to Financing Match liquidity (life) of your assets to the maturity (term) of your financing Means your assets will be generating cash when your liabilities come due (this reduces risk) Balanced Financing Temporary (seasonal) build-up in inventory and accounts receivable finance with trade credit, short-term bank loans, short-term notes payable Permanent (minimum) levels of inventory, receivables + Property and equipment, long-term investments finance with long-term loans, leases, bonds, capital stock, retained earnings

Temporary current assets PPT 6-19 Figure 6-9 Using long-term financing for part of short-term needs (Conservative) Dollars Temporary current assets Short-term financing Long-term financing (debt & equity) Permanent current assets Capital assets Time period

Temporary current assets PPT 6-20 Figure 6-10 Using short-term financing for part of long-term needs (Aggressive) Dollars Temporary current assets Short-term financing Permanent current assets Long-term financing (debt & equity) Capital assets Time period

Table 6-7 Alternative financing plans PPT 6-25 Table 6-7 Alternative financing plans EDWARDS CORPORATION Plan A Plan B Part 1. Current assets Temporary . . . . . . . $250,000 $250,000 Permanent . . . . . . . 250,000 250,000 Total current assets . . . 500,000 500,000 Short-term financing (6%). . 125,000 375,000 Long-term financing (10%) . 375,000 125,000 $500,000 $500,000 Part 2. Capital assets Plant and equipment . . . . $100,000 $100,000 Long-term financing (10%) . $100,000 $100,000 Part 3. Total financing (summary of parts 1 & 2) Short-term (6%) . . . . . $125,000 $375,000 Long-term (10% . . . . . 475,000 225,000 $600,000 $600,000

Table 6-8 Impact of financing plans on earnings PPT 6-26 Table 6-8 Impact of financing plans on earnings EDWARDS CORPORATION Plan A Earnings before interest and taxes $200,000 Interest (short-term), 6%  $125,000 – 7,500 Interest (long-term), 10%  $475,000 – 47,500 Earnings before taxes 145,000 Taxes (50%) 72,500 Earnings aftertaxes $ 72,500 Interest (short-term), 6%  $375,000 – 22,500 Interest (long-term), 10%  $225,000 – 22,500 Earnings before taxes 155,000 Taxes (50%) 77,500 Earnings aftertaxes $ 77,500 Plan B

Working Capital Financing Plans PPT 6-29 Working Capital Financing Plans A conservative (safe or cautious) firm: L/T financing and high liquidity A moderate (balanced) firm: S/T financing and high liquidity OR L/T financing and low liquidity An aggressive (risky) firm: S/T financing and low liquidity Appropriate strategy is determined based on company’s tolerance for risk

Table 6-11 Current asset liquidity and asset financing plan PPT 6-30 Table 6-11 Current asset liquidity and asset financing plan Asset Liquidity Financing Plan Low Liquidity High Liquidity 1 2 Short-term High profit Moderate profit High risk Moderate risk 3 4 Long-term Moderate profit Low profit Moderate risk Low risk

Summary and Conclusions PPT 6-31 Summary and Conclusions Working capital management involves the financing and management of current assets, such as cash, accounts receivable, and inventory As sales increase, a business requires additional current assets to support the higher sales volume In a hedged approach to financing, the financial manager tries to time the due dates of liabilities to the receipt of cash from sales Carrying more long-term debt increases the financing available, but involves a higher interest rate Carrying more short-term debt may reduces interest costs, but increases the risk of capital shortages Carrying more liquid current assets improves bill-paying capability, but may reduce potential profits