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

2. 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

3. 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

4. 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.

5. The Nature of Asset Growth

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

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

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

9. The Nature of Asset Growth.

10. 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

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

12. 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

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

14. Yawakuzi Sales Forecast (in units) Table-1

15. Yawakuzi’s Production Schedule and Inventory
Table 6-2

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

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 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

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

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

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

21. 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

22. Matching Long-Term and Short-Term Needs

23. 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

24. 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

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

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

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

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

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

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

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

32. Impact of Financing Plans on Earnings

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

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

35. Expected Returns for High Risk Firms

36. 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.

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

38. 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

39. Asset Liquidity and Financing Assets