1. Working Capital Management
Chapter 8
Working Capital Management

2. Short term financial management
Short-term financial management—managing current assets and current liabilities—is one of the financial manager’s most important and time-consuming activities.
The goal of short-term financial management is to manage each of the firms’ current assets and current liabilities to achieve a balance between profitability and risk that contributes positively to overall firm value.
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3. Long & Short Term Assets & Liabilities
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4. Working Capital and Net Working Capital
Working Capital includes a firm’s current assets, which consist of cash and marketable securities in addition to accounts receivable and inventories.
Current liabilities represent the firm’s short term financing, which includes accounts payable (trade credit), notes payable (bank loans), and accrued liabilities.
Net Working Capital is defined as total current assets less total current liabilities.
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5. Net Working Capital
When current Assets exceed the Current Liabilities the firm has Positive Net Working Capital
When current Assets are less than the Current Liabilities the firm has Negative Net Working Capital
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6. Trade off between Profitability and Risk
Profitability is the relationship between revenues and cost by using firm’s current and fixed assets
Profits of the firm can go up either increasing revenues or decreasing costs
Risk is the probability that a firm will be unable to pay its bills as they come due
In general the greater the firm’s Net Working Capital lower its Risk
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7. Changes in Current Assets
Ratio = Current Assets
Total Assets
When Ratio increases that is when Current Assets increase
When Ratio decreases that is when Current Assets decrease
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8. Table 14.1 Effects of Changing Ratios on Profits and Risk

9. Central to short-term financial management is an understanding of the firm’s cash conversion cycle.
A firm’s operating cycle (OC) is the time from the beginning of the production process to the collection of cash from the sale of the finished products.
Cash conversion cycle- The amount of time a firm’s resources are tied up: calculated by subtracting the average payment period from the operating cycle.
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10. STRATEGIES FOR MANAGING CASH CONVERSION CYCLE
Turn over inventory as quickly as possible without stock outs that result in lost sales.
Collect accounts receivable as quickly as possible without losing sales from high pressure collection techniques.
Manage mail, processing, and clearing time to reduce them when collecting from customers and to increase them when paying suppliers.
Pay accounts payable as slowly as possible without damaging the firm’s credit rating.
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11. Inventory Management: Inventory Fundamentals
Classification of inventories:
Raw materials: items purchased for use in the manufacture of a finished product
Work-in-progress: all items that are currently in production
Finished goods: items that have been produced but not yet sold
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12. Inventory Management: Differing Views About Inventory
The different departments within a firm (finance, production, marketing, etc.) often have differing views about what is an “appropriate” level of inventory.
Financial managers would like to keep inventory levels low to ensure that funds are wisely invested.
Marketing managers would like to keep inventory levels high to ensure orders could be quickly filled.
Manufacturing managers would like to keep raw materials levels high to avoid production delays and to make larger, more economical production runs.
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13. Techniques of managing Inventory
ABC inventory System
A (Large in value and low in items)
80% value of inventory but only 20% of items
Daily monitoring
C (Large in items and low in Value)
Monitored less carefully
Economic order quantity model
Order size that minimizes total inventory cost
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14. Unsecured Sources of Short-Term Loans: Bank Loans (cont.)
Loan Interest Rates
Most banks loans are based on the prime rate of interest which is the lowest rate of interest charged by the nation’s leading banks on loans to their most reliable business borrowers.
Banks generally determine the rate to be charged to various borrowers by adding a premium to the prime rate to adjust it for the borrowers “riskiness.”
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15. Unsecured Sources of Short-Term Loans: Bank Loans (cont.)
Fixed & Floating-Rate Loans
On a fixed-rate loan, the rate of interest is determined at a set increment above the prime rate and remains at that rate until maturity.
On a floating-rate loan, the increment above the prime rate is initially established and is then allowed to float with prime until maturity.
The increment above prime is generally lower on floating rate loans than on fixed-rate loans.
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16. Unsecured Sources of Short-Term Loans: Bank Loans (cont.)
Line of Credit (LOC)
A line of credit is an agreement between a commercial bank and a business specifying the amount of unsecured short-term borrowing the bank will make available to the firm over a given period of time.
It is usually made for a period of 1 year and often places various constraints on borrowers.
Although not guaranteed, the amount of a LOC is the maximum amount the firm can owe the bank at any point in time.
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17. Unsecured Sources of Short-Term Loans: Bank Loans (cont.)
Line of Credit (LOC)
In order to obtain the LOC, the borrower may be required to submit a number of documents including a cash budget, and recent (and pro forma) financial statements.
The interest rate on a LOC is normally floating and pegged to prime.
In addition, banks may impose operating restrictions giving it the right to revoke the LOC if the firm’s financial condition changes.
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18. Unsecured Sources of Short-Term Loans: Bank Loans (cont.)
Revolving Credit Agreement (RCA)
A RCA is nothing more than a guaranteed line of credit.
Because the bank guarantees the funds will be available, they typically charge a commitment fee which applies to the unused portion of of the borrowers credit line.
A typical fee is around 0.5% of the average unused portion of the funds.
Although more expensive than the LOC, the RCA is less risky from the borrowers perspective.
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