1. 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

2. 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

3. 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

4. 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

5. Cash Conversion Timeline

6. 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).

7. 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

8. 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

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

10. 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”

11. 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

12. 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

13. 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

14. 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

15. 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 , ,000
Total current assets , ,000
Short-term financing (6%) , ,000
Long-term financing (10%) , ,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% , ,000
$600,000 $600,000

16. 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

17. 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

18. 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

19. 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