1. 8.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Chapter 8 Overview of Working Capital Management

2. 8.2 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 1. Explain how the definition of "working capital" differs between financial analysts and accountants. 2. Understand the two fundamental decision issues in working capital management – and the trade-offs involved in making these decisions. 3. Discuss how to determine the optimal level of current assets. 4. Describe the relationship between profitability, liquidity, and risk in the management of working capital. 5. Explain how to classify working capital according to its “components” and according to “time” (i.e., either permanent or temporary). 6. Describe the hedging (maturity matching) approach to financing and the advantages/disadvantages of short- versus long-term financing. 7. Explain how the financial manager combines the current asset decision with the liability structure decision. After Studying Chapter 8, you should be able to:

3. 8.3 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Net Working Capital Fundamentals u Short Term Financial Management: The management of current assets and current liabilities. u Working Capital: Current assets, which represent the portion of investment that circulates from one form to another in the ordinary conduct of business. u Net Working Capital: The portion of current assets financed with long term funds. Calculated by: u NWC = CA – CL u Net Working Capital can be difficult to predict in some cases. However, the more predictable the firm’s cash flow the less net working capital a firm needs.

4. 8.4 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Working Capital Concepts Working Capital Issues Financing Current Assets: Short- Term and Long-Term Mix Combining Liability Structure and Current Asset Decisions Overview of Working Capital Management

5. 8.5 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Net Working Capital Current Assets – Current Liabilities. Gross Working Capital The firm’s investment in current assets. Working Capital Management The administration of the firm’s current assets and the financing needed to support current assets. Working Capital Concepts

6. 8.6 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. In a typical manufacturing firm, current assets exceed one-half of total assets. Excessive levels can result in a substandard Return on Investment (ROI). Current liabilities are the principal source of external financing for small firms. Requires continuous, day-to-day managerial supervision. Working capital management affects the company’s risk, return, and share price. Significance of Working Capital Management

7. 8.7 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. The Tradeoff Between Profitability & Risk u A ‘tradeoff’ exists between profitability and risk. u Profitability: The relationship between revenues and costs generated by using the firm’s assets (current and non current) in productive activities. u Risk: The probability that the firm will become technically insolvent. u Generally, the greater the firm’s net working capital, the more liquid the firm is, and consequently the lower its risk.

8. 8.8 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Assumptions 50,000 maximum units of production Continuous production Three different policies for current asset levels are possible Optimal Amount (Level) of Current Assets 0 25,000 50,000 OUTPUT (units) ASSET LEVEL ($) Current Assets Policy C Policy A Policy B Working Capital Issues

9. 8.9 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Liquidity Analysis PolicyLiquidity AHigh AHigh BAverage BAverage CLow CLow Greater current asset levels generate more liquidity; all other factors held constant. Optimal Amount (Level) of Current Assets 0 25,000 50,000 OUTPUT (units) ASSET LEVEL ($) Current Assets Policy C Policy A Policy B Impact on Liquidity

10. 8.10 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Return on Investment Return on Investment = Net Profit Total Assets Current Assets Let Current Assets = (Cash + Rec. + Inv.) Return on Investment Return on Investment = Net Profit Current Fixed Assets Current + Fixed Assets Optimal Amount (Level) of Current Assets 0 25,000 50,000 OUTPUT (units) ASSET LEVEL ($) Current Assets Policy C Policy A Policy B Impact on Expected Profitability

11. 8.11 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Profitability Analysis Policy Profitability ALow ALow BAverage BAverage CHigh CHigh As current asset levels decline, total assets will decline and the ROI will rise. Optimal Amount (Level) of Current Assets 0 25,000 50,000 OUTPUT (units) ASSET LEVEL ($) Current Assets Policy C Policy A Policy B Impact on Expected Profitability

12. 8.12 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. More risk!Decreasing cash reduces the firm’s ability to meet its financial obligations. More risk! More risk!Stricter credit policies reduce receivables and possibly lose sales and customers. More risk! More risk!Lower inventory levels increase stockouts and lost sales. More risk! Optimal Amount (Level) of Current Assets 0 25,000 50,000 OUTPUT (units) ASSET LEVEL ($) Current Assets Policy C Policy A Policy B Impact on Risk

13. 8.13 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Risk Analysis PolicyRisk ALow ALow BAverage BAverage CHigh CHigh Risk increases as the level of current assets are reduced. Optimal Amount (Level) of Current Assets 0 25,000 50,000 OUTPUT (units) ASSET LEVEL ($) Current Assets Policy C Policy A Policy B Impact on Risk

14. 8.14 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. S UMMARY O F O PTIMAL C URRENT A SSET A NALYSIS PolicyLiquidity Profitability Risk A High Low Low A High Low Low BAverage Average Average BAverage Average Average C Low High High C Low High High 1. Profitability varies inversely with liquidity. 2. Profitability moves together with risk. (risk and return go hand in hand!) Summary of the Optimal Amount of Current Assets

15. 8.15 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Changes In Current Assets & Current Liabilities

16. 8.16 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Time Time Permanent Temporary Components Components Cash, marketable securities, receivables, and inventory Classifications of Working Capital

17. 8.17 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. The amount of current assets required to meet a firm’s long-term minimum needs. Permanent current assets TIME DOLLAR AMOUNT Permanent Working Capital

18. 8.18 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. The amount of current assets that varies with seasonal requirements. Permanent current assets TIME DOLLAR AMOUNT Temporary current assets Temporary Working Capital

19. 8.19 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. The Cash Conversion Cycle u Operating Cycle: The time from the beginning of the production process to collection of cash from the sale of the finished product. u Calculated by: u OC = AAI + ACP[Equation 14.1] u Where: u AAI = Average age of inventory u ACP = Average collection period

20. 8.20 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. The Cash Conversion Cycle u The amount of time the firm’s resources are tied up. u Calculated by: u CCC = OC – APP [Equation 14.2] OR u CCC = AAI + ACP – APP [Equation 14.3] u Where: u OC = Operating cycle u APP = Average payment period

21. 8.21 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. The Cash Conversion Cycle

22. 8.22 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. The Cash Conversion Cycle

23. 8.23 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Strategies For Managing The Cash Conversion Cycle u Aim is to minimise the length of the cash conversion cycle. u Strategies to achieve this include: u Turnover inventory as quickly as possible without stockouts. u Collect accounts receivable as quickly as possible. u Manage mail, processing and clearing time. u Pay accounts as slowly as possible without damaging the firm’s credit rating.

24. 8.24 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Funding Requirements Of The Cash Conversion Cycle u Permanent Funding Requirement: The firm’s constant investment in operating assets resulting from constant sales over time. u Seasonal Funding Requirement: The firm’s investment in operating assets that varies over time as a result of cyclic sales.

25. 8.25 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Funding Requirements Of The Cash Conversion Cycle

26. 8.26 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Funding Requirements Of The Cash Conversion Cycle

27. 8.27 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Funding Requirements Of The Cash Conversion Cycle u Aggressive Funding Strategy: Where the firm funds its seasonal requirements with short term debt and its permanent requirements with long term debt.

28. 8.28 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Funding Requirements Of The Cash Conversion Cycle u Conservative Funding Strategy: Where the firm funds both its seasonal and its permanent requirements with long term debt.

29. 8.29 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Spontaneous Financing: Spontaneous Financing: Trade credit, and other payables and accruals, that arise spontaneously in the firm’s day-to-day operations. Based on policies regarding payment for purchases, labor, taxes, and other expenses. We are concerned with managing non- spontaneous financing of assets. Financing Current Assets: Short-Term and Long-Term Mix

30. 8.30 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. A method of financing where each asset would be offset with a financing instrument of the same approximate maturity. TIME DOLLAR AMOUNT Long-term financing Fixed assets Current assets* Short-term financing** Hedging (or Maturity Matching) Approach

31. 8.31 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. * * Less amount financed spontaneously by payables and accruals. ** ** In addition to spontaneous financing (payables and accruals). TIME DOLLAR AMOUNT Long-term financing Fixed assets Current assets* Short-term financing** Hedging (or Maturity Matching) Approach

32. 8.32 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Fixed assets and the non-seasonal portion of current assets are financed with long- term debt and equity (long-term profitability of assets to cover the long-term financing costs of the firm). Seasonal needs are financed with short- term loans (under normal operations sufficient cash flow is expected to cover the short-term financing cost). Financing Needs and the Hedging Approach

33. 8.33 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Seasonal orders require the purchase of inventory beyond current levels. Increased inventory is used to meet the increased demand for the final product. Sales become receivables. Receivables are collected and become cash. The resulting cash funds can be used to pay off the seasonal short-term loan and cover associated long-term financing costs. Self-Liquidating Nature of Short-Term Loans

34. 8.34 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Long-Term Financing BenefitsLong-Term Financing Benefits Less worry in refinancing short-term obligations Less uncertainty regarding future interest costs Long-Term Financing RisksLong-Term Financing Risks Borrowing more than what is necessary Borrowing at a higher overall cost (usually) ResultResult Manager accepts less expected profits in exchange for taking less risk. Risks vs. Costs Trade-Off (Conservative Approach)

35. 8.35 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Firm can reduce risks associated with short-term borrowing by using a larger proportion of long-term financing. TIME DOLLAR AMOUNT Long-term financing Fixed assets Current assets Short-term financing Risks vs. Costs Trade-Off (Conservative Approach)

36. 8.36 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Short-Term Financing BenefitsShort-Term Financing Benefits Financing long-term needs with a lower interest cost than short-term debt Borrowing only what is necessary Short-Term Financing RisksShort-Term Financing Risks Refinancing short-term obligations in the future Uncertain future interest costs ResultResult Manager accepts greater expected profits in exchange for taking greater risk. Comparison with an Aggressive Approach

37. 8.37 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Firm increases risks associated with short-term borrowing by using a larger proportion of short-term financing. TIME DOLLAR AMOUNT Long-term financing Fixed assets Current assets Short-term financing Risks vs. Costs Trade-Off (Aggressive Approach)

38. 8.38 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Financing Maturity Asset Maturity SHORT-TERMLONG-TERM Low Risk-Profitability Moderate Risk-Profitability Moderate Risk-Profitability High Risk-Profitability SHORT-TERM Temporary (Temporary) LONG-TERM Permanent (Permanent) Summary of Short- vs. Long-Term Financing

39. 8.39 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. level of current assets method of financing those assets interdependent The level of current assets and the method of financing those assets are interdependent. conservative policy aggressive A conservative policy of “high” levels of current assets allows a more aggressive method of financing current assets. conservative A conservative method of financing aggressive policy (all-equity) allows an aggressive policy of “low” levels of current assets. Combining Liability Structure and Current Asset Decisions