Overview of Working Capital Management

8.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson ducation !imited "##$. %reated &' (regor' )uhleme'er.

Working Capital Concepts

Net Working Capital
Current Assets Current Liabilities.

Gross Working Capital

The firms investment in current assets.

Working Capital Management

The a ministration of the firms current assets an the financing nee e to support current assets.
8." Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson ducation !imited "##$. %reated &' (regor' )uhleme'er.

Significance of Working Capital Management

* * * * *

!n a t"pical manufacturing firm# current assets e$cee one%half of total assets. &$cessive levels can result in a substan ar 'eturn on !nvestment ('O!). Current liabilities are the principal source of e$ternal financing for small firms. 'e*uires continuous# a"%to% a" managerial supervision. Working capital management affects the compan"s risk# return# an share price.
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson ducation !imited "##$. %reated &' (regor' )uhleme'er.

8.3

Working Capital Issues

Optimal Amount (Level) of Current Assets
* * *

Assumptions +,#,,, ma$imum units of pro uction Continuous pro uction Three ifferent policies for current asset levels are possible

A00&T L&1&L (2)

/olic" A /olic" 3 /olic" C

Current Assets

-+#,,, O.T/.T (units)

+,#,,,

8.+

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson ducation !imited "##$. %reated &' (regor' )uhleme'er.

Impact on Liquidity
Optimal Amount (Level) of Current Assets Li*ui it" Anal"sis Policy Liquidity A 4igh 3 Average C Low 5reater current asset levels generate more li*ui it"6 all other factors hel constant.
8.,

A00&T L&1&L (2)

/olic" A /olic" 3 /olic" C

Current Assets

-+#,,, O.T/.T (units)

+,#,,,

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson ducation !imited "##$. %reated &' (regor' )uhleme'er.

Impact on !pected Profita"ility

Optimal Amount (Level) of Current Assets
Return on Investment 7
A00&T L&1&L (2) /olic" A /olic" 3 /olic" C

8et /rofit Total Assets Let Current Assets 7 (Cash 9 'ec. 9 !nv.) Return on Investment 7 8et /rofit Current 9 :i$e Assets

Current Assets

-+#,,, O.T/.T (units)

+,#,,,

8.-

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson ducation !imited "##$. %reated &' (regor' )uhleme'er.

Impact on !pected Profita"ility

Optimal Amount (Level) of Current Assets /rofitabilit" Anal"sis Policy Profita"ility A Low 3 Average C 4igh
As current asset levels ecline# total assets will ecline an the 'O! will rise.
8..

A00&T L&1&L (2)

/olic" A /olic" 3 /olic" C

Current Assets

-+#,,, O.T/.T (units)

+,#,,,

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson ducation !imited "##$. %reated &' (regor' )uhleme'er.

Impact on Risk
Optimal Amount (Level) of Current Assets
*

;ecreasing cash re uces the firms abilit" to meet its financial obligations. More risk< 0tricter cre it policies re uce receivables an possibl" lose sales an customers. More risk< Lower inventor" levels increase stockouts an lost sales. More risk<

A00&T L&1&L (2)

/olic" A /olic" 3 /olic" C

Current Assets

-+#,,, O.T/.T (units)

+,#,,,

8.8

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson ducation !imited "##$. %reated &' (regor' )uhleme'er.

Impact on Risk
Optimal Amount (Level) of Current Assets 'isk Anal"sis Policy Risk A Low 3 Average C 4igh
'isk increases as the level of current assets are re uce .
8.$

A00&T L&1&L (2)

/olic" A /olic" 3 /olic" C

Current Assets

-+#,,, O.T/.T (units)

+,#,,,

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson ducation !imited "##$. %reated &' (regor' )uhleme'er.

Summary of t)e &ptimal $mount of Current $ssets

S#MM$R% &' &P(IM$L C#RR
Policy A 3 C Liquidity 4igh Average Low
N(

$SS

$N$L%SIS

Profita"ility Low Average 4igh

Risk Low Average 4igh

=. /rofitabilit" varies inversel" with li*ui it". -. /rofitabilit" moves together with risk. (risk an return go han in han <)
8.1# Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson ducation !imited "##$. %reated &' (regor' )uhleme'er.

Working Capital 'inancing PolicyRisks vs. Costs (rade+&ff of Conservative $pproac)

* *

Lo* Percentage of Current Lia"ility as a Percentage of (otal Lia"ility Long+(erm 'inancing ,enefits
* *

Less worr" in refinancing short%term obligations Less uncertaint" regar ing future interest costs 3orrowing more t)an what is necessar" 3orrowing at a higher overall cost (usuall") Manager accepts less e$pecte profits in e$change for taking less risk.
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson ducation !imited "##$. %reated &' (regor' )uhleme'er.

Long+(erm 'inancing Risks

* *

Result
*

8.11

Working Capital 'inancing PolicyRisks vs. Costs (rade+&ff of $ggressive $pproac)

* *

/ig) Percentage of Current Lia"ility as a Percentage of (otal Lia"ility S)ort+(erm 'inancing ,enefits
* *

:inancing long%term nee s with a lower interest cost than short%term ebt 3orrowing only what is necessar" 'efinancing short%term obligations in the future .ncertain future interest costs Manager accepts greater e$pecte profits in e$change for taking greater risk.
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson ducation !imited "##$. %reated &' (regor' )uhleme'er.

S)ort+(erm 'inancing Risks

* *

Result
*

8.1"