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									     Lecture 8

     Working Capital Definition

lA   firm’s investment in short-term
  assets-cash, marketable securities,
  inventory and accounts receivable.
l Current assets, which represent the
  portion of investment that circulates
  from one form to another in the
  ordinary conduct of business.
Working Capital Terminology
l Working Capital Management: The
  management of short-term assets
  (investments) and liabilities (financing
l Net Working Capital: The difference
  between the firm’s current assets and its
  current liabilities, or, the portion of current
  assets financed with long-term funds; can
  be positive or negative.
    Working Capital Terminology

l Working Capital Policy: Decisions regarding-
Ø The optimal level of investment in current assets

Ø The appropriate mix of short-term and long-term
  financing used to support this investment in
  current assets.
v Profitability: The relationship between
  revenues and costs generated by using the
  firm’s assets- both current and fixed- in
  productive activities.
Importance of Working Capital
v The largest portion of most financial managers’
  time is involved to the day-to-day internal
  operations of the firm, which fall under the
  heading of working capital management.
v Working capital management particularly
  important for small firms. Its possible for them
  to minimize fixed cost but they cannot avoid
  investment in cash, receivable, and
  inventories. They rely heavily on trade credit
  and short term bank loans, both of which affect
  working capital by increasing current liabilities.
Importance of Working Capital
v Current assets represent a large proportion of
  total assets, generally 40 percent. Moreover,
  current assets fluctuate with sales, and sales
  vary over time.
v The relationship between sales growth and the
  need to invest in current assets is close and
  direct. As sales grow, the firm must increase
  receivables and inventories and it may need to
  increase its cash balance as well.
    Trade-off Between Profitability
    & Risk

l   A firm’s profits can be increased by (1)
    increasing revenues or (2) decreasing costs.
    In the context of short-term financial
    management, risk is the probability that the firm
    will be unable to pay its bills as they come due.
    A firm that cannot pay its bills as they come due
    is said to be technically insolvent. The greater
    the firm’s net working capital, the lower its risk
    because of more liquidity and low risk of
    becoming technically insolvent.
       How changing the level of the
       firm’s current assets affects its
       profitability-risk trade-off?
l   It is explained by using the ratio of current assets
    to total assets which indicates the percentage of
    total assets that is current. Here we assume that
    the level of total assets remains unchanged.
    When the ratio increases- that is, when current
    assts increase-profitability decreases. Because
    current assets are less profitable than fixed
    assets. Fixed assets are more profitable because
    they add more value compared to the product
    than provided by current assets. Without fixed
    assets, the firm could not produce the product.
     How changing the level of the
     firm’s current assets affects its
     profitability-risk trade-off?........
l   The risk effect, however, decreases as the
    ratio of current assets to total assets
    increases. Because net working capital
    increases here, thereby reducing the risk of
    technical insolvency.
  The Firm’s Financing Need

Firm’s financing requirements can be separated
  into a permanent and a seasonal need.
Permanent Need- Financing requirements for the
  firm’s fixed assets plus the permanent portion of
  the firm’s current assets; these requirements
  remain unchanged over the year.
Seasonal Need- Financing requirements for the
  temporary portion of current assets, which vary
  over the year.
    Net Working Capital Strategies

l   Aggressive Approach: Strategy by which the firm
    finances at least its seasonal requirements, and
    possibly some of its permanents requirements,
    with short-term funds and the balance of its
    permanent requirements with long-term funds.
Ø   Cost Consideration
Ø   Risk Consideration
    Net Working Capital Strategies

l   Conservative Approach: Strategy by which the
    firm finances all projects funds requirements with
    long term funds and uses short-term financing only
    for emergencies or unexpected outflows.
Ø   Cost consideration
Ø   Risk consideration
Spontaneous Sources of Short-
Term Financing

l Spontaneous Financing- Financing that arises
  from the normal operations of the firm. Major
  sources here:
v Accounts Payable (trade credit from
     # Open accounts
     # Notes Payables
     # Trade Acceptances
v Accrued Expenses/ Accruals
     Open Accounts
l   The most common type of arrangement
    where the seller ships goods to the buyer
    and send an invoice that specifies the goods
    shipped, the total amount due, and the term
    of the sale. Open account credit derives its
    name from the fact that the buyers does not
    sign a formal debt instrument evidencing the
    amount owed to the seller. It appears on the
    buyer’s balance sheet as accounts payable.
    Notes Payable
l   Here the buyer signs a note that
    evidence a debt to the seller. The note
    calls for the payment of the obligation at
    some specified future date. This
    arrangement is employed when the
    seller wants the buyer to acknowledge
    the debt formally.
    Trade Acceptances

l   Under this arrangement, the seller draws a draft
    on the buyer, ordering the buyer to pay the draft
    at some future date. The seller will not release
    the goods until the buyer accepts the time draft.
    Accepting the draft, the buyer designates a
    bank at which the draft will be paid when it
    comes due. At that time, the draft becomes a
    trade acceptance, and depending on the
    buyer’s credit worthiness, it may posses some
    degree of marketability.
Advantages of Trade Credit

ü Ready    availability- because the
  accounts payable of the most firms
  represent a continuous form of credit.
ü There is no need to formally arrange
  financing- it is already there. As old
  bills are paid and new credit purchase
  made, new accounts payable replaces
  the old ones.
Advantages of Trade Credit (cont.)

ü There  is no need to negotiate with
  the supplier, the decision is entirely
  up to the firm.
ü More flexible means of financing
  because the firm does not have to
  sign a note and, pledge collateral, or
  adhere to a strict payment schedule
  on a note.
    Suggested Questions
l   Define working capital and net working capital.
    Why proper managing of working capital is
l   How changing the level of the firm’s current assets
    affects its profitability-risk trade-off? Explain.
l   Explain two forms of net working capital strategies.
l   Identify and explain the spontaneous sources of
    short-term financing.

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