Corporate Finance Fundamentals [FN1]
Module 8 summary
Operating decisions: Working capital management
In this module, you study the management of working capital. The module begins by describing the concept
of net working capital (NWC) and by identifying the objective of NWC management. You develop a cash
budget and analyze its components so as to understand how to plan for cash shortfalls and cash surpluses.
You look at cash management techniques. The module also explains the factors that determine the optimal
levels for current asset accounts and describes the main issues relevant to the management of accounts
payable. You learn the importance of cyclical patterns in NWC. Another important concern in managing
working capital is when facing international complications that arise from multinational operations. Finally,
you apply ethical reasoning in resolving accounts payable management issues.
Define the concept of net working capital (NWC) and identify the objective of NWC management.
Net working capital (NWC)
= current assets – current liabilities
Some components of NWC are not discretionary (accounts receivable, inventory, and taxes).
The theoretical objective of NWC management is marginal benefit of NWC = marginal cost of NWC.
However, the marginal benefits of NWC are very difficult to identify or quantify.
The operational objective is to minimize the firm’s investment in NWC (and thereby the cost of
holding NWC) subject to its operational needs.
Each account in NWC is dependent on the firm’s activities (for example, accounts receivable depends
on the firm’s sales).
The cash budget is the major planning tool in the management of NWC.
Factors affecting the optimal level of current assets
The minimum required level of cash is equal to an amount for transactions plus extra for unexpected
Factors affecting the minimum level of cash include
the expected daily cash flow
the cost of acquiring new loans
The minimum level of cash is affected by the float, which is the amount of cash released to the firm
but not yet received.
The terms of credit affect the level of accounts receivable.
A marginal analysis determines whether the expected benefits from the change in the terms of credit,
such as increased sales, outweigh the increased costs.
The amount of inventory held depends on
the cost of re-stocking the inventory
the demand for the product
the cost of holding a unit of inventory
the degree of uncertainty about future demand for the product
A worksheet to analyze the main aspects of cash budgeting
A cash budgeting worksheet has the following areas:
input data area for such key assumptions as the tax rate, cash flow pattern from sales, purchases,
accounts payable schedule, and sales salaries as a percent of sales
monthly cash receipts section
monthly purchases section
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Corporate Finance Fundamentals [FN1]
monthly cash disbursements area for regular cash expenses as well as dividend and tax payments
monthly net cash flow
Cash management techniques
Float can be controlled through techniques that speed cash collection:
pre-authorized cheque arrangements
pre-authorized electronic debit
Cash disbursements can be controlled through the following:
paying exactly on time
Main issues relevant to the management of accounts payable
The overall level of accounts payable is not discretionary, but depends on the level of production.
A firm should take sales discounts if the cost of foregoing the discounts exceeds the firm’s cost of
Cyclical patterns in NWC
Seasonal fluctuations in sales and production require planning for a source of funds when there is a
shortfall, and for investments when there is an excess of funds.
A firm may adopt one of three strategies for dealing with fluctuating cash flow patterns:
Use sufficient long-term financing to cover the largest possible current asset requirement.
Use sufficient long-term financing to cover the minimum possible current asset requirement.
Use a compromise that has enough long-term financing to cover a portion of current assets.
A worksheet to plan for cash shortfalls and cash surpluses in cash budgeting
The worksheet extends the cash budget to include
a monthly summary taking into account the beginning cash balance, projected net cash flow, and
required ending cash balance to arrive at a net projected cash flow amount for the month
a monthly cumulative borrowing/cumulative excess cash for marketable securities amount
International complications arising from multinational operations
Three additional problems leading to increased uncertainty over cash flows are
government intervention, such as currency restrictions concerning repatriation of earnings
lack of information such as credit-checking facilities
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