Conservative Working Capital Policy

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					Dubai Women’s College            BADM 300      Financial Management Fundamentals



                        Working Capital Management

Working capital management is concerned with current assets and current
liabilities and their relationship to the rest of the firm. Working capital
policies affect the future returns and risk of the company; consequently,
they have an ultimate bearing on shareholder wealth.

What is Working Capital?

A business person usually sells on credit, stocks goods and keeps some cash
in the bank and the office.

Fill in the Blanks:

1. The amount sold on credit becomes __________________________

2. The Stock of goods maintained by a business are called

   ___________________________________________

3. Cash and the above two items when added up together usually

   becomes ___________________________________



Working capital refers to the total investment in current assets.

Net working capital refers to the difference between current assets and
current liabilities.




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Dubai Women’s College                             BADM 300           Financial Management Fundamentals




Working capital management involves two major types of decisions:

1.     The level of investment in current assets.
2.     The method of financing (short-term VS long-term)

Level of Investment in Current assets
Determination of the appropriate level of working capital involves a
tradeoff between risk and profitability.



           Working Capital Issues
         Optimal Amount (Level) of Current Assets

     Assumptions
  50,000 maximum                                                      Policy A
                          ASSET LEVEL (AED)




   units of production                                                 Policy B
  Continuous                                                          Policy C
   production
  Three different                                   Current Assets
   policies for current
   asset levels are
   possible                                   0        25,000                50,000
                                                    OUTPUT (units)




The above figure tells us that

________________________________________________________

________________________________________________________

________________________________________________________




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Dubai Women’s College                                    BADM 300                          Financial Management Fundamentals




                                                            Impact on Liquidity
                                                            Optimal Amount (Level) of Current Assets

                                                     Liquidity Analysis
                                                                                                                                                  Policy A
                                                   Policy       Liquidity




                                                                                 ASSET LEVEL (AED)
                                                     A          High                                                                              Policy B

                                                     B          Average                                                                           Policy C

                                                     C          Low
                                                                                                                                 Current Assets
                                                   Greater current asset
                                                    levels generate more
                                                      liquidity all other
                                                                                                     0                           25,000                50,000
                                                   factors held constant.                                                    OUTPUT (units)




         Impact on
         Expected Profitability
       Optimal Amount (Level) of Current Assets

 Return on Investment =
                          ASSET LEVEL (AED)




                                                                    Policy A
       Net Profit
      Total Assets                                                  Policy B

  Let Current Assets =                                              Policy C
  (Cash + Rec. + Inv.)
                                                   Current Assets
 Return on Investment =
       Net Profit
 Current + Fixed Assets
                                              0      25,000             50,000
                                                  OUTPUT (units)




                                                                    Impact on Risk
                                                                   Optimal Amount (Level) of Current Assets
                                                         Decreasing   cash
                                                                                                         ASSET LEVEL (AED)




                                                          reduces the firm’s ability                                                                            Policy A
                                                          to meet its financial
                                                          obligations. More risk!                                                                               Policy B

                                                         Stricter credit policies                                                                              Policy C
                                                          reduce receivables and
                                                          possibly lose sales and
                                                          customers. More risk!                                                           Current Assets
                                                         Lower inventory levels
                                                          increase stockouts and
                                                          lost sales. More risk!                                             0              25,000                  50,000
                                                                                                                                         OUTPUT (units)




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Dubai Women’s College               BADM 300     Financial Management Fundamentals




Summary
1.  More conservative policies involve holding a greater amount of current
    assets relative to sales. More aggressive policies hold less.

2.     More conservative working capital policies have lower expected
       profitability (measured as return on total assets) since more assets
       are used to produce a given level of income.

3.     More conservative working capital policies have a lower risk of
       insufficient cash to pay bills and insufficient inventory to meet
       demand.

4.     The optimal level of working capital investment is the level which is
       expected to maximize shareholder wealth.



              Summary of the Optimal
              Amount of Current Assets
      SUMMARY OF OPTIMAL CURRENT ASSET ANALYSIS
     Policy             Liquidity   Profitability     Risk
       A                  High         Low            Low
       B                Average      Average         Average
       C                  Low          High           High

       1.   Profitability varies inversely with
            liquidity.
       2.   Profitability moves together with risk.
            (risk and return go hand-in-hand!)




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Dubai Women’s College                                  BADM 300      Financial Management Fundamentals



Nature of Current Assets

Current assets usually fluctuate from month to month. During months when
sales are relatively high, firms usually carry a lot of inventory, accounts
receivable and cash.

The level of inventory declines in other months when there is less selling
activity. But at any given point of time, the firm always has some current
assets.

Permanent current assets and Temporary current assets
The amount of current assets required to meet a firm's long-term minimum
needs are called Permanent current assets.

Current assets that fluctuate due to seasonal or cyclical demand are called
temporary current assets.

                Permanent
                Working Capital
                The amount of current assets required to
                meet a firm’s long-term minimum needs.
DOLLAR AMOUNT




                                  Permanent current assets


                                TIME


                                                       Temporary
                                                       Working Capital
                                                       The amount of current assets that varies
                                                            with seasonal requirements.
                                       DOLLAR AMOUNT




                                                             Temporary current assets




                                                                        Permanent current assets


                                                                        TIME




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Dubai Women’s College            BADM 300      Financial Management Fundamentals



Need for financing of Current assets
Working Capital requirements are for a short period of time as Current
Assets are self-liquidating.

Take a look at the following steps (a simple model):

1.   Inventory purchased on credit.                 Accounts Payable
2.   Inventory stocked in the Warehouse.            Merchandise Inventory
3.   Goods are sold on credit.                      Accounts Receivable
4.   Cash is collected.                             Cash

Usually somewhere between steps 1 and 4, money has to be paid to the
supplier. Let’s assume in this model that money is paid between steps 2 & 3.
In this case Cash is not yet collected. So some sort of finance has to be
arranged till Cash is collected for a short term. Once cash is collected then
the money (from whichever source) that was arranged can be repaid. With
the arrangement of Finance the steps above can be modified as under:



1. Inventory purchased on credit.

2. Inventory stocked in the Warehouse.

 Finance arranged to pay the supplier

3. Goods are sold on credit.

4. Cash is collected.

 Finance that was arranged between steps 2 & 3 can now be re-paid.

The above cycle gets repeated.




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Dubai Women’s College           BADM 300     Financial Management Fundamentals


So Financing needs are short term for Working Capital.



              Self-Liquidating Nature
              of Short-Term Loans
      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.




Nature of Financing (Short-term VS. Long-term)



                  Financing Needs

            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).




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Dubai Women’s College                        BADM 300           Financial Management Fundamentals




    Temporary current assets
                                                            Short
                                                            term


                            asset        s
                    current
             manent




                                                           Long-term
          Per



              Fixed Assets




      Ideal Pattern of Financing




Conservative Policy of Financing:
(LOW Risk; LOW Return approach)

All fixed assets + permanent curr. assets + part of temporary curr. Assets
by long-term debt



       Temporary current assets
                                                                Short
                                                                term



                                         t   s
                                ent asse
                   ent curr
             Perman
                                                        Long-term




                 Fixed Assets




        Conservative working capital policy




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Dubai Women’s College                  BADM 300    Financial Management Fundamentals




            Risks vs. Returns Trade-Off
            (Conservative Approach)

   Long-Term Financing Benefits
        Less worry in refinancing short-term obligations
        Less uncertainty regarding future interest costs

   Long-term Financing Risks
        Borrowing more than what is necessary
        Borrowing at a higher overall cost (usually)
   Result
        Manager accepts less expected profits in
         exchange for taking less risk.




Aggressive policy of financing :
(HIGH Risk; HIGH Return approach)


         Temporary current assets
                                                                   Short
                                                                   term


                                              ts
                                   ent asse
                        ent curr
                 Perman
                                                       Long-term




                    Fixed Assets




          Aggressive working capital policy




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Dubai Women’s College             BADM 300       Financial Management Fundamentals




                       vs.
                 Risks vs. Returns Trade-Off
                 (Aggressive Approach)

       Short-Term Financing Benefits
            Financing long-term needs with a lower interest
             cost short-term debt
            Borrowing only what is necessary
       Short-Term Financing Risks
            Refinancing short-term obligations in the future
            Uncertain future interest costs
       Result
            Manager accepts greater expected profits in
             exchange for taking greater risk.




Combining Level of Current assets with Financing
strategies
AGGRESSIVE PLAN
(SHORT TERM FINANCING/LOW LIQUIDITY)

If you adopt a financing plan which uses short term funds, and your asset
liquidity is low then it is an aggressive and risky approach for the following
reasons:

1. Profit factor - There is a possibility of high profits because your assets
are less liquid and therefore well invested in the business.

2. Profit factor - You are using short term financing and hence the interest
costs could be low resulting in lesser interest expense thereby helping
profits.

3. Risk Factor - Since the financing is short term there is every possibility
that the interest rates could go up resulting in a higher interest expense
when the finances need to be renewed or the lender may refuse to renew.

4. Risk Factor - Since the assets are less liquid there may not be enough
cash to meet short term obligations.


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Dubai Women’s College            BADM 300       Financial Management Fundamentals


MODERATE PLAN
(SHORT TERM FINANCING/HIGH LIQUIDITY                     OR
LONG TERM FINANCING/LOW LIQUIDITY)

This sort of plan is considered moderate because:

1. Risk factor (Short term/Highly liquid)- Even though borrowing is short
term with the possibility of the financing arrangement not being renewed or
a higher interest expense (which is the risk factor) the Assets are highly
liquid hence even if the loan has to be repaid funds would be available.

2. Profit factor (Short term/Highly liquid)- With short term financing the
interest cost could be low and therefore help profits but the Assets being
less liquid would not help returns (profits).

3. Risk factor (Long term/Low liquid)- Since the financing arrangement is
long term there will not be any threat of immediate repayments but the
assets being less liquid could be a problem.



4. Profit factor (Long term/Low liquid)- When the assets are kept less liquid
it would help the profits because they would be well invested but the
interest cost could be high because of long term borrowing.

Conservative
(Long term Financing/Highly liquid assets)

1. Risk Factor - This will be negligible because there is no threat of
immediate repayment as the borrowing is long term and in any case if
anything has to be repaid the business would have the finance anyway as the
assets are highly liquid.

2. Profit Factor - Profitability will be low because the Assets are highly
liquid and the interest rates could be high too.




Compiled: RKVN                                                                11

				
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