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Chapter 14. Working Capital Policy


Academic year: 2021

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Chapter 14


Learning Outcomes

Chapter 14

Discuss why working capital is needed and how working capital accounts are related.

Describe the cash conversion cycle and how it can be used to better manage working capital activities.

Describe the policies that a firm might follow (a) when investing in current assets and

(b) when financing current assets.

Discuss the advantages and disadvantages of using short-term financing rather than long-short-term financing.

Describe how working capital management in

multinational firms is different from working capital management in purely domestic firms.



Working Capital Terminology

Working Capital Management

 The management of short-term (ST) assets

(investments) and short-term (ST)liabilities (financing sources)



Working Capital Terminology

Working Capital

 A firm’s investment in ST assets:

• Cash

• Marketable securities • Inventory



Working Capital Terminology

Net Working Capital =

 Current assets - current liabilities

 Amount of current assets financed by long-term



Working Capital Terminology

Working Capital Policy

 Target levels for each current asset account  How current assets will be financed



Working Capital Terminology

Working capital only includes current liabilities that are specifically used to finance current assets.

Working capital does not include current liabilities that might be due in the current period if they are due from long-term capital decisions, even though these must be considered when assessing the firm’s ability to meet its current obligations.



Working Capital Terminology

Not Working Capital (Liabilities)

 Current maturities of long-term debt

 Financing associated with a construction program that will

be funded with the proceeds of a long-term security issue after the project is completed



The Requirement for External Working

Capital Financing

Seasonal Variations

Business Cycles



The Relationships of Working Capital


A decision affecting one working capital

account (e.g. inventory) will impact other

working capital accounts (e.g. receivables

and payables)

If a firm’s operations are stable, the balance

in accounts receivable and accounts payable

can be computed using this equation



The Cash Conversion Cycle

The length of time from the payment for

purchases of raw materials used to

manufacture a product until the collection of

accounts receivable associated with the sale

of the product



The Inventory Conversion Period

Length of time required to convert materials into finished goods and then to sell those goods

The amount of time the product remains in inventory in various stages of completion



The Receivables Collection Period

Average length of time required to convert the firm’s



The Payables Deferral Period

Average length of time between the purchase of raw materials and labor and the payment of cash for them



The Cash Conversion Cycle

Average length of time a dollar is tied up in

current assets



The Cash Conversion Cycle for Unilate Textiles



Working Capital Investment and Financing


Two Basic Questions

 What is the appropriate level for current assets,

both in total and by specific accounts?



Alternative Current Asset Investment


Relaxed Current Asset Investment Policy

 Relatively large amounts of cash and marketable securities

and inventories are carried and sales are stimulated by a liberal credit policy that results in a high level of receivables

Restricted Current Asset Investment Policy

 Holdings of cash and marketable securities and inventories

are minimized

Moderate Current Asset Investment Policy



Alternative Current Asset Investment Policies



Alternative Current Asset Financing


Maturity matching (“self-liquidating”) approach

 Match asset and liability maturities

Aggressive approach

 Finance all temporary assets with short-term, spontaneous

debt, and finance all fixed assets and some permanent assets with long-term, non-spontaneous funds

Conservative approach

 Use permanent capital to finance all permanent assets and

some seasonal, temporary needs; use spontaneous, short-term debt to finance the rest of the seasonal needs



Maturity Matching, or “Self-Liquidating” Approach

A financing policy that matches asset and liability maturities



Aggressive Approach

A policy in which all of the fixed assets of a firm are financed with long-term capital, but some of the firm’s permanent current assets are financed with short-term non-spontaneous sources of funds



Conservative Approach

A policy in which all of the fixed assets, all of the permanent current assets, and some of the temporary current assets of a firm are



Advantages of Short-Term Financing


 A short-term loan can be obtained much faster

than long-term credit.


 For cyclical needs, avoid long-term debt

• Cost of issuing long-term debt is higher. • Penalties for payoff prior to maturity



Advantages of Short-Term Financing

Cost of Long-Term versus

Short-Term Debt

 Yield curve is generally upward sloping.

 Short term interest rates are generally lower than



Disadvantages of

Short-Term Financing

Risk of Long-Term versus Short-Term Debt

 Short-Term Debt subjects the firm to more risk

than long-term debt does.

• Short-term interest expenses fluctuate.

• Firm may not be able to repay short-term debt



Multinational Working Capital Management

How Working Capital Policies of U.S. Firms

Differ from European Firms:

 Average cash conversion cycle of European firms

more than twice that of U.S. firms.

 U.S. firms follow more conservative working


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