Chapter 14 Working Capital Management

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Chapter 14Working Capital Management

• Key Sections (pages 441 - 446)
• Risk/return trade-offs in Working Capital
  Management
• Hedging principle

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Introduction

• Net WC current assets less current liabilities
• Liquidity management establish current asset
  and liability levels so firm can meet its
  obligations
• Short-term under one year. How much and from
  what sources?
• On average, 15 of sales in working capital

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Current Liabilities

• Advantages
• Flexibility
• Lower interest cost on short-term debt
• Disadvantages
• - Causes increase in risk of illiquidity
  especially
• if financial condition deteriorates
• - Uncertain interest costs year to year

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Risk/Return Trade-offLiquidity versus
Profitability

• Large current assets reduce risk of production
  stoppages, lost sales and inability to pay bills
• But as WC ? , no increase in returns
• With no increase in profits, ROI drops
• Greater reliance on current liabilities, greater
  risk of illiquidity

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Short-term, Long-term Trade-offs

• Risk of illiquidity
• What happens if cant obtain or roll over S-T
  debt?
• Xerox, GM, Ford, etc as ratings deteriorated
• S-T less costly than L-T and more flexible
• Uncertainty of interest costs from year to year
• Trade-off increased risk of illiquidity versus
  increased profitability

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Sources of Financing

• Assets temporary (seasonal) or permanent
• Spontaneous sources arise in normal course of
  business
• Trade credit accounts payable
• Other payables and accruals
• Discretionary sources from an explicit decision
  by management, both short and long-term
  borrowings

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Hedging Principle

• Maturity should follow cash flows of asset being
  financed
• - S-T Financing should be self-liquidating
• After spontaneous sources used, finance
• - Temporary assets with current liabilities.
• - Permanent assets with permanent
  financing, including permanent part of working
  capital

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Hedging Principle