8.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Overview of Overview of Working Capital Working Capital

ManagementManagement

Overview of Overview of Working Capital Working Capital

ManagementManagement

8.2 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Net Working CapitalNet Working CapitalCurrent Assets – Current Liabilities.

Gross Working CapitalGross Working CapitalThe firm’s investment in current assets.

Working Capital ManagementWorking Capital ManagementThe administration of the firm’s current assets and

the financing needed to support current assets.

Working Capital ConceptsWorking Capital Concepts

8.3 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

• In a typical manufacturing firm, current assets exceed one-half of total assets.

• Excessive levels can result in a substandard Return on Investment (ROI).

• Current liabilities are the principal source of external financing for small firms.

• Requires continuous, day-to-day managerial supervision.

• Working capital management affects the company’s risk, return, and share price.

Significance of Working Significance of Working Capital ManagementCapital Management

8.4 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Assumptions• 50,000 maximum

units of production• Continuous

production• Three different

policies for current asset levels are possible

Optimal Amount (Level) of Current Assets

0 25,000 50,000OUTPUT (units)

AS

SE

T L

EV

EL

($)

Current Assets

Policy CPolicy C

Policy APolicy A

Policy BPolicy B

Working Capital IssuesWorking Capital Issues

8.5 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Liquidity Analysis

PolicyPolicy LiquidityLiquidity

AA HighHigh

BB AverageAverage

CC LowLow

Greater current asset levels generate more

liquidity; all other factors held constant.

Optimal Amount (Level) of Current Assets

0 25,000 50,000OUTPUT (units)

AS

SE

T L

EV

EL

($)

Current Assets

Policy CPolicy C

Policy APolicy A

Policy BPolicy B

Impact on LiquidityImpact on Liquidity

8.6 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Return on Investment Return on Investment =

Net ProfitNet ProfitTotal AssetsTotal Assets

Let Current Assets Current Assets = (Cash + Rec. + Inv.)

Return on Investment Return on Investment =

Net ProfitNet ProfitCurrent Current + Fixed AssetsFixed Assets

Optimal Amount (Level) of Current Assets

0 25,000 50,000OUTPUT (units)

AS

SE

T L

EV

EL

($)

Current Assets

Policy CPolicy C

Policy APolicy A

Policy BPolicy B

Impact on Impact on Expected ProfitabilityExpected Profitability

8.7 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Profitability Analysis

PolicyPolicy ProfitabilityProfitability

AA LowLow

BB AverageAverage

CC HighHigh

As current asset levels decline, total assets will decline and the ROI will

rise.

Optimal Amount (Level) of Current Assets

0 25,000 50,000OUTPUT (units)

AS

SE

T L

EV

EL

($)

Current Assets

Policy CPolicy C

Policy APolicy A

Policy BPolicy B

Impact on Impact on Expected ProfitabilityExpected Profitability

8.8 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

• Decreasing cash reduces the firm’s ability to meet its financial obligations. More risk!More risk!

• Stricter credit policies reduce receivables and possibly lose sales and customers. More risk!More risk!

• Lower inventory levels increase stockouts and lost sales. More risk!More risk!

Optimal Amount (Level) of Current Assets

0 25,000 50,000OUTPUT (units)

AS

SE

T L

EV

EL

($)

Current Assets

Policy CPolicy C

Policy APolicy A

Policy BPolicy B

Impact on RiskImpact on Risk

8.9 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Risk Analysis

PolicyPolicy RiskRisk

AA LowLow

BB AverageAverage

CC HighHigh

Risk increases as the level of current assets

are reduced.

Optimal Amount (Level) of Current Assets

0 25,000 50,000OUTPUT (units)

AS

SE

T L

EV

EL

($)

Current Assets

Policy CPolicy C

Policy APolicy A

Policy BPolicy B

Impact on RiskImpact on Risk

8.10 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

SSUMMARYUMMARY O OFF O OPTIMALPTIMAL C CURRENTURRENT A ASSETSSET A ANALYSISNALYSIS

PolicyPolicy LiquidityLiquidity ProfitabilityProfitability RiskRisk

AA High High Low Low Low Low

BB AverageAverage Average Average Average Average

CC Low Low High High High High

1. Profitability varies inversely with liquidity.

2. Profitability moves together with risk.(risk and return go hand in hand!)

Summary of the Optimal Summary of the Optimal Amount of Current AssetsAmount of Current Assets

8.11 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

• Low Percentage of Current Liability as a Low Percentage of Current Liability as a Percentage of Total LiabilityPercentage of Total Liability

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

• Long-Term Financing RisksLong-Term Financing Risks• Borrowing more than what is necessary• Borrowing at a higher overall cost (usually)

• ResultResult• Manager accepts less expected profits in

exchange for taking less risk.

Working Capital Financing Policy: Working Capital Financing Policy: Risks vs. Costs Trade-Off of Risks vs. Costs Trade-Off of

Conservative ApproachConservative Approach

8.12 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

• High Percentage of Current Liability as a High Percentage of Current Liability as a Percentage of Total LiabilityPercentage of Total Liability

• Short-Term Financing BenefitsShort-Term Financing Benefits• Financing long-term needs with a lower interest

cost than short-term debt• Borrowing only what is necessary

• Short-Term Financing RisksShort-Term Financing Risks• Refinancing short-term obligations in the future• Uncertain future interest costs

• ResultResult• Manager accepts greater expected profits in

exchange for taking greater risk.

Working Capital Financing Policy: Working Capital Financing Policy: Risks vs. Costs Trade-Off of Risks vs. Costs Trade-Off of

Aggressive ApproachAggressive Approach