276 Chapter 11 ned 14, nly seasonal sales volume, the level of ‘does not change with changes in seasonal For a retailer with ah investment in demand. a, total assets fixed assets current assets inventory The 4nformation shown below reflects the Jed Company’s current b. c. d. financial position: Fixed assets 1,500,000 P 1,000,000 P 1,200,000 P 1,500,000 P 202,500 1.25 Earnings after taxes Current asset turnover Suppose that Jed’s financial manager decides to adopt a more aggressive working-capital policy by liquidating some current assets and using the proceeds to pay off some long-term debt. Assume that the current assets are perfectly liquid. If the target current ratio is 1.5, then the amount of current assets that must be liquidated is a. — P200,000. c. £600,000. b. P750,000. d. P450,000. A company with a flexible working capital policy would tend to have a current asset turnover and a current ratio than a similar company with a more restricted working capital policy. higher, higher b. higher, lower c. lower, higher d. lower, lower 210. 11. Addressing W sing Working Capital Policies and Management .._275 According to ¢ financed win, CO™PTOMise approach, working capital should be f SPomancously generated funds. » em financing. : Short-term and long-term financing. long-term financing. ie Probability of technical insolvency is reduced by b financine Permanent assets with short-term debt. < ancing fluctuating assets with long-term debt. - maintaining @ high level of liquid assets. d. both bandc. Which of the following actions would increase risk? a. Increase the level of working capital. b. — Change the composition of working capital to include more liquid assets. c. Increase the amount of short-term borrowing. d. Increase the amount of equity financing. The matching principle says to a. match current assets with current liabilities and match fixed assets with long-term debt and equity. b. Match temporary current assets with current liabilities and match permanent current assets and fixed assets with long-term debt and equity. c. Match sales receipts with debt-service payments. d. Match cash inflows with cash outflows. For a retailer with a highly seasonal sales volume, the level of investment in does not change with changes in seasonal demand. a. _ current assets total assets permanent current assets b. c. d. temporary current assets274 Chapter ti Multiple Choice Questions Net working capital is a firm's A current assets b. current liabilities. | © sets less current liabilities. s less total liabilities, Working capital is important for all the following reasons excepr that is a. consi b. affects > consuny d. consists of those as se ree portion of a firm's total a a firm's liquidity and profitability. small portion of the Financial manager's sets that are most manageable. ime on all of the following The optimal level of working capital depends factors excepr the a. kind of firm. b. stability of dividends, ©. variability of cash flows d. length of the cash eyele. sumptions does not underlie risk-return Which of the following tradeoffs ng working capital? main constant, a. b. Current assets are less profitable than fixed assets. ¢. The yield curve is downward sloping, 4. Short-term financing is less expensive than long-term financing, A firm following a Nexible working capital strategy would a. hold substantial amounts: of liquid asset: b. minimize the amount of short-term financing, c. finance fluctuating assets with long-term financing, d. minimize the amount of funds held in liquid assets, Restricted working capital management strategies involve a, low-risk, low-return, b. low-risk, high-return c. high-risk. high-return, d. — moderate-risk, moderate-return,Addressiy ane . \ sing Working Capital Policies and Management .._273 Refer to (b) and the following j; Comnpany;to solve fer oe means information about Five Star Manufacturing Five Star expects it : Fr NOOO ae acl settings before interest and taxes in 0X5 tobe 18 poreent of term debt and 15 percent for rates are projected to remain at 10 percent for short- jor long-term debt. The firm’s tax rate will be 34 percent. Required: e. What is Fi Se 1 Whats Five Star's rate of etum on equity foreach of the tree strategies? relationship between Five Star’s liquidity and profitability. a following information about Five Star Manufacturing Company to solve Five Star wants to determine the impact of changing the financing mix when using an aggressive current asset strategy of having current assets at 30 percent of sales. Earnings before interest and taxes are expected to be P 180,000. Short-term interest rates are 10 percent and long-term rates are 15 percent. The firm’s tax rate is 34 percent. Five Star wants to maintain a mix of $0 percent debt and 50 percent equity under restricted, compromise and flexible financing strategies as shown below. Five Star Manufacturing Company Pro Forina Statement of Financial Position As of December 31, 20X5 Financing Mix Strategies Restricted Compromise Flexible Current assets 300,000 300,000 300,000 Fixed assets 600,000 600,000 600,000 Total assets 900.000 900,000 ‘900,000 Current liabilities (10%) ’ oO re ms0.000 Long-term liabilities (15%) ),000 150,000 ___0 or tabilles { 450,000 450,000 450,000 Stockholders’ equity 450,000 450,000 450,000 Total liabilities and Owners’ equity 900,000 900,000 ‘900,000 eae ed return on equity, net working capital and current ratio g. Show the expect for each proposed strategy-272 Chapter 11 Problem 5 (Working Capital) ‘ The questions (a) through.(g) refer to Five Star Manufacturing Company. Use the Jollowing information to solve for (a) and (b). Five Star Manufacturing Company ‘Statement of Financial Position ‘As of December 31, 20X4 Cash P 20,000 Current Liabilities (10%) P momo Marketable securities 30,000 Long-term liabilities (15%) 300,000 Accounts receivable. 150,000 Total liabilities P 500,000 Inventory 200,000 Total current assets 400,000 Stockholders’ equity P 500,000 Net fixed assets 600,000 Total Liabilities and Total assets 1,000,000 Owners’ equity 21,000,000 During 20X4, the firm’s earnings before interest and taxes were 20 percent of P800,000 in sales. The income tax rate is 34 percent. Required: a. Determine the level of working capital, net working capital and current ratio. b. Calculate the return on equity (net income/stockholders’ equity). Use the following information about Five Star Manufacturing Company to solve for (c) and (a). Five Star Manufacturing Company decides to examine its working capital policy, In addition to its current strategy of maintaining current assets at 50 percent of sales, Five Star is considering two other strategies based on current assets at 30 or 70 percent of next year's sales. Projected net sales and fixed assets for next year are P1,000,000 and 600,000, respectively. Five Star plans to maintain its existing capital structure of 50 percent debt and 50 percent equity. Current liabilities are to be 40 percent of projected total liabilities. Required: ¢. Calculate Five Star’s net working capital and current ratio under each of the three strategies. d. Explain what effect these strategies would have on five Star's liquidity.Adldressing Working Capital Policies and Management .. 271 Problem 3 (Changes in Cyctes) Indicate the impact of the followin, i ively cae " 'g on the cash and opérating cycles, respectively. Use hanes (1) to indicate an increase, the letter (D) for a decrease and letter (N) for no change: Impact a. The terms of cash discounts offered to customers are made less favorable, . b. Fewer raw materials than usual are purchased. c. An increased number of cust cash instead of with credit, The cash discounts offered by suppliers are * decreased; thus, payments are made earlier. e. A greater percentage of raw material purchases are paid for with credit. f. More finished goods are produced for inventory instead of for order. tomers begin to pay in Problem 4 (The Operating and Cash Cycles) Consider the following financial statement information for Avocado Company. tem Beginning Ending Inventory P1273 ee Accounts receivable 3,872 en Accounts payable 1,795 e450 , Net sales 1393 Cost of goods sold : Calculate the operating and cash cycles.270 Chapter 11 NS AND pROBLEMS REVIEW QUESTIO Questions _— ith a long operating cycle? 1. What are some of the characteristics of firm with = fa firm with a long cash cycle? 2. What are some of the characteristics 01 / da just-in-time (JIT) likely to have on the ting cycle. 5 installe 3. Charlene Manufacturing has recently he is inventory system. Describe the effect t : 3 company’s carrying costs, shortage costs and op’ i ting cycle? 4. Is it possible for a firm’s cash cycle to be longer than its operating cy: Explain why or why not. Problems Problem 1 (Cash Equation) Rocco Corporation has a book net worth of P10,380. Long-term debt is P7,500. Net working capital, other than cash, is P2,105. Fixed assets are P15,190. How much cash does the company have? If current liabilities are P1,450, what are current assets? Problem 2 (Changes in the Operating Cycle) Indicate the effect that the following will have on the Operating cycle. Use letter (to indicate an increase, the leter(D) for a decrease and letter (N) for no change: a. Average receivables goes up. Effect b. Credit repayment times for Customers are increased, ¢. Inventory turnover goes from 3 times to6times, d. Payables turnover goes from 6 times to 1] times, >= @. Receivables tumover goes from 7 times 0 8 tn —. f. Payment to suppliers are accelerated. . —___Addressing Working Capital Policies and Management... 269 Relative Interest Rates, Short-term interest rates are usually lower than long-term rates. This implies that it is, on the average, more costly to rely on long-term borrowing as compared to short-term borrowing. If we expec} rates to rise in the future, the firm may want to lock in fixed rates for a longer time by shifting towards a flexible financing policy. With falling rates, the opposite would of course hold true. Availability and Costs of Alternative Financing. Firms with easy and sustained access to alternative sources will want to shift toward more restricted policy. Impact on Future Sales. A more restricted short-term financial policy probably could reduce future sales to level that would be achieved under flexible policy. Wt is also possible that prices can be charged to customers under flexible working capital policy. Customers may be willing to pay higher prices for the quick delivery service and more liberal credit terms implicit in flexible policyi 11-9) . (Figure ’ icy 1 In ith h : Policy II Restricted Finane ns of asset, with long.te or troughs II peak he valleys cing for all peak dema, to finance OFT optterim final ations. The + convenient because jt f II have to See I) of the time. Policy This involves a decisior debt and equity but wi fluctuations for current as: policy is considered the ™ involves seeking some level se Financing Pol in sets aS well as jor ee leas “conservatl the ea Pe shot-er™ financing @ 1-10) usted average level of asset is it ing the seasonally ad -term financin, This involves a firm financing Ht uses both short and roach, the firm borrows it ity. b vl term debt and equit shoreier investing ded, With this compromise approac the Sim ds but it maintains serve in short-term investing as nee in the short-term to cover peak financing nee vod, As current assets build up, the form of marketable securities during SIOw perio jhort-term borrowing. This the’ firm draws down this reserve before doing a m Tas to resort to short-teraf allows for some run-up in current assets before the firm borrowing. igure 1 icy (Figu Policy 111 Compromi: " WHICH FINANCING POLICY SHOULD BE CHOSEN On the question as to what is the most appropriate financing w strategy? There is no definitive answer. orking capital However, the following should -be considered in analyzing the advantages/disadvantages of the alternative financing policy for working capital. Maturity Hedging. Most firms attempt to match the maturities of assets and liabilities. They finance inventories with short-term bank loans and long-term assets with long-term financing. Firms tend to avoid financing long-lived assets with short-term borrowing. This type of maturity mismatching would necessitate frequent refinancing and is inherently risky because short-tem interest rates are more volatile than | . fates. longer-term lL 2. Cash Reserves. ; ; Witle short-term cere financing policy implies surplus cash and @ will experience financial ete Poliy reduces the probability that a firm . . s. Firms m; ° h about meeting recurring, sh lay not have to worry as mu¢! » Short-run obligati we cash and ae gations. H e in marketable securities are zero lowever, investments best. . Net present value investmentsAddressing We dressing Working Capttal Policies and Managentent .._267 Fi -10. Policy Figure 11-10. Poliey 11 COMPROMISE FINANCING POLICY Short-term Financin, Seasonal . : Variation Long-term General growth |( Debt and in fixed assets || Equity Marketable | and permanent Securities | current assets Discussion: Policy I Flexible Financing Policy (Figure 11-8) This involves the decision to finance the peaks of asset requirement with long-term debt and equity. It provides the firm with a large investment surplus in cash and marketable securities most of the time. For example, for a school supplies firm, the peaks might represent inventory building prior to the opening of classes. The valleys would come about because of lower off-season inventories. The firm could keep a relatively large pool of cash and marketable securities. As the need for inventory and other current assets began to rise, the firm would sell off marketable securities and use the cash to purchase whatever was needed. Once the inventory was sold and inventory holdings began to decline, the firm would reinvest in marketable securities. Here, the firm essentially uses a pool of marketable securities as a buffer against changing current asset needs and never does any short-term borrowing except in unusually very high Peak asset demand.Uh Cage 5 Figures 13-4, 11-9 and 11-18 sow SE sa zeusAddressing Wey rking Capital Policies and Management... _265 ALTERNATIVE STRATEGIES IN FINANCING WORKING CAPITAL revious section, | Preset ascets Mion lOOked atthe basic determinarts of the level of investment " S- Now we turn to the financing side of the question. Ene Capital management requires a set of strategies to manage the level composition and financing of a firm’s current assets. Decisions should be based on the simultaneous analysis of their joint impact on return and risk. In addition, consideration should be given on the broad categories of assets. These are: Long-Term/Permanent Assets. These consist of property; plant and equipment, long-term investments and the portion of a firm’s current assets that remain unchanged over the year. Fluctuating or Seasonal Assets. These are current assets that vary over the year due to seasonal or cyclical needs. Figure 11-7 shows the Total Assets Requirement over Time. Figure 11-7. The Total Assets Requirement over Time Seasonal Variation Total Assets Require- ment General growth in fixed assets and permanent current assetsFigure 11-5. Restricted Policy Minimum Point Lcarrying Costs Total Costs a nl Shortage Costs Amount of Current Assets (CA) “yi a priate Current asset holdings are /ow. A restricted policy is most approf when carrying ccsts are high relative to shortage costs. Figure 11-6. Moderate Policy Minimum Point .. | Total Costs of holding Current Assets Carrying Costs Shortage Costs Amount of Current Assets (CA) Current asset holdings are oj total costs. Carrying costs current assets. They i ptimized, Holding this inimi: i amount mini Increase with the ment in level of investment in: they ited with having capital tied up in current xed assets and (b) explicit costs which are costs the current assets (e.g., storage costs). Shortage costs are the costs associat assets instead of more py necessary to maintain the value of roductive fi i ied with not having current assets and can include (a) o, i ‘ 2g as: im ten a yeni Costs such as, sales lost due to not having enough inventory expense for mon tbe transaction fees paid (e.g., extra shipping costs, interest €y borrowed) to replenish the particular type of current asset. Figures 11-4, 11-5 and 11-6 g costs and ; /1-6 show the behavior and trade off between carrying Shortage costs in relation to amount of current assets. On the vertical axis, we have costs measured in pesos and on the horizontal axis, we have the , amount of current assets, Figure 11-4, Relaxed Policy Minimum Point Total Costs *| Carrying Costs Shortage Costs Amount of Current Assets (CA) asset holdings are highest under the relaxed policy. A relaxed ent ri a Cun carrying costs are low relative to policy is most appropriate when shortage costs.262 Chapter 11 Assets Policies if Figure 17-3. ‘Alternative Cure” (P millions) Current assets Relaxed Moderate Restricted 100 150 Sales (P millions) Policy Current Assets to Support Sales of P150 Relaxed 60 Moderate 46 Restricted 32 Note: The sales/current assets relationship is shown here as being linear, but the relationship is often curvilinear. ganeshAddressing Working Capital Policies and Management... __261 ALTERNATIVE POLICIES CURRENT ASSETS AS TO THE SIZE OF INVESTMENT IN There are at least three alternatiy. lici i ‘ @ poli ount of current assets carried: Policies regarding the total amount 1. Relaxed Current Asset Investment Policy This isa Policy under which relatively large amounts of cash, marketable Securities and inventories are carried and under which sales are stimulated by granting liberal credit terms resulting in a high level of receivables. In this policy, marginal carrying costs of current assets will increase while marginal shortage costs will decrease. Restricted Current Asset Investment Policy This is a policy under which holdings of cash, securities, inventories and receivables are minimized. Marginal carrying costs of current assets will decrease while marginal shortage costs will increase. 3. Moderate Current Asset Investment Policy This is a policy that is between the relaxed and restricted policies. This policy dictates that the firm will have just enough current assets so that the marginal carrying costs and marginal shortage costs are equal, thereby minimizing total cost. Figure / 1-3 shows three alternative policies regarding the total amount of current assets carried in relation to sales.scount would certainly by ing ayment period. 260 Chapter 11 4 cash ¢ trade discount "6 -Geferral P the rates of compan) favorable outcome to th ronized. Production of their marketability ang mized. The marketing advertisement, sales priate distribution 3. Marketing Management synch policies shi be sy ould The sale and production enhances ve osts ans quality products at lower CO i.e pe mini saleability. Storage costs would If develop effective people should strive to continually manship and appro promotion activities, effective sales channels. 4. Credit and Collections Policies ies wi ance Manager to i i “ill enable the finance 2 Sound credit and collection policies Ww! Me eee an inventories minimize investment in working capital particular ly ry and receivables. 5.. External Environment The length of operating cycle is equally influenced by external environment. The financial manager should be aware and sensitive to fluctuations in demand, entrants of new competitors, government fiscal and monetary policies, price fluctuations, ete. to be able to anticipate and minimize any adverse impact of the changes to the company. SOME ASPECTS OF SHORT-TERM FINANCIAL POLICY volves The working capital or short-term financial policy that a firm adopts answering two basic questions. ° seep What is the appropriate size of the firm's investment in current assets? 2. How should the current assets be financed?Addressiy " a essing Working Capital Policies and Management ...__259 The following could be the reasons for longer operating cycle period: 1. Defective i i : Sete Policy and practices that could lead to ‘hase of raw materials or merchandise in excess/short of requirements Buying inferior. defective materials thus lengthening the production time . Failure to get credit from suppliers ; Failte to get trade/cash discount, and Inability to purchase goods due to seasonal swings 2. Lack of proper production planning, coordination and control that could result to protracted manufacturing cycle 3. Defective inventory policy 4. Use of outdated machinery, technology as well, poor maintenance and upkeep of plant, equipment and infrastructure facilities 5. Defective credit policy and receivable collection procedures 6. Lack of proper monitoring of external environment Remedies that may be adopted to reduce the length of operating cycle period are as follows: 1, Production Management There should be proper production planning and coordination at all levels of activity. Also, a continuing assessment of the manufacturin : cle, proper maintenance of plant, equipment and infrastructure facilities and improvement ‘of manufacturing system, technology would help shorten manufacturing cycle thus shortening the operating cycle. Purchasing Management The purchasing manager should ensure the availability of the right type, quantity and quality of materials/merchandise obtained at the right price, time and place through proper logistics management. Further, efforts nerted towards lengthening the credit period of the suppliers. increasingChapter pn era —___ Avera Inventory Conversion Period (65 days) 258 Collection Period (55 days) ge Operating Cycle (120 days) we | Cash Conversion Cycle (53 days) Average Payment Period (67 days) 7 ¢ Illustration Figure 11-2. Operating and Cash Conversion Cyel Discussion: | the goods and thus a a i expects to sell On Day 1, Mermaid buys merchandise an fe 55 dave tolealiog convert them to accounts receivable in 65 days. It should a ee ndise ant the receivables. making a total of 120 days between receiving collecting cash, However, Mermaid is able to defer its own payments for only 67 days. Although Mermaid must pay its suppliers after 67 days, it will not receive any cash until davs into the cycle. Therefore, it may have to borrow from its bank on day 67 and it will not be able to repay the loan until it collects from customers on Day 120. Thus, for $3 rsion cycle (CCC), it will owe days which is the cash conver the bank and will be paying interest on this debt, Thus, the shorter the cash ‘ower interest charges, conversion cycle, the better because that will I Therefore. if Mermaid could (a) sell the g00ds faster, (b, ) collect receivables faster, or (c) defer its payables longer without hurting sales or increasing Operating costs, its cash conversion cycle would decline, its imenecy charges wo i | arges we a its profits and stock price would be improved. Bes would be reduced, and How Can OPERATING CYCLE, Be Repucep The aim of every managemen the number of operating eyel capital. IV is therefore necess; reasons for prolong t should be to les in a year j ary that the fi d operation cycle reduce the len, ath . N order to req 8th of operating cycle of . luce the ir nancial e need for working a ie tNBers be able to identify the nd how it could be reduced, *GenifyAddressin, 4, 1g Working Capital Polici id Me Solution: \ icies and Management... 281 The cash conversion cycle will be equal to: Cash Conversion ° Cycle = Operating Accounts Payable x_365 Cycle Cost of Sales = 119.89 — P120,000 x 365 P650,000 = 52.5 days The cash conversion cycle (CCC) may also be calculated as follows: ccc = Inventory Average Payables A aq + - Conversion Period Collection Period Deferral Period Inventory __Average Inventory___P 116,000 Conversion =~ CostofSales =~ _650,000 65.14 days Period 365 days 365 days ~ ‘Average Average Accounts S Receivable _ Colleton edit Sal = 54.75 days ran 365 days 365 days Payables Average Payables 120,000 Deferral = Cost of Sales 650,000 = 67.38 days Period 365 days 365 days Cash Conversion _ + 5475 - 6138 = 52S5ldays” Cyele (CCC)256 Chapter 11 Solution: ‘The operating cycle will be equal f°: sai = ox Credit Sales Operatin Inventory x 365 + Cyele aS Costs of Sales , 36. 150,000 = e000 16.000 6 + ~pj,000,000 = gldiays + SAS = 119,89. days ‘om the time they receive raw fir 120 days or for their finished goods. So it will take Mermaid Industries almost sl materials, to produce, market, sell and collect the ca THE CASH CONVERSION CYCLE The firm’s cash conversion cycle is determined by subtracting the average payment period from the operating cycle. Average Operating Payment Period Cash Conversion - Cycle Cycle | Sah eesin _ Operating Accounts Payable x 365 ~ Accounts Payable x_ 365 ‘ycle Cycle Cost of Sales Caleulation of Cash Conversion Cycle Using the data from the previous exam I le Me i . . the average accounts payable balance r Pon Industries and assuming that conversion cycle? 900, what will be the firm’s cashA vee dldressing Working Capital Policies and Management wx _ 258 < > < > Inventory Conversion Period Average Collection Period | Operating Cycle < >< : > Average Payment Period Cash Conversion Cycle Figure 11-1. Operating and Cash Conversion Cycle Illustration THE OPERATING CYCLE The operating cycle of a company consists of the time period between the procurement of inventory of raw materials and turns them into finished goods (for manufacturing concerns), sell them and receive payment for them, To measure the firm’s operating cycle, the following formula can be used: Operating Inventory + Average Cycle ~ Conversion Period Collection Period Operatin; Inyentory x_365 4 Accounts Receivable x 365 Cyele a Costs of Sales Credit Sales Calculation of Operating Cycle Suppose that Mermaid Industries has annual sales of P| million, cost of goods sold of P630,000, average inventories of P116,000, and average accounts receivable of 150,000. Assuming that all Mermaid Industries sales are on credit, what will be the firm’s operating cycle?ers would start spending credit from their suppliers 284 Chapter 11 nce cient evide' an tt inventory until they sce suffici ‘relied more ¢ “ing short-term loans from hav’ than obtal ecause Of weak again. Also. some companies h be eeancing rather ry that as a substitute form of financing he other hand wort > ales financial institutions. Suppliers on ! them back on bie to pay economy, customers will not be a y sl-return tradeoffs because the leve| wolves risk Fel ffect both a firm’s risk and vent im 5 Working capital management imal away composition and financing of wor its profitabi ‘AL TRACING CASH AND NET WORKING capIT) “s operation. we must measure the To trace cash movement through the firm cycle. * ion operating cycle as well as the firm's cash conversi cas 7 itoring the worki Understanding the following time periods is necessary in monitoring tt ng capital movement 1. Operating Cycle. The length of time in which the firm purchases or produce inventory, sell it and receive cash. i) Cash Conversion Cycle. The length of time funds are tied up in working capital or the length of time between paying for working capital and collecting cash from the sale of inventory. . ¢ Inventory Conversion Period. The average time required to purchase merchandise or to purchase raw materials and convert them into finished goods and then sell them. © Average Collection Period. Th to convert the firm’s receivab| following a sale. * Payables Deferral Peri ee De vrai The average length of time between the of cash for then Or or merchandise and the payment ne average length of time required °S into cash, that is, to collect cash Figure 11-1 shows the relationship between Oper ‘ating and cash conversion cycle.FACTORS A. is no singh i it i a him inal nite Capital policy that is optimal for all firms or for any 5 ca rnnciee ilations. The optimal working capital policy is difficult to eve ecuUSe Not all factors are controllable by management. The significant factors affecting a fj itm’s working capital position are as follows: 1. The Nature of Operations. Working capital requirements differ greatly ons Manufacturing, retailing and service organizations, For example, retailing firms have a high proportion of total assets in the current category because they earn their return from current assets such as inventory. The Volume of Sales. More current assets such as, accounts receivables and inventories, are needed to support a higher level of sales. The Variation of Cash Flows. The greater the fluctuations in the firm’s cash inflows and outflows, the greater the level of net working capital required, 4. The Operating Cycle Period. The operating cycle is the length of time cash is tied up in a firm’s operating process. For example, the operating cycle of a manufacturing firm is the length of time required to purchase raw materials on credit, produce and sell a product, collect the sales receipts and repay the credit. Shortening the operating cycle reduces the amount of time funds are tied up in working capital and thus lowers the level of working capital required. Some questions that will fall under the general heading of working capital management are: 1. What is a reasonable level of cash to keep on hand and in a bank to pay bills? 2. How much credit should the firm extend to customers? 3. How much inventory should the company hold? 4. How much should the firm borrow in the short-term? Working capital management has become particularly difficult in the declining economic environment following the recent financial crisis. Some companies have been stuck with unused inventory while others refrain from purchasing additionalCHAPTER 11 ADDRESSING WORKING CTT OF POLICIES AND MANAGEM. ABILITIES SHORT-TERM ASSETS AND L’ INTRODUCTION Working capital management is associated with short-term Financia decision making. Short-term financial decisions typically involve cash in i an outflows that occur within a year or less. For instance, short-term financial decisions are involved when a firm orders raw materials or merchandise, pays in cash and anticipates selling finished goods in one year for cash. In contrast, fong- term financial decisions are involved when a firm purchases a special equipment that will reduce operating costs over, say, the next five years. Working capital management also involves finding the optimal levels of cash, marketable securities, accounts receivable, and inventory and then financing that working capital at the least cost. Effective working capital management can generate considerable amounts of cash. REASONS WHY WORKING CAPITAL MANAGEMENT IS IMPORTANT 1. Working capital comprises a large portion of the firm’s total assets. Although the level of working capital varies widely among different * industries, firms in manufacturing and trading industries more often than not, keep more than half of their assets in current assets, The financial manager has considerable responsibility and control in managing the level of current assets and current liabilities, 3. Working capital management directly afeets the firm’s long-term growth and survival because higher levels of curr . rent asset: production and sales growth, S are needed to support 4. Liquidity and profitability are likewise di - rect] ir capital management. Without sufficient liquidity x eed haiert pay its liabilities as they mature. The firm’s profitabil may be unable to because current assets must be financed and finaneine oe ested expense. ing involves interest