6

Working Capital and the

Financing Decision
Block, Hirt, and Danielsen
Foundations of Financial Management
18th edition

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 Learning Objectives
• Explain working capital management involves financing and
controlling the current assets of the firm.
• Recall that management must distinguish between current assets
that are easily converted to cash and those that are more
permanent.
• Recognize the financing of an asset should be tied to how long the
asset is likely to be on the balance sheet.
• Explain why long-term financing is usually more expensive than
short-term financing based on the theory of the term structure of
interest rates.
• Recall risk, as well as profitability, determines the financing plan for
current assets.
• Illustrate why expected value analysis may sometimes be employed
in working capital management.
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 Chapter Opening
• Working capital management
• Financing and management of current assets of
firm
• Current assets change constantly, requiring
decisions made by management
• Short-term decisions on working capital
determines whether a firms gets to long term
• Requires immediate action

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 The Nature of Asset Growth
• Key to current asset planning—matching production
schedules with accurate sales forecast
• Differences in actual sales and forecasted sales can
result in
• Unexpected buildup
• Reduction in inventory, affecting receivables and cash flow
• Firm’s current assets can be
• Self-liquidating assets
• “Permanent” current assets

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 Figure 6-1 The Nature of Asset Growth

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 Controlling Assets—Matching Sales
and Production
• Fixed assets grow slowly with
• Increase in productive capacity
• Replacement of old equipment
• Current assets fluctuate in short run,
depending on
• Level of production versus level of sales
• When production is higher than sales, inventory rises
• When sales are higher than production, inventory
declines and receivables increase

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 Controlling Assets—Matching Sales
and Production Continued 1
• Cash budgeting process
• Level production method
• Smooth production schedules
• Use manpower and equipment efficiently to lower cost
• Match sales and production as closely as possible
in short run
• Allows current assets to increase or decrease with level
of sales
• Eliminates large seasonal bulges or sharp reductions in
current assets

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 Controlling Assets—Matching Sales
and Production Continued 2
• Harley Davidson example of seasonal sale
• Most of their sales are during the summer months
Figure 6-2
• Firm’s revenues peak in quarter ended June 30 each
year
• Sales bottom out in last quarter of each year
• June profits are almost always highest quarter, while
December profits are lowest
• 2020 COVID-19 pandemic disrupted normal sales and profits
timeline

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 Figure 6-2 Quarterly Sales and Earnings Per
Share for Harley Davidson

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 Controlling Assets—Matching Sales
and Production Continued 3
• Retail firms like Target and Macy’s also have
seasonal sales patterns
• Figure 6-3
• Sell products that are manufactured for them
• Involved in matching sales with inventory
• Selling seasons affected by weather and holidays,
therefore retailers cannot avoid inventory risk
• Fourth quarter (Nov.–Jan.) is their biggest quarter
and amounts to more than half of their sales

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 Figure 6-3 Quarterly Sales and
Earnings Per Share, Target and Macy's

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 Controlling Assets—Matching Sales
and Production Concluded
• Retail-oriented firms use new, computerized
inventory control systems linked to online point-
of-sales terminals
• Allow either digital input or use of optical scanners
to record inventory code numbers and amount of
each item sold
• Managers can examine sales and inventory levels by
item and adjust orders or production schedules
• Predictability of the market will influence the speed of
manager’s response
• Complexity of production will dictate speed of production
changes
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 Temporary Assets under Level
Production—an Example
• Yawakuzi Motorcycle Company
• Sales fluctuations
• High sales demand during early spring and summer
• Sales drop during October through March
• Decision
• Apply level production method
• 12-month sales forecast issued
• Result
• Level production and seasonal sales combine to
produce fluctuating inventory

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 Table 6-1 Yawakuzi Sales Forecast (in
Units)

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 Table 6-2 Yawakuzi’s Production
Schedule and Inventory

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 Table 6-3 Sales Forecasts, Cash Receipts
and Payments, and Cash Budget

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 Temporary Assets under Level
Production—an Example Continued
• Table 6-3 examines buildup in accounts receivable
and cash
• Sales forecast
• Based on assumptions taken earlier (Table 6-1)
• Cash receipts
• 50 percent represents cash collected during month of sale, and 50
percent pertains to prior month
• Cash payments
• Assumptions of level production plus payments for overhead,
dividends, interest, and taxes
• Cash budget
• Comparison of cash receipts and cash payments schedules to
determine cash flow
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 Table 6-4 Total Current Assets, First
Year ($ millions)

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 Table 6-5 Cash Budget and Assets for Second
Year with No Growth in Sales ($ millions)

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 Figure 6-4 The Nature of Asset Growth
(Yawakuzi)

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 Patterns of Financing
• Selecting of external sources to finance assets
is important
• Most appropriate financing pattern
• Matching asset buildup and financing terms length
• Figure 6-5
• Temporary buildup in current assets
• Permanent current assets and fixed assets

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 Figure 6-5 Matching Long-Term and
Short-Term Needs

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 Alternative Plans
• Challenge of constructing financial plan is
categorizing current assets into temporary and
permanent
• Predicting exact timing of asset liquidation is
difficult
• Difficult to determine amount of short-term
and long-term financing available

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 Long-Term Financing
• Can assure adequate capital at all times
• May rely on long-term funds to cover part of
short-term needs
• Can finance
• Fixed assets
• Permanent current assets
• Part of temporary current assets

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 Figure 6-6 Using Long-Term Financing
for Part of Short-Term Needs

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 Short-Term Financing
(Opposite Approach)
• Many small businesses do not have total
access to long-term financing
• Rely on short-term bank and trade credit
• Advantage: Interest rates are lower
• Short-term finances used for
• Temporary current assets
• Part of permanent working capital needs

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 Figure 6-7 Using Short-Term Financing
for Part of Long-Term Needs

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 The Financing Decision

• Some corporations are flexible while others

are locked into few available fund sources
• During economic boom period
• Shortage of low-cost alternatives exist
• Firms minimize their financing costs
• Raise funds in advance of asset needs
• Important to select right type of financing

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 Term Structure of Interest Rates
• Yield curve—shows relative level of short-term
and long-term interest rates
• U.S. government securities used; free of default risks
• Corporate debt securities move in same direction as
U.S. government securities
• Have higher interest rates due to more financial risk
• Yield curves for both securities change daily to
reflect
• Current competitive conditions
• Expected inflation
• Changes in economic conditions

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 Term Structure of Interest Rates
Continued
• Three basic theories describe shape of yield
curve
• Liquidity premium theory
• Long-term rates should be higher than short-term rates
• Incentive to hold less liquid and more price-sensitive
securities
• Market segmentation theory
• Treasury securities are divided into market segments by
various financial institutions investing in market
• Expectations hypothesis
• Yields on long-term securities are function of short-
term rates
• Over the time period long-term security is outstanding

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 Figure 6-9 Treasury Yield Curve

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 Figure 6-10 Long- and Short-Term
Annual Interest Rates

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 Table 6-7 Alternative Financing Plans
• Decision Process—comparing alternative
working capital financing plans

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 Table 6-8 Impact of Financing Plans
on Earnings

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 Introducing Varying Conditions
• Tight money periods
• Capital is scarce
• Short-term financing may be difficult to find or
may have very high rates
• Inadequate financing may mean loss of sales or
financial embarrassment

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 Table 6-9 Expected Returns under
Different Economic Conditions
• Expected value represents sum of expected
outcomes under both conditions

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 Table 6-10 Expected Returns for
High-Risk Firm

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 Toward an Optimal Policy
• A firm should:
• Attempt to relate asset liquidity to financing patterns
and vice versa
• Decide how it wishes to combine asset liquidity and
financing needs
• Risk-oriented firm will borrow short term and maintain
low level of liquidity
• Conservative firm will establish long-term financing and
maintain high degree of liquidity

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 Table 6-11 Asset Liquidity and
Financing Assets

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