Working Capital Finance

If a firm’s goal is to maximize its earnings per

share, this is the best way to maximize the price
of the common stock and thus shareholder’s
wealth.
If a firm’s goal is to maximize its earnings per
share, this is the best way to maximize the price
of the common stock and thus shareholder’s
wealth.

Answer: True
Net working capital, defined as current assets
minus the sum of payables and accruals, is equal
to the current ratio minus quick ratio.
Net working capital, defined as current assets
minus the sum of payables and accruals, is equal
to the current ratio minus quick ratio.

Answer: False
Net working capital is defined as current assets
divided by current liabilities.
Net working capital is defined as current assets
divided by current liabilities.

Answer: False
An increase in any current asset must be
accompanied by an equal increase in some
current liability
An increase in any current asset must be
accompanied by an equal increase in some
current liability

Answer: False
A conservative current operating asset financing
approach will result in permanent current assets
and some seasonal current assets being
financed using long-term securities.
A conservative current operating asset financing
approach will result in permanent current assets
and some seasonal current assets being
financed using long-term securities.

Answer: True
A firm that follows an aggressive current assets
financing approach uses primarily short-term
credit and thus more exposed to an unexpected
increase in interest rates than is a firm that uses
long-term capital and thus follows a
conservative financing policy.
A firm that follows an aggressive current assets
financing approach uses primarily short-term
credit and thus more exposed to an unexpected
increase in interest rates than is a firm that uses
long-term capital and thus follows a
conservative financing policy.

Answer: True
For financial analysts, working capital equals
current assets.
For financial analysts, working capital equals
current assets.

Answer: True
For accountants, working capital equals current
assets.
For accountants, working capital equals current
assets.

Answer: False
For accountants, working capital equals current
assets minus current liabilities.
For accountants, working capital equals current
assets minus current liabilities.

Answer: True
 Working Capital Management
- administration and control of the company’s
working capital. The primary objective is to
achieve a balance between return (profitability)
and risk.
 Conservative (Relaxed) Policy
- Operations are conducted with too much working
capital; involves financing almost all asset
investments with long-term capital
Advantage:
• Reduces risk of illiquidity
• Eliminates the firm’s exposure to fluctuating loan
rates and potential unavailability of short-term
credit
Disadvantage:
• Less profitable because of higher financing cost
 Aggressive(Restricted) Policy
• Operations are conducted on a minimum
amount of working capital; uses short-term
liabilities to finance, not only temporary, but
also part or all of the permanent current asset
requirement
Advantage:
• Increases return on equity (profitability) by
taking advantage of the cost differential
between long-term and short-term debt
Disadvantage:
• Exposure to risk arising from low working
capital position
• Puts too much pressure on the firm’s short-
term borrowing capacity so that it may have
difficulty in satisfying unexpected needs for
fund
 Matching Policy
• Also called as self-liquidating policy or hedging
policy
• Matching the maturity of a financing source
with specific financing needs

Short term assets Short term liabilities

Long term assets Long term liabilities

 Balanced policy
• Balances trade off between risk and
profitability in a manner consistent with its
attitude toward bearing risk

Long
Risk term
Short
Risk
term
 What is the appropriate working
capital policy?
- The amount of net working capital that a company
should have depends on the amount of risk it is willing
to take. The primary consideration thereof is the trade-
off between returns (profitability) and risk (risk of
illiquidity) associated with:

a. ASSET mix decision – appropriate mix of current and

non-current assets.
b. FINANCING mix decision – appropriate mix of short-
term and long-term liabilities to finance current
assets
 Risk and Return trade off
• The greater the risk, the greater is the
potential for larger returns.
• More current assets lead to greater liquidity
but yield lower returns.
• Fixed assets earn greater returns than current
assets.
• Long-term financing has less liquidity risk than
short-term debt, but has a higher explicit cost,
hence lower return.
MANAGEMENT OF CURRENT ASSETS
- Cash management
- Marketable securities management
- Accounts Receivable management
- Inventory management
FINANCING DECISIONS
 FACTORS considered in selecting the
source of short-term financing
1. Cost
2. Availability of short-term funds when needed
3. Risk
4. Flexibility
5. Restrictions
6. Effect on Credit rating
7. Expected money-market conditions
8. Inflation
9. Company’s profitability and liquidity positions,
as well as stability of operations
Spontaneous sources: Trade credit
• Automatically obtained when a firm purchase
goods or services on credit from a supplier.
• It is a continuous source of financing
• It is more readily available than other
negotiated sources of short-term credit
 Does trade credit have cost?
• Trade credit usually bears no interest, but it is
not costless. Its cost is implicit in the terms of
credit agreed upon (the discount policy and
the credit period)
 1. No trade discount
• Purchases on credit without trade discount
are usually priced higher than cash purchases.
The difference between the selling price is the
implicit cost of credit.
 2. With trade discount
• If a supplier allows a trade discount for
prompt payment, an implicit cost is incurred if
the discount is not availed of
Credit term is 2/10, n/30

Annual rate=
Discount % x Number of days a year
100%-Disocunt % Net period-Disc period

* Net period or number of days the account is

outstanding
Annual rate= 2% x 360
100%-2% 30 days-10days
=36.73%
 Spontaneous sources: Accruals
• Represent liabilities for services that have ben
provided to the company but have not yet
been paid for.

• Cost of accruals- None, whether implicit or

explicit
 Spontaneous sources: Deferred
Income
• Customer’s advance payments or deposits for
goods or services that will be delivered at
some future date

• Cost of deferred income- None

 Negotiated sources
• Unsecured Short-term credit
a. Commercial bank loans
-Line of credit
-Transaction loan
b. Commercial paper
• Secured short-term credit
a. Pledging receivables
b. Pledging inventories
c. Other sources of short-term funds
 Commercial Bank Loans
• Short-term business credit provided by
commercial banks, requiring the borrower to
sign a promissory note to acknowledge the
amount of debt, maturity and interest

a. Line of credit – the bank agrees to lend up a

maximum amount of credit to a firm. This is
applicable to firms that need frequent funding in
varying amounts
Revolving credit agreement – the bank makes
a formal, contractual commitment to provide
the maximum amount to a firm. The firm pays
a minimal commitment fee per year on the
average unused portion of the commitment.
b. Transaction Loan (single payment) – short term credit
for a specific purpose.

Cost of bank loans:

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
a. Regular interest rate =
𝐵𝑜𝑟𝑟𝑜𝑤𝑒𝑑 𝐴𝑚𝑜𝑢𝑛𝑡
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
b. Discounted interest rate =
𝐵𝑜𝑟𝑟𝑜𝑤𝑒𝑑 𝐴𝑚𝑜𝑢𝑛𝑡 −𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
c. Effective interest rate =
𝑈𝑠𝑎𝑏𝑙𝑒 𝑙𝑜𝑎𝑛 𝐴𝑚𝑜𝑢𝑛𝑡
*Usable loan Amount = Loan amount – Discount interest
– Compensating balance
 Commercial Paper
• Short-term, unsecured promissory notes (IOUs)
issued by large firms with great financial strength
and high credit rating to other companies and
institutional investors

• Entail lower cost than bank financing (interest

rate is usually lower)

• Disadvantage: limited access and availability. Only

the largest firms with the greatest financial
strength can issue commercial papers.
 Cost of commercial paper
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑝𝑒𝑟𝑖𝑜𝑑 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑑𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟
x
𝑈𝑠𝑎𝑏𝑙𝑒 𝑙𝑜𝑎𝑛 𝑎𝑚𝑜𝑢𝑛𝑡 𝑁𝑜. 𝑜𝑓 𝑑𝑎𝑦𝑠 𝑓𝑢𝑛𝑑𝑠 𝑎𝑟𝑒 𝑏𝑜𝑟𝑟𝑜𝑤𝑒𝑑

Example:
A corporation plans to issue P500M in a commercial
paper for 180 days at a stated, discounted interest rate of
10%. Dealers of the commercial paper usually charge
P200,000 in placement fees and flotation costs.
𝑃25𝑀∗ 360
Effective Annual = x = 10.53%
𝑃500𝑀 −𝑃25𝑀 −𝑃200,000 180
Interest Rate
180
*Interest cost per period = 500M x 10% x = P25M
360
 Negotiated sources
• Unsecured Short-term credit
a. Commercial bank loans
-Line of credit
-Transaction loan
b. Commercial paper
• Secured short-term credit
a. Pledging receivables
b. Pledging inventories
c. Other sources of short-term funds
 Secured short-term credit
• Pledging receivables
• Pledging inventories
i. Floating lien- creditor has general claim on
all of borrower’s inventory
ii. Trust receipt- lender holds title to specific
units of inventory pledged
iii. Warehouse receipt- inventory pledged is
placed under the lender’s physical and legal
possession
 Secured short-term credit
• Other sources of short-term funds
i. Factoring of Accounts Receivable
ii. Banker’s acceptance- drafts drawn by a non-
financial firm on deposits at a bank; it is a
guarantee of payment at maturity