Business Finance

Working Capital Policy

 Learning Goals
After reading this chapter, you should be able to answer the following questions:
• What is working capital and why is working capital management critical to the survival
of a firm?
• How are working capital accounts related?
• Why is it important for management to understand the firm’s cash conversion cycle?
• What working capital investment policy should a firm follow?
• How should the firm finance its working capital needs?
• Working capital management refers to the management of the current assets and the
current liabilities of a firm.
• Sound working capital management is a requisite for firm survival that helps the firm
achieve value maximization in the long run.
Working Capital Terminology
• 1. The term working capital, sometimes called gross working capital, generally refers
to current assets.
• 2. Net working capital is defines as current assets minus current liabilities.
• 3. The current ratio is calculated by dividing current assets by current liabilities and is
intended to measure a firm’s liquidity.
• 4. The cash budget (forecasts of cash inflows and outflows)focuses on the firm’s ability
to generate sufficient cash inflows to meet its required cash outflows.
• 5. Working capital policy refers to the firm’s basic policies regarding target levels for
each category of current assets and how current assets will be financed.
The Requirement for External Working Capital
Financing
• When spontaneous
sources of
financing are not
sufficient then firm
need to resort to
external financing
sources.
The Relationships Among Working Capital
Accounts
• A firm normally orders and then receives the materials it needs to produce the product
it sells.
• It purchases from its suppliers on credit, so an account payable is created for credit purchases and
remains payable for some day.
• Labor is used to convert the materials into finished goods.
• However wages are not fully paid at the time the work is done, so accrued wages build up, maybe for
a period of one or two weeks.
• The finished products are sold, but on credit; so sales create receivables, not immediate
cash inflows.
• At some point during the cycle, the firm must pay off its accounts payable and accrued
wages.
• If the payments are made before the firm has collected cash from its receivables, a net cash outflow
occurs and this outflow must be financed.
• The cycle is completed when the firm’s receivables are collected.
The Cash Conversion Cycle
• The cash conversion cycle focuses on the length of time between when the company
makes payments, or invests in the manufacturing of inventory, and when it receives cash
inflows, or realizes a cash return from its investment in production.

The inventory conversion

period: It is the average
length of time required to
convert materials into
finished goods and then to
sell those goods. It is the
average amount of time
the product remains in
inventory in various stages
of completion.
The Cash Conversion Cycle
• The receivable collection period is the average length of time required to convert the
firm’s receivables into cash-that is, the time it takes to collect cash following a sale.
The Cash Conversion Cycle
• The payables deferral period is the average length of time between the purchase of raw
materials and labor and the payment of cash for them.
The Cash Conversion Cycle
• The cash conversion cycle is the length of time from the payment for the purchase of
raw materials to manufacture a product until the collection of accounts receivable
associated with the sale of the product.
The Cash Conversion Cycle
• A firms goal should be to shorten its cash conversion cycle as much as possible without
harming operations.
• This would improve profits because the longer the cash conversion cycle, the greater the
need for external, or nonspontaneous financing, and such financing has a cost.
• The cash conversion cycle can be shortened
• by reducing inventory conversion period by processing and selling goods more quickly,
• reducing the receivables collection period by speeding up collections,
• or lengthening the payables deferral period by slowing down it own payments.
Working Capital Investment and Financing
Policies
• Working capital policy involves two basic questions: (1) What is the appropriate level
for current assets, both in total and by specific accounts, and (2) how should current
assets be financed?
Working Capital Investment and Financing Policies:
Alternative Current Asset Investment Policies
• Relaxed current asset
investment policy involves
maintaining a relatively large
amounts of cash and
marketable securities and
inventories and stimulating
sales by the use of a credit
policy that provides liberal
financing to customers and a
correspondingly high level of
receivables.
Working Capital Investment and Financing Policies:
Alternative Current Asset Investment Policies
• Restricted current asset
investment policy involves
minimum holdings of cash
and marketable securities,
inventories, and receivables.

• Moderate current asset

investment policy involves
moderate holdings of cash
and marketable securities,
inventories, and receivables.
Working Capital Investment and Financing Policies:
Alternative Current Asset Investment Policies
• Under conditions of certainty-when sales, costs, lead times, payment periods and so on,
are known for sure-all firms would hold only minimal levels of current assets.

• Any larger amounts would increase the need for external funding without a
corresponding increase in profits, whereas any smaller holdings would involve late
payments to labor and suppliers and lost sales due to inventory shortages and an overly
restrictive credit policy.

• But, under uncertainty, firms hold some minimum amount of cash and inventories
based on expected payments, expected sales, expected order lead times, and so on, plus
additional amounts, or safety stocks, that enable them to deal with departures from the
expected values.
Working Capital Investment and Financing Policies:
Alternative Current Asset Investment Policies
• With a restricted current asset investment policy, the firm would hold minimal levels of
safety stocks for cash and inventories, and it would have a tight credit policy, even
though this would mean running the risk of losing sales.
• A restricted current asset investment policy generally provides the highest expected
return on investment, but it entails the greatest risk, whereas the reverse is true under a
relaxed policy.
• The moderate policy falls in between the two extremes in terms of both expected risk
and return.
• A restricted current asset investment policy as a result would lead to a relatively short
cash conversion cycle, a relaxed policy would lead to a relatively longer cash conversion
cycle, and moderate policy would lead to a cash conversion cycle in between two
extremes.
Working Capital Investment and Financing Policies:
Alternative Current Asset Financing Policies
• Most businesses experience seasonal fluctuations, cyclical fluctuations, or both and
thereby, their current assets (receivables, inventories) fluctuates as well.
• But, current assets rarely drop to zero rather a stable amount of currents assets are held
on an average and this level of current assets is called permanent current assets.
• On the other hand, temporary current assets fluctuate from zero to peak level with
respect to the seasonal or economic conditions of a firm.
• The manner in which the permanent and temporary current assets are financed is called
the firm’s current asset financing policy.
Working Capital Investment and Financing Policies:
Alternative Current Asset Financing Policies
• Maturity Matching, or “Self-Liquidating” Approach
• This approach calls for matching asset and liability maturities to minimize the risk that
the firm will be unable to pay off its maturing obligations if the liquidations of the assets
can be controlled to occur on or before the maturities of the obligations.
• But, exact maturity matching is
unrealistic so firms follow a
moderate current asset
financing policy as inventories
having a conversion period of
30 days should not be financed
with a 30-day loan because
complete cash sales might not
happen.
Working Capital Investment and Financing Policies:
Alternative Current Asset Financing Policies
• Aggressive Approach
• This approach calls for
financing all of the temporary
assets with short-term, non-
spontaneous debt and
financing all the fixed assets
with long-term capital, but
some of the remainder of the
permanent currents assets is
financed with short-term,
nonspontaneous credit.
Working Capital Investment and Financing Policies:
Alternative Current Asset Financing Policies
• Conservative Approach
• This approach calls for financing all
of the permanent assets with
permanent capital as well as some
or all portion the seasonal or
temporary assets with
permanent capital.
• During seasonal peaks the firm
finances temporary asset demands
with short-term nonspontaneous
credit.
• The policy is not as profitable as
the other two approaches.
Advantages and Disadvantages of Short-Term
Financing
• The aggressive policy calls for the greatest use of short-term debt, whereas the
conservative policy requires the least short-term debt, and maturity matching falls in
between.
• Using short-term credit is riskier but has some pros as well.
• Speed
• A short-term loan can be obtained much faster than long-term credit as lenders will
insist on a more thorough financial examination and considerably detailed loan
agreement before extending long-term credit.
• Flexibility
• If the needs for funds are seasonal or cyclical then short-term credit is much flexible as
costs of long-term debt are significantly greater, expensive penalties exist for
prepayment of long-term debt, and rigid covenants of long-term debt agreements
constrain the future actions of the firm.
Advantages and Disadvantages of Short-Term
Financing
• Risk of long-Term versus Short-Term Debt
• Short-term credit subjects the firm to more risk than does long-term financing.
• When a firm borrows on a long-term basis, its interest costs will be relatively stable or
fixed over time, but this is not the case for short-term credit as interest rates fluctuates
frequently.
• Overwhelming amount of short-term financing can lead firm into bankruptcy as the firm
might find it difficult to payoff such huge loans within a very short time period.