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Unformatted text preview: Short-Term
© Jeffrey Van Daele (http://www.fotolia.com/p/62350) Whereas long-term financing decisions concern how the firm finances its assets
over several years, short-term financing decisions concern how the firm can get
the money it needs for daily, weekly, and monthly needs. Cash management is
paramount, either by budgeting the amount on hand, buying supplies on credit,
or borrowing it for short periods of time. Short-term funds are also often used for
investments in accounts receivable and inventory. Chapter 17 begins this section
with an examination of the trade-off that is at the heart of short-term financial
management: liquidity versus profitability. Firms can either keep large balances of
cash and inventory, which increases liquidity but decreases profitability, or they can
keep low balances of cash and inventory, which helps profitability but decreases
liquidity. Somewhere in-between is the proper balance for each individual firm.
Chapters 18 through 20 take up the management of the individual current asset
and current liability accounts. Chapter 18 explains cash management, including
the process of developing a cash budget. Chapter 19 discusses the optimal levels
of inventory and accounts receivable, including the decision process associated
with offering credit to customers. Chapter 20 explores short-term financing
alternatives and discusses how to calculate the effective interest rate for various
types of short-term loans. 485 CHAPTERS 17 Working Capital Policy 18 Managing Cash 19 Accounts Receivable
and Inventory 20 Short-Term Financing Working Capital
“Ready money is Aladdin’s lamp.”
—Lord Byron The U.S. Small Business Administration Helps
Companies Find Needed Working Capital
The Export Working Capital Program (EWCP) was designed to provide
short-term working capital to exporters. The SBA’s Export Working Capital
Program (EWCP) supports export financing to small businesses when that
financing is not otherwise available on reasonable terms. The program
encourages lenders to offer export working capital loans by guaranteeing
repayment of up to $1 million or 90 percent of a loan amount, whichever
is less. A loan can support a single transaction or multiple sales on a
revolving basis. The above comes from the website of the Hartford, CT, Office of the U.S.
Small Business Administration (SBA). It shows how the SBA, which tries to
support small businesses, recognizes the importance of working capital to a
firm. Working capital allows a company to pay its bills and stay in business.
We examine this important topic in this chapter. Source: http://www.sba.gov/ct/CT_FINANCING.html, the website of the U.S. Small Business Administration, Hartford, CT,
office, June 23, 2006. 486 © George Pappas (http://www.fotolia.com/p/46098) Chapter Overview Learning Objectives In this chapter we examine working capital policy—the management of a firm’s
current assets and its financing. First, we’ll see why firms manage working capital
carefully, why they accumulate it, and how to classify current assets. We then
investigate what determines a firm’s working capital policy and look at different
types of policies. Managing Working Capital
Working capital refers to a firm’s current assets. By “current” we mean those
assets that the firm expects to convert into cash within a year. Current assets include
cash; inventory, which generates cash when the items are sold; and accounts
receivable, which produces cash when customers pay off their credit accounts.
Current assets are considered liquid because they can be transformed into cash
in a relatively short time.
Net working capital is the firm’s current assets minus current liabilities.
Current liabilities are business obligations (i.e., debts) that the firm is required to
pay off or otherwise satisfy within a year. Examples include accounts payable—
bills due soon—and notes payable—loans due to be paid in less than a year.
Table 17-1 shows the working capital and net working capital for Green World
Lawn Care Products Company, which manufactures lawn and gardening products
and sells them to retailers. 487 After reading this chapter,
you should be able to: 1. Explain the importance
of managing working
capital. 2. Discuss how the
profitability affects a
firm’s current asset
management policy. 3. Describe how a firm
reaches on optimal
level of current assets. 4. Discuss the effects of
the three approaches
to working capital
financing policy. 488 Part V Short-Term Financing Decisions Table 17-1
Green World Lawn Care Products Company Balance Sheet, as of
December 31, 2009
Cash Accounts Receivable $ 2,000 1,000 Accounts Payable Notes Payable Inventory 10,000 Total Current Liabilities Total Current Assets 13,000 Other Liabilities 32,000 Common Stock Other Assets Total Assets $45,000 Total Liabilities and Equity $ 7,000
$ 45,000 In Table 17-1 we see that Green World has $13,000 in current assets (working
capital), $11,000 in current liabilities, and $2,000 in net working capital ($13,000 –
$11,000 = $2,000). Net working capital is important to firms. It represents the amount of
current assets remaining if they were liquidated to pay the company’s short-term debts.
Working capital policy is the firm’s policy about its working capital level and how
its working capital should be financed. For instance, a firm needs to make decisions
about how much to keep in its cash account, what level of inventory to maintain, and
how much to allow accounts receivable to build up. The firm must also decide whether to
finance current assets with short-term funds, long-term funds, or some mixture of the two.
Together, the level and financing decisions make up the firm’s working capital policy. Why Businesses Accumulate Working Capital
Why do firms accumulate working capital, and why does its level vary over time? In
this section we examine the answers to these two questions. Fluctuating Current Assets
Many factors affect a firm’s working capital policy. For instance, a service firm may
require a different level of current assets than a manufacturing firm. Or a business like
Jason’s Popcorn Wagon (from Chapter 13), which makes and sells popcorn during the
summer months only, has different seasonal working capital needs than a firm that makes
and sells products year-round.
To illustrate the principles of working capital policy, we focus on a manufacturing
firm that has level production—that is, it produces the same amount of product every
month, year-round. However, its sales are seasonal—the firm sells more in certain
time periods than in others. Many businesses are seasonal. (For instance, a swimwear
manufacturer may sell many more swimsuits at the start of summer than it does in other
months. A lawn care products manufacturer will probably have more sales at the start
of the gardening season than it will in other months.)
If a business has level production but not level sales, inventory increases when
production exceeds sales. Inventory then falls when sales exceed production. The firm’s
other current assets may fluctuate during the year as well. Accounts receivable, for
example, will rise when new credit sales exceed customer payments and will fall when Chapter 17 Working Capital Policy 489 Assets (dollars) Fluctuating or “Temporary”
Current Assets Figure 17-1 The
Variation in Current Assets
Over Time for Green World
Lawn Care Products “Permanent” Current Assets Fixed Assets (Plant and Equipment) Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Figure 17-1 shows how the
current assets of a company
tend to fluctuate over time but
never fall below a permanent
level of current assets. customer payments exceed new credit sales. Cash will accumulate as sales revenues are
collected and will decline when bills are paid. Thus, the current assets of the business
will fluctuate over time. Permanent and Temporary Current Assets
Although the level of current assets in the firm may fluctuate, it rarely reaches zero. The
firm will nearly always have some cash on hand, hold some inventory in stock, and be
owed some amount of money. Current assets thus reach various temporary levels but
will rarely fall below some minimal permanent level. This effect is illustrated for Green
World Lawn Care Products Company in Figure 17-1.
Figure 17-1 shows three categories of business assets that affect a firm’s working
1. Temporary current assets represent the level of inventory, cash, and accounts
receivable that fluctuate seasonally.
2. Permanent current assets represent the base level of inventory, cash, and accounts
receivable, which tends to be maintained.
3. Fixed assets represent the land, buildings, equipment, and other assets that would
not normally be sold or otherwise disposed of for a long period of time.
Permanent current assets tend to build up on a firm’s balance sheet year after year.
Cash collections increase as the business grows, accounts receivable grow as the list of
credit customers lengthens, inventory on hand rises as new facilities are opened, and
so on. Figure 17-2 shows how Green World Lawn Care Product’s current assets might
vary over several years. Take Note
The term permanent
current assets may sound
like an oxymoron (like
“jumbo shrimp”), but it’s
not. A portion of a firm’s
current assets is likely
to remain on a firm’s
balance sheet indefinitely. 490 Part V Short-Term Financing Decisions Figure 17-2
The Variation in Current
Assets Over Several Years
for Green World Lawn
Figure 17-2 shows how a
typical firm’s current assets
tend to build up from year to
year, while fluctuating within
each year. The effect occurs
because as firms grow, they
accumulate receivable, and
inventory over time. Assets (dollars) Fluctuating or “Temporary”
Current Assets “Permanent” Current Assets Fixed Assets (Plant and Equipment) Year 1 Year 2 Year 3 As Figure 17-2 shows, businesses have two tasks: First, they must contend with
current assets that fluctuate through their business cycle. Second, they must manage
permanent current asset growth due to long-term business growth over time. In the
sections that follow, we discuss how firms do this. Liquidity versus Profitability
Lenders would like a company to have a large excess of current assets over current
liabilities. But the owners don’t necessarily feel the same way. Think about it. Current
assets—in the form of cash, accounts receivable, and inventory—do not earn the firm
a very high return. Cash is usually held in a commercial bank checking account that
pays no interest.1 Accounts receivable earns no return because it represents money that
customers owe to the firm that the firm doesn’t have yet. Inventory earns no return
until it’s sold. (Inventory being held by the firm is just material sitting in a warehouse,
earning nothing.) These assets have the advantage of being liquid, but holding them is
not very profitable.
Now consider the company’s noncurrent assets—its land, buildings, machinery,
equipment, and long-term investments. These assets often earn a substantial return. The
company’s land, buildings, machinery, and equipment are used to turn raw material into
products that can be sold for a profit. Long-term investments (such as investments in
subsidiaries) generally produce greater returns than current assets. These noncurrent
assets may be profitable, but they are usually not very liquid. Lenders are reluctant to let
firms use them for collateral (protection in the event of a default) for short-term loans.
Why? Because lenders will have to spend more time and expense to sell noncurrent
assets if firms default on their loans and the lenders become the asset owners. As a result,
lenders prefer that firms use liquid assets as loan collateral.
Business checking accounts almost never pay interest. 1 Chapter 17 Working Capital Policy Firms, then, are faced with a trade-off in their working capital management policy.
At one extreme they can seek liquidity, holding a lot of cash and other current assets in
case cash is needed soon. At the other extreme they can seek profitability, holding a low
level of current assets and investing primarily in long-term, high-return-producing assets.
In practice, no firm would actually choose either of these extreme positions. Instead,
managers seek a balance between liquidity and profitability that reflects their desire for
profit and their need for liquidity. Establishing the Optimal Level of Current Assets 491 Interactive Module
Go to www.textbookmedia.
com and find the free
companion material for this
book. Follow the instructions
there. See the importance of
liquidity to a company. The search for a balance between liquidity and profitability serves as a general guide
for financial managers looking for an optimal level of current assets. However, the level
managers eventually achieve is actually a result of their efforts to maintain optimal
levels of each of the components of the current asset group. In other words, a firm’s
optimal level of current assets is reached when the optimal level of cash, of inventory,
and of accounts receivable2 is achieved. Each asset account is managed separately, and
the combined results produce the actual level of current assets. Here’s a description of
the attempt to find the optimal level for each current asset account:
• Cash: Managers try to keep just enough cash on hand to conduct day-to-day business,
while investing extra amounts in short-term marketable securities. We discuss cash
in detail in Chapter 18. • Inventory: Managers seek the level that reduces lost sales due to lack of inventory, while at the same time holding down inventory costs. We discuss inventory
management in Chapter 19. • Accounts receivable: Firms want to enhance sales but hold down bad debt and collection expenses through sound credit policies. We discuss credit policies in
Chapter 19. Once financial managers set policies to attain the optimal level of current assets,
they must turn their attention to the flip side of working capital management: managing
current liabilities. Managing Current Liabilities: Risk and Return
A firm’s current asset fluctuations and any long-term build-up of current assets (its
working capital) must, of course, be financed. The question facing financial managers
is whether to obtain the financing from short-term borrowing, long-term borrowing,
contributions from the owners (equity financing), or some mixture of all three.
As is so often the case, the choice of the firm’s working capital financing blend
depends on managers’ desire for profit versus their aversion to risk. Short-term debt
financing is generally less expensive than long-term debt and always less expensive than
equity financing. Recall from Chapter 2 that short-term interest rates are usually lower
than long-term interest rates. Short-term loans, however, are more risky because a firm
may not have enough cash to repay the loans (due to cash flow fluctuations) or interest
Along with any other current assets the firm possesses, of course. In this book we concentrate on these three major categories
of current assets. 2 Take Note
In our discussion we
assume that a firm has
all available financing
alternative options. In
practice, however, some
firms may have limited
financing options. For
example, small firms
usually have limited
access to long-term
capital markets. 492 Part V Short-Term Financing Decisions rates may increase and increase the cost of short-term funds as loans are renewed. Longterm debt and/or equity financing is less risky from the firm’s perspective because it
puts repayment off (forever, in the case of stock) and locks in an interest rate for a long
time period in the case of long-term debt.
The balance between the risk and return of financing options depends on the firm,
its financial managers, and its financing approaches. We discuss several financing
approaches next. Three Working Capital Financing Approaches
The three primary working capital financing approaches are the aggressive approach,
the conservative approach, and the moderate approach. A firm that takes an aggressive
approach uses more short-term financing to finance current assets. Firm risk increases,
due to the risk of fluctuating interest rates, but the potential for higher returns increases
because of the generally low-cost financing. A firm that implements the conservative
approach avoids short-term financing to reduce risk but decreases the potential for
maximum value creation because of the high cost of long-term debt and equity financing.
The moderate approach tries to balance risk and return concerns. The Aggressive Approach
We know that short-term interest rates are normally lower than long-term interest rates.
We also know that borrowing short term is riskier than borrowing long term because
the loan must be paid off or refinanced sooner rather than later.
The aggressive working capital financing approach involves the use of shortterm debt to finance at least the firm’s temporary assets, some or all of its permanent
current assets, and possibly some of its long-term fixed assets. The aggressive approach
is shown graphically in Figure 17-3.
If we compare current assets and current liabilities in Figure 17-3, we see that all
the firm’s temporary current assets and most of its permanent current assets are being
financed with short-term debt (the current liabilities). As a result, the firm has very little
net working capital. Depending on the nature of the firm’s business, this small amount of
net working capital can be risky. There isn’t much cushion between the value of liquid
assets and the amount of debt due in the short term.
Firms may be more aggressive than the firm depicted in Figure 17-3. If the firm’s
managers financed all working capital from short-term debt, then current assets would
equal current liabilities and the firm would have zero net working capital—no cushion
at all. Managers may go even further and finance a portion of the firm’s long-term assets
(plant and equipment) with short-term debt, creating a negative net working capital.
However, such an approach is very risky. (Think what would happen to a firm using
that approach if short-term interest rates rose unexpectedly.)
What tempts financial managers to take the aggressive approach and use a relatively
large amount of short-term debt for working capital financing? Usually, lower interest
rates tempt them. Managers will take a risk if the promise of return is high enough to
The Conservative Approach
Borrowing long term is considered less risky than borrowing short term. This is because
the borrower has a longer time to use the loan proceeds before repayment is due. Chapter 17 Working Capital Policy 493 The Balance Sheet Working Capital Assets
Current Assets Liabilities and Equity Net Working
Capital Current Liabilities Permanent
Current Assets Long-Term
Fixed Assets Long-Term
Liabilities and Equity Furthermore, if interest rates should go up during the period of the loan, the long-term
borrower has another advantage. The long-term borrower has locked in a fixed interest
rate and may end up paying less total interest than the short-term borrower, who must
renew the loan each time it comes due—at a new, higher interest rate. If market rates
fall, the long-term borrower can usually refinance.
The conservative working capital financing approach involves the use of longterm debt and equity to finance all long-term fixed assets and permanent current assets,
in addition to some part of temporary current assets. The conservative approach is shown
graphically in Figure 17-4.
Compare current assets with current liabilities in Figure 17-4. Note that all the firm’s
permanent current assets and most of its temporary current assets are being financed with
long-term debt or equity. As a result, current assets exceed current liabilities by a wide
margin and the firm has a large amount of net working capital. Having a large amount
of net working capital is a relatively low-risk position because the firm has many assets
that could be liquidated to satisfy short-term debts.
A financial manager who applies an ultra-conservative approach would use cash
from the owners for all asset financing needs (high cash balance supported by equity)
and incur no debt. By using only equity capital, the firm would also have the maximum
amount of net working capital possible because it would have no current liabilities.
The safety of the conservative approach has a cost. Long-term financing is generally
more expensive than short-term financing. Long-term interest rates are higher than
short-term rates when there is an upward sloping yield curve, the normal yield curve
described in Chapter 2. Also, the cost of equity is greater than the cost of either longterm or short-term debt, as described in Chapter 9. So relying on long-term debt and
equity sources to finance working capital consumes funds that could otherwise be put
to more productive use. Figure 17-3
The Aggressive Working
Figure 17-3 shows the firm’s
assets on the left and liabilities
and equity on the right.
Subtracting current liabilities
from current assets shows
that this firm’s working capital
financing strategy is to finance
nearly all current assets with
current liabilities, resulting in a
small amount of net working
capital. 494 Part V Short-Term Financing Decisions
The Balance Sheet Figure 17-4 The
The relative size of the current
asset and current liability
accounts in Figure 17-4 reveals
the firm’s working capital
financing strategy. The figure
shows that this firm is financing
nearly all current assets with
long-term liabilities and equity,
resulting in a high level of net
working capital. Working Capital Assets Liabilities and Equity
Current Liabilities Temporary
Current Assets Permanent
Current Assets Net Working
Liabilities and Equity Long-Term
Fixed Assets The Moderate Approach
An accounting concept known as the matching principle states that the cost of an asset
should be recognized over the length of time that the asset provides revenue, or benefit,
to the business.
The concept of the matching principle can be applied to define a moderate position
between the aggressive and the conservative working capital financing approaches.
According to the matching principle, temporary current assets that are only going to be
on the balance sheet for a short time should be financed with short-term debt—that is,
current liabilities. Permanent current assets and long-term fixed assets that are going to be
on the balance sheet for a long time should be financed from long-term debt and equity
sources. The moderate working capital financing approach is shown in Figure 17-5.
If we look at current assets and current liabilities in Figure 17-5, we see that the
firm has matched its short-term temporary current assets to its current liabilities. It has
also matched its long-term permanent current assets and fixed assets to its long-term
financing sources. This policy gives the firm a moderate amount of net working capital. It
calls for a relatively moderate amount of risk balanced by a relatively moderate amount
of expected return. We all have some feel for the rationale behind this approach. You
would probably not be attracted to a 30-year car loan nor a 6-month mortgage.
Now that we have described three working capital financing policies, we turn to an
analysis of the effect of such policies on a firm. Working Capital Financing and Financial Ratios
The use of ratio analysis highlights how the three approaches to working capital financing
policy can affect the risk and return potential of a firm. In Table 17-2 we compare
selected financial ratios for three different firms that differ only in the manner in which Chapter 17 Working Capital Policy 495 The Balance Sheet Working Capital Assets Liabilities and Equity Temporary
Current Assets Current Liabilities Permanent
Current Assets Net Working
Liabilities and Equity Long-Term
Fixed Assets Table 17-2
Ratio Analysis of Approaches to Working Capital Financing Policy
Data as of the End of
the Last Fiscal Year
Temporary Current Assets Firm A
$ 200 Firm C Conservative Firm M
Moderate $ 200 $ 200 Permanent Current Assets $ 400 $ 400 $ 400 Fixed Assets $ 600 $ 600 $ 600 Total Assets $1,200 $ ,200 1 $1,200 Current Liabilities $ 300 $ 100 $ 200 Long-Term Debt $ 300 $ 500 $ 400 Stockholders’ Equity $ 600 $ 600 $ 600 Total Liabilities and Equity $1,200 $ ,200 1 $1,200 Net Income for the Year $ 126 $ 114 $ 120 Net Working Capital $ 300 $ 500 $ 400 Current Ratio 2.0 6.0 Total Debt to Total Assets Ratio 50% 50% 50.0% 3.0 Return on Equity 21% 19% 20.0% they finance their working capital. Firm A takes the aggressive approach, Firm C takes
the conservative approach, and Firm M takes the moderate approach.
Notice in Table 17-2 that Firm A, which follows an aggressive financing approach,
has the highest net income, smallest amount of net working capital, the lowest current
ratio, and the highest return on stockholders’ equity of any of the three firms. This is Figure 17-5 The
Moderate Working Capital
In Figure 17-5 we see that this
firm’s approach to working
capital financing policy is to
finance its permanent current
assets with long-term debt and
equity and its temporary current
assets with current liabilities.
This results in a moderate level
of net working capital. 496 Part V Short-Term Financing Decisions Table 17-3 Three Approaches to Working Capital Financing Policy—Cost
and Risk Factors
Aggressive Conservative Moderate Cost Low High In-Between Risk High Low In-Between consistent with the relationship between risk and return (the more risk a firm takes, the
more return it earns). There is no guarantee, of course, that net income will be positive.
Firm C, which follows the conservative financing approach, has the lowest net
income, the largest amount of net working capital, the highest current ratio, and the
lowest return on stockholders’ equity of the three firms. This reflects its relatively lower
risk and lower return potential.
Firm M, which follows the moderate approach of matching its short-term temporary
current assets to its current liabilities is, of course, in a position between the other two.
Table 17-3 summarizes the cost and risk considerations of the aggressive,
conservative, and moderate approaches to working capital financing.
In the real world, of course, each firm must decide on its balance of financing sources
and its approach to working capital management based on its particular industry and
the firm’s risk and return strategy. What’s Next
In this chapter we examined the general working capital policy of a firm. In Chapter 18
we will look at cash. Accounts receivable and inventory will follow in Chapter 19 and
short-term financing in Chapter 20. Summary
1. Explain the importance of managing working capital.
A firm’s current assets—such as cash, inventory, and accounts receivable—are referred
to as working capital. Managing the levels and financing of working capital effectively
is necessary to keep the firm’s costs and risk under control while maintaining a firm’s
returns and cash flow over the long term.
Firms accumulate working capital because of fluctuations in sales, production, and
cash or credit payments. For instance, cash accumulates as accounts are collected and
declines when bills are paid. Inventory builds when production exceeds sales and falls
when sales exceed production. Accounts receivable rises as credit sales are made and
falls when customers pay off their accounts. The combined effect of changes in each
current asset account causes working capital to fluctuate. Furthermore, working capital
will gradually build up over time unless the firm takes some concrete action to either
reinvest the funds in long-term assets or distribute them to the firm’s owners. Chapter 17 Working Capital Policy Temporary current assets represents the level of current assets that fluctuates, and
permanent current assets represents the level of current assets a firm keeps regardless
of periodic fluctuations.
2. Discuss how the trade-off between liquidity and profitability affects a firm’s
current asset management policy.
Current asset management involves a trade-off between the need for liquidity and the
desire for profitability. The more current assets a firm holds, the more liquid the firm,
because the assets can be converted to cash relatively quickly. However, tying up funds
to sustain a certain level of current assets prevents the funds from being invested in
long-term, high-return-producing assets.
3. Describe how a firm reaches an optimal level of current assets.
Firms reach an optimal level of current assets when the optimal level for each individual
current asset account (mainly cash, inventory, and accounts receivable) is achieved.
Separate techniques exist for managing each of the current asset accounts. The techniques
for managing each current asset account are described in Chapters 18 and 19.
4. Discuss the effects of the three approaches to working capital financing policy.
Short-term interest rates are usually lower than long-term interest rates, so financing
working capital with short-term debt generally lowers the firm’s financing costs.
However, using short-term debt increases the risk that cash won’t be available to pay
the loans back, and that the firm may have to renew its loans at higher interest rates.
Relying on long-term debt and/or equity sources to finance working capital decreases
risk because firms repay such obligations in the long term, and firms lock in an interest
rate. A firm’s return suffers, however, because long-term financing costs are normally
higher than short-term costs.
The aggressive approach to working capital policy consists of financing all temporary
current assets, and some or all long-term permanent current assets, and possibly a
portion of fixed long-term assets with short-term debt. The conservative approach to
working capital policy consists of financing all permanent current assets and some
short-term temporary current assets with long-term debt and/or equity financing. The
moderate approach consists of financing temporary current assets with short-term debt,
and financing long-term permanent current assets with long-term debt and/or equity. 497 498 Part V Short-Term Financing Decisions Self-Test
ST-1. xplain the liquidity–profitability trade-off
associated with working capital management.
ST-2. ow is the optimal level of working capital
ST-3. sing the following financial data, draw a
diagram showing the company’s temporary
current assets, permanent current assets, and
long-term fixed assets during this last year. ST-4. s of today, a company has $100,000 of
temporary current assets, $50,000 of permanent
current assets, and $80,000 of long-term fixed
assets. If the company follows the moderate
approach to working capital financing, how
much of its assets will be financed with shortterm debt (current liabilities) and how much
will be financed with long-term debt and/or
equity as of today? Selected Financial Data for Past Fiscal Year
(in thousands) Jan 1 Mar 31 Jun 30 Oct 31 Dec 31 Total Assets $ 580 $ 480 $ 80 2 $ 00 4 $ 58 Fixed Assets $ 100 $ 100 $ 00 1 $ 00 1 $ 100 Review Questions
1. What is working capital?
2. What is the primary advantage to a corporation of
investing some of its funds in working capital?
3. Can a corporation have too much working capital?
4. Explain how a firm determines the optimal level
of current assets.
5. What are the risks associated with using a large
amount of short-term financing for working capital?
6. What is the matching principle of working capital
financing? What are the benefits of following this
7. What are the advantages and disadvantages of the
aggressive working capital financing approach?
8. What is the most conservative type of working
capital financing plan a company could implement?
Explain. 499 Chapter 17 Working Capital Policy Build Your Communication Skills
CS-1. esearch a business you find interesting.
Prepare a short report outlining at least two
ways that company could increase its liquidity.
Consider both asset management and liability
CS-2. hoose any company for which you can locate
balance sheet data for the last five years. Plot
on a graph the company’s total assets for each
year and connect the data points with a line.
Next, plot the company’s net fixed assets for
each year and connect the data points with a
line. Finally, sketch a line that just touches
the low points reached by the total asset line
across the graph. You should now have a graph similar to Figure
17-2. Label the appropriate areas of your graph
as temporary current assets, permanent current
assets, and fixed assets.
Refer to the company’s latest balance sheet
and note the amount of current liabilities and
long-term debt and equity shown. Compare
these amounts with the ending amount of
current and fixed assets shown on your graph.
The results will reveal the company’s working
capital financing policy. Explain your findings
to the class. Problems
PS International has the following balance sheet. Twenty-five percent of
its current assets are temporary, and the remainder are permanent current
assets. Cash $ 150,000 Inventory Total Assets Notes Payable Liquidity 90,000 80,000 Long-Term Debt 120,000 500,000 Fixed Assets Working Capital $ 100,000 120,000 Accounts Receivable Accounts Payable Common Equity $ 850,000 540,000 Total Liabilities and Equity $ 850,000 a. What is WPS International’s working capital?
b. What is WPS International’s net working capital?
c. Calculate the temporary current assets.
d. Calculate the permanent current assets. 17-2.
Compare the following two firms and decide which has more liquidity.
Firm 1 Firm 2 Cash $ 10,000 Cash $ 8,000 Inventory $ 3,000 Inventory $ 6,000 Accounts Receivable $ 2,500 Accounts Receivable $ 3,500 Net Fixed Assets $ 15,000 Net Fixed Assets $ 13,000 Accounts Payable $ 7,500 Accounts Payable $ 3,500 Notes Payable $ 4,000 Notes Payable $ 11,000 Long-Term Debt $ 7,000 Long-Term Debt $ 9,000 Common Equity $ 12,000 Common Equity $ 7,000 500 Part V Short-Term Financing Decisions A ssessing Liquidity 17-3. Consider the following two companies:
Company A Cash Company B $ 1,000 Accounts Receivable $ 400 80
880 1,500 1,620 $ 2,900 $ ,580
2 Accounts Payable $ $ 600 Net Fixed Assets 800 1,100 Long-Term Debt Common Equity 900 1,200 $ 2,900 880 $ ,580
Which of the two firms is the more liquid? Why? Current Assets, Current Liabilities, and Net Working Capital 17-4.
Capt. Louis Renault’s Hikewell Outdoor Equipment Company has the
following balance sheet accounts as of the end of last year. One-half current
assets are permanent and one-half are temporary. Accounts Receivable Inventory Fixed Assets Conservative Working Capital Financing Approach Cash $ 30,000 Accounts Payable $ 100,000 a. What is the amount of the company’s current assets, its working capital?
b. What is the amount of the company’s current liabilities?
c. What is the amount of the company’s net working capital?
d. hat percentage of temporary current assets is financed by current
liabilities? Would you consider this an aggressive approach or a
conservative approach? 15,000 Notes Payable 60,000 130,000 Long-Term Debt 90,000 500,000 Common Equity $ 675,000 425,000
$ 675,000 Alexander Sebastian, the finance manager of Hikewell Outdoor Equipment
Company of problem 17-4, thinks the way the company is financing its
current assets is too risky. By the end of next year, he would like the pro
forma balance sheet to look as follows:
Cash Accounts Receivable Inventory Fixed Assets $ 30,000 Accounts Payable $ 30,000 15,000 Notes Payable 20,000 130,000 Long-Term Debt 150,000 500,000 Common Equity $ 675,000 475,000
$ 675,000 Chapter 17 Working Capital Policy 501 a.
What is the amount of the company’s projected current assets, its working
capital? b. What is the amount of the company’s projected current liabilities? c. What is the amount of the company’s projected net working capital? d. hat percentage of temporary current assets is projected to be financed
by current liabilities? Would you consider this an aggressive approach or
a conservative approach? Assessing Working Capital Policy 17-6.
Consider the following balance sheet for Lulu Belle’s Killer Guard
Assets Liabilities and Equity Cash Marketable Securities $ 50 Accounts Receivable Inventories Net Fixed Assets Accounts Payable $ 80 0 Short-Term Debt 90 40 Long-Term Debt 210 70
530 Common Equity 310 $ 690 $ 690 a. How much working capital does Lulu Belle have? b. How much net working capital does Lulu Belle have? c.
What working capital financing policy (aggressive, moderate, or
conservative) is Lulu Belle following? d. xplain what actions Lulu Belle could take to increase the company’s
Laroux Products has the following balance sheet. Its temporary current
assets are 30 percent of the current assets, and the remaining are permanent
Cash $ 100,000 Accounts Payable $ 600,000 Inventory $ 200,000 Notes Payable $ 200,000 Accounts Receivable $ 150,000 Long-Term Debt $ 150,000 Net Fixed Assets $ 550,000 Common Equity $ 50,000 Total Assets $1,000,000 Total Liabilities and Equity $ 1,000,000 company would like to change its financing approach to a more conservative
one. Create a new balance sheet using the conservative approach that the
company could adopt. Laroux estimates the asset amounts will remain the same.
Tony Reynolds, CFO for Ridgeway Building Supplies, has determined that Conservative Working Capital Financing Approach 502 Moderate Working Capital Financing Approach Part V Short-Term Financing Decisions the company would run best if it used the moderate approach to financing.
Recently, the company has thought about switching to this approach. The
following is a partial balance sheet stating its assets. Permanent current
assets are assumed to be 60 percent of the current assets.
Cash $ 50,000 Accounts Receivable Accounts Payable 25,000 Notes Payable Inventory 150,000 Long-Term Debt Fixed Assets 475,000 Common Equity $ 700,000
What would the company’s financing look like if Tony switched to the moderate
approach? Calculate for the following scenarios: a. Accounts payable is $40,000; common equity is $200,000. b. Accounts payable is $30,000; common equity is $425,000. Aggressive Working Capital Financing Approach Moderate Working Capital Financing Approach Using the information given in problem 17-8, what would Ridgeway
Building Supplies’ financing look like if Tony decided to use an aggressive
approach instead? Accounts payable is $180,000, and common equity is
Marian Pardoo, the chief financial officer of Envirosafe Chemical Company,
believes in a moderate approach of financing following the matching
principle. Some of the projected balance sheet accounts of the company for
the end of next year follow: Current and Fixed Assets
Cash $ 30,000 Accounts Receivable Permanent
$ 15,000 15,000 5,000 Inventory 130,000 80,000 Fixed Assets 500,000 Total Assets $ 675,000 Liabilities and Equity
Accounts Payable $ 20,000 Short-Term Debt ? Long-Term Debt ? Common Equity 450,000 Total Liabilities and Equity $ 675,000
How much should Marian finance by short-term debt and long-term debt to
conform to the matching principle?
Use the same data given in problem 17-10. Marian’s boss, Ann Lowell, is the Chapter 17 Working Capital Policy vice president of finance of Envirosafe Chemical Company and she expects
interest rates to decrease in the future and, hence, would like to follow a
very aggressive policy using a large amount of short-term debt and a small
amount of long-term debt. She would also like to decrease net working
capital to $25,000. How much should Ann finance by short-term debt and
how much by long-term debt to conform to her aggressive approach?
17-12. omparative data at the end of this past year for three firms following
aggressive, moderate, and conservative approaches to working capital policy
follow (in thousands of dollars):
Aggressive Moderate Conservative Temporary Current Assets $ 75 $ 75 $ 100 $ 100 Aggressive Working Capital Financing Approach Different Working Capital Financing Approach $ 75 Permanent Current Assets 503 $ 100 Fixed Assets $ 500 $ 500 $ 500 Total Assets $ 675 $ 675 $ 675 Current Liabilities $ 160 $ 75 $ 50 Long-Term Debt $ 90 $ 150 $ 150 Stockholders’ Equity $ 425 $ 450 $ 475 Net Income $ 70 $ 70 $ 70
Calculate, compare, and comment on the current ratios, total debt to asset ratios,
and returns on equity of the three firms.
Greenplanet Recycling Company is considering buying an additional facility
at a cost of $500,000. The facility will have an economic life of five years.
The company’s financial officer, Karen Holmes, can finance the project by: a. A five-year loan at an annual interest rate of 13 percent b. A one-year loan rolled over each year for five years
Compare the total interest expenses for both the preceding alternatives under
the following assumptions, and calculate the savings in the interest expenses
by choosing one of two alternatives: 1.
The one-year loan has a constant interest rate of 11 percent per year over
the next five years. 2.
The one-year loan has an annual interest rate of 11 percent in the first
two years, 14 percent in the third and fourth years, and 16 percent in the
fifth year. Challenge Problem 504 Part V Short-Term Financing Decisions
The Matching Principle 17-14. analyze your company’s working capital financing policy, you
have gathered the following balance sheet data for the past 12 months
Date Total Assets Fixed Assets Jan 31 $45 $14 Feb 28 $46 $14 Mar 31 $34 $14 Apr 30 $48 $14 May 31 $40 $14 Jun 30 $30 $14 Jul 31 $28 $14 Aug 31 $39 $14 Sep 30 $45 $14 Oct 31 $39 $14 Nov 30 $52 $14 Dec 31 $50 $14
Plot these data on a trendline graph. Indicate the amount of your firm’s current
liabilities each month if you follow the matching principle. Comprehensive Problem 17-15.
Milton Warden, the finance manager of WinHeart Gift Company, is
analyzing past data on the firm’s fixed assets, permanent current assets,
and temporary current assets for each month over the last five years. The
company maintains level production, but its sales are seasonal. He found that
the monthly level of the three types of assets over the last five years can be
closely approximated by the following patterns (in thousands of dollars): • Fixed assets remained constant at 39 each month over the last five years.
• Permanent current assets were equal to 2 in January of year 1 and had grown
0.16 per month each month over the last five years. • Temporary current assets followed the same pattern each year, starting at 0 in
January, then each year they increased by 1 monthly until July and reduced
by 1 monthly until they reached 0 again in January of the next year. a. Plot these data on a graph similar to the one shown in Figure 17-2. b.
Calculate and identify on the graph the level of temporary current assets,
permanent current assets, and fixed assets in: (i) The month of September of year 4 (ii) The month of August of year 5 c.
Now calculate the levels of current liabilities in those months if the
company followed: (i) An aggressive working capital financing approach (ii) A moderate working capital financing approach (iii) A conservative working capital financing approach
Assume that the stockholders’ equity remained constant at 20 over those
five years. 505 Chapter 17 Working Capital Policy 17-16.
Buddy Love, a finance officer of Christmas Tree Ornaments and Gifts
Company, is analyzing past data on the fixed assets, permanent current
assets, and temporary current assets of the company each month over the last
several years. The company maintains level production, but its sales peak
at the end of the year. He found that the monthly level of the three types of
assets over the last five years can be closely approximated by the following
equations (in thousands of dollars):
F • ixed assets were equal to 55 and remained constant each month over the
last five years. P
• ermanent current assets were equal to 10 in January of year 1 and had T
• emporary current assets = m(m – 1)/4, where m = 1, 2, . . . , 12 for Jan, grown 0.30 per month each month over the last five years.
Feb, . . . , Dec, respectively. a. Plot these data on a graph similar to the one shown in Figure 17-2. b.
Calculate and identify on your graph the level of temporary current assets,
permanent current assets, and fixed assets at the following times: (i) The month of September of year 2 (ii) The month of October of year 4 (iii) ear 5’s minimum and maximum levels of total assets and the
months those levels occurred c.
Now calculate the levels of current liabilities in the months described in
part b of this problem if the company followed: (i) An aggressive working capital financing approach (ii) A moderate working capital financing approach (iii) A conservative working capital financing approach
Assume that the stockholders’ equity remained constant at 30 over those
five years. Comprehensive Problem Part V Short-Term Financing Decisions Answers to Self-Test
ST-1. orking capital (i.e., current assets in the form of cash, accounts receivable,
inventory, and so on) can normally be exchanged for cash, or liquidated,
in a relatively short time. Therefore, the more working capital a company
maintains, the easier it is to raise cash quickly. However, maintaining
working capital costs money and it ties up funds that could otherwise be
used to invest in long-term income-producing assets, so profits and returns
suffer. For this reason, we say that managing working capital involves
balancing liquidity and profitability.
ST-2. The optimal level of working capital is achieved when the optimal levels of
each current asset account—cash, inventory, accounts receivable, and any
others—are reached. Each current asset category is managed separately and
the combined results produce the optimal level of current assets.
ST-3. $600 $500 $ in Thousands 506 $400 Temporary
Current Assets Temporary
Current Assets $300
Permanent Current Assets $200 $100 Long-Term Fixed Assets 0
Jan 1 Mar 31 Jun 30 Oct 31 Dec 31 Past Fiscal Year ST-4. ollowing the moderate approach, the company will finance its temporary
current assets with short-term debt and the rest of its assets with longterm debt and equity. Therefore, as of today, the company will have on its
Current Liabilities Long-Term Debt and Equity $100,000
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- Spring '10