Working Capital and the Financing Decision

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6

The rapid growth of business firms in the last two decades has challenged the inge–

nuity of financial managers to provide adequate financing. Rapidly expanding sales

may cause intense pressure for inventory and receivables buildup—draining the

cash resources of the firm. As indicated in Chapter 4, “Financial Forecasting,” a large

sales increase creates an expansion of current assets, especially accounts receivable

and inventory. Some of the increased current assets can be financed through the firm’s

retained earnings, but in most cases internal funds will not provide enough financing and

some external sources of funds must be found. In fact, the faster the growth in sales,

the more likely it is that an increasing percentage of financing will be external to the firm.

These funds could come from the sale of common stock, preferred stock, long-term

bonds, short-term securities, and bank loans, or from a combination of short- and long-

term sources of funds.

There is also the problem of seasonal sales that affects many industries such as soft

drinks, toys, retail sales, and textbook publishing. Seasonal demand for products makes

forecasting cash flows and receivables and inventory management difficult. The Internet

and cloud computing are beginning to alleviate some of these problems and help manage-

ment make better plans.

If you have had a marketing course, you have heard about supply chain manage–

ment. Well, financial executives are also interested in the supply chain as an area where

the Internet can help control working capital through online software. McDonald’s

Corporation of Big Mac fame formed eMac Digital to explore opportunities in business-to-

business (B2B) online ventures. One of the first things on the agenda was to have eMac

Digital help McDonald’s reduce costs. McDonald’s wanted to create an online market–

place where restaurants can buy supplies online from food companies. McDonald’s, like

Walmart, Harley-Davidson, and Ericsson, has embraced supply chain management using

web-based procedures. The goal is to squeeze out inefficiencies in the supply chain and

thereby lower costs. One of the big benefits is a reduction in inventory through online

Working

Capital and

the Financing

Decision

LO 6-1 Working capital management involves

financing and controlling the current

assets of the firm.

LO 6-2 Management must distinguish between

current assets that are easily converted to

cash and those that are more permanent.

LO 6-3 The financing of an asset should be tied

to how long the asset is likely to be on the

balance sheet.

LO 6-4 Long-term financing is usually more expensive

than short-term financing based on the theory

of the term structure of interest rates.

LO 6-5 Risk, as well as profitability, determines

the financing plan for current assets.

LO 6-6 Expected value analysis may sometimes be

employed in working capital management.

LEARNING OBJECTIVES

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communications between the buyer and supplier, which speeds up the ordering and

delivery process and reduces the amount of inventory needed on hand. These systems

may also be able to attract a large number of suppliers to bid on the company’s business

at more competitive prices.

Retailers like Walmart require suppliers to ship their goods with radio frequency iden-

tification chips (RFID) embedded in their shipments. These chips eliminate processing

delays, reduce theft, and result in better inventory management. From the financial man-

ager’s viewpoint, anything that can reduce inventory levels without creating out-of-stock

situations will reduce the amount of money needed to finance inventory. You can read

more about Walmart and RFID chips in the nearby Finance in Action box.

Working capital management involves the financing and management of the current

assets of the firm. The financial executive probably devotes more time to working capital

management than to any other activity. Current assets, by their very nature, are changing

daily, if not hourly, and managerial decisions must be made. “How much inventory is to

be carried, and how do we get the funds to pay for it?” Unlike long-term decisions, there

can be no deferral of action. While long-term decisions involving plant and equipment or

market strategy may well determine the eventual success of the firm, short-term decisions

on working capital determine whether the firm gets to the long term.

In this chapter, we examine the nature of asset growth, the process of matching sales

and production, financial aspects of working capital management, and the factors that go

into development of an optimum policy.

Any company that produces and sells a product, whether the product is consumer or

manufacturer oriented, will have current assets and fixed assets. If a firm grows, those

assets are likely to increase over time. The key to current asset planning is the ability

of management to forecast sales accurately and then to match the production sched-

ules with the sales forecast. Whenever actual sales are different from forecast sales,

unexpected buildups or reductions in inventory will occur that will eventually affect

receivables and cash flow.

In the simplest case, all of the firm’s current assets will be self-liquidating assets

(sold at the end of a specified time period). Assume that at the start of the summer

you buy 100 tires to be disposed of by September. It is your intention that all tires will

be sold, receivables collected, and bills paid over this time period. In this case, your

working capital (current asset) needs are truly short term.

Now let us begin to expand the business. In stage two, you add radios, seat cov-

ers, and batteries to your operation. Some of your inventory will again be completely

liquidated, while other items will form the basic stock for your operation. To stay

in business, you must maintain floor displays and multiple items for selection. Fur-

thermore, not all items will sell. As you eventually grow to more than one store, this

“permanent” aggregate stock of current assets will continue to increase. Problems of

inadequate financing arrangements are often the result of the businessperson’s failure

to realize the firm is carrying not only self-liquidating inventory, but also the anomaly

of “permanent” current assets.

The Nature of Asset Growth

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The movement from stage one to stage two of growth for a typical business is

depicted in Figure6-1. In panel A, the buildup in current assets is temporary—while

in panel B, part of the growth in current assets is temporary and part is permanent.

(Fixed assets are included in the illustrations, but they are not directly related to the

present discussion.)

RFID (radio frequency identification technol–

ogy), a system that has been around since

World War II and was used by the military

to keep track of airplanes, continues to gain

traction in inventory/supply chain manage–

ment. RFID chips have been used in trains,

ships, and trucks to track shipment contain–

ers. They are also used in automatic toll sys–

tems that allow drivers to pass through tolling

areas without stopping. The state of Michigan

has used these chips to track livestock; mara–

thon officials have used them to track a run–

ner’s time; and the Defense Department has

used them to track the shelf life of their food

rations. Additionally, they are now being used

to make sure that shipping containers entering

U.S. ports have not been tampered with after

inspection.

Hewlett-Packard, in a business briefing

paper, indicates that there may be as much

as $45 billion of excess inventory in the retail

supply chain that is unaccounted for at any

given time. In short, RFID chips can help a

company track goods and make sure that the

right goods get to the right places on time.

More sophisticated chips can be reused and

can even record a sale. For example, if an

expensive piece of jewelry is sold with a chip

attached, when the chip is decommissioned,

the sale automatically shows up in the store’s

computer system.

In 2005, Walmart mandated that by the

end of 2007, its 300 largest suppliers must

have RFID chips in each pallet of goods

shipped to its distribution centers. Procter

& Gamble was one of the first companies to

comply and found the system beneficial in

managing its own inventory, reducing out-of-

stock inventory levels, and preventing inven–

tory theft or theft of goods in transit. For

manufacturers of expensive products such

as pharmaceuticals, theft reduction can be

a significant cost saving. P&G noted that

when comparing bar codes to RFID chips, it

took 20 seconds to manually tally bar-code

data on a pallet versus five seconds to read

RFID technology. P&G states that it earned a

return on its RFID investment in the millions

of dollars.

According to the RFID Journal’s January 7,

2013, issue, 19 of the top 30 U.S. retailers are

involved at some level with RFID chips, but full

utilization of these chips has a long way to go

before they are used throughout their stores

for all products. Many specialty retailers are

beginning to use RFID technology; American

Apparel has adopted RFID technology at all

280 of its stores.

A rather unique use of these chips is for

high-value poker chips at casinos. In 2010,

a robber came into the Bellagio in Las Vegas

and left with $1.5 million in poker chips. Little

did he know that the chips had embedded

RFID chips, and as soon as he walked out of

the casino, the chips became worthless and

unable to be used anywhere.

A Great Inventory Tracking System

May Be Helping You

Finance in

ACTION

Technology

In most firms, fixed assets grow slowly as productive capacity is increased and old

equipment is replaced, but current assets fluctuate in the short run, depending on the

level of production versus the level of sales. When the firm produces more than it

sells, inventory rises. When sales rise faster than production, inventory declines and

receivables rise.

Controlling Assets—Matching Sales and Production

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As discussed in the treatment of the cash budgeting process in Chapter 4, some

firms employ level production methods to smooth production schedules and use man–

power and equipment efficiently at a lower cost. One consequence of level production

is that current assets go up and down when sales and production are not equal. Other

firms may try to match sales and production as closely as possible in the short run.

This allows current assets to increase or decrease with the level of sales and eliminates

the large seasonal bulges or sharp reductions in current assets that occur under level

production.

Seasonal industries can be found in manufacturing, retailing, electricity, and natural

gas. Demand is uneven in these industries, and many exhibit a seasonal demand. For

example, electricity producers have more demand in the summer for air condition-

ing while natural gas companies have more demand in the winter for heating. One

small manufacturing company that exhibits this type of seasonal demand is Briggs and

Stratton Corporation from Wauwatosa, Wisconsin.

Fixed assets

Time period

B. Stage II: Growth

Dollars

A. Stage I: Limited or no growth

Dollars

Temporary current assets

Permanent

current assets

Fixed assets

Time period

Figure 6-1 The nature of asset growth

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Briggs and Stratton is the largest maker of 3.5 to 25 horsepower air-cooled gas–

oline engines. Chances are if you’ve ever mowed a lawn, your lawnmower had a

Briggs and Stratton engine. Their motors can be found in pressure washers, compres–

sors and pumps, garden tillers, generators, small tractors, lawnmowers, and outboard

marine engines, and about 30 percent of the company’s overall sales are in the inter–

national market.

Briggs and Stratton’s fiscal year ends in June, and Figure 6-2 demonstrates both the

seasonality of sales and the leverage impact on earnings per share that we discussed in

Chapter 5. Because Briggs sells most of its products to other manufacturers who use

the engines as part of their finished products, a large percentage of sales must occur

–0.4

–0.6

–0.2

0.2

0.0

0.6

0.4

0.8

1.0

1.2

0

200

400

600

800

123412341234123412

2011 2012 2013 2014 2015

123412341234123412

2011 2012 2013 2014 2015

Sales in millions $

Earnings per share

Figure 6-2 Quarterly sales and earnings per share for Briggs and Stratton

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early in the year in order to produce the garden equipment that would be in demand

in spring and summer. We can see from Figure 6-2 that sales are lowest in the July to

September quarter, followed by the September–December quarter. Peak sales are in

the third quarter, beginning in January and ending in March. There are carryover sales

in the April to June quarter, which is the second best period for Briggs and Stratton.

Notice that the first quarter of the year always generates negative earnings per

share as the costs of production outweigh the revenue produced. This is most likely

caused by the costs of building inventory. Earnings in the second and fourth quarter

are small, with most of the earnings coming in the peak sales period of the third quar–

ter. For example in 2013, Briggs and Stratton earned $0.90 billion for the year with

$0.89 billion coming in the third quarter; in 2014 the firm earned $0.82 billion with

$0.81 billion coming in the third quarter. The seasonal nature of the company’s sales

can be exacerbated by inventory buildup at the end user and a fall in orders for the next

season. The company has made acquisitions in recent years to diversify its product line

and to smooth out sales and earnings. The future will tell if these acquisitions succeed.

Retail firms such as Target and Macy’s also have seasonal sales patterns. Figure6-3

on the next page shows the quarterly sales and earnings per share of these two compa–

nies, with the quarters ending in April, July, October, and January. These retail compa–

nies do not stock a year or more of inventory at one time. They are selling products that

are either manufactured for them by others or manufactured by their subsidiaries. Most

retail stores are not involved in deciding on level versus seasonal production but rather

in matching sales and inventory. Their suppliers must make the decision to produce on

either a level or a seasonal basis. Since the selling seasons are very much affected by

the weather and holiday periods, the suppliers and retailers cannot avoid inventory risk.

The fourth quarter for retailers, which begins in November and ends in January, is their

biggest quarter and accounts for as much as half of their earnings. You can be sure that

inventory not sold during the Christmas season will be put on sale during January.

Both Target and Macy’s show seasonal peaks and troughs in sales that will also

be reflected in their cash balances, accounts receivable, and inventory. Notice in

Figure6-3 that Target is growing slightly faster than Macy’s, which has a rather flat

trendline. Even so, Macy’s peak earnings per share are higher than Target’s earnings

per share when the fourth quarter sales peak out. Both companies illustrate the impact

of leverage on earnings as discussed in Chapter 5, but we can tell that Macy’s has

higher leverage because its EPS rises and falls with sales more than Target’s EPS (bot-

tom of Figure6-3). We shall see as we go through the chapter that seasonal sales can

cause asset management problems. A financial manager must be aware of these prob-

lems to avoid getting caught short of cash or unprepared to borrow when necessary.

Many retail-oriented firms have been more successful in matching sales and orders

in recent years because of new, computerized inventory control systems linked to

online point-of-sales terminals. These point-of-sales terminals allow either digital

input or use of optical scanners to record the inventory code numbers and the amount

of each item sold. At the end of the day, managers can examine sales and inventory

levels item by item and, if need be, adjust orders or production schedules. The predict-

ability of the market will influence the speed with which the manager reacts to this

information, while the length and complexity of the production process will dictate

how fast production levels can be changed.

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Temporary Assets under Level Production—An Example

To get a better understanding of how current assets fluctuate, let us use the example of

the Yawakuzi Motorcycle Company, which manufactures and sells in the snowy U.S.

Midwest. Not too many people will be buying motorcycles during October through

March, but sales will pick up in early spring and summer and will again trail off during

the fall. Because of the fixed assets and the skilled labor involved in the production

process, Yawakuzi decides that level production is the least expensive and the most

2134123412341234

2011 2012 2013 2014

0

5,000

10,000

15,000

20,000

25,000

Sales in millions $

1234123412341234

2011 2012 2013 2014

Earnings per share

0.0

0.5

1.0

1.5

2.0

2.5

3.0 Target

Macy’s

Target

Macy’s

Figure 6-3 Quarterly sales and earnings per share, Target and Macy’s

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Chapter 6 Working Capital and the Financing Decision 165

1st Quarter 2nd Quarter 3rd Quarter 4th Quarter

October …………… 300 January ……………. 0 April ………………… 1,000 July …………………. 2,000

November ………… 150 February ………….. 0 May …………………. 2,000 August …………….. 1,000

December ………… 50 March ……………… 600 June ………………… 2,000 September ……….. 500

Total sales of 9,600 units at $3,000 each5$28,800,000 in sales.

Table 6-1 Yawakuzi sales forecast (in units)

Production

Inventory

(at Cost of

Table 6-2 Yawakuzi’s production schedule and inventory

efficient production method. The marketing department provides a 12-month sales

forecast for October through September (Table6-1).

After reviewing the sales forecast, Yawakuzi decides to produce 800 motorcycles

per month, or one year’s production of 9,600 divided by 12. A look at Table6-2 shows

how level production and seasonal sales combine to create fluctuating inventory.

Assume that October’s beginning inventory is one month’s production of 800 units.

The ending inventory level is computed for each month and then multiplied by the

production cost per unit of $2,000.

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