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Working Capital and the
Financing Decision
Author's Overview
The chapter introduces the student to the topic of working capital management. The emphasis
is on the build-up of current assets and how they can best be financed. Examples of
McGraw-Hill, Target, and Limited Brands are used to show that seasonal earning and sales go
hand in hand. Companies in cyclical or seasonal industries have a more challenging job of
managing their current assets. Such key topics as the impact of production on financing needs
and the differences between temporary and permanent assets are considered. Also, the relative
costs and volatility of short and long-term financing are evaluated with an emphasis on the term
structure of interest rates. The chapter provides the framework from which to move into the
next two chapters, which cover the management of specific short-term assets and sources of
short-term financing.
Chapter Concepts
LO1. Working capital management involves financing and controlling the current assets of the
firm.
LO2. Management must distinguish between those current assets that are easily converted to
cash and those that are more permanent.
LO3. The financing of an asset should be tied to how long the asset is likely to be on the
balance sheet.
LO4. Long-term financing is usually more expensive than short-term financing based on the
theory of the term structure of interest rates.
LO5. Risk, as well as profitability, determines the financing plan for current assets.
LO6. Expected value analysis may sometimes be employed in working capital management.
Annotated Outline and Strategy
Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
6-1
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I. Introduction:
A. Working capital management involves the financing and management of the
current assets of the firm.
B. It is the financial manager's most time-consuming function.
C. Success in managing current assets in the short run is critical for the firm's
long-run existence.
Finance in Action: A Great Inventory Tracking System May Be Helping You
Radio frequency identification technology (RFID) is now being used by Wal-Mart to keep track
of inventory items. RFID chips allow companies to track goods so that the supply chain is more
efficient. Not only do efficient supply chain operations allow firms to reduce their working
capital requirements, RFID will result in reduced theft losses.
II. The Nature of Asset Growth
A. Changes in current assets may be “temporary” (seasonal) or "permanent."
1. Current assets by definition are those expected to become cash in one
operating cycle, but the level of the current assets may be "permanent" or
”temporary”.
2. Businesses subject to cyclical sales may have temporary fluctuations in
the level of current assets such as inventory. These temporary current
assets are “self-liquidating.” Their use (or sale) will generate sufficient
cash to pay back the funds borrowed to obtain them.
3. Businesses experiencing permanent growth will see a permanent increase
in current assets such as accounts receivable. The average balance in
accounts receivable will go up and stay up as long as sales are high.
PPT The Nature of Asset Growth (Figure 6-1)
III. Controlling Assets - Matching Sales and Production
A. Both accounts receivable and inventory rise when both sales and production
increase. When sales rise faster than production, inventory declines and
receivables rise.
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Education.
6-2
B. Level production (matching production and sales over an entire cycle) may cause
large buildups in current assets (inventory) when sales are slack. These
buildups drop rapidly during peak demand periods when sales exceed the level
production output.
C. Figure 6-2 demonstrates the seasonal nature of textbook sales for McGraw-Hill,
while Figure 6-3 illustrates the same principle for Target and Limited Brands. In
both cases, as sales grow over time, these permanent increases in associated
working capital have to be financed.
PPT Quarterly sales and earnings per share for Briggs and Stratton (Figure 6-2)
PPT Quarterly sales and earnings per share, Target and Macy’s (Figure 6-3)
Perspective 6-1: The Yawakuzi example brings into focus, the relationship among level
production, varying levels of sales and current asset financing. Tables 6-1 through 6-5 and
Figure 6-4 are essential to the presentation
PPT Yawakuzi Sales Forecast (Table 6-1)
PPT Yawakuzi's Production Schedule and Inventory (Table 6-2)
PPT Sales Forecast, Cash Receipts and Payments, and Cash Budget (Table 6-3)
PPT Total Current Assets, First Year (Table 6-4)
PPT Cash Budget and Assets for Second Year with no Growth in Sales (Table 6-5)
PPT The Nature of Asset Growth (Figure 6-4)
IV. Patterns of Financing: Flexible based on management’s willingness to accept risk.
A. Ideally, temporary increases in current assets are financed by short-term funds
and permanent current assets are financed with long-term sources.
PPT Matching Long-Term and Short-Term Needs (Figure 6-5)
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Education.
6-3
B. Matching short-term funds with short-term assets allows the company to
increase and decrease sources and uses of funds as the company’s sales fluctuate.
C. Many firms, however, choose or are forced to use plans that do not match
financing with asset needs.
D. Financing a high percentage of short-term assets with long-term funds means the
firm will have to pay interest costs on the excess funds even when the funds are
not needed.
PPT Using Long-Term Financing for Part of Short-Term Needs (Figure 6-6)
E. Financing permanent current assets and some long-term assets with short-term
funds is quite risky. Short-term funds will be permanently needed and thus cost
is highly volatile. Also, sources of short-term funds are not always available in
tight credit markets.
PPT Using Short-Term Financing for Part of Long-Term Needs (Figure 6-7)
V. The Financing Decision
A. Figure 6-8 presents the various sources of financing that can be used by a
corporation.
B. The term structure of interest rates indicates the relative cost of short and
long-term financing and is important to the financing decision.
Perspective 6-2: The discussion of the term structure of interest rates provides a good
opportunity to relate the cost of financing to the working capital decision.
C. The relationship of interest rates at a specific point in time for securities of equal
risk but different maturity dates is referred to as the term structure of interest
rates.
D. The term structure of interest rates is depicted by yield curves shown in Figure
6-9.
PPT Long-Term and Short-Term Monthly Interest Rates (Figure 6-10)
E. There are three theories describing the shape of the yield curve.
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Education.
6-4
1. Liquidity premium theory: presumes that long-term rates should be higher
than short-term rates because long-term securities are less liquid and
more price sensitive.
2. Market segmentation theory: postulates that the yield curve is “shaped”
by the maturity preferences of the various investors. Some institutions
such as commercial banks are primarily interested in short-term
securities. Others such as insurance companies manifest a preference for
much longer-term securities.
3. Expectations hypothesis: maintains that long-term rates reflect the
average of expected short-term rates over the time period that the
long-term security is outstanding. Table 6-6 demonstrates how the
expectations theory can be used to calculate long-term rates given the
expectations of future one year rates.
F. Types of yield curves
1. Normal: upward sloping; shorter maturities have lower required yields.
2. Humped: intermediate interest rates are higher than both the short-term
and long-term rates.
3. Inverted, downward sloping: short-term rates are higher than intermediate
or long-term rates.
4. Yield curves shift upward and downward in response to changes in
anticipated inflation rates and other conditions of uncertainty.
VI. A Decision Process
A. The composition of a firm’s financing of working capital is made within the
risk-return framework.
B. Short-term financing is generally less costly but more risky than long-term
financing. During tight money periods, short-term financing may be unavailable
or very expensive.
PPT Alternative Financing Plans (Table 6-7)
PPT Impact of Financing Plans on Earnings (Table 6-8)
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Education.
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C. By applying the probabilities of the occurrence of various economic conditions,
an expected value of alternative financing strategies may be computed and used
as a decision basis.
PPT Expected Returns under Different Economic Conditions (Table 6-9)
PPT Expected Returns for High-Risk Firm (Table 6-10)
VII. Shifts in Asset Structure - Since the early 1960’s, business firms have reduced their
liquidity as a result of:
A. Normal economic cycles.
B. Improved inventory management strategies
C. Better utilization of cash balances, through electronic funds transfer.
D. The historical changes in net working capital as a percentage of sales and the
changes in the current ratio are shown in Figure 6-11. We use a composite of five
large industrial companies as a representative example of this shift. Liquidity
improved dramatically after the recession of 2008-09 as the average working
capital to sales rose from about 4 in 2006 to 16 in 2012 as firms repaired their
balance sheets.
VIII. Toward an Optimum Policy
A. An aggressive firm will borrow short term and carry high levels of inventory and
longer-term receivables. Panel 1 in Table 6-11 represents the aggressive firm.
B. The conservative firm (panel 4) will maintain high liquidity and utilize more
long-term financing.
C. Moderate firms compensate for short-term financing with highly liquid assets
(panel 2) or balance low liquidity with long-term financing (panel 3).
PPT Asset Liquidity and Financing Needs (Table 6-11)
D. Risk versus return considerations also affect the composition of the left-hand
side of the balance sheet.
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Education.
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E. A firm may compensate for high risk on the financing side with high liquidity on
the asset side or vice versa.
Finance in Action: Working Capital Problems in a Small Business
The solution to seasonal working capital problems that plague small businesses is sufficient
flexible planning to ensure that profits produced during the peak season are available to cover
losses during the off-season. This is true because small firms have trouble finding sources of
funds for seasonal needs. This can be tied back into financial markets and the changing
structure of banking.
Other Chapter Supplements
Cases for Use with Foundations of Financial Management
Case 5, Gale Force Surfing working capital-Level vs. seasonal production
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Education.
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