6-1
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 buildup of current assets and how they can best be financed. Examples of Briggs and Stratton
Corporation, Target, and Macy’s are used to show that seasonal earning and sales go hand in hand.
Chapter Concepts
LO1. Working capital management involves financing and controlling the current assets of the
firm.
LO3. The financing of an asset should be tied to how long the asset is likely to be on the balance
sheet.
LO5. Risk, as well as profitability, determines the financing plan for current assets.
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Annotated Outline and Strategy
I. Introduction
A. Working capital management involves the financing and management of the current
assets of the firm.
Finance in Action: A Great Inventory Tracking System May Be Helping You
Radio frequency identification technology (RFID) is now being used by Walmart to keep track of
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
2. Businesses subject to cyclical sales may have temporary fluctuations in the
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. When a firm produces more than it sells, inventory rises. When sales rise faster than
production, inventory declines and receivables rise.
B. Level production (matching production and sales over an entire cycle) may cause
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C. Figure 6-2 demonstrates the seasonal nature of sales for Briggs and Stratton, while
Figure 6-3 illustrates the same principle for Target and Macy’s. 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)
PPT Yawakuzi Sales Forecast (in units) (Table 6-1)
PPT Yawakuzi’s Production Schedule and Inventory (Table 6-2)
PPT Sales Forecasts, Cash Receipts and Payments, and Cash Budget (Table 6-3)
PPT Total Current Assets, First Year ($ millions) (Table 6-4)
PPT Cash Budget and Assets for Second Year with No Growth in Sales ($
millions) (Table 6-5)
PPT The Nature of Asset Growth (Yawakuzi) (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)
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.
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C. Many firms, however, choose or are forced to use plans that do not match financing
with asset needs.
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
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.
PPT Treasury Yield Curve (Figure 6-9)
D. The term structure of interest rates is depicted by yield curves shown in Figure 6-9.
PPT Treasury Yield Curve (Figure 6-9)
PPT Long- and Short-Term Annual Interest Rates (Figure 6-10)
E. There are three theories describing the shape of the yield curve.
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1. Liquidity premium theory: presumes that long-term rates should be higher
2. Market segmentation theory: postulates that the yield curve is “shaped” by
the maturity preferences of the various investors. Some institutions such as
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
1. Upward sloping: normal shape; shorter maturities have lower required yields.
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.
PPT Alternative Financing Plans (Table 6-7)
PPT Impact of Financing Plans on Earnings (Table 6-8)
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)
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PPT Expected Returns for High-Risk Firm (Table 6-10)
VII. Shifts in Asset Structure
A. The historical changes in net working capital as a percentage of sales and the changes
PPT Net Working Capital as a Percentage of Sales and the Current Ratio
(Figure 6-11)
VIII. Toward an Optimum Policy
A. An aggressive firm will borrow short term and maintain relatively low levels of
PPT Asset Liquidity and Financing Assets (Table 6-11)
D. Risk versus return considerations also affect the composition of the left-hand side of
Finance in Action: Working Capital Problems in a Small Business
6-7
Other Chapter Supplements
Cases for Use with Foundations of Financial Management
Case 5, Gale Force Surfing working capital—Level vs. seasonal production