BAFINMAX Handout Introduction To Working Capital Management

BAFINMAX – FINANCIAL
MANAGEMENT
INTRODUCTION TO WORKING CAPITAL MANAGEMENT
3RD TERM AY 2019-2020

J.A. SIMBILLO
DEFINITION OF TERMS:
Working Capital
 A firm’s investment in short-term assets— cash, marketable securities, inventory, and accounts receivable.
 The portion of the firm’s assets used in day-to-day transactions
 The primary elements of working capital circulate from one form to another in the ordinary course of business
 The conversion of current assets from inventory to accounts receivable to cash provides an important source of funds that
firms use to pay current liabilities
 Sometimes called gross working capital, simply refers to current assets used in operations
Net Working Capital

 The difference between the firm’s current assets and its current liabilities
Net Operating Working Capital

 Defined as current assets minus non-interest-bearing current liabilities.
 More specifically, net operating working capital is often expressed as cash and marketable securities, accounts receivable,
and inventories, less accounts payable and accruals.
Working Capital Policy

 Basic policy decisions regarding:
(1) target levels for each category of current assets and;
(2) how current assets will be financed.
Working Capital Management

 involves both setting working capital policy and carrying out that policy in day-to-day operations.
 Management of current assets and current liabilities
IMPORTANCE OF WORKING CAPITAL MANAGEENT

1. Improvement in the Credit Profile and Solvency of the Company
2. Use of Fixed Assets Efficiently
3. Ability to Face Crises
4. Expansion
TRADE-OFF BETWEEN PROFITABILITY AND RISK

• A tradeoff exists between a firm’s profitability and its risk
• Profitability is the relationship between revenues and costs generated by using the firm’s assets—both current and fixed—
in productive activities
• A firm can increase its profits by (1) increasing revenues or (2) decreasing costs
• The risk of becoming insolvent is the probability that a firm will be unable to pay its bills as they come due
• Insolvent
– Describes a firm that is unable to pay its bills as they come due
• Other things being equal, the greater the firm’s net working capital, the lower its risk of insolvency. In other words, the
more net working capital, the more liquid the firm and therefore the lower its risk of becoming insolvent
• Changes in Current Assets
– To understand how changing the level of the firm’s current assets affects its profitability–risk tradeoff, consider
the ratio of current assets to total assets
– This ratio indicates the percentage of total assets that is current
– When the ratio increases—that is, when current assets increase—profitability decreases
– Other things being equal, if firms cut back on current assets, they tend to increase risk
• Changes in Current Liabilities
– Changing the level of the firm’s current liabilities affects its profitability–risk tradeoff
– This can be measured using the ratio of current liabilities to total assets
– When the ratio increases, profitability increases because the firm uses more of the less-expensive current
liabilities financing and less long-term financing
– Current liabilities are less expensive because they bear no interest (with the exception of notes payable)
– However, when the ratio of current liabilities to total assets increases, the risk of insolvency also rises because the
increase in current liabilities in turn decreases net working capital
– The opposite effects on profit and risk result from a reduction in the ratio of current liabilities to total assets
Effects of Changing Ratios on Profits and Risk

Ratio Change in ratio Effect on profit Effect on risk
BAFINMAX – FINANCIAL
MANAGEMENT
Current assets Increase Decrease Decrease
Total assets Decrease Increase Increase
Current liabilities Increase Increase Increase
Total assets Decrease Decrease Decrease
WORKING CAPITAL INVESTMENT AND FINANCING POLICIES
Working capital management has two main decisions at two consecutive stages. They are as follows:
1. The level of Current Assets – How much to invest in Current Assets to achieve the Targeted Revenue?
2. Means of Financing Current Assets – How should the above Current Asset Investment be financed i.e. the mix of long and
short term finance?
Types of Working Capital Policies

1. Restricted Policy
 Current Asset estimation is done very aggressively without considering for any contingencies and provisions for any
unforeseen event.
 Implemented without any tolerance of deviation
 Saves interest cost due to lower working capital requirement due to the lower level of current assets which in turn
produces higher profitability i.e. higher return on investment (ROI).
2. Relaxed Policy
 Current Asset estimation is done after careful consideration of various factors such as seasonal fluctuations, a sudden
change in the level of activities or sales, etc.
 After the reasonable estimates also, a cushion to avoid any unforeseen circumstances is left to avoid the maximum
possible risk.
 Advantage of almost no risk or low risk. Thus, This policy guarantees the entrepreneur of the smooth functioning of
the operating cycle.
 On the other hand, there is a disadvantage of lower return on investment because higher investment in the current
assets attracts higher interest cost which in turn reduces profitability.
3. Moderate Policy
 Balance between the other 2 policies as it assumes the characteristics of both policies.
 Risk is lower than the restricted but higher than conservative.
 Reasonable assurance of smooth operations of working operating capital cycle with moderate profitability.
Diagram of Working Capital Policies
Aggressive & Conservative Approach

 Aggressive- All of the fixed assets of a firm are financed with long-term capital, but some of the firm's permanent current
assets are financed with short-term non spontaneous sources of funds.
 Conservative- All of the fixed assets, all of the permanent current assets, and some of the temporary current assets of a
firm are financed with long-term capital.
 Maturity Matching (Self-Liquidating) Approach - Financing policy that matches asset and liability maturities. This would
be considered a moderate current asset financing policy.

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BAFINMAX – FINANCIAL

INTRODUCTION TO WORKING CAPITAL MANAGEMENT

3RD TERM AY 2019-2020

Net Working Capital

Net Operating Working Capital

Working Capital Policy

Working Capital Management

IMPORTANCE OF WORKING CAPITAL MANAGEENT

TRADE-OFF BETWEEN PROFITABILITY AND RISK

Effects of Changing Ratios on Profits and Risk

WORKING CAPITAL INVESTMENT AND FINANCING POLICIES

Types of Working Capital Policies

Diagram of Working Capital Policies

Aggressive & Conservative Approach

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