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HANDOUTS ON FUNDAMENTALS OF b) The permanent component of

FINANCIAL MANAGEMENT 1 (For current assets and all fixed assets


Classroom Discussion) would be financed with long-term debt
(Ms. Carmelita U. de Guzman)
or equity.
Chapter 8: Overview of Working
6. In general, the longer the
Capital Management
composite maturity schedule of the
(Reference: Van Horne and John M.
financing used by the firm, the less
Wachowicz, Fundamentals of Financial
risky is that financing. However the
Management, 13th edition)
longer this maturity schedule, the
1. There are two major concepts of
more costly the financing is likely to
working capital: net working capital
be. Consequently, we have yet
(current assets minus current
another trade-off between risk and
liabilities) and gross working capital
profitability.
(current assets).
7. The two key facets of working
2. In finance, working capital is
capital management what level of
synonymous with current assets.
current assets to maintain and how to
Working capital management
finance current assets are
concerns the administration of the
interdependent, hence, must be
firms current assets along with the
considered jointly.
financing (especially current liabilities)
needed to support current assets. Chapter 16: Working Capital
3. In determining the appropriate Management
amount, or level, of current assets, (Reference: Brigham, Eugene,
management must consider the trade- Fundamentals of Financial
off between profitability and risk. Management, 12th edition)
a) The greater the level of current 1) Working capital management
assets, the greater the liquidity of the involves finding the optimal levels for
firm, all other things equal. cash, marketable securities, accounts
b) With greater liquidity comes less receivable, and inventory
risk, but also less profitability. In the and then financing that working
management of working capital, we capital for the
see the two most basic principles of least cost.
finance in operation: 2) Current Assets Financing Policies
b.1) profitability varies inversely with a) Investments in current assets must
liquidity be financed; and the primary sources
b.2) profitability moves together with of funds include bank loans, credit
risk from suppliers (accounts payable),
4. We can classify working capital accrued liabilities, long-term debt,
a) by components cash, marketable and common equity. Each of those
securities, receivables, and inventory sources has advantages and
or disadvantages, so each firm must
b) by time, as either permanent or decide which sources are best for it.
temporary. b) Most businesses experience
b.1) Permanent working capital the seasonal and/or cyclical fluctuations.
amount of current assets required to For example, construction firms tend
meet a firms long-term minimum to peak in the summer, retailers peak
needs. around Christmas, and the
b.2) Temporary working capital the manufacturers who supply both
amount of current assets that varies construction companies and retailers
with seasonal needs. follow related patterns. Similarly, the
5. If the firm adopts a hedging sales of virtually all businesses
(maturity matching) approach to increase when the economy is strong;
financing, each asset would be offset hence, they build up current assets at
with a financing instrument of the those times but let inventories and
same approximate maturity. receivables fall when the economy
a) Short-term or seasonal variations weakens.
in current assets would be financed c) Note, though, that current assets
with short-term debt. rarely drop to zerocompanies

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maintain some permanent current an important difference: The bank has
assets, which are the current assets a legal obligation to honor a revolving
needed at the low point of the credit agreement, and it receives a
business cycle. Then as sales increase commitment fee. Neither the legal
during an upswing, current assets are obligation nor the fee exists under
increased, and these extra current informal lines of credit.
assets are defined as temporary 7. Commercial paper is a promissory
current assets as opposed to note issued by a large, strong firm
permanent current assets. The way most often a financial institutionthat
these two types of current assets are wants to borrow on a short-term basis.
financed is called the firms current Commercial paper is sold primarily to
assets financing policy. other business firms, insurance
3. Firms generally make purchases companies, pension funds, money
from other firms on credit and record market mutual funds, and banks in
the debt as an account payable. denominations of at least $100,000. It
Accounts payable, or trade credit, is is generally unsecured; but asset-
the largest single category of short- backed paper secured by credit card
term debt, representing about 40% of debt and other small, short-term loans
the average corporations current has also been issued.
liabilities. This credit is a spontaneous
source of financing in Chapter 17: Addressing Working
the sense that it arises spontaneously Capital Policies and Management
from ordinary business transactions. of Short-term Assets and
4. Bank Loans: The terms of a bank Liabilities
loan are spelled out in a promissory (Reference: Cabrera, Ma. Elenita
note. If a loan is secured by Balatbat, Financial Management
equipment, buildings, accounts (Principles and Applications, vol. 1)
receivable, or inventories, this fact is 2015 edition)
indicated in the note as collateral. 1) Working capital management is
Restrictive covenants: The note may associated with short-term financial
also specify that the borrower must decision making. Short-term financial
maintain certain ratios at or better decisions typically involve cash
than specified levels, and it spells out inflows and outflows that occur within
what happens if the borrower defaults a year or less.
on those covenants. Default 2) Reasons why working capital
provisions often allow the lender to management is important:
demand immediate payment of the a) Working capital comprises a large
entire loan balance. Also, the interest portion of the firms total assets.
rate on the loan might be increased. Although the level of working capital
Loan guarantees: If the borrower is a varies widely among different
small corporation, the bank will industries, firms in manufacturing and
probably insist that its larger trading industries more often than
stockholders personally guarantee the not, keep more than half of their
loan. Troubled companies owners assets in current assets.
have been known to divert assets b) The financial manager has
from the company to relatives or other considerable responsibility and control
entities they own, so banks protect in managing the level of current
themselves by obtaining personal assets and current liabilities.
guarantees. c) Working capital management
5. A line of credit is an agreement directly affects the firms long-term
between a bank and a borrower growth and survival because higher
indicating the maximum amount of levels of current assets are needed to
credit the bank will extend to the support production and sales growth.
borrower. d) Liquidity and profitability are
6. A revolving credit agreement is likewise directly affected by working
a formal line of credit. Note that a capital management. Without
revolving credit agreement is similar sufficient liquidity, a firm may be
to an informal line of credit, but with

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unable to pay its liabilities as they Payables deferral period - the
mature. The firms profitability is also average length of time between the
affected because current assets must purchase of materials and labor or
be financed and financing involves merchandise and the payment of cash
interest expense. for them.
e) Working capital management b) Cash conversion cycle: the
involves risk-return tradeoffs because length of time funds are tied up in
the level composition and financing of working capital or the length of time
working capital always affect both a between paying for working capital
firms risk and its profitability. and collecting cash from the sale of
3) Factors affecting the firms working inventory.
capital policy Cash Conversion Cycle = Operating
a) Nature of operations: Working cycle Average payment period or
capital requirements differ greatly Cash Conversion Cycle = Operating
among manufacturing, retailing and cycle Accounts payable x 365 /
service organizations. Cost of sales
b) Volume of sales: More current 5) How can operating cycle be
assets are needed to support a higher reduced?
level of sales, such as accounts a) Reasons for longer operating
receivables and inventories. cycle period
c) Variation of cash flows: The a.1) Defective purchasing policy and
greater the fluctuations in the firms practices that could lead to: purchase
cash inflows and outflows, the greater of raw materials or merchandise in
the level of net working capital excess/short of requirements; buying
required. inferior, defective materials thus
d) Operating cycle period: The lengthening the production time;
operating cycle is the length of time failure to get credit from suppliers;
cash is tied up in a firms operating failure to get trade/cash discount, and
costs. Shortening the operating cycle inability to purchase goods due to
reduces the amount of time funds are seasonal swings.
tied up in working capital and thus 1.2) Lack of proper production
lowers the level of working capital planning, coordination and control
required. that could result to protracted
4) Time periods in monitoring the manufacturing cycle
working capital movement 1.3) Defective inventory policy
a) Operating cycle: consists of the 1.4) Use of outdated machinery,
time period between the procurement technology as well, poor maintenance
of inventory of raw materials and and upkeep of plant, equipment and
turns them into finished goods (for infrastructure facilities
manufacturing concerns), sell them 1.5) Defective credit policy and
and receive payment for them. receivable collection procedures
Operating Cycle = Inventory 1.6) Lack of proper monitoring of
conversion period + Average external environment
collection period * b) Remedies to reduce the length
Operating Cycle = Inventory x 365 of operating cycle period
/Cost of sales + Accounts receivable b.1) Production management: There
x 365 / Credit sales should be proper production planning
* Inventory conversion period - the and coordination at all levels of
average time required to purchase activity. Also, a continuing
merchandise or to purchase raw assessment of the manufacturing
materials and convert them into cycle, proper maintenance of plant,
finished goods and then sell them. equipment and infrastructure facilities
Average collection period the and improvement of manufacturing
average length of time required to system, technology would help
convert the firms receivables into shorten manufacturing cycle thus
cash, that is, to collect cash following shortening the operating cycle.
a sale. b.2) Purchasing management: The
purchasing manager should ensure

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the availability of the right type, assets will increase while marginal
quantity and quality of materials/ shortage cost will decrease.
merchandise obtained at the right a.2) Restricted Current Asset
price, time and place through proper Investment Policy: This is a policy
logistics management. Efforts exerted under which holdings of cash,
towards lengthening the credit period securities, inventories and receivables
of the suppliers, increasing the rates are minimized. Marginal carrying
of trade discount and cash discount costs of current assets will decrease
would certainly bring favorable while marginal shortage costs will
outcome to the companys deferral increase.
payment period. a.3) Moderate Current Asset
b.3) Marketing management: The sale Investment Policy: This is a policy that
and production policies should be is between the relaxed and restricted
synchronized. Production of quality policies. This policy dictates that the
products at lower costs enhances their firm will have just enough current
marketability and saleability. Storage assets so that the marginal carrying
costs would likewise be minimized. costs and marginal shortage costs are
The marketing people should strive to equal, thereby minimizing total cost.
continually develop effective b) How should the current assets
advertisement, sales promotion be financed?
activities, effective salesmanship and b.1) Effective working capital
appropriate distribution channels. management requires a set of
b.4) Credit and collection policies: strategies to manage the level,
Sound credit and collection policies composition and financing of a firms
will enable the finance manager to current assets. Decisions should be
minimize investment in working based on the simultaneous analysis of
capital particularly on inventory and their joint impact on return and risk.
receivables. (1) Flexible Financing Policy: involves
b.5) External environment: The length the decision to finance the peaks of
of operating cycle is equally asset requirement with long-term debt
influenced by external environment. and equity. It provides the firm with a
The financial manager should be large investment surplus in cash and
aware and sensitive to fluctuations in marketable securities most of the
demand, entrants of new competitors, time.
government fiscal and monetary (2) Restricted Financing Policy:
policies, price fluctuations, etc. to be involves a decision to finance the
able to anticipate and minimize any valleys or troughs of asset, with long-
adverse impact of the changes to the term debt and equity but will have to
company. seek short-term financing for all peak
6. The working capital or short-term demand fluctuations for current assets
financial policy that a firm adopts as well as for in-between demand
involves answering two basic situations. This policy is considered
questions: the most conservative but the least
a) What is the appropriate size of convenient because it involves
the firms investment in current seeking some level of short-term
assets? financing almost all of the time.
There are at least three alternative (3) Compromise Financing Policy:
policies regarding the total amount of involves a firm financing the
current assets carried: seasonally adjusted average level of
a.1) Relaxed Current Asset asset demand with long-term debt
Investment Policy: a policy under and equity. It uses both short-term
which relatively large amounts of financing and short-term investing as
cash, marketable securities and needed. With this compromise
inventories are carried and under approach, the firm borrows in the
which sales are stimulated by granting short-term to cover peak financing
liberal credit terms resulting in a high needs but it maintains a cash reserve
level of receivables. In this policy, in the form of marketable securities
marginal carrying costs of current during slow period. As current assets

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build up, the firm draws down this e) Impact on Future Sales: A more
reserve before doing any short-term restricted short-term financial policy
borrowing. This allows for some run- probably could reduce future sales to
up in current assets before the firm level that would be achieved under
has to resort to short-term borrowing. flexible policy. It is also possible that
b.2) In addition, consideration should prices can be charged to customers
be given on the broad categories of under flexible working capital policy.
assets: Customers may be willing to pay
(1) Long-term/ Permanent Assets: higher prices for the quick delivery
consist of property, plant and service and more liberal credit terms
equipment, long-term investments implicit in flexible policy.
and the portion of a firms current
assets that remain unchanged over
the year.
(2) Fluctuating or Seasonal Assets:
currents assets that vary over the
year due to seasonal or cyclical needs.
7. The following should be considered
in analyzing the
advantages/disadvantages of the
alternative financing policy for
working capital:
a) Maturity Hedging: Most firms
attempt to match the maturities of
assets and liabilities. They finance
inventories with short-term bank loans
and long-term assets with long-term
financing. Firms tend to avoid
financing long-lived assets with short-
term borrowing. This type of maturity
mismatching would necessitate
frequent refinancing and is inherently
risky because short-term interest rates
are more volatile than longer-term
rates.
b) Cash Reserves: The flexible
financing policy implies surplus cash
and a little short-term borrowing. This
policy reduces the probability that a
firm will experience financial distress.
Firms may not have to worry as much
about meeting recurring, short-run
obligations. However, investments in
cash and marketable securities are
zero net present value investment at
best.
c) Relative Interest Rates: Short-
term interest rates are usually lower
than long-term rates. This implies
that it is, on the average, more costly
to rely on long-term borrowing as
compared to short-term borrowing.
d) Availability and Costs of
Alternative Financing: Firms with
easy and sustained access to
alternative sources will want to shift
toward more restricted policy.

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