Chapter 2

Working Capital Management

 Maximizing shareholder wealth is tied to the
firm’s efficiency with which current assets are
used in operations and how those assets are
financed
 Relevant Terminologies
1. Working Capital, sometimes called gross
working capital, simply refers to current assets
used in operations.
2. Net working capital is the difference between
current assets and current liabilities.
 Working Capital Management
3. Working capital policy . It deals with:
(a) setting target levels for each category
of current assets and
(b) determining how current assets will be
financed.
4. Working capital management.
It involves both setting working capital
policy and carrying out the policy in day-
to-day operations.
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 Management of Current Assets
Alternative Current Assets Investment Policies
1. Relaxed Current Asset Investment (or “fat
cat”) Policy
– A policy in which relatively large
amounts current assets are carried
– Associated with a liberal credit policy
to stimulate sales and a corresponding
high level of receivables

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Relaxed Current Asset Investment Policy

This policy is characterized by:

Increased risk of loss from doubtful
accounts,
High opportunity cost of idle cash, and
High cost of inventory obsolescence
Though the risk of loss of sales is low, it
has the lowest expected return on
investment due to increased costs.

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Management of Current Assets
2. Restricted Current Asset
Investment (or “lean-and-mean”)
Policy
– A policy that minimizes the holdings
of cash, securities, inventories, and
receivables.
– Associated with a tight credit policy;
more risk of losing sales and profit

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Restricted Current Asset Investment Policy

This policy is characterized by:

Decreased risk of loss from
uncollectible,
Relatively low cost of idle cash, and
Less cost from inventory
obsolescence
Though it has the greatest risk of
loss of sales , it has the highest
expected return on investment due
to reduced costs.
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 Management of Current Assets
3. Moderate Current Asset
Investment Policy
– A policy that propagates neither too
large investment in current assets nor
too little investment in current assets

– The moderate policy falls in between

the two extremes in terms of expected
return and risk.
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 Management of Current Assets
3. Moderate Current Asset
Investment Policy
– A policy that propagates neither too
large investment in current assets nor
too little investment in current assets

– The moderate policy falls in between

the two extremes in terms of expected
return and risk.
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Management of Current Assets
 A successful working management practice
attempts to minimize the time between cash
expenditure on materials or goods and cash
collections from sales- the cash or cash
conversion cycle.
 The cash cycle is the difference between the
operating cycle and the payable deferral
period.
 The operating cycle is the sum of inventory
conversion period and receivable collection
period.
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Management of Current Assets
 Reducing the cash cycle can be achieved by
reducing the operating cycle and extending the
payable deferral period without harming
operations and credits’ relationship.
• Eventually, the shorter the operating cycle and
the cash cycle, the lower is the firm’s
investment in inventories and receivables and
the higher the total asset turn over and its ROA
and ROE.
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Management of Current Assets
 Example: Addis Co. has ACP of 30
days, average age of inventory of 40 and
average age of payables of 45 days.
 Compute the operating cycle and the cash
cycle.
 OC= 30 days + 40 days = 70 days
 CC= 70 days - 45 days = 25 days

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 Financing Current Assets
• Two types of current assets:
– Temporary current assets: part of current
assets that vary along with the change in sales.
– Permanent current assets: part of current
assets that will exist even when sales is at its lowest
point.
• Two types of short-term financing sources:
– Spontaneous ST financing sources: e.g. Accounts
payable and accruals.
– Non-spontaneous ST financing sources: e.g.
Short-term bank loans.
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Current Assets Financing Strategies
Alternative Current Asset Financing Policies
1. Maturity Matching, or “Self-Liquidating,”
Approach (or Moderate Policy)
– Attempts to match the life of the asset with the
term of the financing source.
– Non-spontaneous ST financing sources are
used only for temporary current assets.
– Challenges: The life of the asset may not be
equal to the life of the financing source.

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Current Assets Financing Strategies
Maturity Matching Approach
Non Spon.
Temporary C.A. STD
Birr

Perm. C.A. LTD,

Equity,
&
Spont.
STD
Fixed Assets

Year

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 Current Assets Financing Strategies
2. Aggressive Approach
–Non-spontaneous financing sources
are used beyond the temporary current
assets
–Cheaper but riskier financing strategy
– It can be a relatively aggressive (uses
Non-sp. STD up to half of PA) or
highly aggressive (uses Non-sp. STD
up to a portion of FA) strategy.
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 Current Assets Financing Strategies

Relatively Aggressive Approach

T.C.A
NS STD
Br

P. C.A.
LTD,
Equity,
Fixed Assets &
Sp. STD

Year

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 Current Assets Financing Strategies

3. Conservative Approach.
–Long-term financing sources and
spontaneous sources are used to
finance all assets except only some
portion of temporary current assets
–Expensive but safer financing
strategy

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 Current Assets Financing Strategies
Conservative Strategy
Temp. C.A. NS STD
Br

LTD,
Permanent C. A. Equity,
&
Sp. STD

Fixed Assets

Year

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Current Assets Financing Strategies
• Sources of Short-term Financing
1. Accruals: No explicit cost and not controllable by a
firm
2. Accounts (Trade) Payables: influenced by credit
period and volume of sales
• Accruals and trade payables are spontaneous
sources of financing.
3. Short-term bank loans
4. Commercial papers (CP): Instruments of loan
issued by large financially strong firms.
• ST bank loans and C.P. are non-spontaneous
financing sources.

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 Current Assets Financing Strategies

• Use of security for short-term

financing
– Short-term business borrowings may involve
the use of accounts receivable and
inventories as collateral
– Commercial papers don’t requires security as
they are issued by strong firms

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Current Assets Financing Strategies
Activity 2
1. “Short-term debts are riskier to finance
current assets than long term debts? “ Do
you agree? Why?
2. If you give more emphasis for your
convenience rather than cost, which type of
financing source is appropriate? Why?
3. “Accruals are cost free financing but not
controllable by a firm .” Do you agree?
Why?.
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