Working capital management, Risk, Profitability and Liquidity - Working capital policies, Conservative, Aggressive, Moderate

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Corporate Finance FIN 622

Lesson 26

WORKING CAPITAL MANAGEMENT

The following topics will be discussed in this lecture.

- Working capital management

o Risk, Profitability and Liquidity

- Working capital policies

o Conservative

o Aggressive

o Moderate

- Risk and return of current liabilities

Working Capital Management

Decisions relating to working capital and short term financing are referred to as working capital management.

These involve managing the relationship between a firm's short-term assets and its short-term liabilities. The

goal of Working capital management is to ensure that the firm is able to continue its operations and that it

has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses.

Decision Criteria

By definition, Working capital management entails short term decisions - generally, relating to the next one

year period - which is "reversible". These decisions are therefore not taken on the same basis as Capital

Investment Decisions (NPV or related, as above) rather they will be based on cash flows and / or

profitability.

· One measure of cash flow is provided by the cash conversion cycle - the net number of days from

the outlay of cash for raw material to receiving payment from the customer. As a management tool,

this metric makes explicit the inter-relatedness of decisions relating to inventories, accounts

receivable and payable, and cash. Because this number effectively corresponds to the time that the

firm's cash is tied up in operations and unavailable for other activities, management generally aims

at a low net count.

· In this context, the most useful measure of profitability is Return on capital (ROC). The result is

shown as a percentage, determined by dividing relevant income for the 12 months by capital

employed; Return on equity (ROE) shows this result for the firm's shareholders. Firm value is

enhanced when, and if, the return on capital, which results from working capital management,

exceeds the cost of capital, which results from capital investment decisions as above. ROC

measures are therefore useful as a management tool, in that they link short-term policy with long-

term decision making.

Management of Working Capital

Guided by the above criteria, management will use a combination of policies and techniques for the

management of working capital. These policies aim at managing the current assets (generally cash and cash

equivalent, inventories and debtors) and the short term financing, such that cash flows and returns are

acceptable.

· Cash Management. Identify the cash balance which allows for the business to meet day to day

expenses, but reduces cash holding costs.

· Inventory Management. Identify the level of inventory which allows for uninterrupted

production but reduces the investment in raw materials - and minimizes reordering costs - and

hence increases cash flow.

· Debtor's Management. Identify the appropriate credit policy, i.e. credit terms which will attract

customers, such that any impact on cash flows and the cash conversion cycle will be offset by

increased revenue and hence Return on Capital (or vice versa).

· Short Term Financing. Identify the appropriate source of financing, given the cash conversion

cycle: the inventory is ideally financed by credit granted by the supplier; however, it may be

necessary to utilize a bank loan (or overdraft), or to "convert debtors to cash" through "factoring".

Financial Risk Management

Risk Management is the process of measuring risk and then developing and implementing strategies to

manage that risk. Financial risk management focuses on risks that can be managed ("hedged") using traded

Corporate Finance FIN 622

financial instruments (typically changes in commodity prices , internet rates, foreign exchange rates and

stock prices). Financial risk management will also play an important role in cash management.

This area is related to corporate finance in two ways. Firstly, firm exposure to business risk is a direct result

of previous Investment and Financing decisions. Secondly, both disciplines share the goal of creating, or

enhancing, firm value. All large corporations have risk management teams, and small firms practice

informal, if not formal, risk management.

Derivatives are the instruments most commonly used in financial risk management. Because unique

derivative contracts tend to be costly to create and monitor, the most cost-effective financial risk

management methods usually involve derivatives that trade on well-established financial markets. These

standard derivative instruments include options, future contacts, forward contacts, and swaps.

Working Capital Policies

· Conservative Use permanent capital for permanent assets and temporary assets.

· Moderate Match the maturity of the assets with the maturity of the financing.

· Aggressive Use short-term financing to finance permanent assets.

Let's view the characteristics of each policy.

1. CONSERVATIVE WORKING CAPITAL POLICY;

high level of investment in current assets

support any level of sales and production

high liquidity level

Avoid short-term financing to reduce risk, but decreases the potential for maximum value

creation because of the high cost of long-term debt and equity financing.

Borrowing long-term is considered less risky than borrowing short-term.

This approach involves the use of long-term debt and equity to finance all long-term fixed

assets and permanent assets, in addition to some part of temporary current assets.

The firm has a large amount of net working capital. It is a relatively low-risk position.

The safety of conservative approach has a cost.

Long-term financing is generally more expensive than short-term financing.

2. AGGRESSIVE WORKING CAPITAL POLICY;

Low level of investment

More short-term financing is used to finance current assets.

Support low level of production & sales

Borrowing short-term is considered more risky than borrowing long-term.

Firm risk increases, due to the risk of fluctuating interest rates, but the potential for higher

returns increases because of the generally low-cost financing.

This approach involves the use of short-term debt to finance at least the firm's temporary

assets, some or all of its permanent current assets, and possibly some of its long-term fixed

assets. (Heavy reliance on short term debt)

The firm has very little net working capital. It is more risky.

May be a negative net working capital. It is very risky

3. MODERATE WORKING CAPITAL POLICY

This approach tries to balance risk and return concerns.

Temporary current assets that are only going to be on the balance sheet for a short time

should be financed with short-term debt, current liabilities. And, permanent current assets

and long-term fixed assets that are going to be on the balance sheet for a long time should

be financed from long-term debt and equity sources.

The firm has a moderate amount of net working capital. It is a relatively amount of risk

balanced by a relatively moderate amount of expected return.

In the real world, each firm must decide on its balance of financing sources and its

approach to working capital management based on its particular industry and the firm's

risk and return strategy.

Corporate Finance FIN 622

LIQUIDITY & PROFITABILITY:

· Lenders prefer a company having a large excess of current assets over current liabilities whereas the

owners prefer a high return.

· Current assets have the advantage of being liquid, but holding them is not very profitable.

· Cash account is paid no interest.

· Accounts receivable earns no return.

· Inventory earns no return until it is sold.

· Non-current assets can be profitable, but they are usually not very liquid.

· Firms are usually faced with creating trade-off in their working capital management policy.

· They seek a balance between liquidity and profitability that reflects their desire for profit and their

need for liquidity.

OPTIMAL LEVEL OF CURRENT ASSETS

A firm's optimal level of current assets is reached when the optimal level of cash, inventory, accounts

receivable, and other current assets is achieved.

Cash: firms try to keep just enough cash on hand to conduct day-to-day business, while investing extra

amounts in short-term marketable securities.

Inventory: firms seek the level that reduces lost sales due to lack of inventory, while at the same time

holding down bad debt and collection expenses through sound credit policies.

· PROJECTING THE ALL THREE POLICIES

· CONSERVATIVE = A

· MODERATE = B

· AGGRESSIVE = C

LIQUIDITY

PROFITABILITY

RISK

HIGH

NOR

LOW

The chart tells us two things:

- Profitability varies inversely with liquidity; increased liquidity can be achieved at the expense of

(decreased) profitability

- Profitability & risk have same direction; in order to have greater profitability, we need to take

greater risk.

- Conclusion: optimal level of each current asset will depend on the management's attitude

towards risk & return.

Risk and Return of Current Liabilities

The goal of the return management process is to maximize earnings in the context of an acceptable level of

risk.

Firm's working capital is financed from short-term borrowing, long-term borrowing, equity financing, or

some mixture of all three.

The choice of the firm's working capital financing depends on manager's desire for profit versus their

degree of risk aversion.

The balance between the risk and return of financing options depends on the firm, its financial managers,

and its financing approaches.

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