Chapter 4
Working Capital
Management
FUNDAMENTAL OF FINANCE FIN242 SEPT19-JAN20
CHAPTER OUTLINE
1 Definition of Working Capital
2 Basic Policies of Working Capital
3 Approach to Working Capital Management
4
WC Concept
The WCM involves day – to day Net working capital:
01 decisions regarding investment in
Current Assets (CA).
02 Current assets – Current liabilities.
Total Current Assets Working capital policy:
03 (i.e. Marketable Sec, Cash,
Inventories, Receivables)
04 ◼ The level of each Current asset.
◼ How current assets are
Financed?
Managing WC WC will affect the
involve Risk-Return Firm’s Profitability
Trade-Off Amount of and Liquidity
Current Asset, &
Source of Financing
Working
Profitability Liquidity
Capital Policy
Increase
CA Lower Higher
Increase
CL Higher Lower
WC Policies
RELAX MODERATE RESTRICTED
✔Low risk policy ✔Mixture of
✔Maintain large Relaxed and ✔High risk policy
amount of Current Restricted policy ✔Maintain low
Assets with flexible ✔Moderate Risk & amount of Current
credit policy Return Assets couple with
✔High liquidity & ✔Maintain Liquidity Stringent credit
potentially Low ✔Invest in policy
Profitability (i.e. low Productive Assets ✔Invest in Fixed
return) from and at the same Asset (i.e.
investments due to time holds productive assets),
low productivity of sufficient Current which result to
CA relative to FA Assets High Profitability
but Low Liquidity
WC Policies
Current Asset
(RM) Relaxed
Moderate
Restricted
Sales (RM)
WC Financing Strategies
Some concepts:
How Firm Finance its Current
⮚Permanent Asset – hold more
Assets
than One Year (e.g. minimum cash Base on Risk-Return Trade-Off
balance and inventories) (i.e. Higher Risk, Higher Return) ⮚Short-term fiancing(i.e.
⮚Temporary Asset – fluctuate with current liabilities) – lower cost of
sales, < One yr (e.g. Receivable & borrowing (i.e. lower interest
Inventory) rate), shorter duration (i.e.
⮚Temporary Sources of Financing payback period)
– current liabilities (i.e. Notes ⮚Long-term financing – higher
Payable) cost of borrowing (i.e. higher
⮚Permanent Sources of Financing interest rate), longer duration
– long term finance (e.g. l/term debt, (i.e. payback period)
preferred stocks, common stocks)
⮚Spontaneous Sources of
Financing – trade credit (i.e.
account payable) arise from day-to-
day operation
3 Financing Strategies (Approach)
Hedging Approach Aggressive Approach Conservative
Approach
✔Matches the maturity ✔ Uses short term financing
of the assets with the to finance some permanent ✔The firm uses long
maturity of the financing assets. term financing for the
✔Firm use short term ✔Finance all FA with long majority of its assets
financing to finance term financing, but only a ✔The firm supports
temporary CA and portion of the permanent fixed, permanent
✔Long term financing to CA would be financed by current & average
finance permanent assets long term financing. temporary CA with
(i.e. CA & FA) ✔The remaining permanent long term financing
✔This approach results in & the fluctuating CA would be ✔This approach
moderate risk with financed with short term result in lower risk
moderate returns financing. with lower return
✔This approach result in
higher risk with higher return
HEDGING APPROACH
AGGRESSIVE APPROACH
CONSERVATIVE APPROACH
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