Finansal Yönetim Working Capital and the Financing Decision Chapter McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. Working Capital and the Financing Decision 66- 2 Chapter Outline Working capital management • Current asset management • Asset financing • Long-term versus short-term financing • Risk and profitability vis- à -vis asset financing • Expected value analysis may sometimes be • employed6- 3 Working Capital Management The financing and management of the • current assets of a firm Crucial to achieving long-term objectives of the – firm or its failure Requires immediate action –6- 4 The Nature of Asset Growth Effective current assets management • requires matching of the forecasted sales and production schedules Differences in actual sales and forecasted • sales can result in: Unexpected buildup. – Reduction in inventory, affecting receivables and – cash flow Firm’s current assets could be: • Self-liquidating – ‘Permanent’ current assets. –6- 5 The Nature of Asset Growth (cont ’ d)6- 6 Controlling Assets – Matching Sales and Production Fixed assets grow slowly with: • Increase in productive capacity – Replacement of old equipment – Current assets fluctuate in the short run, • depending on: Level of production versus the level of sales – When production is higher than sales the inventory • rises When sales are higher than production, inventory • declines and receivables increase6- 7 Controlling Assets – Matching Sales and Production (cont ’ d) Cash budgeting process • Level production method – Smooth production schedules • Use of manpower and equipment efficiently to lower • cost Match sales and production as closely as – possible in the short run Allows current assets to increase or decrease with the • level of sales Eliminates the large seasonal bulges or sharp • reductions in current assets6- 8 Matching Sales and Production-McGraw- Hill Companies, Inc. A good example of seasonal sale • Has significant share of sales and earnings • in the third and fourth quarters Due to seasonal nature of textbook • publishing Lenders and financial managers need to plan – inventory Lack of correct inventory planning can lead to – lost sales6- 9 Quarterly Sales and Earnings Per Share for McGraw Hill6- 10 Seasonal Sales Pattern in Target and Limited Brands Like publishers, retail companies do not • stock inventory for more then a year Fourth quarter is the biggest quarter for • retailers As per the figure, the Target is growing much • faster than the Limited Brands Even then, in the fourth quarter, peak • earnings are almost equal for both the companies6- 11 Quarterly Sales and Earnings Per Share, Target and Limited Brands6- 12 Point-of-Sales Terminals Retail-oriented firms use new, computerized • inventory control systems linked online Digital inputs or optical scanners – Helps adjust orders or production schedules • Radio Frequency Identification (RFID) –6- 13 Temporary Assets under Level Production – An Example Yawakuzi Motorcycle Company • Sales fluctuations: High sales demand during – early spring and summer; sales drop during October through March Decision: Apply level production method - 12- – month sales forecast is issued Result: Level production and seasonal sales – combine to produce fluctuating inventory6- 14 Yawakuzi Sales Forecast (in units)6- 15 Yawakuzi ’ s Production Schedule and Inventory6- 16 Sales Forecasts, Cash Receipts, and Payments, and Cash Budget6- 17 Sales Forecasts, Cash Receipts, and Payments, and Cash Budget (cont ’ d) Table 6-3 is created to examine the buildup • in accounts receivable and cash Sales forecast: Based on assumptions taken – earlier (table 6-1) Cash receipts: 50% cash collected during the – month of sale and 50% pertains to the prior month Cash budget: a comparison of cash receipt and – payment schedules to determine cash flow6- 18 Total Current Assets, First Year ($millions)6- 19 Yawakuzi ’ s Nature of Asset Growth6- 20 Cash Budget and Assets for II Year With No Growth in Sales ($millions) Graphic presentation of the current asset • cycle.6- 21 Patterns of Financing Selection of external sources to fund • financial assets is an important decision The appropriate financing pattern: • Matching of asset buildup and length of financing – pattern 6- 22 Matching Long-Term and Short- Term Needs6- 23 Alternative Plans It is important to consider other alternatives • The challenge of constructing a financial plan is – to prioritize the current assets into temporary and permanent The exact timing of asset liquidation, even in the – light of ascertaining dollar amounts is onerous It is also difficult to judge the amount of short- – term and long-term financing available6- 24 Long-Term Financing Firms can be assured of having adequate • capital at all times: Use long-term capital to cover part of the short- – term needs Long-term capital can be used to finance: – Fixed assets • Permanent current assets • Part of the temporary current assets •6- 25 Using Long-Term Financing for Part of Short-Term Needs6- 26 Short- Term Financing Small businesses do not have total access to • long-term financing They rely on short-term bank and trade credit – Advantage: interest rates are lower – Short-term finances are used finance: – Temporary current assets • Part of the permanent working capital needs •6- 27 Using Short-Term Financing for Part of Long-Term Needs6- 28 Term Structure of Interest Rates A yield curve – that shows the relative level • of short-term and long-term interest rates U.S. government securities are popular as they – are free of default risks Corporate debt securities entail a higher interest – rate due to more financial risks Yield curves for both securities change daily to – reflect: Current competitive conditions • Expected inflation • Changes in economic conditions •6- 29 Basic Theories - Yield Curve Liquidity premium theory • Long-term rates should be higher than short- – term rates Market segmentation theory • Treasury securities are divided into market – segments by the various financial institutions investing in the market Expectations hypothesis • Yields on long-term securities is a function of – short-term rates6- 30 Long- and Short-Term Annual Interest Rates Relative volatility and the historical level of • short-term and long-term rates6- 31 Alternative Financing Plans A Decision Process: Comparing alternative • financing plans for working capital6- 32 Impact of Financing Plans on Earnings6- 33 Varying Condition and its Impact Tight money periods • Capital is scarce making short-term financing – difficult to find or may ensue very high rates Inadequate financing may mean loss of sales or – financial embarrassment Expected value • Represents the sum of the expected outcomes – under both conditions6- 34 Expected Returns under Different Economic Conditions6- 35 Expected Returns for High Risk Firms6- 36 Toward an Optimal Policy A firm should: • Attempt to relate asset liquidity to financing – patterns, and vice versa Decide how it wishes to combine asset liquidity – and financing needs Risk-oriented firm - short-term borrowings and low • degree of liquidity Conservative firm - long-term financing and high • degree of liquidity6- 37 Net working capital as a percentage of sales—S&P Industrials6- 38 Asset Liquidity and Financing Assets