Short-term finance: Working capital management

Question 1

1. Working capital management

What are current assets and examples of such?

What are current liabilities and examples of such?

What is the equation?

Answer 1

• Current assets = assets with maturities of less than one year

E.g., raw materials, work-in-progress and finished goods, trade receivables, short-term investments and cash

• Current liabilities = liabilities with maturities of less than one year

E.g., trade payables, overdrafts and short-term loans

(Net) Working Capital = current assets - current liabilities

Question 2

1. Working capital management

What is a key factor in a company liquidity position?

What must a company be able to do?

Why is working capital management a key factor in the company’s long term success?

The greater the extent to which current assets exceed current liabilities…?

Answer 2

The level of current assets is a key factor in a company’s liquidity position. A company must have or be able to generate enough cash to meet its short-term needs if it is to continue in business.

Therefore, working capital management is a key factor in the company’s long-term success: without the ‘oil’ of working capital, the ‘engine’ of non-current (fixed) assets will not function.

The greater the extent to which current assets exceed current liabilities, the more solvent or liquid a company is likely to be, depending on the nature of its current assets

Question 3

1. Working capital management

What 2 advantages does this have?

The twin goals…?

Answer 3

• Increase the profitability of a company
• Ensure that the company has sufficient liquidity to meet short-term obligation
• The twin goals of profitability and liquidity will often conflict since liquid assets give the lowest returns. E.g., cash kept in a safe will not generate a return.

Question 4

1. Working capital management: the level

What are levels and what effects do they have?

Answer 4

• An aggressive policy: a company chooses to operate with lower levels of inventory, trade receivables and cash for a given level of activity or sales.

   - increase profitability but increase risk 

• A conservative and more flexible working capital policy for a given level of turnover: would be associated with maintaining a larger cash balance.

   - lower risk of financial problems or investment problems but reduce profitability

• A moderate policy: would tread a middle path between the aggressive and conservative approaches.

Question 5

1. Working capital management: Short-term finance

3 types, what are they and what is good/bad about them?

What are two advantages of short term finance?

Answer 5

• Overdraft: an agreement by a bank to allow a company to borrow up to a certain limit without the need for further discussion.

     - The company will borrow as much or as little as it needs up to the overdraft limit and the bank will charge daily interest at a variable rate on the debt outstanding. 
    -  An overdraft is a flexible source of finance in that a company only uses it when the need arises.

• Short-term bank loans: a fixed amount of debt finance borrowed by a company from a bank, with repayment to be made in the near future, for example, after one year.

    - The company pays interest on the loan at either a fixed or a floating (i.e., variable) rate at regular intervals, for example quarterly.
    - less flexible than an overdraft

• Trade credit: an agreement to take payment for goods and services at a later date than that on which the goods and services are supplied to the consuming company.

      - It is common to find one, two or even three months’ credit being offered on commercial transactions
    - a major source of short-term finance for most companies.

• Short-term sources of finance are usually cheaper and more flexible than long-term ones.
• Short-term interest rates are usually lower than long-tern interest rates

Question 6

2. Cash conversion cycle (CCC)

What is it?

What can it be used for?

CCC is the period of time between…?

The longer CCC …?

Answer 6

CCC: interaction between the components of working capital and the flow of cash within a company

• CCC can be used to determine the amount of cash needed for any sales level.
• CCC is the period of time between outlay of cash on raw materials and the inflow of cash from the sale of finished goods, and represents the number of days of operation for which financing is needed.
• The longer the CCC, the greater the amount of investment required in working capital.

Question 7

2. Cash conversion cycle (CCC)

The length of the CCC depends on the length of: (3)

What is the formula for CCC?

Answer 7

The length of the CCC depends on the length of:

• Inventory conversion period: the average time taken to use up raw materials PLUS the average time taken to convert raw materials into finished goods PLUS the average time taken to sell finished goods to customers.
• Trade receivables collection period: the average time taken by credit customers to settle their accounts
• Trade payables deferral period: the average time taken by a company to pay its trade payables (i.e., its suppliers)

CCC = Inventory days + Trade receivables days – Trade payables days

Question 8

3. Financing working capital

When a business has decided on the level of working capital needed, it then needs to decide how this working capital is to be financed.

Three different types of assets:

Answer 8

When a business has decided on the level of working capital needed, it then needs to decide how this working capital is to be financed.

Three different types of assets:

• Non-current assets (NCA): long-term assets from which a company expects to derive benefit over several periods, e.g., factory building, production machinery.
• Permanent current assets (PCA): the core level of investment needed to sustain normal levels of business or trading activity, e.g., investment in inventories and average level of a company’s trade receivables.
• Fluctuating current assets (FCA): correspond to the variations in the level of current assets arising from normal business activity.

Permanent: this is the minimum net current assets that the business is likely to need to continue to operate. At no point in the business cycle is the level of net current assets likely to fall below this.

Fluctuating: in many businesses, the net current assets will fluctuate between minimum and maximum levels.

Question 9

3. Financing working capital:

Three different funding policies?

Which one is chosen is dependent on: (4)

Answer 9

Three different funding policies:

• Matching funding policy: finances fluctuating current assets (FCA) with short-term funds and permanent current assets (PCA) and non-current assets (NCA) with long-term funds. The maturity of the funds roughly matches the maturity of the different types of assets.
• Conservative funding policy: uses long-term funds to finance not only non-current assets (NCA) and permanent current assets (PCA), but some fluctuating current assets (FCA) as well  lower risk but higher cost of long-term finance (lower profitability).
• Aggressive funding policy: uses short-term funds to finance not only fluctuating current assets (FCA), but some permanent current assets (PCA) as well.  greatest risk to solvency, but highest profitability and increases shareholder value.

Which one is chosen is dependent on:

• Companies access to finance
• Extent of liquidity issues
• Ability to pay finance costs
• Other finance commitments