Week 2 Everything Flashcards
Gross working capital
The firm’s total investment in current assets.
Net working capital
The difference between the firm’s current assets and its current liabilities.
Current liabilities
Current liabilities are a company’s debts or obligations that are due within one year or within a normal operating cycle. They are short-term debts, accounts payables, accrued liabilities, and other similar debts.
Working capital 2 issues to consider
How much short-term financing should the firm use?
What specific sources of short-term financing should the firm select?
Net working capital represents
the amount of current assets that is financed with long-term funds
An increase (change) in working capital
means the company has increased its receivables or other current assets or reduced its current liabilities (e.g. paid off short-term creditors)
Working capital management
Working capital management is the management of short-term assets (investments) and liabilities (financing sources) to ensure that the firm has ability to have sufficient cash (from current assets) to pay for the current liabilities when they fall due. Poor working capital management generally results in financial distress and bankruptcy
Operating cycle
the time period between the acquisition of inventory and the collection of cash from receivables.
Operating cycle = Inventory period + A/cs receivable period
Cash cycle
the time period between the outlay of cash for purchases and the collection of cash from receivables.
Cash cycle = Operating cycle – A/cs payable period
Cash conversion cycle
15/3/19
What Specific Sources of Short-Term Financing Should the Firm Select?
Three basic factors influence the decision:
The effective cost of credit
The availability of credit in the amount needed and for the period that financing is required
The influence of a particular credit source on the cost and availability of other sources of financing
Current assets
A firm’s current assets are assets, such as cash and marketable securities, accounts receivable, inventories, that are expected to be converted to cash within 1 year, or within a normal operating cycle.
The Risk-Return Trade-Off
Holding more current assets will reduce the risk of illiquidity. However, liquid assets like cash and marketable securities earn relatively less compared to other assets. Thus, larger amounts of liquid investments will reduce overall rate of return. Increased liquidity must be traded off against the firm’s reduction in return on investment.
Use of Current versus Long-Term Debt
Other things remaining the same, the greater the firm’s reliance on short-term debt or current liabilities in financing its assets, the greater the risk of illiquidity. Other things remaining the same, the greater the firm’s reliance on short-term debt or current liabilities in financing its assets, the greater the risk of illiquidity
The Advantages of Current Liabilities: Return
Flexibility:
Current liabilities can be used to match the timing of a firm’s needs for short-term financing. Example: Obtaining seasonal financing versus long-term financing for short-term needs.
Interest Cost:
Interest rates on short-term debt are lower than on long-term debt.
The Disadvantages of Current Liabilities: Risk
Risk of illiquidity increases due to:
Short-term debt must be repaid or rolled over more often
Uncertainty of interest costs from year to year
What would be the an Appropriate level of working capital?
Managing working capital involves interrelated decisions regarding investments in current assets and use of current liabilities. Hedging principle or principle of self-liquidating debt provides a guide to the maintenance of appropriate level of liquidity.
The Hedging Principle
The hedging principle involves matching the cash-flow-generating characteristics of an asset with the maturity of the source of financing used to finance its acquisition. Thus, a seasonal need for inventories should be financed with a short-term loan or current liability. On the other hand, investment in equipment that is expected to last for a long time should be financed with long-term debt.
Permanent investments
Investments that the firm expects to hold for a period longer than one year
Temporary investments
Current assets that will be liquidated and not replaced within the current year
Sources of Financing
Total assets will be equal to sum of temporary, permanent, and spontaneous sources of financing.
Temporary sources of financing
Temporary sources of financing consist of current liabilities such as short-term secured and unsecured notes payable
Permanent sources of financing
Permanent sources of financing include intermediate-term loans, long-term debt, preferred stock, and common equity.
Spontaneous Sources of Financing
Spontaneous sources of financing arise spontaneously in the firm’s day-to-day operations. Trade credit is often made available spontaneously or on demand from the firm’s suppliers when the firm orders its supplies or more inventory of products to sell. Trade credit appears on balance sheet as accounts payable. Wages and salaries payable, accrued interest, and accrued taxes also provide valuable sources of spontaneous financing
