chapter 14 - working capital policy

how working capital policies of US firms differ from EU firms

- average cash conversion cycle of EU firms more than twice that of US firms - US firms allow more conservative working capital policies than EU firms do

not included in working capital (liabilities)

- current maturities of long term debt - financing associated with a construction program that will be funded with the proceeds of a long term security issue after the project is completed - use of short term debt to finance fixed assets

the requirements for external working capital financing

- seasonal variations - business cycles - expansion requires more working capital

disadvantages of long term vs short term debt

- short term debt subjects the firm to more risk than long term debt does --> short term interest expenses fluctuate --> firm may not be able to repay short term debt and be forced into bankruptcy

advantages of short term financing

- speed: a short term loan can be obtained much faster than long term credit - flexibility: for cyclical needs, avoid long term debt - cost of short term vs long term debt --> yield curve is generally upward sloping --> short term interest rates are generally lower than long term rates

working capital policy

- targets levels for each current asset account - how current assets will be financed

working capital

- working capital only includes current liabilities that are specifically used to finance current assets - working capital does not include current liabilities that might be due in the current period if they are due from long-term capital decisions, even though these must be considered when assessing the firms ability to meet its current obligations

net working capital formula

= current assets - current liabilities

the relationships of working capital accounts

a decisions affecting one working capital account (e.g. inventory) will impact other working capital accounts (e.g. receivables and payables)

moderate current asset investment policy

a policy that is between relaxed and restricted policies

net working capital

amount of current assets financed by current liabilities

cash conversion cycle

average length of time a dollar is tied up in current assets

the payables deferral period

average length of time between the purchase of raw materials and labor and the payment of cash for them

the receivables collection period

average length of time required to convert the firms receivables into cash; also called days sales outstanding (DSO)

aggressive approach

finance all temporary assets with short term, spontaneous debt, and finance all fixed assets and some permanent assets with long term, non spontaneous funds

restricted current asset investment policy

holdings of cash and marketable securities and inventories are minimised

inventory conversion period

length of time required to convert materials into finished goods and then to sell those goods

maturity matching ("self-liquidating") approach

match asset and liability maturities

relaxed current asset investment policy

relatively large amounts of cash and marketable securities and inventories are carried and sales are stimulated by a liberal credit policy that results in a high level of receivables

the cash conversion cycle

the length of time from the payment for purchases of raw materials used to manufacture a product until the collection of accounts receivable associated with the sale of the product

working capital management

the management of short term assets and short term liabilities

conservative approach

use permanent capital to finance all permanent assets and some seasonal, temporary needs; use spontaneous, short term debt to finance the rest of the seasonal needs