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