Modern
Working Capital Management
Frederick C Scherr
Chapter 1
PowerPoint Presentation By
Khaleda Khatun
Professor
Department of Finance, University of Dhaka
Introduction: Management of Working Capital
• You know that financial management of a
business firm involves 3 major functions –
namely
• (1) Management of long-term assets
• (2) Accumulation or management of long-term capital funds &
• (3) Management of day-to-day operation or daily operation of the firm.
Functions of Finance
• The finance functions are:
• The 1st function involve capital budgeting issues, the
• 2nd function involve the capital structure & dividend
issues, while the
• 3rd function involve management of working capital or
current assets & current liability management issues.
• In this course, we will focus on the third functions only
Working Capital Management involves
•(a) Current assets such as
• (i) Cash,
• (ii) Marketable securities
• (iii) A/C receivables
• (iv) Inventory
• (v) Pre-paid expenses etc. (bill receivable)
Working Capital Management Includes
•(b) Current liability include liabilities such as
• (i) A/Cs payable
• (ii) Wages payable
• (iii) Different accruals
• (iv) Bank O/D (overdraft) & other short-term loan,
• (v) Commercial paper issued
• (vi) Unpaid dividend, etc.
Meaning of Working Capital
• In general working capital refers to all of these
current assets & liabilities.
• However, by the concept of working capital we
mean the net amount working capital, which is
the difference between current assets & current
liabilities (WC = CA-CL) of a firm.
Different Approaches to Working Capital
Management
• In a healthy firm, typically the current asset is quite in excess of the
current liabilities (CA>CL).
• A significant part of the current assets are being financed through
long-term liabilities.
• This approach is known as traditional or conservative approach to
Working Capital management.
• This goes by a rule of thumb that,
• current ratio of a normal firm should be 2:1.
• This magnitude of the ratio indicates that
• for every two-taka investment in current assets 1 taka is financed by current
liabilities
• while the other taka obviously from long-term funds of the firm.
Different Approaches to Working Capital
Management
• In another approach called ‘Matching approach’
of working capital management policy,
• In this approach it is expected that 1 taka
investment in current asset is to be matched by 1
Taka finance through current liabilities only,
• Therefore this approach is making the average
net working capital equal to ‘O’ zero.
Different Approaches to Working Capital
Management
• On the other hand, in case of “Aggressive” working capital
management a firm’s total working capital as well as a
part of long-term assets are financed using current
liabilities.
• Firm’s faces massive liquidity problem,
• It is observed that the volume of current liability is in
excess of the volume of current assets.
• Theoretically it implies negative WC or a situation where
firms long-term assets are financed through short–term
capital..
Working Capital Decisions
In this course we shall analyze decision such as –
• (i) how should the firm manage its cash
• (ii) to whom should the firm extend credit,
• (iii) how much inventorying should the firm have
• (iv) what should be the composition of the firm’s current debt or
liability
Why working capital is necessary?
• As mention above working capital is required for
the day-to-day operation of the firm. It involves
• (i) Getting right raw material supplied in right time,
• (ii) Wages & utility bills are properly cleared,
• (iii) Customers are smoothly getting their
demanded goods & services regularly
Working Capital and Uncertainty
• In a perfect world with certainty, both borrowing & lending rate are equal,
• along with completely certain forecast of demand & supply of goods &
services prevail
• There is no need for having inventory accruals & other current assets &
liabilities.
• But in real world with uncertain situation
• with costly information,
• limitation in production capacity expansion,
• The manager must maintain provisions for the unforeseen events ,i.e. the
manager must maintain some inventory of liquidity(cash or equivalent) as well
as inventory of raw material and finish goods.
• Therefore in a world of uncertainty the manager must get involve into the job
of WC management.
Uncertainty
• There is uncertainty – this exists because
• The information is not equally available and is costly and does not always
reflect the true price. Because and there exists:
• (i) Fixed(long term financing need) as well as variable (short term financing need)
costs associated with producing goods/services for sale;
• (ii)Differences (spreads) between borrowing and lending rates for investments and of
financing equal risk opportunities.
• (iii) challenges of day-to-day affairs.
• Off course there can be different strategies to overcome such problematic
situations,
• Among these strategies, the one that utilizes the investment or financing
with working capital accounts often offer a substantial advantages over the
other techniques.
The Importance of Working Capital:
• In addition as the means to handle the day-to-day
operational uncertainties, the working capital plays crucial
role in maintaining the financial health of a firm.
• This can be visualized from the next figure (adopted from
P-4 of your book).
• The figure of the working capital cycle of a firm along with
its overall relationship with the other activities of the
firm.
• It considers the cash-balance (cash and marketable
securities) as the heart of the firm while cash flows as the
blood-stream of the firm
.
Used in
Production Accrued Direct
Labor & Material Accrued Fixed
Process
Operating Expen.
Generates
Used to Used to
Purchase Purchase
Inventory
Cash & Marketable Fixed
Securities Assets
Via Sales Generate
Collection
Process External Finance
Accounts Returns to Cap.
Receivables
Suppliers of Capital
Div/ Interest
Working Capital Cycle of a Firm
(Dash Line indicates W. Cap. Mgt Area)
Importance in present financial market context
• As you are told about the importance of working
capital management from firm’s operational
aspect; some developments during the 70’s &
80’s enhance the concern for working capital
management further.
Working Capital Management in Modern World
• Two of the most important developments in
modern financial world were:
• (i) The relatively higher cost of investment along with wider opportunities for
financing mix
• This has made the working capital management activities more challenging. In the light
of this changing situation, the financial decision regarding working capital are made
based on some principles of finance like:
a) share holder's wealth maximization &
b) b) incremental cash flow-based decisions approach
• (ii) the appearance of deregulated money market.
• The managers of working capital must optimize their decisions
around these realities
Working Capital Management in Modern World
• It is empirically established that in the context of developed financial
markets the share holders of the firms react very little on historical
Accounting information & are more sensitive to information about
future cash flow potential.
• So the future cash flow information are communicated through public
announcement, dividend declaration, capital structure policies etc.
• The future cash flow as you know are required to be discounted with
appropriate risk adjusted discount rate.
• In fact it is the NPV of future uncertain net cash flow is the main
factor which determine how much value of the shareholders wealth
will change.
• But as the future cash flow is uncertain the risk must be handled
carefully. In this regard two steps are taken namely:
Strategic Steps for Risk Management
1. The risk is assessed
2. Risk is handled by
➢ offsetting strategies
➢Avoidance of risk; or
➢ By doing nothing or totally ignoring risk – the most aggressive or risky
strategy
3. Developing long-term risk management strategies/ operational tools
Risk Assessment
• The risk of the firm as you know can be viewed as
• Total Risk; and
• Segmented Risk
• Total risk refers to overall variability of outcome, which include–
• systematic and
• diversifiable risk.
• The total risk can be assessed using
• (1) sensitivity analysis and or
• (2) simulation.
Risk Segments
• In case of segmented risk
• the diversifiable risk are not valued by the
managers/shareholders
• You already know that the shareholders value the non-
diversifiable or market risk only
• The market risk is measured by ꞵ (or the ratio of
covariance of return from risky assets to the variance
of market return)
Sensitivity Analysis
The sensitivity analysis require changes in one variable at a time with an
approach of “what if” & then observe the effect on output of the other
variables.
• For example, in case of cash budgeting, changes in value of any one
of following variables in any direction
(i) future sales price
(ii) sales volume
(iii) cost or volume of material purchase, or
(iv) wage rate, etc.
and observing the impact of such changes on cash balance
• It is performed by changing possible variable inputs to test the
sensitivity of it on the cash balance - the out put
• This case is also be shown graphically if we create several assessments
with various possible changes and present it in graph
Graphical Presentation of Sensitivity Analysis
A Possible Sensitivity Plot
Output Variable
Most likely
Outcome
Best Estimate or average
value
Various levels of Input Variable
Where the horizontal line shows the changes in input variable, while in the vertical axis shows the
outcome variable here cash balance
The steeper is the slope of the line more sensitive the output variable to the input variable & vise
versa.
Sensitivity Analysis
• Characteristics of Sensitivity Analysis
• One Change at a Time
• One of the simplest and most common approaches is that of changing
one factor at a time.
• Whether the assumption is about the change in a borrowing rate or a
change in the working capital metrics (Days Sales, Days Payable, or
Day of Inventory),
• one can change each assumption individually to see the outcome on
working capital, profitability or loan covenants.
Simulation
The sensitivity analysis examines the effect of only one variable
at a time.
But in real life; business experiences movement of several
variables at a time.
This is why simulation is used for the assessment of total risk
But if no computer assistance is available, it is difficult to use
simulation as it will require computation of several situations
with some probability distribution
Manually, this is a very cumbersome Job to do
However, as in now-a-days different computer packages are
easily available, it is easier to resolve the problem
So total risk can easily be assessed.
Simulation: an Example
Models for Risk Adjusted Returns/Cost of Funds
• The Capital Asset Pricing Model as developed by Sharp in late 50s is
one of the popular model used to estimate a risk adjusted rate of return
or cost of funds for a firm.
• The model estimates risk adjusted required rate of return (Ri) for any
firm i as under:
E(Ri)=Rf + ßi (Rm –Rf)
Where - ßi =Cov(RiRm)/Var(Rm).
Separate Risk Modeling
• In addition to normal risk management through assessment of risk in
discount rate and discounting the cash flow to eliminate the effect of risk,
the firm can seek alternative approach. This is known as ‘separate risk
modeling’.
• Under separate risk modeling, the managers separate the estimation base
from the measure of risk.
• Therefore, an expected value is estimated and than risk provisions are made
separately so that future uncertainty can be negated (neutralized).
• The inventory management through EOQ ordering with a provision for
safety stock is the example for such risk management
• The provisions like safety stock, negates the effects of inventory crisis is
known as hedging
• The term ‘hedging’ refers to such actions, which neutralizes the effects of a
risk variability in demand totally or partially
Dilemma In Risk Cost Vs Return
• In case of working capital management the managers always remains
in a dilemma as to how much hedging is optimal.
• Because without hedging he can be in
(i) risk of loosing market confidence (cash crisis) or
(ii) customers confidence (stock out) and
(iii) thus loosing ground for business
• Too much hedging (stockpile of inventory or huge cash or marketable
security) is highly costly
• Thus the working capital management involves the manager in
optimizing between hedged and un-hedged situation
• The following graph shows the situation
Situations Leading to Negative Working
Capital Balance
• A firm can have negative working capital balance under following
situations:
• Continuous sustaining of loss and short-term borrowing
• Aggressive working capital management policy
• A large amount of long-term debt become payable in a year
• Significant depletion of major current assets for writing off significant volume of
obsolete inventory held for long time
Contributing Factors for Negative Cash Balance
a. When return on total asset fall while
b. Firm’s efficiency ratio or asset turn over ratio remain same
c. Sales increase at a declining rate
d. Total debt declining in comparison to TA indicating greater dependence on
equity
e. CA>CL where CA increase significantly in comparison to that of CL meaning
current assets are financed by long term liabilities.
f. A/Cs Receivable increase at a rate greater than that of sales means credit sale
increase or collection period enhanced & collection slowed down
g. Inventory turnover ratio declined meaning significant growth of inventory
means poor inventory management or significant volume of funds are tied up in
inventory
• Here a, c, & e are contributing factors while f & g-are direct factors-
towards creating negative cash balance.
