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Topic 2.1 Working-Capital Management Introduction

Learning Outcomes
• List the determinants of a firm’s net working capital and explain their relationships • Utilize working capital in managing firm activities • Describe the hedging principle of short-term debt • Calculate the cash conversion cycle

• Understand the risk/return trade-off in managing working capital

I. Background

The business manager must continually be alert to changes in working capital accounts, the cause of these changes and the implications of these changes for the financial health of the company. One convenient and effective method to highlight the key managerial requirements in this area is to view working capital in terms of its major components: A. Cash and Equivalents

This most liquid form of current assets, cash and cash equivalents (usually marketable securities or short-term certificate of deposit) requires constant supervision. A well-planned and maintained cash budgeting system is essential to answer key questions such as: Is the cash level adequate to meet current expenses as they come due? What are the timing relationships between cash inflows and outflows? When will peak cash needs occur? What will be the magnitude of bank borrowing required to meet any cash shortfalls? When will this borrowing be necessary and when may repayment be expected? B. Accounts Receivable

Almost all businesses are required to extend credit to their customers. Key issues in this area include: Is the amount of accounts receivable reasonable in relation to sales? On the average, how rapidly is accounts receivable being collected? Which customers are "slow payers?" What action should be taken to speed collections where needed? C. Inventories

Inventories often make up 50 percent or more of a firm's current assets and therefore, are deserving of close scrutiny. Key questions which must be considered in this area include: Is the level of inventory reasonable in relation to sales and the operating characteristics of the business? How rapidly is inventory turned over in relation to other companies in the same industry? Is any capital invested in dead or slow moving stock? Are sales being lost due to inadequate inventory levels? If appropriate, what action should be taken to increase or decrease inventory? D. Accounts Payable and Trade Notes Payable

In a business, trade credit often provides a major source of financing for the firm. Key issues to investigate in this category include: Is the amount of money owed to suppliers reasonable in relation to purchases? Is the firm's payment policy such that it will enhance or detract from the firm's credit rating? If available, are discounts being taken? What are the timing relationships between payments on accounts payable and collection on accounts receivable? E. Notes Payable

Notes payables to banks or other lenders are a second major source of financing for the business. Important questions include: What is the amount of bank borrowing employed? Is this debt amount reasonable in relation to the equity financing of the firm? When will principal and interest payments fall due? Will funds be available to meet these payments on time? F. Accrued Expenses and Taxes Payable

Accrued expenses and taxes payable represent obligations of the firm as of the date of balance sheet preparation. Accrued expenses represent such items as salaries payable, interest payable on bank notes, insurance premiums payable, and similar items. Of primary concern in this area, particularly with regard to taxes payable, is the magnitude, timing, and availability of funds for payment. Careful planning is required to insure that these obligations are met on time.

II. Introduction to Working Capital

A. There are two basic aspects of managing the operations of a firm. First, the firm must manage revenues and costs to ensure there is a profit. Second,...
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