FIN/571: Corporate Finance
Lawrence Sports Simulation
On a routine daily basis, businesses make financial decisions that affect operations. The majority of these decisions are related to managing working capital. A firm’s current assets minus its current liabilities determine working capital. According to Emery, Finnerty, & Stowe, (2007), “Working capital management involves all aspects of the administration of current assets and current liabilities.” (p. 639). How well a company manages working capital determines the available assets that can be applied to its operation. Lawrence Sports, a $20 million revenue company manufactures and distributes sports equipment for baseball, football, basketball, and volleyball (Lawrence Sports Simulation, University of Phoenix, 2013). They source materials to produce the products that they provide to retailers. In the following paper we examine and determine the effectiveness of their working capital management policies. Associated Risks for Working Capital Policies
Types of Working Capital Policies
There are three types of Working Capital policies which essentially is the capital the company should maintain. There are advantages and disadvantages to each, but ultimately the approach they prefer will depend on whether they want a zero-risk arrangement or something a little uncertain. The three policies detailed below are the aggressive, conservative, and maturity- matching. There are varying risks associated with each of the three major working capital philosophies or policies. Lawrence Sports will need to review the benefits and risks of each policy and understand risk-return trade-offs before determining what is right for their company. This will include the risks for the three philosophies of financing working capital and evaluating the impact on Lawrence Sports. Aggressive Approach
The goal of the aggressive approach is to raise profitability and relies heavily on short-term debt to finance current assets (Emery et. al, 2007). It follows the financial principle of risk-return trade-off in that expected profitability comes at a higher risk. The risk of short-term borrowing is known to be riskier than long-term financing as interest rates may fluctuate compared to a locked-in rate with long-term financing (Emery et. al, 2007). If Lawrence Sports believe that interest rates will be declining, this approach may be of interest to them. Companies that use an aggressive working capital approach have minimal current assets on hand, pay their creditors as late as possible, and must demand to receive on-time payments from their customers. Lawrence will need to examine their customer credit terms if choosing this approach and how any changes will affect current customer relationships, such as their long-standing relationship with Mayo. Maintaining a planned level of sales is critical for this approach. Because lower levels of inventory are kept, stock-outs must be avoided that would lead to a reduction in sales. In general, companies who use the aggressive working capital approach pay their creditors as late as possible. Liquidity can be a significant challenge when using this method. Unable to pay a creditor or meeting the terms of other short-term liabilities may cause Lawrence’s credit rating to decline, which in turn would affect the company’s borrowing power. Conservative Approach
Opposite to the aggressive working capital approach, there is a high level of investment in current assets with the conservative approach (Emery et. al, 2007). So much so that a risk with this method is that it may yield a lower return as more inventory and other assets are acquired than needed (Corporate Finance, n.d.). Firms that use a conservative approach focus on long-term financing rather than short-term. Although a steady interest rate may be advantageous over more risky short-term loans, if interest rates fall the company will be left...