working capital management

Chapter 2
Overview of Working Capital Management

After studying this chapter, you should be able to:
Explain the definition of working capital
Understand the two fundamental decision issues in working capital management -- and the trade-offs involved in making these decisions.
Discuss how to determine the optimal level of current assets.
Describe the relationship between profitability, liquidity, and risk in the management of working capital.
Explain how to classify working capital according to its “components” and according to “time” (i.e., either permanent or temporary).
Describe the hedging (maturity matching) approach to financing and the advantages/disadvantages of short- versus long-term financing.

Overview of Working Capital Management
Working Capital Concepts
Working Capital Issues
Financing Current Assets: Short-Term and Long-Term Mix
Working Capital Concepts

Net Working Capital-Current Assets - Current Liabilities.
Gross Working Capital- The firm’s investment in current assets.
Working Capital Management- The administration of the firm’s current assets and the financing needed to support current assets.

Significance of Working Capital Management
In a typical manufacturing firm, current assets exceed one-half of total assets.
Excessive levels can result in a substandard Return on Investment (ROI).
Current liabilities are the principal source of external financing for small firms.
Requires continuous, day-to-day managerial supervision.

Working Capital Issues
Assumptions
50,000 maximum units of production
Continuous production
Three different policies for current asset levels are possible
Optimal Amount (Level) of Current Assets

Impact on Expected Liquidity
Liquidity Analysis
Policy Liquidity A High B Average C Low
Greater current asset levels generate more liquidity; all other factors held constant.

Impact on Expected Profitability
Return on Investment =Net Profit/Total Assets
Let Current Assets = (Cash + Rec. + Inv.)
Return