Approaches to Working Capital Financing

Understanding the Needs of the Business

Working capital needs will vary depending on the type of the business and its operational requirements.

Learning Objectives

Describe the goals of a business in the context of ts working capital needs

Key Takeaways

Key Points

  • Sufficient working capital is required to ensure that a firm is able to continue its operations and that it has sufficient funds to satisfy both maturing short-term and long-term debt and upcoming operational expenses.
  • The management of working capital involves managing inventories, accounts receivable and payable, and cash.
  • When calculating working capital we think in terms of net working capital, which is calculated as current assets minus current liabilities.
  • In any company, large or small, there is an inherent tradeoff between liquidity and profitability.

Key Terms

  • inventory: The stock of an item on hand at a particular location or business

Understanding the Business Needs

Working capital is a financial metric which represents the operating liquidity available to a business. Working capital is considered a part of operating capital along with fixed assets, such as plant and equipment. Sufficient working capital is required to ensure that a firm is able to continue its operations and that it has sufficient funds to satisfy both maturing short-term and long-term debt and take care of upcoming operational expenses. However, too much working capital can carry with it a higher cost of capital. A company can be endowed with assets and profitability but short of liquidity if its assets cannot readily be converted into cash. The management of working capital involves managing inventories, accounts receivable and payable, and cash.

Calculation of Working Capital

When calculating working capital, we think in terms of net working capital, which is calculated as current assets minus current liabilities. This is the figure commonly used in valuation techniques such as discounted cash flows. If current assets are less than current liabilities, an entity has a working capital deficiency, also called a working capital deficit. Current assets and current liabilities include three accounts which are of special importance. These accounts represent the areas of the business where managers have the most direct impact:

  1. Accounts receivable (current asset)
  2. Inventory (current asset)
  3. Accounts payable (current liability)

A company ideally wants accounts receivable to be collected as quickly as possible in order to have as much use of the funds as possible. Conversely, a firm strives to put off the settlement of accounts payable as long as possible for the same reason. The current portion of debt is also critical, because it represents a short-term claim to current assets and is often secured by long term assets. Common types of short-term debt are bank loans and lines of credit. Inventory is a special case in which even non-financial managers have a stage. Too much inventory on hand will reduce the risk of a company failing to satisfy customer needs, but it can also reduce profitability. An example of reduced profitability would be in the computer industry, where inventories regularly lose value because of the fast-moving nature of the industry.

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Inventory Software: This is an example of modern inventory software that enables managers to precisely track orders and inventory levels.

Profitability and Liquidity Tradeoff

In any company, large or small, there is an inherent tradeoff between liquidity and profitability. Large companies possess resources to help them manage this tradeoff, such as an accounting department, negotiating power with their suppliers, or access to the capital markets. For the entrepreneur, however, who is often resource-starved and doesn’t have enough operating history to secure additional credit, managing this tradeoff can feel like walking a tightrope. Consider the case of a new customer for a small company. This new customer has the potential to offer huge growth in the company’s sales, but this growth in sales will be accompanied by a subsequent growth in variable costs. The company may not have the resources, i.e., working capital, to meet these variable costs that come with increased sales.

Long-Term Approach

Recognize the broader objectives of working capital, as well as how organizations can consider a long-term perspective when viewing the utilization of working capital.

Learning Objectives

Identify the primary objectives of working capital, and how a longer-term perspective can offer insights

Key Takeaways

Key Points

  • Working capital demonstrates the current operating liquidity of a given organization through subtracting the current liabilities from the current assets.
  • The primary objectives of working capital are profitability and liquidity.
  • Short-term planning is predominately what is used when discussing working capital management, as working capital is intrinsically a short-term assessment.
  • However, some long-term perspectives can be utilized when approaching working capital. This includes how working capital is considered strategically, and the organizational policies around availability and utilization of working capital.

Key Terms

  • Working capital: The total available cash and cash equivalents after subtracting current liabilities from current assets.

Working Capital

Working capital is a calculation of the overall operating liquidity an organization has access to at a given moment, derived through a simple calculation from the balance sheet:

Working Capital = Current Assets – Current Liabilities

Current assets are items a business owns that are either current cash, or assets that can be rapidly converted to cash, such as accounts receivables, cash, cash equivalents, short-term investments, and inventory. Current liabilities are debts owed in the short term, such as accounts payable, short-term debts, and other obligations within a short operational cycle.

When you subtract what is owed in the short term from what is available, an organization can project how much free working capital is on hand during the operating cycle.

Long Term Planning

This free working capital can be utilized in a variety of ways. Working capital under-utilized incurs the opportunity costs associated with the time value of money, and organizations must use financial planning to ensure appropriate utilization of this capital over the longer term.

While short-term planning is predominately what is used in respect to working capital (due to the short term nature of the inputs and outputs involved), it is reasonable to set long-term polices and strategies for incorporating changes in working capital into financial strategy. The primary benefits of leveraging working capital are liquidity and profitability, each of which can be viewed through a longer term lens.

Liquidity

When discussing long-term objectives, the focal point is broader strategy (as opposed to tactics). From a strategic perspective, there is a certain amount of liquidity business would like to maintain at any given moment to ensure that they can capture external opportunities in the market. Having easily accessible working capital at any given moment enables organizations to minimize the opportunity cost of foregone opportunities, and careful regulation of working capital strategic criteria can ensure the appropriate amount is available.

Profitability

The other broader objective of working capital is how effectively it is utilized over a given time period. From the long-term perspective, this profitability metric will be quite a bit different than the short term. From a longer-term perspective, working capital profitability decisions revolve around how much should be available within any short-term time frame in order to maximize the return (on average) of existing working capital. By looking at differences in working capital availability over a long period of historical data, the organization can make rough estimations of the optimal amount of working capital availability that allows optimal growth.

Despite the potential advantages of longer-term planning in working capital, it is still largely a field of shorter term decision making. Generally, working capital should be considered within a one year or less time frame, making it more often a shorter term decision.

Short-Term Approach

Decisions relating to working capital are usually short-term, since it is the difference between current assets and current liabilities.

Learning Objectives

Explain how the cash conversion cycle influences working capital management

Key Takeaways

Key Points

  • The main considerations for working capital are cash flow / liquidity and profitability / returns on capital.
  • The most widely used measure of cash flow is the net operating cycle or cash conversion cycle.
  • The cash conversion cycle measures how long a firm will be deprived of cash if it increases its investment in resources in order to expand customer sales.
  • The aim of the study and calculation of the cash conversion cycle is to change the policies relating to credit purchase and credit sales.

Key Terms

  • discounting: The process of finding the present value using the discount rate.

Short-Term Approach to Working Capital Management

Working capital is the amount of capital that is readily available to an organization. Working capital is the difference between cash resources or assets readily convertible into cash ( current assets ) and cash obligations ( current liabilities ). As a result, the decisions relating to working capital are almost always current, i.e., short term, decisions. In other words, working capital management differs from capital investment decisions – specifically in terms of discounting and profitability. Working capital management applies different criteria in decision making. The main considerations are cash flow / liquidity and profitability / returns on capital. The most widely used measure of cash flow is the net operating cycle or cash conversion cycle. This measures how long a firm will be deprived of cash if it increases its investment in resources in order to expand customer sales.

The cash conversion cycle indicates the firm’s ability to convert its resources into cash and informs management of the liquidity risk entailed by growth. Because this number effectively corresponds to the time that the firm’s cash is tied up in operations and unavailable for other activities, management generally aims at shortening the cash conversion cycle as much as possible. However, shortening the cycle creates its own risks. While a firm could even achieve a negative cash conversion by collecting from customers before paying suppliers, a policy of strict collections and lax payments is not typically sustainable. The aim of the study and calculation of the cash conversion cycle is to change the policies relating to credit purchase and credit sales. A firm can change its standards for payment on credit purchases and getting payment from debtors on the basis of cash conversion cycle. If the firm is in an effective cash liquidity position, it can maintain its past credit policies.

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Cash Conversion Cycle: Above is a chart showing a sample cash conversion cycle.

Choosing a Policy

A firm will use a combination of policies for managing working capital, focusing on cash flow, liquidity, profitability, and capital return.

Learning Objectives

Describe refinancing risk and how it influence working capital policy

Key Takeaways

Key Points

  • Working capital policies aim at managing current assets – generally, cash and cash equivalents, inventories, and debtors – and short term financing, such that cash flows and returns are acceptable.
  • One of the objectives within working capital management and general financing decisions is to match the maturity of liabilities with the life expectancy of assets.
  • If the maturity of liabilities is less than the life expectancy of assets, a firm faces refinancing risk since it will have to raise new capital to pay off liabilities.

Key Terms

  • credit policy: Credit terms given to customers that affect sales and collection practices.

Choosing a Policy

Guided by criteria measuring cash flow, liquidity, profitability, and return on capital, the management of a firm will use a combination of policies and techniques for the management of working capital. These policies aim to manage the current assets – generally, cash and cash equivalents, inventories and debtors – and the short term financing, such that cash flows and returns are acceptable. As with any decision involving the management of capital, the firm’s goal should be to minimize the overall cost of capital and maximize value to the shareholders. In order to effectively manage cash flow, a firm should identify the cash balance which allows for the business to meet day to day expenses, but reduces cash holding costs – i.e., the opportunity cost of holding cash as opposed to investing it.

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Policies Regarding Liquidity: This chart lays out sample working capital issues and some possible solutions.

A company should also identify the level of inventory which allows for uninterrupted production, but reduces the investment in raw materials – and minimizes reordering costs – and therefore increases cash flow. Another area of concern for a firm will be managing debtors. Management should identify the appropriate credit policy so that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and return on capital. Moreover, management should implement appropriate credit scoring policies and techniques so that the risk of default on any new business is acceptable given these criteria.

A final area management should be concerned with when deciding on a working capital policy is short-term financing. A firm should identify the appropriate source of financing, given the cash conversion cycle. Inventory is ideally financed by credit granted by the supplier. However, it may be necessary to utilize a bank loan.

Refinancing Risk

One of the objectives within working capital management and general financing decisions is to match the maturity of liabilities with the life expectancy of assets. This allows liabilities to be self-liquidating. If the maturity of liabilities is less than the life expectancy of assets, a firm faces refinancing risk since it will have to raise new capital to pay off liabilities. If the maturity of liabilities is longer than the life expectancy of assets, then there should be sufficient working capital available to pay off debts. The mismatching of liabilities with assets can occur if financing is not available.

For example, suppose long-term financing is not available. Short-term sources of financing may have to be used. Mismatching can also be intentional. For example, suppose a company expects long-term interest rates to fall. The firm may want to finance assets with short-term maturities since it can refinance in a few years at much lower rate.