1. 1
Chapter 14 Working Capital
Management and Policies
McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Revisiting the Balance Sheet Model of
the Firm
• Current assets
– Most liquid
– Less profitable than fixed assets
– Represent net amount firm has to fund
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3. Revisiting the
Balance Sheet Model
• Net working capital =
Current Assets – Current Liabilities
– Firm’s objective is to fund the least amount of net
working capital possible
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4. Tracing Cash and
Net Working Capital
• Operating Cycle is the time needed to
– Acquire raw materials and turn into finished goods
– Sell and receive payment for them
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5. Operating Cycle
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6. Cash Cycle
• Portion of operating cycle firm must finance
• Time between payment for inventory and sales
receipts
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7. Short Term Financial Policy
• Firms reduce net working capital needs
– Manage need for current assets
– Obtain current liabilities to fund current assets
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8. Size of Current Assets Investment
Two categories of carrying costs:
1) Opportunity costs with capital tied up in current
assets
2) Explicit costs to maintain value of current assets
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9. Financing Terms Consider Asset
Demand Peaks and Valleys
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10. Alternative Financial Policies for
Current Assets
• Flexible financing policy
• Restrictive financing policy
• Compromise financing policy
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11. Flexible Financing
Long-Term Debt for Peak Asset Demand
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12. Restrictive Financing:
Long-Term Debt/Equity for Trough Asset Demand
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13. Compromise Financing
Seasonal Average Asset Demand Financed with
Long-Term Debt/Equity
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14. Short-Term Financial Plans
• Firms not using flexible financing will need to
seek short-term solutions
– Unsecured loans
– Secured loans
– Other short-term financing alternatives
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15. Unsecured Loans
• Commercial loan from bank
– Usually a line of credit
– Fees can be explicit and implicit
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16. Secured Loans
• Asset-based loans
– Lenders charge lower interest rates
– Real estate, accounts receivable, inventory used as
collateral
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17. Other Financing Sources
• Commercial paper
• Banker’s acceptances
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18. Cash Management
• Clarification on terminology cash flow vs. cash
account
– Cash flows are good
– Cash account is a current asset with high liquidity
and low profitability
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19. Reasons for Holding Cash
• Transaction facilitation
• Compensating balances
• Investment opportunities
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20. Baumol Model
• Strength: Minimizes sum of opportunity costs
and trading costs
• Weakness: Unrealistic assumptions
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21. The Miller-Orr Model
• Assumes daily net cash flows normally
distributed
• Allows for cash inflows and outflows
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22. Other Factors Influencing Target
Cash Balance
• Short-term borrowing for unexpected cash
demands
• Declining trading costs
• Firm requirement to maintain compensating
balances
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23. Float Control: Collection and
Disbursement of Cash
Float – the period of time after check is written
but not yet cleared and deposited
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24. Float Control
• Three types of collection float
– Mail
– In-house processing
– Availability
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25. Delaying Disbursements
Legal ways to increase disbursement float
– Zero-balance account
– Drafts
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26. Ethical and Legal Questions
Illegal practices
– Using collected cash before receiving it
– Continuing to use disbursed cash after check sent
– Check kiting is drawing money against account
with insufficient funds
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27. Investing Idle Cash
• Most large firms invest in their own
marketable securities
• Smaller firms invest in money-market fund or
bank sweep account
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28. Why Firms Have Excess Cash
• Seasonal fluctuations
• Preparation for a planned expenditure
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29. What to Do with Surplus Cash
• Appropriate investments
– Treasury bills
– Federal Funds
– Repurchase agreements
– Commercial paper
– Negotiable CDs
– Banker’s acceptances
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30. Credit Management
Trade-off between the opportunity cost of lost
sales, and the carrying costs of funding
Accounts Receivable (AR) plus the expected
costs of default on AR
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31. Credit Policy: Terms of the Sale
Credit terms include
– Credit period
– Cash discount
– Description of the type of credit instrument
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32. Credit Analysis
• Determination of the borrower’s ability and
willingness to pay
• 5 C’s of credit:
1. Capacity
2. Character
3. Capital
4. Collateral
5. Conditions
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33. Collection Policy
• Collecting past-due accounts from customers
• Typical procedure
– Send delinquency letters
– Initiate telephone calls
– Employ collection agency
– Legal action against the customer
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