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Chapter 14 Working Capital Management

Chapter 14 Working Capital Management. Key Sections (pages 441 - 446) Risk/return trade-offs in Working Capital Management Hedging principle. Introduction. Net WC – current assets less current liabilities

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Chapter 14 Working Capital Management

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  1. Chapter 14Working Capital Management • Key Sections (pages 441 - 446) Risk/return trade-offs in Working Capital Management Hedging principle

  2. Introduction • Net WC – current assets less current liabilities • Liquidity management – establish current asset and liability levels so firm can meet its obligations • Short-term – under one year. How much and from what sources? • On average, 15% of sales in working capital

  3. Current Liabilities Advantages • Flexibility • Lower interest cost on short-term debt Disadvantages - Causes increase in risk of illiquidity especially if financial condition deteriorates - Uncertain interest costs year to year

  4. Risk/Return Trade-offLiquidity versus Profitability • Large current assets reduce risk of production stoppages, lost sales and inability to pay bills • But as WC  , no increase in returns • With no increase in profits, ROI drops • Greater reliance on current liabilities, greater risk of illiquidity

  5. Short-term, Long-termTrade-offs • Risk of illiquidity • What happens if can’t obtain or roll over S-T debt? • Xerox, GM, Ford, etc as ratings deteriorated • S-T less costly than L-T and more flexible • Uncertainty of interest costs from year to year • Trade-off – increased risk of illiquidity versus increased profitability

  6. Sources of Financing Assets – temporary (seasonal) or permanent Spontaneous sources – arise in normal course of business Trade credit – accounts payable Other payables and accruals Discretionary sources – from an explicit decision by management, both short and long-term borrowings

  7. Hedging Principle • Maturity should follow cash flows of asset being financed - S-T Financing should be self-liquidating • After spontaneous sources used, finance - Temporary assets with current liabilities. - Permanent assets with permanent financing, including permanent part of working capital

  8. Hedging Principle

  9. Working Capital ManagementNeed for Integrative Approach • People are expensive so automate! • Requires external and internal teamwork to integrate systems for paperless environment • Customers, suppliers, banks, company • MSIS, Finance and Production

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