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CHAPTER 5: WORKING CAPITAL MANAGEMENT - Coggle Diagram
CHAPTER 5: WORKING CAPITAL MANAGEMENT
definition
working capital concept
comprises the day-to-day management of CA (cash, AR, marketable securities and inventories)
involves decisions regarding investment in CA
NWC = CA - CL
working capital policy
relaxed policy
potentially low return from investment due to low productivity of CA relative to FA
high liquidity
low risk policy
restricted policy
lower investments in CA enable the firm to increase investment in other productive investments
higher returns
high risk policy
moderate policy
high CA investments under relaxed policy will reduce risk of technical insolvency
also results in lower returns due to lower productivity of CA
investment in CA should be at a minimum level without sacrificing the liquidity requirements
moderate risk and returns
working capital strategies
range from aggressive to conservative approach that will produce different levels of profitability and risk exposure
aggressive policy - sacrifices safety or liquidity for return
conservative policy - sacrifices return for safety
base on Risk-Return Trade-Off (i.e. higher risk, higher return)
approaches
aggressive approach
finance all
FA with l/term financing
, but only a portion of the
permanent CA
would be financed by l/term financing
the remaining
permanent & the fluctuating CA
would be financed
with s/term borrowing
uses
short term (temporary) financing
to finance
some permanent assets
s/term debt is often cheaper
than l/term debt, so many firms may be willing to sacrifice safety for possibly higher
profits
conservative approach
lowest risk approach
the firm uses
long term financing
for the majority of its assets
the firm supports fixed, permanent current & average temporary CA with long term financing
when there are excess funds, there are invested in marketable securities
maturity matching (hedging) approach
firm use
short term financing
to finance
temporary CA
and
long term financing
to finance
permanent assets
results in moderate risk with moderate returns
hedge risk by matching the maturities of assets and liabilities
no excess funds
concept of working capital management
temporary sources of financing
- CL (notes payable)
permanent sources of financing
- LT finance (LTD/preferred stocks/common stocks)
temporary asset
- fluctuate with sales < 1 year (receivable & inventory)
spontaneous sources of financing
- trade credit (AP) arise from day-to-day operation
permanent asset
- hold more than 1 year (minimum cash balance and inventories)
which approach to maintain appropriate level of liquidity or margin of safety is the BEST?
depend on profitability of the firm
depend on liquidity of the firm's assets
depend on stability of cash flows
depend on management attitude towards risk
depend on the expected future interest rates
key takeaways
the return on equity is lowest for the conservative approach and highest for aggressive approach
this relates directly to the liquidity and risk position for each of the approaches:
CA to CL ratio
6:1 for conservative (i.e. 120/20)
3:1 for hedging (i.e. 120/40)
1.7:1 for aggressive (i.e. 120/70)