Topic 3: Working capital finance

Topic Learning Outcomes

After this topic, you should be able to:
1. Understand the concepts of working capital management and its application
2. Discuss the trade-off between profitability and risk

Let’s Discuss
1. Concepts and significance of working capital management
2. Trade-Off between Profitability and Risk
3. Working capital investment and financing policies (conservative vs. aggressive)

WORKING CAPITAL FINANCE

Working capital
• “current assets” because these assets “turn over” and are used and then replaced during the year
Net working capital
• Current assets less current liabilities
Net operating working capital
• Working capital that is used for operating purposes.
• Excludes interest bearing notes payable

𝑁𝑒𝑡 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 (𝑁𝑂𝑊𝐶) = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − (𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 − 𝑁𝑜𝑡𝑒𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒)

Working Capital Management

• Administration of company’s working capital with primary objective of balance between risk and return

Temporary Current Assets

• Current assets that fluctuate with the firm’s operations, or with seasonal or cyclical variations in sales
Permanent Current Assets
• These are required to maintain daily operations
• Current assets that firm must carry even at the through of its cycle

Working Capital Investment Policies

a. Relaxed Investment Policy
b. Restricted Investment Policy
c. Moderate Investment Policy
Working Capital Financing Policy
a. Conservative (Relaxed) Policy
o Operations with too much working capital; financing almost all assets with long-term capital
b. Aggressive (Restricted) Policy
o Operations with minimal amount of working capital; uses short-term liabilities to finance not only
temporary, but also part or all of the permanent current asset requirement.
c. Matching Policy (or Self-Liquidating Policy or Hedging Policy)
o Short-term Assets: Short-Term Liabilities
o Long-term Assets: Long-Term Liabilities

This study source was downloaded by 100000848966590 from CourseHero.com on 06-25-2022 23:07:38 GMT -05:00

https://www.coursehero.com/file/74623857/3-Working-capital-finance-1pdf/
 SAMPLE PROBLEM
Wakanda Corp. has a total fixed asset of 200,000.
2nd
1st Quarter Quarter 3rd Quarter 4th Quarter
Cash P 40,000 20,000 25,000 30,000
Accounts Receivable 76,000 35,000 67,000 108,000
Inventories 40,000 85,000 89,000 30,000

1. If Wakanda Corp.’s policy is to finance all fixed asset and half the permanent current assets with long-term
financing and the rest with short-term financing, what is the level of long-term financing?
2. Describe the type of financing of the company’s working capital in (1).
3. If Wakanda Corp.’s policy in financing its working capital is describe as moderate, what is the level of long-term
financing?
4. If Wakanda Corp.’s policy is to finance all the fixed and permanent assets and half the seasonal assets with long-
term financing and the rest with short-term financing, describe the financing it employs.

Answer

Current Asset
1st Quarter 156,000
2nd Quarter 140,000
3rd Quarter 181,000
4th Quarter 168,000

Notes:
o Fixed Assets remain constant throughout the quarters at a level of 200,000.
o On the illustration above, everything above 200,000 mark is the current asset.
o Current assets that are not affected by seasonal cycles are considered to be a permanent current asset.

This study source was downloaded by 100000848966590 from CourseHero.com on 06-25-2022 23:07:38 GMT -05:00

https://www.coursehero.com/file/74623857/3-Working-capital-finance-1pdf/
 o On the problem, the 2nd quarter current assets amounting to 140,000 is the minimum amount of current asset
that is needed to sustain the operation throughout the year (i.e. 140,000 amounts of current asset must stay or
be permanent all throughout the quarters).
o Permanent Current Asset, although classified under financial reporting as current asset, acts “somehow” as a fixed
asset since it must be constant to sustain the operation of the firm.
o Any excess above the level of permanent current asset each quarter are called Seasonal or Temporary Current
Asset. These Current assets exist specifically to support the operation of the firm whose service or product are
affected by seasonality trends (e.g. school supplies have high seasonality trend during months when school
commences).

Answers:
1. • fixed asset + half of permanent current assets
• 200,000 + (140,000/2) = 270,000

2. The type of financing of the Wakanda Corp.'s working capital in (1) is aggressive because short-
term liabilities is used to finance not only the temporary but also part of the permanent current
asset.

3. • Under Moderate Investment Policy or Matching Policy, Short-Term and Long-Term Assets
and Liabilities are appropriately Matched.
•• Moderate Investment Policy or Matching Policy: Long-Term Financing = Fixed Assets (or
Non-current Assets) + Permanent Current Assets
• Long-Term Financing = 200,000 + 140,000 = 340,000

4. Wakanda Corp. employs Conservative (or Relaxed) Policy since it finances almost all assets with
long-term capital.

Financial forecasting using Additional Funds Needed (AFN)

Firm’s Primary Capital Sources

a. Spontaneously generated funds
• Spontaneous Increase in Accounts Payable and Accruals
• Fund that rise out of normal business operations
b. Additions to Retain Earnings
• Depending on the firm’s profit margin and its retention ratio
• Retention Ratio (PBR) is the portion of the income reinvested in the firm
c. Additional Funds Needed (AFN)
• Amount of external capital necessary to acquire the required assets
• May be interest-bearing debt or preferred or common stock

Additional Funds Needed (AFN) Equation

𝐴𝐹𝑁 = 𝐴𝑠𝑠𝑒𝑡𝑠0 ∗ 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 − 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠0 ∗ 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 − (𝑆𝑎𝑙𝑒𝑠1 )(𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛)(𝑃𝑙𝑜𝑤 𝐵𝑎𝑐𝑘 𝑅𝑎𝑡𝑖𝑜)

Capital Intensity Ratio

• The ratio of Assets required per dollar of sales
Excess Capacity Adjustment
• Changes Made to the existing asset forecast because the firm is not operating at full capacity

This study source was downloaded by 100000848966590 from CourseHero.com on 06-25-2022 23:07:38 GMT -05:00

https://www.coursehero.com/file/74623857/3-Working-capital-finance-1pdf/
 SAMPLE PROBLEM
Problem 1 – Asset requirement
Blue Corp. forecasted its sales to be 5,000,000, gross profit margin to be 30% and its return on sales to be 10%. Accounts
receivable is expected to be 10% of sales while inventory is expected to be 20% of cost of sales. Blue has a minimum
cash balance of 250,000 and fixed assets of 3,500,000. How much is the total asset requirement?

Problem 2 – AFN
Jelly Inc. uses Additional Funds Needed as a plug item. It has a new capital budget of 2,000,000, a profit of 3,000,000 and
a payout ratio of 60%, how much must be raised in external funds?

Problem 3 – AFN (operation not in full capacity)

Airline Enterprise’s Balance sheet as of December 31, 2019 is as follows:
Current Assets P 600,000 Accounts Payable P 100,000
Accruals 100,000
Notes Payable 100,000
Long-term Liabilities 300,000
Fixed Assets 400,000 Equity 400,000
P 1,000,000 P 1,000,000

In 2019, the company reported sales of 5,000,000, net income of 100,000, and dividends of 60,00. Sales are projected to
increase by 20% next year. Both profit Margin and the dividend pay-out ratio will remain the same. Operations are at full
capacity. Assume external fund will be raised through issuances of long-term debt.
a. How much long-term will the company have to issue next year?
b. If the operations are not in full capacity, what will be your answer?

Problem 1
Asset Requirement
Cash 250,000.00
AR 500,000.00
Inventory 700,000.00
Fixed Asset 3,500,000.00
4,950,000.00

Problem 2
AFN = 2,000,000 – [3,000,000 * (100% - 60%)]
AFN = 800,000

Problem 3
a. AFN = 𝐴𝑠𝑠𝑒𝑡𝑠0 ∗ 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 – 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠0 ∗ 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 − (𝑆𝑎𝑙𝑒𝑠1)(𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛)(𝑃𝑙𝑜𝑤 𝐵𝑎𝑐𝑘 𝑅𝑎𝑡𝑖𝑜)
100,000 100,000−60,000
AFN = (1,000,000 * 20%) – (200,000 * 20%) – (5,000,000 *1.2) (5,000,000) ( 100,000 )
AFN = 112,000

100,000 100,000−60,000
b. AFN = (600,000 * 20%) – (200,000 * 20%) – (5,000,000 *1.2) (5,000,000) ( )
100,000
AFN = 32,000

Note: Assets are only 600,000 in (b) since the company does not operate at full capacity. It needs to utilize first the fixed
asset before it must be included in the asset that need to be increased

This study source was downloaded by 100000848966590 from CourseHero.com on 06-25-2022 23:07:38 GMT -05:00

https://www.coursehero.com/file/74623857/3-Working-capital-finance-1pdf/
 References
Gitman, L. J., & Zutter, C. J. (2015). Principles of Managerial Finance. Pearson Education Limited.
Brigham, E. F., & Houston, J. F. (2019). Fundamentals of Financial Management. Cengege.
Roque, R. S. (2013). Reviewer in Management Advisory Services.

Other online resources

https://www.fundingoptions.com/knowledge/working-capital-finance/
https://www.investopedia.com/terms/w/workingcapital.asp
https://www.youtube.com/watch?v=bHK77lbdyWA

This study source was downloaded by 100000848966590 from CourseHero.com on 06-25-2022 23:07:38 GMT -05:00

https://www.coursehero.com/file/74623857/3-Working-capital-finance-1pdf/
Powered by TCPDF (www.tcpdf.org)