Working Capital
amount of the firm's current assets
(cash, accounts receivable, marketable securities, inventory and prepaid expenses)
Net Working Capiatal
Current Assets - Current Liabilities
Benefits of Working Capital
Higher Liquidity (lowers risk)
Cost of Working Capital
Lower Returns- $$ invested in lower returning securities rather than production
Current Ratio
Current Assets/Current Liabilities
Return on Assets
Net Income/Assets
Conservative Approach
Finance all fixed assets, permanent current assets, and some temporary with LT debt or equity. Short Term Financing is used for the remaining temp. current assets
Lower risk, lower return
Moderate Approach
Maturity Matching
Finance fixed assets and permant current assets with Long term funds and temporary current assets with short term fnuds
Moderate Risk, moderate return
Aggressive Approach
Use Short Term debt finance at least the temporary current assets, and possibly some of the long-term fixed assets
Conservative Financing
Current Liabilities less than Total Current Assets
Agressive Financing
Current Liabilities greater than Total Current Assets
Moderate Financing
Current Liabilities equal Total current assets
Short Term Financing
More profitable (higher ROA) because lower interest rate but more risky
Long term Financing
Safer but less profitable (lower ROA) because of higher interest rates
Current Assets
More Liquid than Fixed assets but less profitable because of lower returns
If net working capital is positive
The current ratio is less than 1
Commercial Paper and Bank Loans
External Sources of funding
Discount interest rate
Pay initial interest at beginning of loan
Short-term loans
borrowing from banks and other financial institutions for one year or less.
Trade credit
the act of obtaining funds by delaying payment to suppliers
Even though it is obtained by simply delaying payment, it is not always free
Commercial paper
only available to large credit- worthy businesses
Types of short term loans
Promissory note
Self-liquidating loan
Line of Credit
Revolving Credit
Self-liquidating loan
The proceeds of the loan are used to acquire assets that generate cash to repay the loan (e.g. inventory)
Promissory note
A legal IOU that spells out the terms of the loan agreement, usually the loan amount, the term of the loan and the interest rate.
Often requires that loan be repaid in full with interest at the end of the loan period
Line of Credit
The borrowing limit that a bank sets for a firm.
May include many promissory notes that the firm has taken out at different times and with overlapping payment periods.
Usually informal agreement and may change over time
Revolving credit agreement
Formal agreement with bank to extend credit to a firm for a period of time (can be more than one year)
Effective Interest Rate
Used to determine the cost of the credit to be able to compare differing terms
Discount loan
Interest be paid up front on a loan
Blanket Lien
A general claim against the borrowers inventory if there is a default
Trust Receipt
A legal document that identifies specific inventory as security for a loan
Warehousing
Inventory pledged as collateral is removed from the control of the borrower (either in an on-site or public warehouse)