CHAPTER

SIX

Working Capital and

the Financing Decision

McGraw-Hill Ryerson

McGraw-Hill Ryerson Limited 2000

FIF T H

Foundations of Financial
Management

th
CANADIAN

PPT 6-1

EDI TI ON

Figure 6-1a
The nature of asset growth
A. Stage I: Limited or no Growth
Dollars

Temporary current assets

Capital assets
Block
Hirt
Short

Time period
McGraw-Hill Ryerson

McGraw-Hill Ryerson Limited 2000

FIF T H

Foundations of Financial
Management

th
CANADIAN

PPT 6-1

EDI TI ON

Figure 6-1b
The nature of asset growth
B. Stage II: Growth
Dollars
Temporary current assets

Permanent
current assets
Capital assets
Block
Hirt
Short

Time period
McGraw-Hill Ryerson

McGraw-Hill Ryerson Limited 2000

FIF T H

Foundations of Financial
Management

th
CANADIAN

PPT 6-1

EDI TI ON

Figure 6-1b
The nature of asset growth
B. Stage II: Growth
Dollars
Temporary current assets

Permanent
current assets
Capital assets
Block
Hirt
Short

Time period
McGraw-Hill Ryerson

McGraw-Hill Ryerson Limited 2000

FIF T H

Foundations of Financial
Management

th
CANADIAN

PPT 6-2

EDI TI ON

Figure 6-2a
Sales and earnings for McGraw-Hill Ryerson, 1990-1998
35000
30000

$ thousands

25000
20000
15000
10000
5000

Sources: www.sedar.com
www.mcgrawhill.ca Symbol: MHR

McGraw-Hill Ryerson

98
3r
d

97
3r
d

96
3r
d

95
3r
d

94
3r
d

93
3r
d

92
3r
d

91
3r
d

Block
Hirt
Short

3r
d

90

Quarterly sales
McGraw-Hill Ryerson Limited 2000

FIF T H

Foundations of Financial
Management

th
CANADIAN

PPT 6-2

EDI TI ON

Figure 6-2b
Sales and earnings for McGraw-Hill Ryerson, 1990-1998
5000
4000
3000

1000

98
3r
d

97
3r
d

96
3r
d

95
3r
d

94
3r
d

93
3r
d

92
3r
d

91
3r
d

90

0
3r
d

$ thousands

2000

-1000
-2000
-3000
-4000

Block
Hirt
Short

-5000

Sources: www.sedar.com
www.mcgrawhill.ca Symbol: MHR

McGraw-Hill Ryerson

Quarterly earnings
McGraw-Hill Ryerson Limited 2000

FIF T H

Foundations of Financial
Management

th
CANADIAN

PPT 6-2

EDI TI ON

Figure 6-3a
Sales and earnings for Hudsons Bay Co. and Sears Canada
2500

$ millions

2000

1500

1000

500

0
4th
1990

4th
1991

4th
1992

4th
1993

4th
1994

4th
1995

4th
1996

4th
1997

4th
1998

Sales
Hudson's Bay

Block
Hirt
Short

Se ars

Sources: www.sedar.com
www.hbc.com Symbol: HBC
www.sears.ca Symbol: SCC

McGraw-Hill Ryerson

McGraw-Hill Ryerson Limited 2000

FIF T H

Foundations of Financial
Management

th
CANADIAN

PPT 6-2

EDI TI ON

Figure 6-3b
Sales and earnings for Hudsons Bay Co. and Sears Canada
200000

150000

$ thousands

100000
50000
0
4th
199 0

4th
199 1

4th
199 2

4th
199 3

4th
199 4

4th
199 5

4th
199 6

4th
199 7

4th
199 8

-50000
-100000

Earnings
Block
Hirt
Short

Hudson's Bay

Sears

Sources: www.sedar.com
www.hbc.com Symbol: HBC
www.sears.ca Symbol: SCC

McGraw-Hill Ryerson

McGraw-Hill Ryerson Limited 2000

FIF T H

Foundations of Financial
Management

th
CANADIAN

PPT 6-3

EDI TI ON

Expanded cash flow cycle

Customers
Customers

Inventory
Inventory
FinishedGoods
Goods
Finished
Goodsininprocess
process
Goods
Rawmaterials
materials
Raw

Sales
Sales
Geographicalarea
area
Geographical
Productor
ordivision
division
Product
Customertype
type
Customer

Materialsand
andservice
service
Materials
Suppliers:accts.
accts.payable
payable
Suppliers:
Labor:wages
wagespayable
payable
Labor:
Other:expenses
expenses
Other:
Governmenttaxes
taxes
Government
Federalincome
incometaxes
taxes
Federal
Provincialtaxes
taxes
Provincial
Othertaxes
taxes
Other

Block
Hirt
Short
McGraw-Hill Ryerson

Cash
Cash

Accountsreceivable
receivable
Accounts
0-30days
days
0-30
31-60
days
31-60 days
61-90days
days
61-90
91-120days
days
91-120
Marketablesecurities
securities
Marketable
Interest and dividends

Short-termlenders
lenders
Short-term
Charteredbanks
banks
Chartered
Non-banklenders
lenders
Non-bank
Foreignbanks
banksand
andlenders
lenders
Foreign
McGraw-Hill Ryerson Limited 2000

FIF T H

Foundations of Financial
Management

th
CANADIAN

PPT 6-4

EDI TI ON

Table 6-1
Yawakuzi sales forecast (in units)

1st Quarter

2nd Quarter

3rd Quarter

4th Quarter

October . 300
November ..150
December ... 50

January .. 0
February . 0
March .. 600

April .1,000
May ..2,000
June ..2,000

July . 2,000
August .1,000
September ..500

Total sales of 9,600 units at $3,000 each = $28,800,000 in sales.

Block
Hirt
Short
McGraw-Hill Ryerson

McGraw-Hill Ryerson Limited 2000

FIF T H

Foundations of Financial
Management

th
CANADIAN

EDI TI ON

Table 6-2
Yawakuzis production schedule and inventory
Production
Beginning
(level
inventory + production) Sales =

Block
Hirt
Short

PPT 6-5

Ending
inventory

Inventory
(at cost of
$2,000
per unit)

October
November
December
January

800
1,300
1,950
2,700

800
800
800
800

300
150
50
0

1,300
1,950
2,700
3,500

$2,600,000
3,900,000
5,400,000
7,000,000

February
March
April
May

3,500
4,300
4,500
4,300

800
800
800
800

0
600
1,000
2,000

4,300
4,500
4,300
3,100

8,600,000
9,000,000
8,600,000
6,200,000

June
July
August
September

3,100
1,900
700
500

800
800
800
800

2,000
2,000
1,000
500

1,900
700
500
800

3,800,000
1,400,000
1,000,000
1,600,000

McGraw-Hill Ryerson

McGraw-Hill Ryerson Limited 2000

FIF T H

Foundations of Financial
Management

th
CANADIAN

PPT 6-6

EDI TI ON

Table 6-3a
Sales forecast, cash receipts and payments, and cash budget
Oct Nov

Dec Jan

Feb

Mar

Apr

May June July

Aug

Sept

Sales Forecast ($ millions)

Sales (units)

300

150

50

600 1,000 2,000 2,000 2,000 1,000

500

Sales
$0.9 $0.45 $0.15
(unit price, $3,000)

$1.8

$1.5

$3.0

$6.0

$6.0

$6.0

$3.0

Cash Receipts Schedule ($ millions)

50% cash
50% cash from

.45 $.225 $.075

prior months sales

Total cash
receipts

$0.9

.75* 0.450 0.225 0.075

$1.20 0.675 $0.300 $0.075

$0.9

$1.5

$3.0

$3.0

$3.0

$1.5

$.75

0. 9

1.5

3.0

3.0

3.0

1.50

$2.4 $4.5

$6.0

$6.0 $4.5 $2.25

*Assumes September sales of $1.5 million.

Block
Hirt
Short
McGraw-Hill Ryerson

McGraw-Hill Ryerson Limited 2000

FIF T H

Foundations of Financial
Management

th
CANADIAN

PPT 6-6

EDI TI ON

Table 6-3b
Sales forecast, cash receipts and payments, and cash budget
Oct

Nov

Dec

Jan

Feb

Mar Apr

May June July

Aug

Sept

Cash Payments Schedule ($ millions)

Constant production
of 800 units/month

$1.6
.4
Overhead

Dividends & interest

.3
Taxes

$1.6
.4

$1.6
.4

$1.6
.4

.3

$1.6 $1.6
.4
.4

Total cash
payments

$2.0

$2.0

$2.3

$2.0

(cost $2,000 per unit)

$2.3

$1.6
.4

.3

$2.0 $2.3

$1.6
.4

$2.0

$1.6
.4

$2.0

$1.6
.4

.3
$2.3

$1.6 $1.6
.4
.4
1.0

$3.0 $2.0

Cash Budget ($ millions; required minimum balance is $0.25 million)

Cash flow
$(1.1) $(1.325) $(1.7) $(2.225 ) $(2.0) $(1.1)
.25 .25
.25
.25
.25 .25
Beginning cash
Cumulative
$(.85) $(1.075) $(1.45) $(1.975) $(1.75) $(.85)
cash balance
Monthly loan
1.1
1.325 1.7
2.225 2.0 1.1
or (repayment)
1.1
2.425 4.125 6.350 8.35 9.45
Block Cumulative loan
.25
.25
.25
.25
.25 .25
Hirt Ending cash balance

$.1 $2.5 $4.0

$3.7 $1.5
.25
.25
.25
.25 1.1

$.25
2.60

$.35 $2.75 $4.25 $3.95 $2.6 $2.85

(0.1) (2.5) (4.0) (2.85)
9.35 6.85 2.85

.25
.25
.25 1.1
2.6 2.85

Short Assumes cash balance of $.25 million at the beginning of October and that this is the desired minimum cash balance.
McGraw-Hill Ryerson

McGraw-Hill Ryerson Limited 2000

FIF T H

Block
Hirt
Short

Foundations of Financial
Management

th
CANADIAN

PPT 6-7

EDI TI ON

Table 6-4

Total current assets, first year ($ millions)

October
November
December
January
February
March
April
May
June
July
August
September
McGraw-Hill Ryerson

Cash

Accounts
Receivable

Inventory

$0.25
0.25
0.25
0.25
0.25
0.25
0.25
0.25
0.25
1.10
2.60
2.85

$0.450
0.225
0.075
0.00
0.00
0.90
1.50
3.00
3.00
3.00
1.50
0.75

$2.6
3.9
5.4
7.0
8.6
9.0
8.6
6.2
3.8
1.4
1.0
1.6

Total Current
Assets
$3.30
4.375
5.725
7.25
8.85
10.15
10.35
9.45
7.05
5.50
5.10
5.20

McGraw-Hill Ryerson Limited 2000

FIF T H

Foundations of Financial
Management

th
CANADIAN

PPT 6-8

EDI TI ON

Table 6-5a
Cash budget and assets for second year with no growth in sales
($ millions)
End of
First Year
Sept

Cash flow
Beginning
cash
Cumulative
cash balance

Second Year
Mar Apr

May

June July

$0.25 $(1.1) $(1.325) $(1.7) $(2.225 $(2.0) $(1.1) $0.1

$2.5

$4.0 $3.7 $1.5 $0.25

2.60
2.85

Oct

2.85
1.75

Nov

1.75
0.425

Monthly loan

or (repayment)
Cumulative loan

Ending cash
$2.85 $1.75 $0.425
balance

Dec

Jan

Feb

0.425
0.25 0.25 0.25 0.25 0.25
(1.275) (1.975) (1.75) (0.85) 0.35 2.75

1.525 2.225
1.525 3.750
$0.25 $0.25

2.0
5.75

Aug Sept

0.25 0.25 3.7

4.25 3.95 5.2

1.1 (0.1) (2.5) (4.0) (0.25)

6.85 6.75 4.25 0.25
.

5.2
5.45

$0.25 $0.25 $0.25 $0.25 $0.25 $3.70 $5.2 $5.45

Block
Hirt
Short
McGraw-Hill Ryerson

McGraw-Hill Ryerson Limited 2000

FIF T H

Foundations of Financial
Management

th
CANADIAN

PPT 6-8

EDI TI ON

Table 6-5b
Cash budget and assets for second year with no growth in sales
($ millions)
End of
First Year
Sept

Oct

Second Year
Nov

Dec

Jan

Feb

Mar

Apr

May

June

July

Aug

Sept

Total Current Assets

Ending cash
$2.85 $1.75 $0.425 $0.25 $0.25
balance
Accounts
receivable
0.75 0.45 0.225 0.075 .
Inventory
Total current assets

1.6

2.6

$5.2

$4.8

3.9

5.4

7.0

$4.55 $5.725 $7.25

$0.25 $0.25 $0.25 $0.25 $0.25 $3.70 $5.2 $5.45

.
8.6

0.95
9.0

1.50 3.0
8.6 6.2

3.0
3.8

3.0
1.4

1.5
1.0

0.75
1.60

$8.85 $10.15 $10.35 $9.45 $7.05 $8.1 $7.7 $7.80

Block
Hirt
Short
McGraw-Hill Ryerson

McGraw-Hill Ryerson Limited 2000

FIF T H

Foundations of Financial
Management

th
CANADIAN

PPT 6-9

EDI TI ON

Figure 6-6
The nature of asset growth (Yawakuzi)
11

$ millions

10

Accounts
receivable

Total
current
assets

8
7
6

Cash

5
4

Inventory

Cash

Inventory

Block
Hirt
Short

Accounts
receivable

Inventory
O N D J F M A M J J A S O N D J F M A M J J A S

McGraw-Hill Ryerson

McGraw-Hill Ryerson Limited 2000

FIF T H

Foundations of Financial PPT 6-10

Management

th
CANADIAN

EDI TI ON

Figure 6-7
Matching long-term and short-term needs
Dollars
Temporary current assets
Short-term
financing

Permanent
current assets

Long-term
financing
(debt & equity)

Capital assets
Block
Hirt
Short

Time period
McGraw-Hill Ryerson

McGraw-Hill Ryerson Limited 2000

FIF T H

Foundations of Financial PPT 6-11

Management

th
CANADIAN

EDI TI ON

Figure 6-8
Using long-term financing for part of short-term needs
Dollars
Temporary current assets
Short-term
financing

Permanent
current assets

Long-term
financing
(debt & equity)

Capital assets
Block
Hirt
Short

Time period
McGraw-Hill Ryerson

McGraw-Hill Ryerson Limited 2000

FIF T H

Foundations of Financial PPT 6-11

Management

th
CANADIAN

EDI TI ON

Figure 6-9
Using short-term financing for part of long-term needs
Dollars
Temporary current assets

Short-term
financing

Permanent
current assets
Capital assets
Block
Hirt
Short

Long-term
financing
(debt & equity)

Time period
McGraw-Hill Ryerson

McGraw-Hill Ryerson Limited 2000

FIF T H

Foundations of Financial
Management

th
CANADIAN

PPT 6-12

EDI TI ON

Figure 6-11
A. Flat yield curve, March 1999

9.00

Percent

8.00
7.00
6.00
5.00
4.00
1

10 11 12 13 14 15 16

Years
Block
Hirt
Short
McGraw-Hill Ryerson

McGraw-Hill Ryerson Limited 2000

FIF T H

th
CANADIAN

Foundations of Financial
Management

PPT 6-12

EDI TI ON

Figure 6-11(2)
A. Normal yield curve, July 1993

Block
Hirt
Short
McGraw-Hill Ryerson

McGraw-Hill Ryerson Limited 2000

FIF T H

th
CANADIAN

Foundations of Financial
Management

PPT 6-12

EDI TI ON

Figure 6-11(3)
C. Inverted yield curve, December 1989

Block
Hirt
Short
McGraw-Hill Ryerson

McGraw-Hill Ryerson Limited 2000

FIF T H

th
CANADIAN

Foundations of Financial
Management

PPT 6-13

EDI TI ON

Figure 6-12
Long-term and short-term interest rates

Block
Hirt
Short
McGraw-Hill Ryerson

McGraw-Hill Ryerson Limited 2000

FIF T H

Foundations of Financial PPT 6-14

Management

th
CANADIAN

EDI TI ON

Table 6-7
Alternative financing plans
EDWARDS CORPORATION
Plan A
Part 1. Current assets

Plan B

Temporary . . . . . . .
Permanent . . . . . . .
Total current assets . . .

$250,000
250,000
500,000

$250,000
250,000
500,000

Short-term financing (6%). .

Long-term financing (10%) .

500,000
0
$500,000

150,000
350,000
$500,000

Part 2. Capital assets

Plant and equipment . . . .
Long-term financing (10%) .

$100,000
$100,000

$100,000
$100,000

Part 3. Total financing (summary of parts 1 & 2)

Block
Hirt
Short

Short-term (6%) . .
Long-term (10% . .
McGraw-Hill Ryerson

. .
. .

.
.

$500,000
100,000
$600,000

$150,000
450,000
$600,000
McGraw-Hill Ryerson Limited 2000

FIF T H

Foundations of Financial PPT 6-14

Management

th
CANADIAN

EDI TI ON

Table 6-8
Impact of financing plans on earnings
EDWARDS CORPORATION

Block
Hirt
Short

Plan A
Earnings before interest and taxes
Interest (short-term), 6% $500,000
Interest (long-term), 10% $100,000
Earnings before taxes
Taxes (50%)
Earnings aftertaxes

$200,000
30,000
10,000
160,000
80,000
$ 80,000

Plan B
Earnings before interest and taxes
Interest (short-term), 6% $150,000
Interest (long-term), 10% $450,000
Earnings before taxes
Taxes (50%)
Earnings aftertaxes

$200,000
9,000
45,000
146,000
73,000
$ 73,000

McGraw-Hill Ryerson

McGraw-Hill Ryerson Limited 2000

FIF T H

th
CANADIAN

Foundations of Financial PPT 6-15

Management

EDI TI ON

Table 6-9
Expected returns under different economic conditions
EDWARDS CORPORATION
1. Normal
conditions

Expected higher return

under Plan A
$7,000

Probability of
Expected
normal conditions outcome
.80
= + $5,600

2. Tight
money

Expected lower return

under Plan A
($15,000)

Probability of
tight money
.20
=

Expected value of return for Plan A versus Plan B

(3,000)
+$2,600

Block
Hirt
Short
McGraw-Hill Ryerson

McGraw-Hill Ryerson Limited 2000

FIF T H

th
CANADIAN

Foundations of Financial PPT 6-15

Management

EDI TI ON

Table 6-10
Expected returns for high-risk firm
EDWARDS CORPORATION
1. Normal
conditions

Expected higher return

under Plan A
$7,000

Probability of
Expected
normal conditions outcome
.80
= +$5,600

2. Tight
money

Expected lower return

under Plan A
($50,000)

Probability of
tight money
.20
=

Expected value of return for Plan A versus Plan B

(10,000)
($4,400)

Block
Hirt
Short
McGraw-Hill Ryerson

McGraw-Hill Ryerson Limited 2000

FIF T H

Foundations of Financial PPT 6-16

Management

th
CANADIAN

EDI TI ON

Table 6-11
Current asset liquidity and asset financing plan

Asset Liquidity
Financing Plan Low Liquidity

High Liquidity

Short-term

1
High Profit
High risk

2
Moderate profit
Moderate risk

Long-term

3
Moderate profit
Moderate risk

4
Low profit
Low risk

Block
Hirt
Short
McGraw-Hill Ryerson

McGraw-Hill Ryerson Limited 2000

FIF T H

th
CANADIAN

Foundations of Financial
Management

EDI TI ON

Chapter 6 - Outline

LT 6-1

What is Working Capital Management?

Hedged Approach to Financing
Short-Term vs. Long-Term Financing
Term Structure of Interest Rates
Block
Hirt
Short

Working Capital Financing Plans

McGraw-Hill Ryerson

McGraw-Hill Ryerson Limited 2000

FIF T H

th
CANADIAN

Foundations of Financial
Management

EDI TI ON

Working Capital Management

LT 6-2

Working Capital Management is financing and controlling

the current assets of a firm
Sales growth often leads to a buildup in inventory and
accounts receivable. Firm may require additional external
financing
Crucial to short-term success or failure of a business

Block
Hirt
Short
McGraw-Hill Ryerson

McGraw-Hill Ryerson Limited 2000

FIF T H

Foundations of Financial
Management

th
CANADIAN

EDI TI ON

Hedged Approach to Financing

LT 6-3

Match liquidity (life) of your assets to the maturity (term) of your

financing
Means your assets will be generating cash when your liabilities come
due

Balanced Financing
Temporary (seasonal) build-up in inventory and accounts receivable
finance with trade credit, short-term bank loans, short-term notes
payable

Block
Hirt
Short

Permanent (minimum) levels of inventory, receivables +

Property and equipment, long-term investments
finance with long-term loans, leases, bonds, capital stock, retained
earnings
McGraw-Hill Ryerson

McGraw-Hill Ryerson Limited 2000

FIF T H

Block
Hirt
Short

th
CANADIAN

Foundations of Financial
Management

EDI TI ON

Short-Term vs. Long-Term Financing

LT 6-4

Short-term financing is less expensive but riskier

lower interest rates
short-term rates are volatile
risk of default if sales slow down
risk that bank may not extend / renew loans
Long-term financing is more expensive but less risky
usually higher interest rates,
you may pay interest on funds you dont always need
you have capital at all times
Firm must decide the appropriate mix

McGraw-Hill Ryerson

McGraw-Hill Ryerson Limited 2000

FIF T H

th
CANADIAN

Foundations of Financial
Management

EDI TI ON

Term Structure of Interest Rates

LT 6-5

The Term Structure of Interest Rates is also known as the

Yield Curve
A graph showing the interest rate for Government of
Canada securities with different maturity dates
Normally, long-term rates are higher than short-term rates

Block
Hirt
Short
McGraw-Hill Ryerson

McGraw-Hill Ryerson Limited 2000

FIF T H

th
CANADIAN

Foundations of Financial
Management

EDI TI ON

Working Capital Financing Plans

A moderate (balanced) firm:
S/T financing and high liquidity
L/T financing and low liquidity

LT 6-6

OR

An aggressive (risky) firm:

S/T financing and low liquidity

Block
Hirt
Short

A conservative (safe or cautious) firm:

L/T financing and high liquidity
Appropriate strategy is determined based on companys
tolerance for risk
McGraw-Hill Ryerson

McGraw-Hill Ryerson Limited 2000