Financial Management Working Concepts

Working Capital

the amount of current assets (financial management view) or current assets net of current liabilities (accounting view) used to finance the firm's short-term operations.

Working Capital

the lifeblood of the business organization. It is needed to sustain the normal operations of the business.

Current Assets

those convertible to cash within 1 year or a normal operating cycle, whichever is longer, to support operations like payment of short-term obligations. It includes cash, marketable securities, receivables, inventories, and prepayments.

Temporary Current Assets

current assets required to support fluctuations in the firm's level of activity

Permanent Current Assets

current assets required to maintain normal operations.

Current Liabilities

obligations to be paid within 1 year, through current assets or incurrences of another liability. It includes trade payables, accrued expenses, short-term debts, and the current portion of long-term debts

Working Capital Management

Refers to the efficient and effective utilization of working capital to attain organizational objectives related to:

• Profitability of operations

• Liquidity of financial resources

• Minimization of risks of company costs

Working Capital Management involves managing 2 things which are?

• the company's investment in current assets

• the company's use of current liabilities

Working Capital Policy

refers to the basic decisions regarding:

• target levels of each category of current assets

• how current assets will be financed

Investment Policy

Working capital policy that deals with current assets

Relaxed Current Investment Policy

carries a relatively large amount of current assets. Sales are stimulated by liberal credit policy resulting in a high level of receivables. The firm carries a large amount of inventory.

Restricted Current Investment Policy

current assets are minimized. The firm implements a tight credit policy through means running the risk of losing sales, holds minimal safety stock of cash and inventory, and works out the highest current asset turnover;

Moderate Current Investment Policy

policy between relaxed and restricted

Financing Policies

Working capital policy that deals with current liabilities

Conservative Policy

almost all investment assets are financed by long-term debts, resulting in lesser amounts of short-term debts. It reduces liquidity risk but also reduces profit due to greater financing costs

Aggressive Policy

uses short-term debts to finance, not only temporary but also part of the permanent current asset requirements. Thus, leading to greater amounts of short-term debts and lesser amounts of long-term debts. - It increases profits due to lesser financing costs of short-term debts but also exposes the firm to liquidity risks due to low working capital position

Maturity Matching Policy

(Hedging Principle / Self-Liquidating debt Principle) It matches the maturities of obligations to the income (cash flow) generating characteristics of the assets financed. Long term debts are used to finance long-term assets (permanent working capital) requirements while short-term debts are to finance short-term assets

Balanced Policy

balances the trade-off between risk and profitability in a manner consistent with its attitude toward bearing risk.

Permanent

A financing requirement that refers to property, plant, and equipment (fixed assets) and permanent current assets that must always be with the company throughout the year.

Seasonal (Temporary)

additional requirements arising from fluctuation in the volume of activity (production and sales) arising from seasonal changes in demand level for products during the year.

Deciding the appropriate working capital policy

primary consideration is the trade-off between risk (liquidity) and return (profitability) associated with asset mix decision and financing mix decision

Asset mix decision

appropriate mix of current and noncurrent assets

Financing mix decision

appropriate mix of short-term and long-term debts to finance current assets.

Requirements to minimizing working capital

1. Efficiency in cash, receivable, and raw materials management

2. Reduction of the time lag between completion and shipment of finished goods

3. Obtaining favorable credit terms and suppliers.

Cash Management

involves the maintenance of cash and marketable securities investment level which enhances the ability of the company to meet its cash requirements while maximizing the income on idle funds.

Main objective of Cash Management

attain the optimum cash balance which balances liquidity and profitability (implying the attainment of reasons for holding cash)

Golden Rule in Debt Investing

Interest Rates go up, Prices of Bonds go down

Risk Avoider

less likely to do research before they invest, so fear of the unknown may be behind your aversion to risk

Risk Mitigator

willing to take a chance on an investment once they’ve done significant research

Risk Manager

they are doing almost everything right when it comes to investing

Risk Embracer

they thrive on danger, the most risky type of investor

Expected Return

The weighted average of the possbile return where the weights represent the probabilities of occurence

Standard Deviation

The statistical measure of the variation or dispersion around the most likely expected return on an investment

Master Budget

a comprehensive short term financial plan that is divided into both operating and financial budgets

Operating Budget

deals with the income-generating activities of a business and culminates in the production of a budget or pro forma income statement for the upcoming year

Financial Budget

consists of the long-term sales forecast, capital budget, cash budget, budgeted balance sheet and budgeted statement of cash flows

Operating Cycle

refers to the days required for a business to receive inventory, sell the inventory, and collect cash from the sales of the inventory

Cash Conversion Cycle

Cash-Payables-Inventory-Receivables-Cash

Cash Management

the process of collecting and managing cash flows

Cash Conversion Cycle

a metric that expresses the time it takes for a company to convert its investments in inventory and other resources into cash flows from sales

Working Capital Cycle

Cash- Raw Materials/Inventory- Finished Goods- Accounts Receivable- Cash

Risk Return Trade-off

Investment with high risk tend to have high returns and vice versa

Credit Risk

Risk that the person you have given to

Political Risk

risk wherein government will suddenly change its policies

Foreign Exchange Risk

applies to any financial instrument that are denoted in a currency other than your own

Inflationary Risk

when the real return on your investment is reduced due to inflation eroding the purchasing power of your funds by the time they mature

Market Risk

value of an investment will fall due to market risk factor like equity rise, interest rate rise, currency rise, commodity rise