Working-Capital

Management
and Short-Term Financing

Current Assets
cash, marketable securities, inventory, accounts receivable
Long-Term Assets
equipment, buildings, land

Which earn higher rates of return?

Which help avoid risk of illiquidity?

Current Assets
cash, marketable securities, inventory, accounts receivable
Long-Term Assets
equipment, buildings, land

Risk-Return Trade-off:
Current assets earn low returns, but help reduce the risk of
illiquidity.

Current Liabilities
short-term notes, accrued expenses, accounts payable
Long-Term Debt and Equity
bonds, preferred stock, common stock

Which are more expensive for the firm?

Which help avoid risk of illiquidity?

Current Liabilities
short-term notes, accrued expenses, accounts payable
Long-Term Debt and Equity
bonds, preferred stock, common stock
Risk-Return Trade-off:
Current liabilities are less expensive, but increase the risk of
illiquidity.
 Balance Sheet
Current Assets Current Liabilities
Fixed Assets Long-Term Debt
Preferred Stock
Common Stock

To illustrate, let’s finance all current assets with current liabilities, and
finance all fixed assets with long-term financing.

Balance Sheet
Current Assets Current Liabilities

Fixed Assets Long-Term Debt

Preferred Stock
Common Stock

Suppose we use long-term financing to finance some of our current assets.

This strategy would be less risky, but more expensive!

Balance Sheet
Current Assets Current Liabilities

Fixed Assets Long-Term Debt

Preferred Stock
Common Stock

Suppose we use current liabilities to finance some of our fixed assets.

This strategy would be less expensive, but more risky!

Permanent Assets (those held > 1 year)

should be financed with permanent and spontaneous sources of financing
Temporary Assets (those held < 1 year)
should be financed with temporary sources of financing

Balance Sheet
 Temporary
Current Assets

Balance Sheet
Temporary Temporary
Current Assets Short-term financing

Balance Sheet
Temporary Temporary
Current Assets Short-term financing

Permanent
Fixed Assets

Balance Sheet
Temporary Temporary
Current Assets Short-term financing

Permanent Permanent
Fixed Assets Financing
and
Spontaneous
Financing

Permanent Financing
intermediate-term loans, long-term debt, preferred stock, common stock
Spontaneous Financing
accounts payable that arise spontaneously in day-to-day operations (trade
credit, wages payable, accrued interest and taxes)
Short-term financing
unsecured bank loans, commercial paper, loans secured by A/R or
inventory

Interest = principal x rate x time

ex: borrow $10,000 at 8.5% for 9 months

Interest = $10,000 x .085 x 3/4 year

= $637.50

We can use this simple relationship:

Interest = principal x rate x time
to solve for rate, and get the
Annual Percentage Rate (APR)

We can use this simple relationship:

Interest = principal x rate x time
to solve for rate, and get the
Annual Percentage Rate (APR)
interest 1
principal time

interest 1
principal time

interest 1
principal time
example: If you pay $637.50 in interest on $10,000 principal for 9
months:

interest 1
principal time
example: If you pay $637.50 in interest on $10,000 principal for 9
months:
APR = 637.50/10,000 x 1/.75 = .085
= 8.5% APR
Annual Percentage Yield (APY) is similar to APR, except that it
accounts for compound interest:

Annual Percentage Yield (APY) is similar to APR, except that it

accounts for compound interest:
m
i
m

Annual Percentage Yield (APY) is similar to APR, except that it

accounts for compound interest:
m
i
m
i = the nominal rate of interest
m = the # of compounding periods per year

What is the (APY) of a 9% loan with monthly payments?

APY = ( 1 + ( .09 / 12 ) 12 -1 ) .0938

= 9.38%

Unsecured

Unsecured
accrued wages and taxes

Unsecured
accrued wages and taxes
trade credit
Unsecured
accrued wages and taxes
trade credit
bank credit

Unsecured
accrued wages and taxes
trade credit
bank credit
commercial paper

Unsecured
accrued wages and taxes
trade credit
bank credit
commercial paper
Secured

Unsecured
accrued wages and taxes
trade credit
bank credit
commercial paper
Secured
accounts receivable loans

Unsecured
accrued wages and taxes
trade credit
bank credit
commercial paper
Secured
accounts receivable loans
inventory loans