A s we saw in Part Three, managers base decisions about investing in

A s we saw in Part Three, managers base decisions about investing in

long-term projects on judgments about future cash flows, the uncer- tainty of those cash flows, and the opportunity costs of the funds to be invested. As we turn in Part Five to the management of short-term assets, we will see that such decisions are made in similar ways, but over much shorter time horizons. Thus considerations of risk will take a smaller role in our discussions in the next few chapters, while the oper- ating cycle becomes more important.

Recall from our discussion in Chapter 6 that the operating cycle refers to the time it takes to turn the investment of cash (e.g., buying raw materials) back into cash (e.g., collecting on accounts receivables). As our opening example shows, the operating cycle in part determines how long it takes for a firm to generate cash from its short-term assets and, therefore, the risk and cost of its investment in current assets, or working capital. Working capital is the capital that managers can immediately put to work to generate the benefits of capital investment. Working capital is also known as current capital or circulating capital.

Firms invest in current assets for the same reason they invest in long- term, capital assets: to maximize owners’ wealth. But because managers evaluate current assets over a shorter time frame (less than a year), they focus more on their cash flows and less on the time value of money.

How much should a firm invest in current assets? That depends on several factors:

■ The type of business and product ■ The length of the operating cycle

MANAGING WORKING CAPITAL

■ Customs, traditions, and industry practices ■ The degree of uncertainty of the business

The type of business, whether retail, manufacturing, or service, affects how a firm invests. In some industries, large investments in machinery and equipment are necessary. In other industries, such as retail firms, less is invested in plant and equipment and other long-term assets, and more is invested in current assets such as inventory.

The firm’s operating cycle—the time it takes the firm to turn its investment in inventory into cash—affects how much the firm ties up in current assets. The operating cycle comprises the time it takes to: manu- facturer the goods, sell them and collect on their sale. The net operating cycle considers the benefit from purchasing goods on credit; the net operating cycle is the operating cycle less the number of days of pur- chases. The longer the net operating cycle, the larger the investment in current assets.

Let’s look at firms’ investments in current and noncurrent assets, as summarized in Exhibit 19.1. As shown in Panel (a), approximately 30 to 40% of firms’ investment is in current assets. As we see in Panel (b), within current assets, inventories are the largest investment, followed by cash and cash equivalents. Firms that manufacture goods, such as steel, tend to have more invested in long-term assets than, say, retail shoe stores. Of the manufacturing firms, those with greater raw material price uncertainty, such as the sugar and confectionery processors and the beverage producers, tend to have more invested in current assets.

EXHIBIT 19.1 Asset Composition of U.S. Corporations

Panel a: Current versus Noncurrent Assets

Management of Cash and Marketable Securities

EXHIBIT 19.1

(Continued) Panel b: Current Assets by Type

Source: Statistical Abstract of the United States, 2001, U.S. Census Bureau EXHIBIT 19.2 Current Asset Composition for a Sample of Firms, 2001

Source: Company annual reports The differences in how these industries invest in current assets is illus-

trated in more detail Exhibit 19.2. Here, current assets are broken down for a sample of firms by type: cash, marketable securities, accounts receiv- able, inventory, and “other.” “Other” includes prepaid expenses (which are short-term assets because these are expenses paid but not yet incurred) and income tax refunds (because they are refunds that are coming, but have not yet arrived). We do not discuss either in detail in this chapter.

MANAGING WORKING CAPITAL

Inventory plays a small role for Disney, but is significant for retailers, such as Wal-Mart. Accounts receivable, however, are not important to Wal- Mart, since they typically do not extend credit to customers, but they are important to shoe manufacturers, like Nike, which typically do. Manufac- turers tend to have more invested in cash than, say, retailers.

The working capital decision requires an evaluation of the benefits and costs associated with each component. In this chapter, we will look at the management of cash and marketable securities and see how we can evalu- ate the benefits and costs associated with the investment in these assets.