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VP of Accounting Meeting with the CFO

You and the VP of Accounting are meeting with the CFO next week to discuss critical areas of the operating budget for next year and the capital budget as well. Of particular concern to the CFO is the company's working capital position, the impact of some short-term notes that the company must pay-off next year, the company's current ratio, and determining how to finance a major capital project (construction of a new production plant).

Assume you are organizing your thoughts for the meeting with the VP of Accounting in preparation to meet with the CFO later. Discuss the following topics, giving examples: (1) how working capital can impact a company's finances; (2) what the company can do to handle short-term debt that is coming due; (3) explain current ratio, discuss its implications, and describe a good current ratio; and (4) describe briefly how businesses make capital budgeting decisions.

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(1) How working capital can impact a company's finances;

Working capital is the firm's total current assets used in operations.
Working capital = total current assets

These current assets include cash, marketable securities, prepaid expenses, accounts receivable, inventory, and other current assets. Working capital represents the liquid portion of the firm.

Net Working Capital means the difference between current assets and current liabilities, and therefore, represents that position of current assets, which the firm has to finance either from long-term funds or bank borrowings.

Impact of working capital
Working capital provides the resources for the day to day operations of the firm.

Without cash, the firm cannot pay its bills. Without receivables, the company would have difficulty selling merchandise. Without inventory, the firm would be unable to make immediate delivery of goods.

Investment in short term assets
It should be approached differently because short-term assets or working capital provides the resources for the day to day operations of the firm. Without cash, the firm cannot pays its bills. Without receivables, the company would have difficulty selling merchandise. Without inventory, the firm would be unable to make immediate delivery of goods. On the other hand long-term assets are purchased for providing for long term benefit to the organizations. For example Plant and Machinery, Building etc.

Thus working capital management entails short-term decisions - generally, relating to the next one-year period - which are "reversible". These decisions are therefore not taken on the same basis as Capital Investment Decisions (NPV or IRR) rather they will be based on cash flows and / or profitability. There is a trade off between the liquidity and profitability in case of investment in short term assets.

(2) What the company can do to handle short-term debt that is coming due;

This is an issue of short term financing. If the short term debt is due then the company can access other means of short term financing. These can be:

Methods of Short term financing

Trade Credit
Organization gets trade credit from supplier of goods in normal course of business. Its an informal arrangement, granted on an open account basis, not formally acknowledge as a debt. It may also take the form of bills payable. It will depend on the credit terms. Credit terms refers to the conditions of due date and cash discount. Other related forms are accrued Expenses and Deferred Income.
Trade credit represents one of the main sources of short-term finance for a business, Such, trade credit represents an interest free short-term loan, and constitutes approximately 60%, of current liabilities in the average non-financial business. In a period of high inflation there are clear advantages to purchasing via trade ...

Solution Summary

You and the VP of Accounting are meeting with the CFO next week to discuss critical areas of the operating budget for next year and the capital budget as well. Of particular concern to the CFO is the company's working capital position, the impact of some short-term notes that the company must pay-off next year, the company's current ratio, and determining how to finance a major capital project (construction of a new production plant).

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