CHAPTER 13
It is useful to begin the discussion of working capital policy by reviewing some basic
definitions and concepts.
Working capital, sometimes called gross working capital, generally refers to current assets,
while net working capital is defined as current assets minus current liabilities—the amount
of current assets financed by long-term liabilities.
The current ratio, calculated as current assets divided by current liabilities, is intended to
measure a firm’s liquidity.
A high current ratio does not insure that a firm will have the cash required to meet its
needs.
The best and most comprehensive picture of a firm’s liquidity position is obtained by
examining its cash budget, which forecasts a firm’s cash inflows and outflows. It focuses
on what really counts, the firm’s ability to generate sufficient cash inflows to meet its
required cash outflows.
Working capital policy refers to the firm’s basic policies regarding target levels for each
category of current assets and how current assets will be financed.
We must distinguish between those current liabilities that are specifically used to finance
current assets and those current liabilities that represent (1) current maturities of long-term
debt; (2) financing associated with a construction program that after completed will be
funded with the proceeds of a long-term security issue; or (3) the use of short-term debt to
finance fixed assets.
Even though we define long-term debt coming due in the next accounting period as a
current liability, it is not a working capital decision variable in the current period.
Similarly, when construction is temporarily financed with a short-term loan and later
replaced with mortgage bonds, the construction loan would not be considered part of
working capital management.
Although such accounts are not part of the working capital decision process, they cannot be
ignored because they are due in the current period, and they must be considered when the
cash budget is constructed and the firm’s ability to meet its current obligations is assessed.
A firm’s current asset levels and financing requirements rise and fall with business
cycles and seasonal trends. At the peak of such cycles, businesses carry their
maximum amounts of current assets. Similar fluctuations in financing needs can
occur over these cycles; typically, financing needs decline during recessions but
increase during booms.
Once a firm’s operations have stabilized and cash collections from credit sales and cash
payments for credit purchases have begun, the balance in accounts receivable and accounts
payable can be computed using the following equation:
Account = Amount of × Average life .
balance daily activity of the account
A decision affecting one working capital account will have an impact on other working
capital accounts.
The cash conversion cycle focuses on the length of time between when the company
makes payments, or invests in the manufacture of inventory, and when it receives
cash inflows, or realizes a cash return from its investment in production.
The following terms and definitions are used:
Inventory conversion period is the average length of time required to convert materials into
finished goods and then to sell these goods; it is the amount of time the product remains in
inventory in various stages of completion.
Inventory
Inventory
=
.
conversion period  Cost of goods sold 


360


Receivables collection period is the average length of time required to convert the firm’s
receivables into cash, that is, to collect cash following a sale. It is also called the days sales
outstanding (DSO).
Receivables = DSO = Receivables .
collection period
 Credit sales 


360


Payables deferral period is the average length of time between the purchase of raw
materials and labor and the payment of cash for them.
Accounts payable
Payables
.
= DPO =
deferral period
 Cost of goods sold 


360


The cash conversion cycle, which nets out the three periods just defined, equals the length
of time between the firm’s actual cash expenditures to pay for (invest in) productive
resources (materials and labor) and its own cash receipts from the sale of its products.
Thus, the cash conversion cycle equals the average length of time a dollar is tied up in
current assets.
Using these definitions, the cash conversion cycle is defined as follows:
Inventory Receivables Payables
Cash
conversion = conversion + collection − deferral .
period
period
period
cycle
To illustrate, suppose it takes a firm an average of 79.0 days to convert raw materials and
labor to widgets and to sell them, and it takes another 43.2 days to collect on receivables,
while 8.8 days normally lapse between the receipt of materials (and work done) and
2
payments for materials and labor. In this case, the cash conversion cycle is 79.0 days +
43.2 days – 8.8 days = 113.4 days.
The firm’s goal should be to shorten its cash conversion cycle as much as possible without
increasing costs or depressing sales. This would maximize profits because the longer the
cash conversion cycle, the greater the need for external, or nonspontaneous, financing and
such financing has a cost.
The cash conversion cycle can be shortened (1) by reducing the inventory conversion
period by processing and selling goods more quickly, (2) by reducing the receivables
collection period by speeding up collections, or (3) by lengthening the payables deferral
period by slowing down its own payments.
When taking actions to reduce the inventory conversion period, a firm should be careful to
avoid inventory shortages that could cause good customers to buy from competitors.
When taking actions to speed up the collection of receivables, a firm should be careful to
maintain good relations with its good credit customers.
When taking actions to lengthen the payables deferral period, a firm should be careful not
to harm its own credit reputation.
Actions that affect the inventory conversion period, the receivables collection period, and
the payables deferral period all affect the cash conversion cycle; hence, they influence the
firm’s need for current assets and current asset financing.
3