INTRODUCTION TO
CORPORATE FINANCE
SECOND EDITION
Lawrence Booth & W. Sean Cleary
Prepared by Ken Hartviksen & Jared Laneus
Chapter 23
Working Capital Management:
General Issues
23.1 The Importance of Working Capital
Management
23.2 An Integrated Approach to Net Working Capital
(NWC) Management
23.3 Analyzing Cash Inflows and Outflows
23.4 Working Capital Management
Booth/Cleary Introduction to Corporate Finance, Second Edition
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Learning Objectives
23.1 Explain why the management of net working capital is
critical for the survival of a firm.
23.2 Explain how managing receivables, inventory, and
payables is related to an integrated approach to net working
capital management.
23.3 Explain how the financing and current asset investment
decisions interact to determine a company’s overall working
capital position.
23.4 List and describe some common ways to analyze a firm’s
management of its net working capital.
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The Importance of Working Capital
Management
• Working capital management is the way in which a firm
manages both its current assets and current liabilities
• Good working capital management is characterized by:
1. Maintaining optimal cash balances
2. Investing any excess liquid funds in marketable securities that
provide the best possible return, considering any liquidity or
default-risk constraints
3. Effectively managing accounts receivable
4. Efficiently managing inventory
5. Maintaining an appropriate level of short-term financing in
the least expensive and most flexible manner
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An Integrated Approach to Net Working
Capital Management
• Cash flow management is important because the exhaustion
of liquid resources can leave a firm insolvent (i.e., unable to
pay its obligations as they come due)
• Firms can deplete liquid financial resources for bad reasons:
• Continuing to produce inventory even when sales are falling
• Selling products and services for less than their variable cost of
production
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An Integrated Approach to Net Working
Capital Management
• Firms can also deplete liquid financial resources for
seemingly good reasons:
• Rapid growth in production and sales can cause a firm to use
up all of its cash pursuing growth, leaving it invested in illiquid
assets like inventories, accounts receivable and net fixed
assets
• A firm may be highly profitable in an accounting sense, but on
the verge of bankruptcy if it cannot collect its receivables to
generate the cash necessary to fund sales growth
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Cash Flow Cycle
• The cash flow cycle is a crucial part of understanding how a
business functions because it gives managers an awareness
of the dynamics of working capital management
• The cash flow cycle can be used to help managers determine
the impact of changes in variables on the cash account:
• Examples:
•
•
•
•
Increasing sales requires additional investment in inventory
Increasing accounts receivable reduces cash
Delaying the payment of payables preserves cash
Speeding up collections of receivables improves the cash
position
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Increasing and Decreasing Cash
Activities that Increase Cash
• Increasing long-term debt
• Increasing equity
• Increasing current liabilities
• Decreasing current assets
other than cash
• Decreasing fixed assets
Booth/Cleary Introduction to Corporate Finance, Second Edition
Activities that Decrease Cash
• Decreasing long-term debt
• Decreasing equity
• Decreasing current liabilities
• Increasing current assets other
than cash
• Increasing fixed assets
• Paying cash dividends
8
The Cash Budget
• The monthly cash budget is a management tool for forecasting
the timing, magnitude and duration of both cash surpluses and
deficits and their cumulative impact over time
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The Cash Budget
• Management can change plans before they are implemented to
produce a more favourable cash result
• Management can choose the best investment option for forecast cash
surpluses, and arrange financing solutions for forecast cash deficits
Investing Forecast Surpluses
• Small surpluses (i.e., less than $100,000) available for short periods of
time (i.e., 30 to 90 days) can be kept in a current account
• Small surpluses available for longer periods of time can be paid out as a
cash dividend or used to retire debt obligations
• Large surpluses (i.e., greater than $100,000) available for short periods
of time (i.e., 30 to 90 days) can be invested in marketable securities
with minimal risk like Treasury bills
• Large surpluses available for longer periods of time can be used to pay
cash dividends, or to invest in longer-maturity, higher-yielding
investments
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The Cash Budget
Financing Forecast Deficits
• Small deficits (i.e., less than $100,000) lasting for short periods of
time (i.e., 30 to 90 days) can be resolved by delaying purchases,
speeding up collections or trying to better synchronize cash flows.
An operating line of credit could also be negotiated with a financial
institution.
• Small deficits lasting for longer periods of time must be financed by
more permanent solutions to under-funding
• Large deficits (i.e., greater than $100,000) lasting for short periods of
time (i.e., 30 to 90 days) can be resolved with operating lines of
credit or other longer-term permanent capital solutions, particularly
if large cash flow deficits are likely to reoccur
• Large deficits lasting for longer periods of time must be financed with
permanent increases in capital in the form of debt and/or equity
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Analyzing Cash Inflows and Outflows
• Equation 23-1 analyzes the impact of sales growth on the firm’s
cash position:
Cash  S t 1 1  b(1  2 g )
where:
• g = monthly sales growth
• b = the cash production cost and (1 – b) = unit contribution
margin
• St – 1 = Sales in the previous time period
• The sensitivity of cash to sales growth is strongly related to the
firm’s inventory and accounts receivable policies.
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Analyzing Cash Inflows and Outflows
• Equation 23-2 shows that the change in cash each month
depends on credit, inventory management and payables policies:
Cash  S1  (1   ) S t 1  bS t  b(1   )S t 1  b (S t  S t 1 )
where:
• α = the proportion of sales collected this month (credit policy)
• 1 – α = the proportion of sales collected next month (only two
periods)
• β = the proportion of this month’s production costs paid this month
• 1 - β = the proportion of production costs paid next month
• γ = the proportion of the firm’s monthly sales tied up in inventory
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Analyzing Cash Inflows and Outflows
• We can simplify Equation 23-2 into Equation 23-3 by including the sales
growth rate and removing the different sales levels:
Cash
 (1  b)  g   b(    )
S t 1
• Equation 23-4 solves Equation 23-3 for the sales growth rate at which
the firm can grow without either needing or generating cash:
g
1 b
b(    )  
• A firm can grow faster if:
• It has a higher gross margin (1 – b)
• It lowers production costs b
• It collects receivables more quickly α
• It pays its bills more slowly β
• It has less inventory γ
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Analyzing Cash Inflows and Outflows
• The slope of the line is determined by the firm’s credit, inventory and
payables policies
• A shallower slope reduces the sensitivity of cash to changes in sales
• A shallower slope can be achieved by: collecting AR more quickly,
delaying AP payments, and increasing inventory turnover.
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Working Capital Management
• Ratios are commonly used to assess or summarize a firm’s working
capital management, focusing on:
• Liquidity management
• Asset utilization
• Current liability management
Liquidity Ratios
• The current ratio and the quick ratio assess a firm’s liquidity
• Excessive liquidity reduces ROI and ROE, and can also indicate
credit policy is too lenient or excess inventories
Current ratio 
Quick ratio 
Current assets (CA)
Current liabilitie s (CL)
Cash (C )  Marketable Securities ( MS )  Accounts Receivable ( AR)
Current liabilitie s (CL)
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Working Capital Management
Working Capital Ratios – Accounts Receivable
• Changes in receivables turnover and average collection period
can indicate deteriorating or improving collection efforts
• The shorter the collection period, the less sensitive cash balances
are to changes in sales
Sales
Receivable s Turnover 
AR
AR
Average Daily Sales
365

Receivable s Turnover
Average Collection Period (ACP) 
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Working Capital Management
Working Capital Ratios – Inventory
• Cost of goods sold is unlikely to be comparable across firms, so an
alternative is to use sales revenue in the numerator
• The higher the inventory turnover, the less sensitive cash is to
changes in sales
Cost of Goods Sold
Sales
Inventory Turnover 
OR
Inventory
Inventory
Inventory
Average Days Sales in Inventory (ADSI) 
Average Daily Sales
365

Inventory Turnover
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Working Capital Management
Working Capital Ratios – Accounts Payable
• Payables turnover shows how many times per year, on average, a
firm pays its suppliers
• ADSP shows how long, in days, a firm defers payments to its
suppliers
Sales
Payables Turnover 
AP
AP
Average Days Sales in Payables (ADSP) 
Average Daily Sales
365

Payables Turnover
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Operating Cycle and Cash Conversion Cycle
• The operating cycle is the time period between the acquisition of
inventory and the collection of cash from receivables, and is defined by
Equation 23-14:
OC  ADSI  ACP
• The operating cycle is the sum of average days sales in inventory and
the average collection period
• The cash conversion cycle is the time between cash disbursement and
cash collection, or an estimate of the average time between when a
firm pays cash for its inventory purchases and when it receives cash for
its sales.
• The cash conversion cycle is the average number of days of sales that
must be financed outside the use of trade credit, and is defined by
Equation 23-15: CCC  OC  ADSP
CCC  ADSI  ACP  ADSP
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Importance of the Cash Conversion Cycle
• Management of the cash cycle can make an important
difference in the amount of financing required, assets
employed to generate a given level of sales … and therefore
can affect ROA and ROE
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Copyright
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