Working Capital Management
Management need to understand the
management of working capital so that
management can efficiently manage current
assets and decide whether to finance the
firm’s funds requirements aggressively or
conservatively.
ABC Company
Balance Sheet
As of December 31, 19xx
Assets:
Liabilities & Equity:
Current Assets
Current Liabilities
Cash & M.S.
Accounts payable
Accounts receivable
Notes Payable
Inventory
Total Current Assets
Fixed Assets:
Gross fixed assets
Total Current Liabilities
Long-Term Liabilities
Total Liabilities
Equity:
Less: Accumulated dep.
Common Stock
Goodw ill
Paid-in-capital
Other long-term assets
Retained Earnings
Total Fixed Assets
Total Assets
Total Equity
Total Liabilities & Equity
Current assets & Current liabilities:
• Current assets, commonly called working
capital, represent the portion of investment
that circulates from one to another in the
ordinary conduct of business.
• Current liabilities represent the firm’s shortterm financing, because they include all debts
of the firm that come due (must be paid) in 1
year or less.
Working Capital
• Working Capital includes a firm’s current assets,
which consist of cash and marketable securities in
addition to accounts receivable
and inventories. It also consists of current liabilities,
including accounts payable (trade credit), notes
payable (bank loans), and accrued liabilities.
• Net Working Capital is defined as total current assets
less total current liabilities. Often called working
capital.
Short-term financial management
In U.S. manufaturing firms, current assets
account for about 40 percent of total assets;
current liabilities represent about 26 percent
of total financing. Therefore, it should not be
surprising to learn that short-term financial
management – managing current assets and
current liabilities - is one of the financial
manager’s most important and timeconsuming activities.
The goal of short-term financial management is
to manage each of the firm’s current assets
and current liabilities to achieve a balance
between profitability and risk that contributes
positively to the firm’s value.
Net Working Capital
Current Assets - Current Liabilities.
Gross Working Capital
The firm’s investment in current assets.
Working Capital Management
The administration of the firm’s current assets
and the financing needed to support current
assets.
Significance of Working Capital
Management:
• In a typical manufacturing firm, current assets
exceed one-half of total assets.
• Excessive levels can result in a substandard Return on
Investment (ROI).
• Current liabilities are the principal source of external
financing for small firms.
• Requires continuous, day-to-day managerial
supervision.
• Working capital management affects the company’s
risk, return, and share price.
Alternative Current Asset Investment
Policies:
1. Relaxed Current Asset Investment Policy
2. Moderate Current Asset Investment Policy
3. Restricted Current Asset Investment Policy
Optimal Amount (Level) of Current Assets
ASSET LEVEL ($)
Policy A
Policy B
Policy C
Current Assets
0
25,000
50,000
Liquidity Analysis
Policy
Liquidity
• A
High
• B
Average
• C
Low
Greater current asset levels generate more
liquidity; all other factors held constant.
Profitability Analysis
Return on Investment =
Net Profit
Total Assets
Current Assets = (Cash + Rec. + Inv.)
Return on Investment =
Net Profit
Current + Fixed Assets
Policy
Profitability
• A
Low
• B
Average
• C
High
As current asset levels decline, total
assets will decline and the ROI will
rise.
The trade-off between profitability and risk
• Profitability
The relationship between revenues and costs
generated by using the firm’s assets- both current
and fixed assets- in productive activities.
• Risk (of technical insolvency)
The probability that a firm will be unable to pay its bills
they come due.
Impact on Risk
• Decreasing cash reduces the firm’s ability to
meet its financial obligations. More risk!
• Stricter credit policies reduce receivables and
possibly lose sales and customers. More risk!
• Lower inventory levels increase stockouts and
lost sales. More risk!
Policy
Risk
• A
Low
• B
Average
• C
High
Risk increases as the level of current assets
are reduced.
Summary of the Optimal Amount of
Current Assets
Policy
A
B
C
Liquidity
High
Average
Low
Profitability Risk
Low
Low
Average
Average
High
High
The Tradeoff Between
Profitability & Risk
• Positive Net Working Capital (low return and low risk)
low
return
Current
Assets
Net Working
Capital > 0
Current
Liabilities
Long-Term
Debt
low
cost
high
cost
high
return
Fixed
Assets
Equity
highest
cost
Negative Net Working Capital (high return and high risk)
low
return
Current
Assets
high
return
Fixed
Assets
Current
Liabilities
Net Working
Capital < 0
low
cost
Long-Term
Debt
high
cost
Equity
highest
cost
The Tradeoff Between
Profitability & Risk (cont.)
Cash Conversion Cycle
Central to short-term financial
management is an understanding of
the firm’s cash conversion cycle.
The Operating Cycle (OC) is the time from beginning of
thr production process to collection of cash from
the sale of finished products.
The Cash Conversion Cycle (CCC) measures the length
of time required a company to convert cash invested
in its operations to cash received as a result of its
operations.
• Operating Cycle (OC) = AAI + ACP
• Cash Conversion Cycle (CCC) = OC - APP
CCC :
(inventory period + accounts receivable
period) – accounts payable period.
Inventory period = average inventory
annual CGS/365
A/R period =
average A/R
annual credit sales/365
A/P period =
average A/P
annual credit purchases/365
A/R turn over = 365
A/R period
Average A/R = credit Sales : A/R turn over
A/P turn over = 365
A/P period
Average A/P = credit purchases : A/P turn over
Gitman & Zutter (2012:604)
In 2007, IBM had annual revenues of $ 98,786 million,
cost of revenue of $ 57,057 millon, and accounts
payable of $ 8,054 million. IBM has an average age
of inventory (AAI) of 17.5 days, an average collection
period (ACP) of 44.8 days, and an average payment
period (APP) of 51.2 days (IBM purchases were $
57,416 million). Thus CCC for IBM was 11.1 days.
The resources IBM had invested in this CCC
were:
Inventory, $ 57,057 millon x (17.5/365) = $ 2,735,610
A/R, $ 98,786 million x (44.8/365) =
12,124,967
A/P, $ 57,416 million x (51.2/365) =
8,053,970
$ 6,806,607
$ 6,8 billion committed to working capital.
• The end of 2009, IBM has lowered its ACP to 24.9
days. This dramatical increase in working capital
efficiency . It would shorten the CCC and reduce the
amount of resources IBM has invested in operations.
• CCC = - 7.6 days
Strategies for Managing the CCC
1. Turn over inventory as quickly as possible without
stock outs that result in lost sales.
2. Collect accounts receivable as quickly as possible
without losing sales from high-pressure collection
techniques.
3. Manage, mail, processing, and clearing time to
reduce them when collecting from customers and
to increase them when paying suppliers.
4. Pay accounts payable as slowly as possible without
damaging the firm’s credit rating.
Funding Requirements of the CCC
• permanent funding requirement, a constant
investment in operating assets resulting from
constant sales over time.
• seasonal funding requirement, an investment
in operating assets that varies over time as
result of cyclic sales.
Kebutuhan Modal (Rp)
Temporary current assets
Permanent current assets
Waktu
Permanent vs. Seasonal Funding Needs
Nicholson Company holds, on average, $50,000
in cash and marketable securities, $1,250,000
in inventory, and $750,000 in accounts
receivable.
Nicholson’s business is very stable over time, so
its operating assets can be viewed as
permanent.
In addition, Nicholson’s accounts payable of
$425,000 are stable over time.
Nicholson has a permanent investment in
operating assets of $1,625,000 ($50,000 +
$1,250,000 + $750,000 - $425,000).
This amount would also equal the company’s
permanent funding requirement.
In contrast, Semper Pump Company has
seasonal sales, with its peak sales driven by
purchases of bicycle pumps.
Semper holds, at minimum, $25,000 in cash and
marketable securities, $100,000 in inventory,
and $60,000 in accounts receivable.
At peak times, Semper’s inventory increases to
$750,000 and its accounts receivable increase
to $400,000. To capture production
efficiencies, Semper produces pumps at a
constant rate throughout the year.
Thus, accounts payable remain at $50,000
throughout the year.
Semper has a permanent funding requirement
for its minimum level of operating assets of
$135,000 ($25,000 + $100,000 + $60,000 $50,000) and peak seasonal funding
requirements of $990,000 [($25,000 +
$750,000 + $400,000 - $50,000) - $135,000].
Semper’s total funding requirements for
operating assets vary from a minimum of
$135,000 (permanent) to a seasonal peak of
$1,125,000 ($135,000 + $990,000) as shown in
Figure 15.3.
Aggressive versus Conservative
Seasonal Funding Strategies
Semper Pump has a permanent funding requirement of
$135,000 and seasonal requirements that vary
between $0 and $990,000 and average $101,250
(calculated from data not shown).
If Semper can borrow short-term funds at 6.25% and
long term funds at 8%, and can earn 5% on any
invested surplus, then the annual cost of the
aggressive strategy would be:
• Alternatively, Semper can choose a
conservative strategy under which surplus
cash balances are fully invested, this surplus
would be the difference between the peak
need of $1,125,000 and the total need, which
varies between $135,000 and $1,125,000
during the year.
The aggressive strategy’s heavy reliance on
short-term financing makes it riskier than the
conservative strategy because of interest rate
swings and possible difficulties in obtaining
needed funds quickly when the seasonal
peaks occur.
The conservative strategy avoids these risks
through the locked-in interest rate and longterm financing, but is more costly.
The final decision is left to management.
P15-4 The forecast of total funds
requirements for coming year:
Month
Amount
Month
Amount
January
$ 2,000,000 July
$ 12,000,000
February
$ 2,000,000 August
$ 14,000,000
March
$ 2,000,000 September $ 9,000,000
April
$ 4,000,000 October
$ 5,000,000
May
$ 6,000,000 November
$ 4,000,000
June
$ 9,000,000 December
$ 3,000,000
• Permanent component $ 2,000,000
• Seasonal component, 0 - $ 12,000,000 average $ 4,000,000 per month
Accounts Receivable
Management
The objective for managing accounts receivable
is to collect accounts receivable as quickly as
possible without losing sales from highpressure collection techniques.
Topics of Accounts Receivable
Management:
• Credit Selection and Standards: Five C’s of
credit; credit scoring; credit standard.
• Credit Terms: cash discount; cash discount
period; credit period.
• Credit monitoring: average collection period;
aging of accounts reveivable; collection
techniques.
Numerical Credit Scoring categories:
– The customer’s character
– The customer’s capacity to pay
– The customer’s capital
– The collateral provided by the customer
– The condition of the customer’s business
Changing Credit Standards
A company is currently selling a product for $10 per unit. Sales
(all on credit) for last year were 60,000 units. The variable
cost per unit is $6 and total fixed costs are $120,000.
A company is currently contemplating a relaxation of credit
standards that is anticipated to increase sales 5% to 63,000
units. It is also anticipated that the Average Collection Period
will increase from 30 to 45 days, and that bad debt expenses
will increase from 1% of sales to 2% of sales. The opportunity
cost of tying funds up in receivables is 15%.
Should a company relax its credit standards?
Contribution margin
A/R turn over
Total variable costs
present
$ 240,000
12.2 x
$ 360,000
proposed
$ 252,000
8.1 x
$ 378,000
Investment in A/R
Cost of fund
Bad debt expenses
$ 29,508
$ 4,426
$ 6,000
$ 46,667
$ 7,000
$ 12,600
Credit Terms
• Credit terms: the terms of sale for customers
who have been extended credit by the firm.
• Cash discount: a percentage deduction from
the purchase price; available to the credit
customer who pays its account within a
sepcified period.
• Cash discount period: the number of days
after the beginning of the credit period during
which the cash discount is available.
Gitman & Zutter (2012:620-621)
MAX Company has an average collection period of 40
days, A/R turnover = 365/40 = 9.1.
MAX is considering initiating a cash discount by
changing its credit terms from net 30 to 2/10 net 30.
The firm expects this change to reduce an average
collection period to 25 days, A/R turnover = 365/25 =
14.6.
•
•
•
•
Harga jual $ 3,000 per unit
Biaya variabel $ 2,300 per unit
Opportunity cost of funds = 14%
Volume penjualan 1.100 unit dan akan naik
menjadi 1.150 unit
• Konsumen yang akan menggunakan
kesempatan cash discount sebanyak 80%