SESSION 6
WORKING CAPITAL MANAGEMENT
Slide 1
Session Overview
• Aside from investments in long-term assets, a firm
must also invest in working capital, the assets that
drive the profits of the firm: inventory, receivables
and cash. This is the nerve centre of the business.
Identifying the right balance is critical to the financial
performance of a firm.
• This section takes the student through
• effective and efficient techniques of working capital
management.
• Relevance of inventory management.
Slide 2
Session Objectives
• At the end of this session, students should be able to:
1. Explain the relevance of efficient working capital
management to the financial well-being of a firm
2. Trace the working capital cycle
3. Quantify the benefits and costs in working capital
management
4. Execute efficient working capital management in a business
setting i.e. Inventory, receivables and cash
Slide 3
Session Outline
The key topics to be covered in the session are as follows:
• Topic 1 – Overview of working capital management and
policies
• Topic 2 – Inventory Management
• Topic 3 –Trade Credit and Payables Management
• Topic 4 – Cash and Marketable Securities Management
Slide 4
Topic One
OVERVIEW OF WORKING CAPITAL
MANAGEMENT AND POLICIES
FINC 301
Slide 5
Working Capital
•
•
•
•
Working capital comprises the assets on the balance
sheet that typically have a lifespan of one year or less.
In other words, these assets convert to cash in one year
or under.
Working capital management also intrinsically involves
the management of current liabilities
Working capital is also referred to as Gross current
assets and made up of inventory, receivables, cash and
marketable securities. Net working capital is the
difference between current assets and current
liabilities.
Slide 6
• Working capital management involves two basic
questions:
– What is the appropriate amount of current assets, both in
total and for each specific account, and
– How should those current assets be financed?
• How an organization responds to the questions
above defines the working capital policy that is
operating within the firm
Slide 7
Working Capital Policies
• Working capital policies typically fall into three (3)
broad categories:
– Conservative working capital policy
– Aggressive working capital policy
– Maturity matching
• The type of policy is defined by the volume
inventory, receivables and cash that a firm keeps and
whether these are financed by short-term or longterm funding.
Slide 8
• Conservative working capital policy (relaxed) :
– large amounts of cash and inventories are carried, where
sales are stimulated by the use of a credit policy that
provides liberal financing to customers and a
corresponding high level of receivables
• Aggressive working capital policy (restricted):
– the holdings of cash, inventories, and receivables are
minimized, and accruals and payables are maximized.
• Maturity matching (moderate) : a middle point
between these two extremes. Match the maturity of
the assets with the maturity of the financing.
Slide 9
Determinants of Working Capital Levels
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•
•
•
•
Nature and size of business
Production cycle
Sales growth
Firm’s credit policy
Availability of credit
Slide 10
Topic Two
INVENTORY MANAGEMENT
FINC 301
Slide 11
The Relevance of Inventory
Management
• Insufficient inventories can lead to lost sales.
• Excess inventories means higher costs than
necessary.
• Large inventories, but wrong items leads to both high
costs and lost sales.
• Inventory management is more closely related to
operations than to finance.
Slide 12
• The overall goal of inventory management is to
minimize total inventory costs while maximizing
customer satisfaction.
– The objective is to minimize the level of investment in
stocks for a given level of cash flow or sales.
• Practical
• Two primary decisions must be made:
– Establish the reorder quantity (the number of items to
order)
– Establish the reorder point (level of inventory at which a
new order will be placed).
Slide 13
• Types of inventories
– Raw materials are the items that a company uses in
producing its final product.
– Work-in-process inventories are made up of those items
that are being produced.
– Finished goods inventories are made up of those items
that are actually sold by the business.
– Maintenance, repair, and operating (MRO) inventories are
made up of those items that are used by the firm in
normal operations, but are not manufactured or sold by
the firm.
Slide 14
• Carrying Costs: Storage and handling costs,
insurance, property taxes, depreciation, and
obsolescence.
• Ordering Costs: Cost of placing orders,
shipping, and handling costs.
• Costs of Running Short: Loss of sales, loss of
customer goodwill, and the disruption of
production schedules.
Slide 15
Approaches to Inventory Managment
• Economic Order Quantity Formula:
– Attempts to balance ordering costs against storage costs
and provide firm with the most economic quantity to order
to minimize overall inventory costs.
EOQ 
2DCo
HC
– Where
D = Total annual demand for the item
Co = Total ordering cost for the item
HC = Holding / Carrying cost for the item
Slide 16
• Reorder Point Calculations
– The reorder point (ROP) has three factors that are used in
determining the quantity of an item that exists when we
actually place an order:
• Lead-time (L) is the time that lapses from order placement
to order receipt.
• Daily demand (d) is the quantity of a product that is used per
day.
• Safety Stock (ss) the quantity of stock you keep for variations
in demand.
ROP  Ld  ss
Slide 17
Topic Two
TRADE CREDIT AND PAYABLES
MANAGEMENT
FINC 301
Slide 18
Accounts receivable management
• The goal of accounts receivable management
is to increase sales by offering credit to
customers.
– Options to offering credit include:
• The business issuing its line of credit.
• Factoring—selling accounts receivable to
another firm at a discount off of the
original sales price.
Slide 19
• Components of Credit Policy
– Terms of sale - the terms of sale establish how the firm
proposes to sell its goods and services.
– Credit Analysis - process of determining the probability
that customers will not pay. Use of 6C’s.
– Collection policy - procedures followed by a firm in
collecting accounts receivable.
Slide 20
• Credit terms are the requirements that our business
establishes for payment of a loan (the use of credit
by a customer).
– To speed up collections, cash discounts are often
offered to a business customer. An example would
be 2/10 net 30. If the customer pays the bill
within 10 days of the invoice a 2 percent discount
is given. Otherwise the entire net is due 20 days
later or at the 30th day.
Slide 21
Conducting a credit analysis
• Credit analysis involves an assessment of the
customer to ascertain their creditworthiness. A firm
can make use of the C’s of credit to do the analysis
• The 6 C’s of credit:
– A customer’s character is favorable if that customer has
paid his or her bills on time in the past and has favorable
credit references from other creditors.
– Capacity to pay refers to whether the customer has
enough cash flow or disposable income to pay back a loan
or pay off a bill.
Slide 22
• The 6 C’s of credit:
– Collateral is the ability to satisfy a debt or pay a
creditor by selling assets for cash.
– Capital - ability to generate enough
available cash to repay the debt
– Conditions - recent trends in the debtor’s
line of work or industry and how changing
economic conditions might affect the debt.
– Control - whether changes in law and
regulation could adversely affect the debtor.
Slide 23
• Use of collection days:
– If collection days exceed our credit terms, then we have to
speed up collections.
• Example: If we give terms of 30 days and we collect in 61
days as previously shown, then we have to speed up
collections in order to better manage accounts receivable.
We may also have to re-evaluate our credit policies.
– If collection days are less than our terms, then we have
increased our liquidity. May also consider loosening credit
policy.
Slide 24
• Aging of accounts receivable is accomplished by
determining the amounts of accounts receivable,
the various lengths of time for which these accounts
have been due, and the percentage of accounts that
falls within each time frame.
Slide 25
Aging of Accounts Receivable
Custome r
1
2
3
4
5
6
7
8
9
10
Total
Outsta nding
Da ys
Ba la nce
Outsta nding
5,000
30
7,000
45
15,000
30
12,000
70
8,000
90
15,000
60
6,000
120
10,000
100
13,000
45
9,000
90
100,000
Aging Schedule
Da ys Outsta nding
Custome r
1
2
3
4
5
6
7
8
9
10
Totals
Percentage
Outstanding
0–30
31–60
61–90
90+
5,000
7,000
15,000
12,000
8,000
15,000
6,000
10,000
13,000
9,000
20,000
20%
35,000
29,000
16,000
35.00%
29.00%
16.00%
Slide 26
Accounts Payable Management
• Cash discounts are offered to credit customers to
entice them to pay promptly.
– The seller views a cash discount as a sales discount.
– The customer views it as a purchase discount.
– The terms of a cash discount play an important role in
determining how the invoice will be paid.
Accounts Payable Management
• Cash discounts will normally appear on an invoice in
terms such as 2/10 n30.
– This means that the customer may deduct 2 percent off
of the invoice price if he or she pays within 10 days.
– If the customer does not pay within 10 days, he has the
use of 98% of the money owed for the next 20 days.
– If the customer pays within 30 days, the net, or total
amount, of the invoice is due.
– If he or she pays after 30 days, the credit agreement with
the seller normally stipulates that a monthly interest
charge be added to the unpaid balance.
Accounts Payable Management
• Calculations used in cash discounts:
– A $10,000 invoice with terms of 2/10 n30
– Option 1: Pay off the $10,000 with a payment of $9,800
within 10 days of the invoice date.
• This is computed by multiplying the invoice price by 1
minus the discount (1 - 0.02 = 0.98, and $10,000 x 0.98 =
$9,800).
• Or by taking the invoice price times the discount and
subtracting it from the invoice price ($10,000 x 0.02 =
$200, and $10,000 - $200 = $9,800).
Accounts Payable Management
• Calculations used in cash discounts (continued):
– A $10,000 invoice with terms of 2/10 n30
– Option 2: Pay the invoice price of $10,000 on the 30th
day after the invoice date. If this option is chosen, he will
pay the equivalent of 36.7 percent annual interest
because of his delaying payment. The logic is shown on
the following page.
Accounts Payable Management
• Calculations used in cash discounts:
– $200 is the cost paid on $9,800 for 20 days, or an interest rate
of 2.04 percent ([$200  $9,800] x 100).
– This will result in an effective annual interest rate of 36.7
percent (2.04 x [360  20days]).
– The effective annual interest rate is obtained by multiplying the
time period interest rate by the number of time periods in an
accounting year (360  20).
– 0.02/.98 *360/20 = 36.7%
Reading List
• Brealey, Myres and Marcus (BMM), Fundamentals of Corporate
Finance, Third Edition or better, McGraw Hill or any other
edition of the text book. Section 2
• Ross, S. A; Westerfield R.W., Jordan B, D., Foundations of
Corporate Finance, McGraw Hill, 2006 or better. Chapter 1
Slide 32