Working Capital
Management
By: Handema M.
MBA(Fin), MAEPM, PGDLM, BBA, Mech. Dip.
Objectives:

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

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Explain how the definition of "working capital" differs between
financial analysts and accountants.
Understand the two fundamental decision issues in working
capital management -- and the trade-offs involved in making
these decisions.
Discuss how to determine the optimal level of current assets.
Describe the relationship between profitability, liquidity, and risk
in the management of working capital.
Describe the hedging (maturity matching) approach to financing
and the advantages/disadvantages of short- versus long-term
financing.
List and explain the motives for holding cash.
Understand the purpose of efficient cash management.
Working Capital Concepts
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
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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.
Working Capital Issues
Optimal Amount (Level) of Current Assets
Policy A
ASSET LEVEL ($)
Assumptions
 50,000 maximum
units of production
 Continuous
production
 Three different
policies for current
asset levels are
possible
Policy B
Policy C
Current Assets
0
25,000
OUTPUT (units)
50,000
Impact on Liquidity
Optimal Amount (Level) of Current Assets
Greater current asset
levels generate more
liquidity; all other
factors held constant.
Policy A
ASSET LEVEL ($)
Liquidity Analysis
Policy
Liquidity
A
High
B
Average
C
Low
Policy B
Policy C
Current Assets
0
25,000
OUTPUT (units)
50,000
Impact on
Expected Profitability
Optimal Amount (Level) of Current Assets
Return on Investment =
Let Current Assets =
(Cash + Rec. + Inv.)
Return on Investment =
Net Profit
Current + Fixed Assets
Policy A
ASSET LEVEL ($)
Net Profit
Total Assets
Policy B
Policy C
Current Assets
0
25,000
OUTPUT (units)
50,000
Impact on
Expected Profitability
Optimal Amount (Level) of Current Assets
As current asset levels
decline, total assets will
decline and the ROI will
rise.
Policy A
ASSET LEVEL ($)
Profitability Analysis
Policy
Profitability
A
Low
B
Average
C
High
Policy B
Policy C
Current Assets
0
25,000
OUTPUT (units)
50,000
Impact on Risk
Optimal Amount (Level) of Current Assets
 Decreasing
Policy A
ASSET LEVEL ($)
cash
reduces the firm’s ability
to meet its financial
obligations. More risk!
 Stricter credit policies
reduce receivables and
possibly lose sales and
customers. More risk!
 Lower inventory levels
increase stockouts and
lost sales. More risk!
Policy B
Policy C
Current Assets
0
25,000
OUTPUT (units)
50,000
Impact on Risk
Optimal Amount (Level) of Current Assets
Risk increases as the
level of current assets
are reduced.
Policy A
ASSET LEVEL ($)
Risk Analysis
Policy
Risk
A
Low
B
Average
C
High
Policy B
Policy C
Current Assets
0
25,000
OUTPUT (units)
50,000
Summary of the Optimal
Amount of Current Assets
SUMMARY OF OPTIMAL CURRENT ASSET ANALYSIS
Policy
A
B
C
Liquidity
High
Average
Low
Profitability
Low
Average
High
Risk
Low
Average
High
1. Profitability varies inversely with
liquidity.
2. Profitability moves together with risk.
(risk and return go hand in hand!)
Classifications of
Working Capital
 Components
Cash, marketable securities,
receivables, and inventory
 Time
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Permanent

Temporary
Permanent
Working Capital
DOLLAR AMOUNT
The amount of current assets required to
meet a firm’s long-term minimum needs.
Permanent current assets
TIME
Temporary
Working Capital
DOLLAR AMOUNT
The amount of current assets that varies
with seasonal requirements.
Temporary current assets
Permanent current assets
TIME
Hedging (or Maturity
Matching) Approach
A method of financing where each asset would be offset with
a financing instrument of the same approximate maturity.
DOLLAR AMOUNT
Short-term financing**
Current assets*
Long-term financing
Fixed assets
TIME
Financing Needs and
the Hedging Approach

Fixed assets and the non-seasonal portion
of current assets are financed with longterm debt and equity (long-term profitability
of assets to cover the long-term financing
costs of the firm).

Seasonal needs are financed with shortterm loans (under normal operations
sufficient cash flow is expected to cover the
short-term financing cost).
Working Capital
Management Approaches
Conservative

High levels of working capital to avoid system
breakdown at the expense of profitability.
Aggressive

Approaches
Low levels of working capital for more profitability
Moderate

Approach
Approach
Seeks to balance both profitability and liquidity
Levels of working capital
Over
 Too
capitalization
much liquidity
Undercapitalization
 Insufficient
liquidity
Overtrading
 Too
many activities with limited resources
The Working Capital/Cash
Operating Cycle

The working capital/cash operating cycle
measures the time in days that cash is tied up in
working capital. Ideally, the shorter the cycle the
better.
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The working capital cycle is normally measured
as follows:

The Inventory Turnover Period

Plus: The Accounts Receivable Period
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Less: The Accounts Payable Period
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These individual ratios are determined as follows:
The Working Capital/Cash
Operating Cycle

The Working Capital/Cash
Operating Cycle

The Working Capital/Cash
Operating Cycle
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Cash Management
Motives for Holding Cash:
Transactions Motive -- to meet payments
arising in the ordinary course of business
Speculative Motive -- to take advantage of
temporary opportunities
Precautionary Motive -- to maintain a cushion
or buffer to meet unexpected cash needs
Cash Management System
Disbursements
Collections
Marketable securities
investment
Control through information reporting
= Funds Flow
= Information Flow
Speeding Up
Cash Receipts
Collections
 Expedite
preparing and mailing the
invoice
 Accelerate
the mailing of payments from
customers
 Reduce
the time during which payments
received by the firm remain uncollected
Earlier Billing
Accelerate preparation and
mailing of invoices

computerized billing

invoices included with shipment

invoices are faxed

advance payment requests

preauthorized debits
S-l-o-w-i-n-g D-o-w-n
Cash Payouts

“Playing the Float”
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Control of Disbursements
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Payable through Draft (PTD)
Payroll and Dividend
Disbursements
Zero Balance Account (ZBA)
Remote and Controlled Disbursing
Control of Disbursements
Firms should be able to:
1. shift funds quickly to banks from which
disbursements are made.
2. generate daily detailed information on
balances, receipts, and disbursements.
Solution:
Centralize payables into a single (smaller number
of) account(s). This provides better control of the
disbursement process.
Cash Balances to Maintain
The optimal level of cash should
be larger than:
(1) the transaction balances required
when cash management is
efficient.
(2) the compensating balance
requirements of commercial
banks.
Cash Management Models
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Investment in
Marketable Securities
Marketable Securities are shown
on the balance sheet as:
1. Cash equivalents if maturities are
less than three (3) months at the
time of acquisition.
2. Short-term investments if remaining
maturities are less than one (1) year.
Accounts Receivable and
Inventory Management
Credit Standards -- The minimum quality of credit worthiness of a
credit applicant that is acceptable to the firm.
Why lower the firm’s credit standards?
The financial manager should continually lower the firm’s credit
standards as long as profitability from the change exceeds the
extra costs generated by the additional receivables.
Costs arising from relaxing credit standards
A larger credit department
Additional clerical work
Servicing additional accounts
Bad-debt losses
Opportunity costs
Credit Terms
Credit Terms -- Specify the length of time
over which credit is extended to a customer
and the discount, if any, given for early
payment.
Credit Period -- The total length of time over
which credit is extended to a customer to
pay a bill. For example, “net 30” requires
full payment to the firm within 30 days from
the invoice date.
Credit Terms
Cash Discount Period -- The period of time
during which a cash discount can be taken for
early payment. For example, a policy which
allows a cash discount in the first 10 days from
the invoice date.
Cash Discount -- A percent (%) reduction in
sales or purchase price allowed for early
payment of invoices. For example, a policy
which allows the customer to take a 2% cash
discount during the cash discount period.
Seasonal Dating
Seasonal Dating -- Credit terms that
encourage the buyer of seasonal products
to take delivery before the peak sales period
and to defer payment until after the peak
sales period.
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Avoids carrying excess inventory and the
associated carrying costs.
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Accept dating if warehousing costs plus the
required return on investment in inventory exceeds
the required return on additional receivables.
Analyzing the
Credit Applicant
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Obtaining information on the
credit applicant
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Analyzing this information to
determine the applicant’s
creditworthiness
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Making the credit decision
Sources of Information
The company must weigh the amount
of information needed versus the time
and expense required.
Financial statements
 Credit ratings and reports
 Bank checking
 Trade checking
 Company’s own experience

Credit Analysis
A credit analyst is likely to utilize
information regarding:
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the financial statements of the firm
(ratio analysis)
the character of the company
the character of management
the financial strength of the firm
other individual issues specific to
the firm
Inventory
Management and Control
• Inventory management is concerned with maintaining acceptable
levels of inventory while minimizing the associated holding
costs, administrative cost and stock out costs.
Inventories form a link between production and sale of a product
Inventory types:

Raw-materials inventory

Work-in-process inventory

In-transit inventory

Finished-goods inventory
.
Inventory Management
Systems
 Two
bin system
 Single
bin system
 Periodic
 Slow
 Just
review system
moving inventory
in time (JIT) system
 Inventory
control systems
Appropriate
Level of Inventories
How does a firm determine
the appropriate level of
inventories?
Employ a cost-benefit analysis
Compare the benefits of economies of
production, purchasing, and product
marketing against the cost of the
additional investment in inventories.
How Much to Order?
The optimal quantity to order
depends on:
Forecast usage
Ordering cost
Carrying cost
Ordering can mean either the purchase or
production of the item.
Total Inventory Costs
INVENTORY
(in units)
Total inventory costs (T) =
C (Q / 2) + O (S / Q)
Q
Average
Inventory
Q/2
TIME
C: Carrying costs per unit per period
O: Ordering costs per order
S: Total usage during the period
Economic Order Quantity
The quantity of an inventory item to order
so that total inventory costs are minimized
over the firm’s planning period.
The EOQ or
optimal
quantity
(Q*) is:
Q* =
2 (O) (S)
C
Example of the
Economic Order Quantity
Kafue Textiles is attempting to determine the
economic order quantity for fabric used in
production.

10,000 yards of fabric were used at a constant
rate last period.

Each order represents an ordering cost of k200.
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Carrying costs are k1 per yard over the 100-day
planning period.
What is the economic order quantity?
Economic Order Quantity
We will solve for the economic order quantity
given that ordering costs are k200 per order,
total usage over the period was 10,000 units,
and carrying costs are k1 per yard (unit).
Q* =
2 (k200) (10,000)
k1
Q* = 2,000 Units
Total Inventory Costs
EOQ (Q*) represents the minimum
point in total inventory costs.
Costs
Total Inventory Costs
Total Carrying Costs
Total Ordering Costs
Q*
Order Size (Q)
When to Order?
Issues to consider:
Lead Time -- The length of time between the
placement of an order for an inventory item and
when the item is received in inventory.
Order Point -- The quantity to which inventory
must fall in order to signal that an order must
be placed to replenish an item.
Order Point (OP) = Lead time X Daily usage
Example of When to Order
Mr. Mutelo of Kafue Textiles has determined that
it takes only 2 days to receive the order of fabric
after the placement of the order.
When should he order more fabric?
Lead time
Daily usage
Order Point
= 2 days
= 10,000 yards / 100 days
= 100 yards per day
= 2 days x 100 yards per day
= 200 yards
Safety Stock
Safety Stock -- Inventory stock held in reserve
as a cushion against uncertain demand (or
usage) and replenishment lead time.
Our previous example assumed certain demand
and lead time. When demand and/or lead time are
uncertain, then the order point is:
Order Point =
(Avg. lead time x Avg. daily usage) + Safety stock
How Much Safety Stock?
What is the proper amount of
safety stock?
Depends on the:

Amount of uncertainty in inventory demand

Amount of uncertainty in the lead time

Cost of running out of inventory

Cost of carrying inventory
Just-in-Time
Just-in-Time -- An approach to inventory
management and control in which inventories
are acquired and inserted in production at the
exact times they are needed.
Requirements of applying this approach:
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A very accurate production and
inventory information system
Highly efficient purchasing
Reliable suppliers
Efficient inventory-handling system
Useful formulae in
Inventory control
Thank You….