CHAPTER 21
Working Capital Management
Topics in Chapter
•
•
•
•
•
Working capital policies
Cash, inventory, and A/R management
Accounts payable management
Short-term financing policies
Bank debt and commercial paper
21-2
Basic Definitions
• Gross working capital:
Total current assets
• Net working capital (NWC):
Current assets - Current liabilities
• Net operating working capital (NOWC):
Operating CA – Operating CL =
(Cash + Inv. + A/R) – (Accruals + A/P)
21-3
Working Capital Management
• Day-to-day control
•
•
•
•
•
Cash
Inventories
Accounts receivable
Accruals
Accounts payable
• Working capital policy
• The level of each current asset
• How current assets are financed
21-4
Cash Conversion Cycle
The time between payments made for materials
and labor and payments received from sales:
(21-4)
Cash
Inventory
Receivables
Conversion = Conversion + Collection −
Cycle
Period
Period
Payables
Deferral
Period
21-5
Inventory Conversion Period
• Average time required to convert
materials into finished goods and to
sell those goods:
Inventory
InventoryConversionPeriod
Sales per day
21-6
Receivables Collection Period
• Average length of time required to
convert the firm’s receivables into
cash:
Receivables
Receivables Collection Period 
Sales / 365
Receivables Collection Period =
DSO = Days Sales Outstanding
21-7
Payables Deferral Period
• Average length of time between the
purchase of materials and labor and
the payment of cash for them:
Payables
Payable DeferralPeriod
Purchasesper Day
Payables

Cost of goodssold / 365
21-8
Real Time Computer
Cash Conversion Data
Real Time Computer Company
Sales
$10,000,000
annual
COGS
$8,000,000
annual
Inventories
$2,000,000
average
AR
$657,534
average
AP
$657,534
average
Days/year
365
21-9
Inventory Conversion Period
Real Time Computer Company
Sales
$10,000,000
annual
COGS
$8,000,000
annual
Inventories
$2,000,000
average
AR
$657,534
average
AP
$657,534
average
Days/year
365
Inventory
Sales per day
$2,000,000
InventoryConversionPeriod
 73 days
$10,000,000 / 365
InventoryConversionPeriod
21-10
Receivables Collection Period
Real Time Computer Company
Sales
$10,000,000
annual
COGS
$8,000,000
annual
Inventories
$2,000,000
average
AR
$657,534
average
AP
$657,534
average
Days/year
365
Re ce ivables
Sale s / 365
$657,534
Re ce ivables Colle ctionPe riod
 24 days
$10,000,000 / 365
Re ce ivables Colle ctionPe riod
21-11
Payables Deferral Period
Real Time Computer Company
Sales
$10,000,000
annual
COGS
$8,000,000
annual
Inventories
$2,000,000
average
AR
$657,534
average
AP
$657,534
average
Days/year
365
Payable s
Purchas e spe r Day
Payable s

Cos t of goodss old / 365
$657,534

 30 days
$8,000,000 / 365
Payable De fe rralPe riod
21-12
Cash Conversion Cycle
Cash
Inventory
Receivables
Payables
Conversion = Conversion + Collection − Deferral
Cycle
Period
Period
Period
CCC =
73 days + 24 days – 30 days
CCC =
67 days
(21-4)
21-13
Cash Conversion Cycle
Figure 21-1
21-14
Cash Conversion Objective
• Shorten the cash conversion cycle as
much as possible without hurting
operations:
• Reduce Inventory Conversion period
• Process & sell goods quicker
• Reduce Receivables Collection period
• Speed up collections
• Lengthen Payables Deferral Period
• Slow firm’s payments
21-15
Real Time Computer
TABLE 21.1
21-16
Real Time Computer
Original
$10,000,000
8,000,000
Improved
10,000,000
8,000,000
73
24
30
67
65
23
31
57
$2,000,000
657,534
657,534
$1,780,822
630,137
679,452
Net operating working capital (NOWC)
$2,000,000
Improvement in FCF = Original NOWC - Improved NOWC
$1,731,507
$268,493
Annual sales
Costs of goods sold (COGS)
Inventory conversion period (days)
Receivables collection period (days)
Payable deferral period (days)
Cash conversion cycle (days)
Inventorya
Receivablesb
Payablesc
Notes: a Inventory = (Inventory conversion period)(Sales/365)
b
Receivables = (Receivables collection period)(Sales/365)
c
Payables = (Payables deferral period)(Sales/365)
21-17
Alternative NOWC Policies
Cash & Inventory
Holdings
Credit
Policy
Receivables
Payables &
Accruals
Restricted
Minimum
Tight
Minimum
Maximum
Moderate
Moderate
Moderate
Moderate
Moderate
Large
Liberal
Large
Minimum
Aggressive
21-18
Cash Management:
Cash = “Non-earning Asset”
• Transactions:
• Must have some cash to pay current bills.
• Precautionary balances = “Safety stock”
• Compensating balances:
• For loans and/or services provided.
• Speculation:
• Take advantage of bargains
• Take discounts
21-19
Cash Budget:
The Primary Cash Management Tool
• Projected cash inflows, outflows, and
ending cash balances forecast loan
needs and funds available for temporary
investment
• Daily, weekly, or monthly, depending
upon budget’s purpose
• Monthly for annual planning
• Daily for actual cash management
21-20
Data Required for Cash
Budget
• Sales forecast
• Information on collections delay
• Forecast of purchases and payment
terms
• Forecast of cash expenses: wages,
taxes, utilities, and so on
• Initial cash on hand
• Target cash balance
21-21
MicroDrive Cash Budget
Input Data
Collections during month of sale
Collections during 1st month after sale
Collections during 2nd month after sale
Discount on first month collections
Purchases as a % of next month's sales
Lease payments
Construction cost for new plant (Oct)
Target cash balance
Sales adjustment factor
20%
70%
10%
2%
70%
$15
100
$10
0.00
21-22
THE CASH BUDGET
May
Collections and purchases worksheet
Sales (gross)
Collections
During month of sale - 2% discount
During first month after sale
During second month after sale
Total collections
$200
Purchases
70% of next months sales
Payments on last month's purchases
Cash gain or loss for month
Collections
Payments for purchases
Total Other Expenses
Taxes
Payment for plant construction
Total payments
Net cash gain (loss) during month
Loan requirement or cash surplus
Cash at start of month if no borrowing
Cumulative cash
Target cash balance
Cumulative surplus cash or loans
outstanding to maintain $10 target cash balance
Jun
$250
$210
Jul
Aug
Sep
Oct
Nov
Dec
$300
$400
$500
$350
$250
$200
59
$175
$20
$254
78
$210
$25
$313
98
$280
$30
$408
69
$350
$40
$459
49
$245
$50
$344
39
$175
$35
$249
$280
$210
$350
$280
$245
$350
$175
$245
$140
$175
$140
$254
210
55
$313
280
70
$408
350
85
30
$459
245
70
$344
175
55
$249
140
55
20
$265
($11)
$350
($37)
$465
($57)
100
$415
$44
$230
$114
$215
$34
$ 15
$4
$10
$4
($33)
$10
($33)
($90)
$10
($90)
($46)
$10
($46)
$68
$10
$68
$102
$10
($6)
($43)
($100)
($56)
$58
$92
Table 21-2
21-23
May
Collections and purchases worksheet
Sales (gross)
Collections
During month of sale - 2% discount
During first month after sale
During second month after sale
Total collections
$200
Purchases
70% of next months sales
Payments on last month's purchases
Cash gain or loss for month
Collections
Payments for purchases
Total Other Expenses
Taxes
Payment for plant construction
Total payments
Net cash gain (loss) during month
Loan requirement or cash surplus
Cash at start of month if no borrowing
Cumulative cash
Target cash balance
Cumulative surplus cash or loans
outstanding to maintain $10 target cash balance
Jun
$250
$210
Jul
Aug
$300
$400
59
$175
$20
$254
78
$210
$25
$313
$280
$210
$350
$280
$254
210
55
$313
280
70
$265
($11)
$350
($37)
$ 15
$4
$10
$4
($33)
$10
($6)
($43)
21-24
Input Data
Collections during month of sale
Collections during 1st month after sale
Collections during 2nd month after sale
Discount on first month collections
Purchases as a % of next month's sales
Target cash balance
20%
70%
10%
2%
70%
$10
THE CASH BUDGET
May
Jun
Collections and purchases worksheet
Sales (gross)
$200
$250
Collections
$300*20%*98% =
During month of sale - 2% discount
$250*70% =
During first month after sale
$200*10% =
During second month after sale
Total collections
Purchases
$300*70% =
70% of next months sales
Payments on last month's purchases
$210
Jul
Aug
$300
$400
59
$175
$20
$254
78
$210
$25
$313
$280
$210
$350
$280
21-25
MicroDrive Cash Budget
May
Cash gain or loss for month
Collections
Payments for purchases
Total Other Expenses
Taxes
Payment for plant construction
Total payments
Net cash gain (loss) during month
Loan requirement or cash surplus
Cash at start of month if no borrowing
Cumulative cash
Target cash balance
Cumulative surplus cash or loans
outstanding to maintain $10 target cash balance
Jun
Jul
Aug
$254
210
55
$313
280
70
$265
($11)
$350
($37)
$ 15
$4
$10
$4
($33)
$10
($6)
($43)
21-26
THE CASH BUDGET
May
Collections and purchases worksheet
Sales (gross)
Collections
During month of sale - 2% discount
During first month after sale
During second month after sale
Total collections
$200
Purchases
70% of next months sales
Payments on last month's purchases
Cash gain or loss for month
Collections
Payments for purchases
Total Other Expenses
Taxes
Payment for plant construction
Total payments
Net cash gain (loss) during month
Loan requirement or cash surplus
Cash at start of month if no borrowing
Cumulative cash
Target cash balance
Cumulative surplus cash or loans
outstanding to maintain $10 target cash balance
Jun
$250
$210
Jul
Aug
Sep
Oct
Nov
Dec
$300
$400
$500
$350
$250
$200
59
$175
$20
$254
78
$210
$25
$313
98
$280
$30
$408
69
$350
$40
$459
49
$245
$50
$344
39
$175
$35
$249
$280
$210
$350
$280
$245
$350
$175
$245
$140
$175
$140
$254
210
55
$313
280
70
$408
350
85
30
$459
245
70
$344
175
55
$249
140
55
20
$265
($11)
$350
($37)
$465
($57)
100
$415
$44
$230
$114
$215
$34
$ 15
$4
$10
$4
($33)
$10
($33)
($90)
$10
($90)
($46)
$10
($46)
$68
$10
$68
$102
$10
($6)
($43)
($100)
($56)
$58
$92
Table 21-2
21-27
Other Cash Budget Line Items
• Interest earned or paid
• = Interest rate x surplus/loan line of cash
budget for preceding month
• Interest on any other outstanding loans
• Bad debt expense
• Collections reduced by bad debt losses.
• For example, if 3% bad debt losses,
collections would = 97% of sales
21-28
Cash Budget with Adjustments
Input Data
Interest on monthly surplus/deficit
Bad debt collections adjustment
10%
3.0%
THE CASH BUDGET
Cash gain or loss for month
Collections adjusted for bed debt write-offs
Payments for purchases
Wages and salaries
Lease payments
Other expenses
Interest on surplus/loan at 10%
Total Other Expenses
Taxes
Payment for plant construction
Total payments
Net cash gain (loss) during month
Loan requirement or cash surplus
Cash at start of month if no borrowing
Cumulative cash
Target cash balance
Cumulative surplus cash or loans
outstanding to maintain $10 target cash balance
Cumulative Surplus/Deficit WITHOUT INTEREST
$246
210
30
15
10
55.0
$304
280
40
15
15
0.12
70.1
$396
350
50
15
20
0.50
85.5
30
$265
($19)
$350
($46)
$ 15
($4)
$10
$445
245
40
15
15
1.08
71.1
$334
175
30
15
10
0.84
55.8
$242
140
30
15
10
(0.02)
55.0
20
$465
($70)
100
$416
$29
$231
$103
$215
$27
($4)
($50)
$10
($50)
($120)
$10
($120)
($91)
$10
($91)
$12
$10
$12
$39
$10
($13.8)
($59.9)
($129.7)
($100.9)
$1.9
$28.7
($6.2)
($42.8)
($99.8)
($56.2)
$57.8
$92.0
21-29
Cash Management Techniques
• Synchronize inflows and outflows
• Billing cycle = Payment cycle
• Use Float
• Remote disbursement accounts (+)
• Collections float (-)
Net
Float
• Lockbox Plan
• Payment by wire transfer or automatic debit
• Reduce the need for a cash “safety stock”:
• Increase forecast accuracy
• Hold marketable securities instead of a cash
• Negotiate a line of credit
21-30
Inventory Management Goals
1. Ensure that the inventory needed to
sustain operations is available
2. Minimize the costs of ordering and
carrying inventory
Trade-off to balance goals
21-31
Inventory Management:
Categories of Inventory Costs
• Carrying Costs
•
•
•
•
•
Storage and handling
Insurance
Property taxes
Depreciation
Obsolescence
21-32
Inventory Management:
Categories of Inventory Costs
• Ordering Costs
• Cost of placing orders
• Shipping
• Handling costs
21-33
Inventory Management:
Categories of Inventory Costs
• Costs of Running Short
• Loss of sales
• Loss of customer goodwill
• Disruption of production schedules
21-34
Receivables Management
A/R = Credit sales/day X Collection Period
Depends on volume of credit sales
Average time from credit sale to
collection of cash
• Credit policy
• Receivables monitoring
21-35
Elements of Credit Policy
• Credit Period = How long to pay?
• Shorter period reduces DSO
• Reduces average A/R
• May discourage sales
• Cash Discounts
• Lowers price
• Attracts new customers
• Reduces DSO
21-36
Elements of Credit Policy
• Credit Standards
• Tighter standards reduce bad debt losses,
• May reduce sales
• Fewer bad debts reduces DSO
• Collection Policy
• Tougher policy will reduce DSO
• May damage customer relationships
21-37
Receivables Monitoring
Credit sale events:
1. Inventories reduced by COGS
2. A/R increased by sales price
3. Price – COGS = Profit
Profit  Retained Earnings
DSO = Days Sales Outstanding
DSO = Average Collection Period
21-38
Days Sales Outstanding
ADS  AverageDaily Sales
AnnualSales (Units Sold) (SalesPrice)
ADS 

365
365
(21- 6)
Receivables  (ADS)  (DSO)
(21- 7)
DSO 
Receivables
Receivables

Sales per Day
Sales/365
21-39
Receivables Aging Schedule
• Breaks down firm’s receivables by age
TABLE 21.3
21-40
Accruals
• Accrued wages and accrued taxes
• Increase spontaneously
• Accruals are free in that no explicit
interest is charged
• Firms have little control over the level of
accruals
• Levels influenced by industry custom,
economic factors, and tax laws
21-41
Trade Credit
• Credit furnished by a firm’s suppliers
• Accounts Payable
• Often largest source of short-term credit,
especially for small firms
• Spontaneously increases
• Easy to get, but cost can be high
• Example: 2/10, net 30
• 2% discount if paid within 10 days
• Due in 30 days
21-42
The Cost of Trade Credit
• Microchip sells on terms of 2/10, net 30
• True price = 98% of selling price
• PCC buys $100 of memory chips from
Microchip
• If paid within 10 days  Cost = $98
• If PCC wants 20 extra days to pay  Cost = $100
• List price = $98 true cost + $2 finance charge
21-43
PCC’s Trade Credit Cost
• PCC buys an average of $11,923,333
from Microchip
• $32,666.67 per day
• If PCC pays on day 10
• PCC A/P average = 10(32,667) = $326,667
• PCC is receiving $326,667 credit from
Microchip
21-44
PCC’s Trade Credit Cost
• If PCC takes the extra 20 days to pay
• PCC A/P average = 30(32,667) = $980,000
• PCC is receiving $980,000 - 326,667 = $653,333
credit from Microchip
• PCC is foregoing a 2% discount
• PCC’s total cost = $11,923,333/0.98
= $12,166,666
• Annual finance cost = $12,166,666 –
11,923,333 = $243,333 = 37.2%
21-45
Nominal Cost Formula
2/10, net 30
rNOM = Discount % × Days365 days
Discount
1 - Discount %
Taken - Period
2
365
=
×
= 0.0204 × 18.25
98
20
= 0.372 = 37.2%
PCC Pays 2.04% 18.25 times per year
21-46
Effective Annual Rate (EAR)
2/10, net 30
• Periodic rate = 0.02/0.98 = 2.04%
• Periods/year = 365/(30 – 10)
= 18.25
• EAR
= (1 + Periodic rate)n – 1.0
= (1.0204)18.25 – 1.0
= 44.6%
21-47
The Cost of Trade Credit
TRADE CREDIT
Credit Terms
1/10, net 20
1/10, net 30
2/10, net 20
2/10, net 30
3/15, net 45
Cost of Additional Credit if
Cash Discount Not Taken
Nominal Cost
Effective Cost
36.9%
44.32%
18.4%
20.13%
74.5%
109.05%
37.2%
44.59%
37.6%
44.86%
21-48
Trade Credit
• Two components:
• Free trade credit = discount period credit
• Costly trade credit = cost implied by
foregone discount
Firms should always use the free credit
Use the costly credit only after careful
analysis and comparison with other sources
21-49
Working Capital Financing
Policies
• Moderate = Match the maturity of the assets
with the maturity of the financing
• “Maturity matching”
• “Self-liquidating”
• Aggressive = Use short-term financing
to finance permanent assets
• Conservative = Use permanent capital
for permanent assets and temporary
assets
21-50
FIGURE 21.2
Page 751
21-51
Moderate Financing Policy
$
Temp. NOWC
}
Perm NOWC
S-T
Loans
L-T Fin:
Stock &
Bonds,
Fixed Assets
Years
Lower dashed line, more aggressive.
21-52
Conservative Financing Policy
$
Marketable Securities
Zero S-T
debt
Perm NOWC
L-T Fin:
Stock &
Bonds
Fixed Assets
Years
21-53
Short-term Investments
• Marketable securities
• Lower yields than operating assets
• Held for same reasons as cash
• Benefits:
• Reduces risk and transactions costs
• Won’t need to issue securities or borrow as
frequently
• Ready cash for opportunities = “speculative
balances”
• Disadvantages
• Low after-tax return
21-54
Short-term Financing
• Advantages
• Funds available relatively quickly
• Lower cost
• Yield curve usually upward sloping
• Lower flotation costs
• Can repay early without penalty
• Less restrictive loan covenants
21-55
Short-term Financing
• Disadvantages
•
•
•
•
Higher risk
Interest expense fluctuates
Required repayment comes quicker
Firm may have trouble rolling over
loans
21-56
Short-term Bank Loans
• = Notes payable
• Maturity
• 2/3 are for less than 1 year
• Frequently 90 days
• Promissory Note
• Signed when bank loan approved
• Specifies:
•
•
•
•
Amount
Interest rate
Repayment schedule
Collateral
21-57
Short-term Bank Loans
• Compensating Balances
• Raises the effective loan rate
• Illegal in many states
• Informal Line of Credit
• Maximum amount bank will extend
• Revolving Credit Agreement
• Formal line of credit
• Periodic commitment fee
• Bank legally obligated to honor agreement
21-58
Commercial Paper (CP)
• Short term, unsecured promissory notes
issued by large, strong companies
• Maturity = 1-9 months; average 5 months
• Interest rates fluctuate daily just above the
T-bill rate
• Less personal than bank relationships
21-59
Security in Short-term Financing
• Commercial paper is never secured
• Better to borrow on an unsecured basis
• Lower bookkeeping costs
• Collateral options:
•
•
•
•
•
Marketable securities
Land or buildings
Equipment
Inventory
Receivables
21-60