Working Capital Policy
Helena Sůvová ©
helsu@centrum.cz
Guest lecture for the Czech University of
Agriculture
Course: Corporate Finance
November, 2006
1
Content of the lecture
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Working Capital Terminology
Working Capital Decisions
Cash Conversion Cycle
Importance of Working Capital
Working Capital Strategy
Working Capital – other issues
Summary of the lecture
Assignments for the tutorial
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Working Capital Terminology
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•
•
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(Net) Working capital = current assets - current
liabilities.
Working capital is also known as operating capital. It
represents the amount of day-by-day operating liquidity
available to a business.
Typical current assets include :
– cash and cash equivalents,
– accounts receivable,
– inventory.
Working capital, sometimes called gross working capital,
simply refers to the firm's total current assets.
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Working Capital Terminology
•
Working capital policy refers to decisions
– Target levels of each category of current assets
– How current assets will be financed
– Flexible rate financing versus fixed rate financing
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Working capital management: setting working capital policy and
carrying out that policy in day-to-day operations
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Working Capital Decisions
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The basic working capital decisions include:
1.
2.
3.
4.
5.
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manage collections from customers and disbursement to suppliers,
employees, taxes
bank relations
liquidity management – determinate expected cash surplus or deficicit
receivables management – firm´s credit policy, collection procedures
inventory management – investments in inventory and financing
Q: Which financial ratios reflect working capital
management?
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Cash Conversion Cycle
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Cash Conversion Cycle
Purchase
Sale on credit
Cash received
made
Inventory conversion period
Receivables
collection period
Operating cycle
Payable deferral
period
Cash conversion cycle
Cash outlay
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Cash Conversion Cycle
• Operating cycle = inventory collection period + avrg
receivables collection period
• Cash conversion cycle = operating cycle – payable
deferral period
• How can we calculate cash conversion cycle?
–
–
–
–
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accounts receivable turnover = net credit sales/avrg accounts receivable
receivable collection period = 365/accounts receivable turnover
inventory turnover = cost of goods sold/ avrg inventory
inventory conversion (collection) period = 365/inventory turnover ratio
payables turnover = (cost of goods sold + general, selling, administrative
expenses)/current liabilities
– payable deferral period = 365/payables turnover
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Cash Conversion Cycle
• Liquidity
ongoing
liquidity
protective
liquidity
• Ongoing liquidity – inflows and outflows of cash
• Protective liquidity – ability to adjust rapidly to unforeseen cash
demands
• Cash conversion cycle = quick and convenint way to analyse
ongoing liquidity
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Importance of Working Capital
• Why do firms have working capital?
– Under perfect markets a firm would hold exactly enough current assets
and the value of the firm would be independent of its working capital
decisions.
– But the world is not perfect…
• Current assets typically > 40 % of total assets=> large
investment
• Current assets are relatively volatile and directly and closely
dependent on sales
• Working capital accounts are the most manageable
• The firm´s well-being shows up first in its working capital
accounts and the flow of cash
• Working capital management must ensure that a firm can meet
its short-term maturity obligations
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Working Capital Strategy
• There is a theoretical optimum for working
capital.
• Working Capital > optimum → + higher safety (lower risk)
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- lower rate of return
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= conservative working capital policy
• Working Capital < optimum → - lower safety (higher risk)
•
? rate of return
• rate of return depends upon the degree of reduction in sales
•
= aggresive working capital policy
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Working Capital Strategy – Current
Assets
• Factors influencing the level of current
assets:
– the nature of the firm´s business
– the size of the firm (smaller firms usually have
higher proportions of current assets … up to 70 %)
– rate of increase in sales
– stability of the firm´s sales (more stable sales …
lower lavel of current assets)
– current asset (working capital) policy
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Working Capital Strategy – Current
Assets
• Aggressive policy
Safety stock
Total
current
assets
Required
minimum
of current
assets
• Conservative policy
Safety stock
Required
minimum
of current
assets
Total
current
assets
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Working Capital Strategy – Current
Assets
• Aggressive current asset policy:
–
–
–
–
low level of current assets, but effectively managed
short cash conversion cycle
lower expenses and potentially higher returns
high risk … high required returns
• Conservative current asset policy
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–
–
–
high level of current assets
long cash conversion cycle
higher expenses, lower EBIT
low risk… low required return
• Remember: different types of current assets affect both risk and
return differently (e. g. cash reduces risk severely than receivables
or inventory)
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Working Capital Strategy – Current
Liabilities
Aggressive liability policy
Current
liabilities
Long-term
liabilities
Stockholder´s
equity
Conservative liability policy
Current
liabilities
Long-term
liabilities
Stockholder´s
equity
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Working Capital Strategy – Current
Liabilities
• Aggressive liability policy:
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–
–
–
high level of current liabilities
short cash conversion cycle
lower interest costs if short-term rates lower than long-term
high risk … high required returns
• Conservative liability policy
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–
–
–
low level of current liabilities
long cash conversion cycle
higher interest costs if long-term rates higher than short-term
low risk… low required return
• Current liabilities = accounts payable, short-term loans, notes
payable, current principal of long-term debt due.
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Working Capital Strategy –
Altogether
• Idealized model for
agriculture
Current
assets
EUR
Fixed assets
Time
Short-term
credit
Long-term
debt plus
equity
• Fixed assets
growing steadily
• Current assets
jump at season
X
• In real world
different patterns
• But seasonal
patterns exist and
cause fluctuations
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Working Capital Strategy –
Altogether
• Permanent current assets – some (minimum)
level of current assets that is always maintained
• Matching principle:
– Permanent assets (= fixed assets + permanent
current assets) financed with permanent sources of
financing
– Temporary assets – temporary financing
– The idea is to match the cash flow generating
characterics with the maturity of the financing
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Working Capital Strategy –
Altogether
• Working capital strategy:
– Moderate: Match the maturity of the assets with the
maturity of the financing.
– Aggressive: Use short-term financing to finance permanent
assets.
– Conservative: Use permanent capital for permanent assets
and temporary assets.
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Working Capital Strategy – Moderate
$
Fluctuating current assets
}
Permanent current assets
Short-term
financing
Permanent
(L-T financing):
Stock & Bonds
Fixed Assets
Years
Lower dashed line, more aggressive.
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Working Capital Strategy –
Conservative
$
Zero S-T
debt
Permanent current assets
L-T Fin:
Stock &
Bonds
Fixed Assets
Years
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Working Capital – other issues
• Short term versus long term financing
– floating rate financing - interest rate tied on the bank prime
lending rate
– may reduce risks if the sales are correlated with the health of
economy
• Recognizing and dealing with liquidity problems
– deferral of payments, reduce inventory and receivables,
reduce long term (planned) expenditures, lay off employess
– protective liquidity – e.g. line of credit
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Summary
• Working capital management involves management of
current assets and current liabilities
• Net working capital = current assets – current liabilities
• Cash conversion cycle is a way to analyse the liquidity
and helps to set the level of net working capital.
• Conservative versus aggressive working capital policy
• Working capital strategy – matching principle, aggresive
versus conservative strategy
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Assignments for the tutorial
1.
2.
3.
4.
Give your reaction: „Merely increasing the level of current
assets does not necessarily reduce the riskiness of the firm,
rather, composition of the currenr assets is important to
consider.“ (Q 11.1.)
How does seasonal nature of a firm´s sales influence the level
of current assets and the decision amount of short-term
credit? (Q 11.2.)
What is the advantage of matching the maturities of assets
and liabilities? What is the disadvantage? (Q 11.3.)
There have been times when short-term rates were higher than
long-term rates. Does this imply that a firm should use only
long-term debt and no short-term? (Q 11.4.)
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Assignments for the tutorial
5.
Define and explain:
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6.
A firm´s cash conversion cycle is 40 days. The receivables
turnover is 8, payables turnover is 10
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7.
working capital
ongoing and protective liquidity
cash conversion cycle
permanent current assets
seasonal, or temporary current assets
matching principle
What is the firm´s inventory turnover?
What are accounts receivable if credit sales are 920 000 EUR?
What was the net working capital of ČEZ in 2005 and 2004?
What is the main source of CEZ´s short-term financing? Can
we recognize whether CEZ´s working capital strategy is
conservative or aggressive?
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Assignments for the tutorial
8.
Windsor Distributors have the following financial
statements.
a) determine Windsor´s liquidity situation by calculating
the current ratio, net working capital, cash conversion
cycle
b) What is the current market price per share of Windsor
stock if its P/E ratio is 8 times earnings?
c) CFO is conservative and wants to sell 2500 shares at 20
EUR/Share.
• What will be the new liquidity position?
• New market share?
• Is the issue of the new shares good?
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Assignments for the tutorial
Windsor Distributors
Balance Sheet (thousands EUR)
25 000
Cash
Receivables
60 000
Inventory
65 000
Long-term asstes
350 000
Total assets
500 000
Accounts payable plus salaries,
benefits and payroll taxes payable
80 000
Other current liabilities
20 000
Long-term debt
100 000
Stockholders´equity (50 000 shares)
300 000
Total liabilities and equity
Income statement (thousands
EUR)
Sales
Cost of goods sold
900 000
400 000
General, selling and
administrative expenses
100 000
All other expenses
250 000
Net income (EAT)
150 000
500 000
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Assignments for the tutorial
9.
a)
b)
c)
The Warner Flooring sales 1.2 mil. USD. Fixed assets total 500
000 USD, it wishes to maintain 60 % debt ratio, interest cost is
10 % on both S-T and L-T debt. Three alternatives regarding
projected current assets: 1) aggressive (current asstes = 45 %
of sales), 2) average (50 % of sales), 3) conservative (60 % of
sales). Expected EBIT is 12 % of sales, tax rate is 40 %.
What is the expected ROE under each strategy?
There is an assumption that earnings rate and level of
expected sales are independent of current asset policy. Is this a
valid assumption?
How would the overall riskiness of the firm vary under each
policy? (P 11.2.)
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