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Introduction to
Working Capital
Working Capital
Approaches to Working Capital Financing
Overview of the Working Capital Financing Decision
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Introduction to Working Capital > Working Capital
Working Capital
• Calculating Working Capital
• Controlling the Components of Working Capital
• Importance of Working Capital
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Introduction to Working Capital > Working Capital
Calculating Working Capital
• WC is current assets minus current liabilities. Companies want positive WC.
• WC is an signal of whether or not the company has enough assets to turn into
cash to pay upcoming expenses or debts.
• WC is a measurement of liquidity and is not a guarantee that a company can pay
for its liabilities.
Buying Food
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Introduction to Working Capital > Working Capital
Controlling the Components of Working Capital
• Increasing current assets or decreasing current liabilities increases WC, and vice
versa.
• Four common mechanisms for controlling WC are cash management, inventory
management, debtors management, and financing management.
• Having too little WC impairs a company's ability to meet it's financial obligations,
while having too much WC can also be bad because it means that there are
assets that are not being invested in the long-term.
Walmart CFO
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Introduction to Working Capital > Working Capital
Importance of Working Capital
• WC is important for large companies' ability to borrow, increase their share price,
pay expenses and short-term debts.
• WC is important for small companies that cannot access financial markets to
borrow, and for start-ups that need to survive until they break even.
• WC cannot guarantee whether a company is financially sound, but it gives some
insight.
Cash
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Introduction to Working Capital > Approaches to Working Capital Financing
Approaches to Working Capital Financing
• Understanding the Needs of the Business
• Long-Term Approach
• Short-Term Approach
• Choosing a Policy
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Introduction to Working Capital > Approaches to Working Capital Financing
Understanding the Needs of the Business
• Sufficient working capital is required to ensure that a firm is able to continue its
operations and that it has sufficient funds to satisfy both maturing short-term and
long-term debt and upcoming operational expenses.
• The management of working capital involves managing inventories, accounts
receivable and payable, and cash.
• When calculating working capital we think in terms of net working capital, which is
calculated as current assets minus current liabilities.
• In any company, large or small, there is an inherent tradeoff between liquidity and
profitability.
Inventory Software
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Introduction to Working Capital > Approaches to Working Capital Financing
Long-Term Approach
• The classification of assets as 'current' or 'non-current' may not be appropriate for
describing the operations of a firm because different operations are classified
together.
• Difficulties in working capital management can arise from the complexity of many
business enterprises and the resultant inability to determine the length of the
operating cycle.
• Working capital is a static concept, and debt-paying ability is dynamic. Therefore,
working capital is not necessarily a good indication of the ability of the firm to pay
current liabilities.
The Operating Cycle
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Introduction to Working Capital > Approaches to Working Capital Financing
Short-Term Approach
• The main considerations for working capital are cash flow / liquidity and
profitability / returns on capital.
• The most widely used measure of cash flow is the net operating cycle or cash
conversion cycle.
• The cash conversion cycle measures how long a firm will be deprived of cash if it
increases its investment in resources in order to expand customer sales.
• The aim of the study and calculation of the cash conversion cycle is to change the
policies relating to credit purchase and credit sales.
Cash Conversion Cycle
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Introduction to Working Capital > Approaches to Working Capital Financing
Choosing a Policy
• Working capital policies aim at managing current assets - generally, cash and
cash equivalents, inventories, and debtors - and short term financing, such that
cash flows and returns are acceptable.
• One of the objectives within working capital management and general financing
decisions is to match the maturity of liabilities with the life expectancy of assets.
• If the maturity of liabilities is less than the life expectancy of assets, a firm faces
refinancing risk since it will have to raise new capital to pay off liabilities.
Policies Regarding Liquidity
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Introduction to Working Capital > Overview of the Working Capital Financing Decision
Overview of the Working Capital Financing Decision
• Evaluating Interest Rates
• Decision Criteria
• Identifying Varying Conditions
• Calculating Expected Value
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Introduction to Working Capital > Overview of the Working Capital Financing Decision
Evaluating Interest Rates
• The interest rate most commonly used in working capital management is the cost
of capital.
• Firm value is enhanced when, and if, the return on capital, which results from
working-capital management, exceeds the cost of capital, which results from
capital investment decisions.
• Working capital decision criteria that focus on interest rates include debtors
management and short-term financing.
• The discount rates typically applied to different types of companies show
significant differences.
Interest
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Introduction to Working Capital > Overview of the Working Capital Financing Decision
Decision Criteria
• The decisions relating to working capital are always current (i.e., short-term
decisions.
• The most useful measure of profitability is return on capital (ROC).
• One measure of cash flow is provided by the cash conversion cycle (CCC)–the
net number of days from the outlay of cash for raw material to receiving payment
from the customer.
• The most useful measure of profitability is return on capital (ROC).
Cash cycle
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Introduction to Working Capital > Overview of the Working Capital Financing Decision
Identifying Varying Conditions
• The goal of working capital management is to ensure that the firm is able to
continue its operations and that it has sufficient cash flow to satisfy both maturing
short-term debt and upcoming operational expenses.
• Identify the cash balance which allows for the business to meet day to day
expenses, but reduces cash holding costs.
• Identify the level of inventory which allows for uninterrupted production but
reduces the investment in raw materials - and minimizes reordering costs - and
hence increases cash flow.
• Identify the appropriate credit policy and the appropriate source of financing,
given the cash conversion cycle.
Inventory
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Introduction to Working Capital > Overview of the Working Capital Financing Decision
Calculating Expected Value
• Positive working capital is required to ensure that a firm is able to continue its
operations and that it has sufficient funds to satisfy both maturing short-term debt
and upcoming operational expenses.
• The management of working capital involves managing inventories, accounts
receivable and payable, and cash.
• Current assets and current liabilities include three accounts which are of special
importance: accounts receivable, inventory, and accounts payable.
• Working capital is equal to accounts receivable plus the value of inventory, minus
accounts payable.
Working Capital Equation
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Appendix
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Introduction to Working Capital
Key terms
• balance sheet A summary of a person's or organization's assets, liabilities and equity as of a specific date.
• cash conversion cycle how long a firm will be deprived of cash if it increases its investment in resources in order to expand
customer sales.
• cost of capital The rate of return that capital could be expected to earn in an alternative investment of equivalent risk.
• credit policy Credit terms given to customers that affect sales and collection practices.
• credit rating An estimate, based on a company or person's history of borrowing and repayment and/or available financial
resources, that is used by creditors to determine the maximum amount of credit it can extend to a without undue risk.
• Current Asset An asset on the balance sheet, such as cash, accounts receivable, and inventory that is expected to be sold or
otherwise used up in the near future, usually within one year or one business cycle, whichever is longer.
• Current Asset An asset on the balance sheet, such as cash, accounts receivable, and inventory that is expected to be sold or
otherwise used up in the near future, usually within one year or one business cycle, whichever is longer.
• current liabilities All liabilities of the business that are to be settled in cash within the fiscal year or the operating cycle of a given
firm, whichever period is longer.
• current liabilities All liabilities of the business that are to be settled in cash within the fiscal year or the operating cycle of a given
firm, whichever period is longer.
• discounting The process of finding the present value using the discount rate.
• Finished good Finished goods are goods that have completed the manufacturing process but have not yet been sold or
distributed to the end user.
• inventory The stock of an item on hand at a particular location or business
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Introduction to Working Capital
• liquidity Availability of cash over short term: ability to service short-term debt.
• liquidity Availability of cash over short term: ability to service short-term debt.
• M&A Mergers and acquisitions (M&A) are aspects of corporate strategy, corporate finance, and management dealing with the
buying, selling, dividing, and combining of different companies and similar entities that can help an enterprise grow rapidly in its
sector or location of origin, or a new field or new location, without creating a subsidiary, other child entity or using a joint
venture.
• operating liquidity The ability of a company or individual to quickly convert assets to cash for the purpose of paying operating
expenses.
• service industry An industry that does not produce any goods, but only provides a service such as a bank or insurance
company.
• static Fixed in place.
• Work in process Work in process (WIP) or in-process inventory includes the set at large of unfinished items for products in a
production process. These items are not yet completed but either just being fabricated or waiting in a queue for further
processing or in a buffer storage.
• working capital A financial metric that is a measure of current assets of a business that exceeds its liabilities and can be applied
to its operation.
• working capital A financial metric that is a measure of current assets of a business that exceeds its liabilities and can be applied
to its operation.
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Introduction to Working Capital
Interest
Interest rates of working capital financing can be largely affected by discount rate, WACC and cost of capital.
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Introduction to Working Capital
Inventory
Identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials and minimizes reordering costs and,
hence, increases cash flow.
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Introduction to Working Capital
Policies Regarding Liquidity
This chart lays out sample working capital issues and some possible solutions.
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Introduction to Working Capital
Buying Food
Most purchases, including food, must be made with a specific asset–cash. Not all current assets can be used to pay off expenses of debts.
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Introduction to Working Capital
Cash Conversion Cycle
Above is a chart showing a sample cash conversion cycle.
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Introduction to Working Capital
Walmart CFO
Charles Holley, the Chief Financial Officer (CFO) of Wal-Mart, is in charge of making sure all of Wal-Mart's assets are allocated as optimally as possible.
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Introduction to Working Capital
Working Capital Equation
Working capital is equal to accounts receivable, plus current inventory, minus accounts payable.
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Introduction to Working Capital
Inventory Software
This is an example of modern inventory software that enables managers to precisely track orders and inventory levels.
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Introduction to Working Capital
Cash cycle
Cash conversion cycle is a main criteria for working capital management.
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Introduction to Working Capital
The Operating Cycle
Above is a flow chart for a sample operating cycle for a firm.
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Introduction to Working Capital
Cash
Liquidity is a measurement of a company's ability to quickly turn assets into cash.
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Introduction to Working Capital
A company has $20,000 in cash, $10,000 in accounts receivable
and $45,000 in fixed assets. It has $12,5000 in accounts payable.
It owes $50,000 in two years on a note that has an annual interest
payment of $5,000. What is its working capital?
A) $7,500
B) $12,500
C) $17,500
D) $57,500
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Introduction to Working Capital
A company has $20,000 in cash, $10,000 in accounts receivable
and $45,000 in fixed assets. It has $12,5000 in accounts payable.
It owes $50,000 in two years on a note that has an annual interest
payment of $5,000. What is its working capital?
A) $7,500
B) $12,500
C) $17,500
D) $57,500
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Introduction to Working Capital
A company wants to adjust its working capital by adjusting its
current liabilities. Therefore the company should focus on its
____.
A) Financing management.
B) Debtors management.
C) Inventory management.
D) Cash management.
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Introduction to Working Capital
A company wants to adjust its working capital by adjusting its
current liabilities. Therefore the company should focus on its
____.
A) Financing management.
B) Debtors management.
C) Inventory management.
D) Cash management.
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Introduction to Working Capital
Complete the following statement so that it is always true: If a
company has significant working capital, _____.
A) it is guaranteed to have enough cash to pay all of its expenses.
B) the company is growing at the highest rate possible.
C) All of these answers.
D) it will probably be able to obtain credit at a lower interest rate.
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Introduction to Working Capital
Complete the following statement so that it is always true: If a
company has significant working capital, _____.
A) it is guaranteed to have enough cash to pay all of its expenses.
B) the company is growing at the highest rate possible.
C) All of these answers.
D) it will probably be able to obtain credit at a lower interest rate.
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Introduction to Working Capital
Which of the following factors need to be considered evaluating a
company's working capital strategy?
A) All of these answers.
B) The level of inventory necessary to ensure that a company can meet
its customers demands.
C) The number of days it takes a business to obtain payment from its
customers for its completed sales.
D) The number of days the company can wait before it must pay its
debts.
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Introduction to Working Capital
Which of the following factors need to be considered evaluating a
company's working capital strategy?
A) All of these answers.
B) The level of inventory necessary to ensure that a company can meet
its customers demands.
C) The number of days it takes a business to obtain payment from its
customers for its completed sales.
D) The number of days the company can wait before it must pay its
debts.
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Introduction to Working Capital
Which of the following explains why working capital may not be a
pure measure of short-term assets and liabilities?
A) The distinction between "current" and "non-current" is arbitrary.
B) Many businesses are complex, making it difficult to determine the
length of the operating cycle.
C) Cash flows available for paying current liabilities may be closely
related to long-term assets.
D) All of these answers.
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Introduction to Working Capital
Which of the following explains why working capital may not be a
pure measure of short-term assets and liabilities?
A) The distinction between "current" and "non-current" is arbitrary.
B) Many businesses are complex, making it difficult to determine the
length of the operating cycle.
C) Cash flows available for paying current liabilities may be closely
related to long-term assets.
D) All of these answers.
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Introduction to Working Capital
Which of the following statements regarding the cash conversion
cycle is correct?
A) The cash conversion cycle can be shortened by delaying payments to
suppliers.
B) A firm can achieve and sustain a negative cash conversion cycle.
C) The cash conversion cycle measures a company's credit risk
associated with growth.
D) All of these answers.
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Introduction to Working Capital
Which of the following statements regarding the cash conversion
cycle is correct?
A) The cash conversion cycle can be shortened by delaying payments to
suppliers.
B) A firm can achieve and sustain a negative cash conversion cycle.
C) The cash conversion cycle measures a company's credit risk
associated with growth.
D) All of these answers.
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Introduction to Working Capital
Which of the following statements regarding refinancing risk is
correct?
A) If liabilities mature after the life of the assets, there won't be sufficient
working capital.
B) A company should always closely match its liabilities to its assets.
C) Generally, liabilities should be self-liquidating.
D) All of these answers.
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Introduction to Working Capital
Which of the following statements regarding refinancing risk is
correct?
A) If liabilities mature after the life of the assets, there won't be sufficient
working capital.
B) A company should always closely match its liabilities to its assets.
C) Generally, liabilities should be self-liquidating.
D) All of these answers.
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Introduction to Working Capital
A company is a late stage startup. What should be its target rate
of return for its equity?
A) 50%-100%
B) 30%-50%
C) 40%-60%
D) 10%-25%
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Introduction to Working Capital
A company is a late stage startup. What should be its target rate
of return for its equity?
A) 50%-100%
B) 30%-50%
C) 40%-60%
D) 10%-25%
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Introduction to Working Capital
Which of the following correctly defines a factor that influences a
company's working capital financing decisions?
A) A CCC is the number of days from the purchase of materials until the
customer pays for the product.
B) A company's return on capital is income divided by the capital used to
earn that revenue.
C) All of these answers.
D) Credit policy is how a company uses credit to make purchases and
whether it allows sales on credit.
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Introduction to Working Capital
Which of the following correctly defines a factor that influences a
company's working capital financing decisions?
A) A CCC is the number of days from the purchase of materials until the
customer pays for the product.
B) A company's return on capital is income divided by the capital used to
earn that revenue.
C) All of these answers.
D) Credit policy is how a company uses credit to make purchases and
whether it allows sales on credit.
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Introduction to Working Capital
Which of the following correctly defines one of the four main areas
of variability that must be considered during working capital
management?
A) Cash management balances having enough cash for expenses while
minimizing cash holding costs.
B) Inventory management ensures uninterrupted production while
minimizing investment in raw materials.
C) Debtors management finds the appropriate credit policy.
D) All of these answers.
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Introduction to Working Capital
Which of the following correctly defines one of the four main areas
of variability that must be considered during working capital
management?
A) Cash management balances having enough cash for expenses while
minimizing cash holding costs.
B) Inventory management ensures uninterrupted production while
minimizing investment in raw materials.
C) Debtors management finds the appropriate credit policy.
D) All of these answers.
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Introduction to Working Capital
A company has $350,000 in accounts receivable, $100,000 in
current inventory, and $125,000 in accounts payable. What is its
working capital?
A) $375,000
B) $225,000
C) $450,000
D) $325,000
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Introduction to Working Capital
A company has $350,000 in accounts receivable, $100,000 in
current inventory, and $125,000 in accounts payable. What is its
working capital?
A) $375,000
B) $225,000
C) $450,000
D) $325,000
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Boundless - LO. "Boundless." CC BY-SA 3.0 http://www.boundless.com/
Introduction to Working Capital
Attribution
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Introduction to Working Capital
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Introduction to Working Capital
• Wiktionary. "inventory." CC BY-SA 3.0 http://en.wiktionary.org/wiki/inventory
• Wikipedia. "Working capital." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Working_capital
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• Wikipedia. "Current liabilities." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Current_liabilities
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