Working Capital Management
Cash Management
by
Imran Khan
What is cash conversion cycle?
Cash conversion cycle as discussed in the previous
lecture emphasize on the length of time between
when the firm makes payments and when it
receives cash as inflows.
Items involved in the Cash Conversion cycle
Inventory conversion period:
It refers to the average time needed to convert
materials into finished goods and then sell these
goods out.
Inventory conversion period (days)= Inventory/ sales per day
How a firm can shorten its Cash Conversion cycle?
The cash conversion cycle can be shortened by:
• Reducing the inventory conversion period (by
processing and selling goods faster).
• Reducing the receivables collection period by
speeding-up collections.
• Increasing the payables deferral period by slowing
down the firm’s own payments.
Receivables collection period
It refers to the average length of time required to
convert a company’s receivables into cash or in other
words it is the time required to collect cash following
a sale.
Also known as Days Sales Outstanding (D.S.O)
Receivables collection period= receivables
sales/365
Payables deferral period
It refers to the average length of time between the
purchase of labor and materials and the payment of
cash for them.
Summing up the above items
When the three items from the previous slides are
summed up, it results in cash conversion cycle.
Hence,
Inventory conversion period+ receivables collection period- Payables deferral
period= Cash conversion cycle
Question
Medwig Corporation has a DSO of 17 days. The
company averages $3500 in credit sales each day.
What is the company’s average accounts receivable?
Why do firms hold cash?
• Cash Management is one of the key areas of Working
Capital management.
• Firms hold cash for three of the following reasons:
Transactions motive: To meet payments including
purchases, salaries and taxes arising in the business.
Precautionary motive: For safety purpose where cash
acts as a cushion to meet unexpected cash needs.
Examples of precautionary motive:
• Floods, strikes and failure of important customers;
• Unexpected slow down in collection of accounts
receivable;
• Cancellation of some order for goods as the customer is
not satisfied
• Sharp increase in cost of raw materials.
Why do firms hold cash?
• Speculative motive: To take advantage of
temporary opportunities typically outside the
normal course of business such as sudden fall in the
price of a raw material.
Cash Management
• Cash management involves efficient allocation,
disbursement and temporary investment of cash.
• A cash budget as part of this process tells us how
much cash we are likely to have, when we are likely
to have it and for how long.
Cash Management strategy
Objective: Earn reasonable return while taking on
very limited credit and liquidity risk.
Company should write investment policy statement to
manage cash effectively
• Describe purpose, authorities, limitations, etc.
Passive strategy: Follow pre-defined rules
Active strategies:
• Match timing of cash inflow and outflow
• Other active strategies: Mismatching and laddering
(these can be risky)
Example
A firm which purchases raw materials on credit is
required by the credit terms to make payments within
30 days. On its side, the firm allows its credit buyers to
pay within 60 days. Its experience has been that it
takes, on an average, 35 days to pay its accounts
payable and 70 days to collect its accounts receivable.
Moreover, 85 days elapse between the purchase of
Raw materials and the sale of finished goods, that is to
say, the average age of inventory is 85 days. What is the
firm’s cash cycle?