Chapter 13
Working Capital
Policy
Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 1 of 20
Working Capital Policy: Overview
• Financial management decisions are divided into the
management of assets (investments) and management
of liabilities (liabilities).
• The short-term financial management (working capital
management) involves the management of a firm’s
current assets and current liabilities
• The maximization of the firm’s value in the long run
depends on its survival in the short-run, i.e. meeting its
working capital needs.
Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 2 of 20
Working Capital Policy: Definitions
• Working capital, sometimes called gross working capital,
generally refers to current assets, while net working capital is
defined as current assets minus current liabilities—the amount
of current assets financed by long-term liabilities.
• The current ratio, calculated as current assets divided by
current liabilities, is intended to measure a firm’s liquidity.
– A high current ratio does not insure that a firm will have the cash
required to meet its needs.
• The best and most comprehensive picture of a firm’s liquidity
position is obtained by examining its cash budget, which
forecasts a firm’s cash inflows and outflows. It focuses on what
really counts, the firm’s ability to generate sufficient cash
inflows to meet its required cash outflows.
Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 3 of 20
Working Capital Policy: Definitions
• Distinction should be made between current liabilities,
specifically used to finance current assets and current liabilities
that represent (a) current maturities of long-term debt; (b)
financing associated with a construction program, after its
completion will be funded with proceeds of a long-term security
issue; or (c) the use of short-term debt to finance fixed assets.
– Even though we define long-term debt coming due in the next accounting
period as a current liability, it is not a working capital decision variable in
the current period.
– Similarly, when construction is temporarily financed with a short-term
loan and later replaced with mortgage bonds, the construction loan
would not be considered part of working capital management.
– Although such accounts are not part of the working capital decision
process, they cannot be ignored because they are due in the current
period, and they must be considered when the cash budget is
constructed and the firm’s ability to meet its current obligations is
assessed.
Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 4 of 20
Relationship between the current asset
levels and financing requirements and
the business cycle
• At the peak of a business cycle, business carry their
maximum amounts of current assets
• Financing needs decline during recessions and
increase during booms
Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 5 of 20
The firm’s accounts balance
• Once a firm’s operations have stabilized and cash
collections from credit sales and cash payments for
credit purchases have begun, the balance in
accounts receivable and accounts payable can be
computed using the following equation:
• A decision affecting one working capital account will
have an impact on other working capital accounts.
Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 6 of 20
The cash conversion cycle
• The cash conversion cycle focuses on the
length of time between when the company
makes payments, or invests in the manufacture
of inventory, and when it receives cash inflows,
or realizes a cash return from its investment in
production.
Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 7 of 20
The cash conversion cycle - Definitions
• Inventory conversion period is the average
length of time required to convert materials into
finished goods and then to sell these goods;
it is the amount of time the product remains in
inventory in various stages of completion.
Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 8 of 20
The cash conversion cycle – Inventory
conversion period
• Inventory conversion period is the average length of time
required to convert materials into finished goods and
then to sell these goods;
it is the amount of time the product remains in inventory
in various stages of completion.
Inventory
Inventory

.
conversion period  Cost of goods sold 


360


Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 9 of 20
The cash conversion cycle –
Receivables collection period
• Receivables collection period is the average length of
time required to convert the firm’s receivables into cash,
that is, to collect cash following a sale. It is also called
the days sales outstanding (DSO).
Receivable s  DSO  Receivable s .
collection period
 Credit sales 


360


Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 10 of 20
The cash conversion cycle – Payables
deferral period
• Payables deferral period is the average length of time
between the purchase of raw materials and labor and the
payment of cash for them.
Accounts payable
Payables
 DPO 
.
deferral period
 Cost of goods sold 


360


Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 11 of 20
Analysis of the cash conversion cycle
• The cash conversion cycle, which nets out the three
periods just defined, equals the length of time between
the firm’s actual cash expenditures to pay for (invest in)
productive resources (materials and labor) and its own
cash receipts from the sale of its products. Thus, the
cash conversion cycle equals the average length of time
a dollar is tied up in current assets.
• Using these definitions, the cash conversion cycle is
defined as follows:
Inventory
Cash
Receivable s Payables
conversion  conversion  collection  deferral .
cycle
period
period
period
Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 12 of 20
Analysis of the cash conversion cycle
• If receivables (debtors) are collecred faster, then
– cash is released from the cycle
• If receivables (debtors) are collected slower
– receivables soak up cash
• If better credit (in terms of duration or amount) from
suppliers is obtained
– cash resources are increased
• If inventory (stocks) is shifted faster
– Cash is freed up
• If inventory (stocks) move slower
– more cash is being consumed
Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 13 of 20
The cash conversion cycle - Example
• Suppose it takes a firm an average of 79.0 days
to convert raw materials and labor to widgets
and to sell them, and it takes another 43.2 days
to collect on receivables, while 8.8 days normally
lapse between the receipt of materials (and work
done) and payments for materials and labor. In
this case, the cash conversion cycle is 79.0 days
+ 43.2 days – 8.8 days = 113.4 days.
Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 14 of 20
The cash conversion cycle and the goal
of the corporation
• The firm’s goal should be to shorten its cash conversion
cycle as much as possible without increasing costs or
depressing sales. This would maximize profits because
the longer the cash conversion cycle, the greater the
need for external, or nonspontaneous, financing and
such financing has a cost.
• The cash conversion cycle can be shortened
– by reducing the inventory conversion period by processing and
selling goods more quickly,
– by reducing the receivables collection period by speeding up
collections
– by lengthening the payables deferral period by slowing down its
own payments.
Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 15 of 20
Cash conversion cycle: things to note
• When taking actions to reduce the inventory conversion
period, a firm should be careful to avoid inventory
shortages that could cause good customers to buy from
competitors.
• When taking actions to speed up the collection of
receivables, a firm should be careful to maintain good
relations with its good credit customers.
• When taking actions to lengthen the payables deferral
period, a firm should be careful not to harm its own
credit reputation.
• Actions that affect the inventory conversion period, the
receivables collection period, and the payables deferral
period all affect the cash conversion cycle; hence, they
influence the firm’s need for current assets and current
asset financing.
Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 16 of 20
Cash conversion cycle: Example 1
• A firm purchases raw materials on June 1st. It
converts the raw materials into inventory by the
last day of the month, June 30th. However, it
pays for the materials on June 20th. On July
10th, it sells the finished goods for inventory.
Then the firm collects cash from the sale one
month later on August 10th. If this sequence
accurately represents the firm’s average working
capital cycle, what is the firm’s cash conversion
cycle?
Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 17 of 20
Cash conversion cycle: Solution 1
Inventory conversio n per iod
(40 days)
Payables
deferral
per iod
(20 days)
6/1
•
•
•
•
Receivables
collection
period
(31 days)
Cash conve rsion cycle
(51 days)
6/20
7/10
8/10
Payables deferral period = 20 days (June 1 to June 20).
Inventory conversion period = 40 days (June 1 to July 10).
Receivables collection period = 31 days (July 10 to August 1
Cash conversion cycle = 40 + 31 – 20 = 51 days.
Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 18 of 20
Cash conversion cycle: Example 2
• The Cairn Corporation is trying to determine the
effect of its inventory turnover ratio and days
sales outstanding (DSO) on its cash flow cycle.
Cairn’s sales (which were all on credit) were
$750,000, and it earned a net profit margin of 12
percent, or $90,000. It turned over its inventory 9
times during the year, its DSO (receivables
collection period) was 45 days, and the firm’s
cost of goods sold (COGS) was two-thirds of
sales. The firm had fixed assets totaling
$60,000. Cairn’s payables deferral period is 30
days. What is Cairn’s cash conversion cycle?
Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 19 of 20
Cash conversion cycle: Solution 2
• DSO = 45 days; Payables deferral period = 30 days.
Because inventory is turned over 9 times during the year, the
inventory conversion period must be 40 days = (360 days)/9.
Alternatively, calculate the average inventory balance:
• Cost of goods sold (COGS) = $750,000(2/3) = $500,000.
• Inventory = ($500,000)/9 = $55,556. So, the inventory
conversion period is:
Inventory
Inventory
$55,556
conversion 

 40 days.
COGS
$500,000
period
360
360
Inventory
Payables
Cash conversion 
Receivable
s


cycle
conversion period collection period deferral period
 40 days  45 days - 30 days  55 days.
Essentials of Managerial Finance by S. Besley & E. Brigham
Slide 20 of 20