Chapte
4
Slides Developed by:
Terry Fegarty
Seneca College
The Management of
Working Capital
Chapter 4 – Outline (1)
• Working Capital Basics
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Working Capital and the Current Accounts
Working Capital and Funding Requirements
Objective of Working Capital Management
Working Capital Trade-offs
Operations—The Cash Conversion Cycle
The Operating Cycle and the Cash Conversion Cycle
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Chapter 4 – Outline (2)
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Permanent and Temporary Working Capital
Maturity Matching Principle
Financing Net working Capital
Short-Term vs. Long-Term Financing
Working Capital Policy
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Chapter 4 – Outline (3)
• Cash Management
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Objectives of Cash Management
Marketable Securities
Yield on a Discounted Money Market Security
Components of Float
Cheque Disbursement and the Cheque Clearing
process
Accelerating Cash Receipts
Electronic Funds Transfer
Managing Cash Outflow
Evaluating Cash Management Services
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Chapter 4 – Outline (4)
• Managing Accounts Receivable
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Tradeoffs in Managing Accounts Receivable
Credit Policy
Terms of Sale
Collections policy
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Chapter 4 – Outline (5)
• Inventory Management
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Benefits and Costs of Carrying Adequate Inventory
Inventory Ordering Costs
Inventory Control and Management
Economic Order Quantity Model
Safety Stocks, Reorder Points and Lead Times
Inventory on Hand Including Safety Stock
Tracking Inventories—The ABC System
Just In Time (JIT) Inventory System
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Working Capital Basics
• Working Capital
 Assets/liabilities required to operate
business on day-to-day basis
•
•
•
•
•
Cash
Accounts Receivable
Inventory
Accounts Payable
Accruals
 Short-term in nature—turn over regularly
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Working Capital and the Current
Accounts
• Gross working capital = Current assets
 Gross Working Capital (GWC) represents
investment in current assets
• (Net) working capital =
Current assets – Current liabilities
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Working Capital and Funding
Requirements
• Working Capital Requires Funds
 Maintaining working capital balance requires
permanent commitment of funds
• Example: Firm will always have minimum level of
Inventory, Accounts Receivable, and Cash—this
requires funding
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Working Capital and Funding
Requirements
• Spontaneous Financing
 Firm will also always have minimum level of
Accounts Payable—in effect, money you have
borrowed
• Accounts Payable (and Accruals) are generated
spontaneously
• Arise automatically with inventory and expenses
• Offset the funding required to support current assets
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Working Capital and Funding
Requirements
• Net working capital is Gross Working
Capital – Current Liabilities (including
spontaneous financing)
 Reflects net amount of funds needed to
support routine operations
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Objective of Working Capital
Management
• To run firm efficiently with as little money
as possible tied up in Working Capital
 Involves trade-offs between easier operation
and cost of carrying short-term assets
• Benefit of low working capital
• Money otherwise tied up in current assets can be
invested in activities that generate higher payoff
• Reduces need for costly financing
• Cost of low working capital
• Risk of shortages in cash, inventory
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Working Capital Trade-offs
Inventory
High Levels
Benefit:
• Happy customers
• Few production delays (always have needed
parts on hand)
Cost:
• Expensive
• High storage costs
• Risk of obsolescence
Low Levels
Cost:
• Shortages
• Dissatisfied customers
Benefit:
• Low storage costs
• Less risk of obsolescence
Cash
High Levels
Benefit:
• Reduces risk
Cost:
• Increases financing costs
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Low Levels
Benefit:
• Reduces financing costs
Cost:
• Increases risk
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Working Capital Trade-offs
Accounts Receivable
High Levels (favourable credit terms)
Benefit:
• Happy customers
• High sales
Cost:
• Expensive
• High collection costs
• Increases financing costs
Low Levels (unfavourable
terms)
Cost:
• Dissatisfied customers
• Lower Sales
Benefit:
• Less expensive
Accounts Payable and Accruals
High Levels
Low Levels
Benefit:
• Reduces need for external finance--using a
spontaneous financing source
Cost:
• Unhappy suppliers
Benefit:
• Happy suppliers/employees
Cost:
• Not using a spontaneous
financing source
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Working Capital Trade-offs
Current Assets
Profitability
Risk
High Level
Lower
Lower
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Low Level
Higher
Higher
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Operations—The Cash Conversion
Cycle
• Firm begins with cash which then
“becomes” inventory and labour
 Which then becomes product for sale
 Eventually this will turn into cash again
• Firm’s operating cycle is time from
acquisition of inventory until cash is
collected from product sales
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Figure 4.1:
The Cash Conversion
Cycle
Product is
converted into
cash, which is
transformed into
more product,
creating the cash
conversion cycle.
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Figure 4.2:
Cycle
Time Line Representation
of the Cash Conversion
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The Operating Cycle and the Cash
Conversion Cycle
plus:
equals:
minus:
equals:
Inventory conversion period
Receivable collection period
Operating cycle
Payables deferral period
Cash conversion cycle
• Shortening cash conversion cycle frees up cash
to reinvest in business or to reduce debt and
interest
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Cash Conversion Cycle Analysis
Inventory
Conversion
Period
Receivables
Collection
Period
Payables
Deferral
Period
=
=
=
365
Inventory Turnover
Accounts Receivable × 365
Annual Credit Sales
Accounts Payable × 365
Cost of Goods Sold
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Cash Conversion Cycle
Purchase
Inventory
Sell Inventory
on Credit
Pay for
Inventory
Collect
Receivables
Operating Cycle
Inventory Conversion Period
Receivables Collection Period
Payables Deferral Period
Cash Conversion Cycle
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Working Capital
Needs of Different Firms
Figure 4.3:
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Permanent and Temporary
Working Capital
• Working capital is permanent to the
extent that it supports constant or
minimum level of sales
• Temporary working capital supports
seasonal peaks in business
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Maturity Matching Principle
• Maturity (due date) of financing should
roughly match duration (life) of asset
being financed
 Then financing /asset combination becomes
self-liquidating
• Cash inflows from asset can be used to pay off
loan
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Financing Net Working Capital
• According to maturity matching principle
 Temporary (seasonal) should be financed
with short-term borrowing
 Permanent working capital should be
financed with long-term sources, such as
long-term debt and/or equity
• In practice, firms may use more or less
short-term funds to finance working
capital
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Figure 4.4(a):
Working Capital
Financing Policies
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Figure 4.4(b): Working
Capital
Financing Policies
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Short-Term vs. Long-Term
Financing
• The mix of short- or long-term working
capital financing is a matter of policy
 Use of long-term funds is a conservative
policy
 Use of short-term funds is an aggressive
policy
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Short-Term vs. Long-Term
Financing
• Short-term financing
 Cheap but risky
• Cheap—short-term rates generally lower than
long-term rates
• Risky—because you are continually entering
marketplace to borrow
• Borrower will face changing conditions (ex; higher
interest rates and tight money)
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Short-Term vs. Long-Term
Financing
• Long-term financing
 Safe but expensive
• Safe—you can secure the required capital
• Expensive—long-term rates generally higher
than short-term rates
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Working Capital Policy
• Firm must set policy on following issues:
 How much working capital is used
 Extent to which working capital is supported
by short- vs. long-term financing
 How each component of working capital is
managed
 The nature/source of any short-term
financing used
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Cash Management
• Cash management—determining:
 Optimal size of firm’s liquid asset balance
 Appropriate types and amounts of
short-term investments
 Most efficient methods of controlling
collection and disbursement of cash
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Cash Management
• Why have cash on hand?
 Transactions demand: need money to pay bills
(employees, suppliers, utility/phone, etc.)
 Precautionary demand: to handle emergencies
(unforeseen expenses)
 Speculative demand: to take advantage of
unexpected opportunities (purchase of raw materials
that are on sale)
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Objectives of Cash Management
• Cash doesn’t earn a return
• Want to maintain liquidity
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Take cash discounts
Maintain firm’s credit rating
Minimize interest costs
Avoid insolvency
• Good cash management implies maintaining
adequate liquidity with minimum cash in bank
 Can place portion of cash balance into marketable
securities (AKA: near cash or cash equivalents)
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Marketable Securities
• Liquid investments that can be held
instead of cash and earn a modest return
 Examples include Treasury bills,
commercial paper, bankers’ acceptances
 Many are bought and sold at a discount in
money market
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Examples of Marketable Securities
• Treasury Bills
 Short-term government notes issued at a
discount with principal repaid at maturity
• Commercial Paper
 Short-term unsecured promissory notes
issued by corporations with good credit
• Bankers’ Acceptances
 Short-term promissory notes issued by a firm
and accepted (or guaranteed) by a bank
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Yield on a Discounted Money Market
Security
• Annualized yield
r
= 100 – P ×
P
365
d
where P = Discounted price as a
percentage of maturity value
d = Number of days to maturity
r = Annualized yield
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Components of Float
• Mail Float
 delay between when cheque is sent to a payee and is
received by payee
• Processing Float
 time between receipt of payment by a payee and the
deposit of the payment in the payee’s account
• Clearing Float
 time between depositing a cheque and having
available spendable funds
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Cheque Disbursement and the
Cheque Clearing Process
• When you pay a bill,
 You write cheque and mail to payee (2-3
days of mail float)
 Payee receives cheque and performs internal
processing (1 day of processing float)
 Payee deposits cheque in its own bank (1 day
of processing float)
 Payee’s bank sends cheque into interbank
clearing system which processes cheque (2
days of clearing float)
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Figure 4.5:
The Cheque-Clearing
Process
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Accelerating Cash Receipts
• Lock-box systems
 Post office box(es) located near customers in
order to shorten mail and processing float
• Local bank empties the box, deposits payments
into firm’s account, and reports payments to firm
 May involve significant fees
 More cost-effective if small number of larger
deposits
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A Lock Box System in
the Cheque-Clearing Process
Figure 4.6:
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Accelerating Cash Receipts
• Concentration Banking
 Customers send cheques sent to firm’s local
collection centres, where they are deposited
 Local deposits are transferred electronically
into one central concentration account
 Reduces mail float
 Funds available for paying loans or investing
in marketable securities
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Electronic Funds Transfer
• Electronic funds transfer mechanisms
are reducing the importance of float
management techniques for many
companies
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Electronic Funds Transfer
• Wire Transfers
 Transferring money electronically
• Preauthorized Cheques
 Customer gives payee signed cheque-like
documents in advance
 When payee ships product, it deposits
preauthorized cheque in its bank account
• Eliminates mail float
• Payee must trust payer
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Managing Cash Outflow
• Zero balance accounts (ZBAs)
 Decentralization of cash payments can lead to large
number of cash balances around the country
 Divisions write cheques on ZBAs—funded from
central account only when cheques are cleared
 Solves problem of idle cash in decentralized bank
accounts
• Remote disbursing
 Using bank in remote location for disbursement
chequing account
• Increases mail float
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Evaluating Cash Management
Services
• Evaluation involves comparison of costs
versus benefits of faster collection
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Evaluating Cash
Management Services
Example
Example 4.1:
Q: Kelso Systems Inc. has customers in British Columbia that remit
about 500 cheques a year. The average cheque is for $10,000.
West coast cheques currently take an average of eight days
from the time they are mailed to clear into Kelso’s east coast
account.
A British Columbia bank has offered Kelso a lock box system for
$1,000 a year plus $0.20 per cheque. The system can be
expected to reduce the clearing time to six days.
Is the bank’s proposal a good deal for Kelso if it borrows at 8%?
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Evaluating Cash
Management Services
Example
Example 4.1:
A: The cheques represent revenue of: 500 × $10,000 =
$5,000,000 per year.
The average amount tied up in the cheque clearing process is:
8/365 x $5,000,000 = $109,589.
The proposed lockbox system will reduce this to: 6/365 x
$5,000,000 = $82,192, thus freeing up $27,397 of cash.
Kelso will be able to borrow $27,397 less, thus saving: $27,397
x 0.08 = $2,192 in interest
The system is expected to cost: $1,000 + ($0.20 x 500) =
$1,100.
The net saving is: $2,192 - $1,100 = $1,092
The bank’s proposal should be accepted
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Managing Accounts Receivable
• Generally firms like as little money as possible
tied up in receivables
 Reduces costs (firm has to borrow to support the
receivable level)
 Minimizes bad debt exposure
• But, having good relationships with customers
is important
 Increases sales
• Firm needs to strike a balance on these issues
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Trade-offs in Receivable
Managing Accounts
Receivable
Management
Strict Management
Less sales and gross
More sales and gross
margin, but
margin, but
Less bad debts
More bad debts
Lower collection costs
Higher collection costs
Less discount
More discount
expenses
expenses
Lower receivables
Higher receivables
Shorter collections
Longer collections
Less interest expense
More interest expense
Liberal Management
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Managing Accounts Receivable
• Policy Decisions Influencing Accounts
Receivable
 Credit Policy
• Criteria used to screen credit applications
• Controls quality of accounts to which credit is extended
 Terms of Sale
• Terms and conditions under which credit extended must be
repaid
 Collections Policy
• Methods employed to collect payment on past due accounts
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Credit Policy
• Must examine creditworthiness of potential
credit customers
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Credit report
Customer’s financial statements
Bank references
Customer’s reputation among other vendors
• Conflicts often arise between sales and credit
departments
 Sales department’s job to generate sales
 Credit department may refuse credit to high risk
accounts
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Terms of Sale
• Credit sales are made according to
specified terms of sale
 Example: 2/10, net 30 means customer
receives 2% discount if payment is made
within 10 days, otherwise entire amount is
due by 30 days
 Customers pay quickly to save money
 Firm’s terms of sale generally follow
industry practice
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Collections Policy
• Firm’s collection policy—manner and aggressiveness
with which firm pursues payment from delinquent
customers
 Being overly aggressive can damage customer relations
• Function of collections department— to follow up on
overdue receivables (called dunning)
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Mail polite letter
Follow up with additional dunning letters
Phone calls
Collection agency
Lawsuit
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Inventory Management
• Inventory management— establishes a balance
between carrying enough inventory to meet
sales or production requirements while
minimizing inventory costs
• Inventory usually managed by manufacturing
or operations
 However, finance department has an oversight
responsibility
• Monitor level of lost or obsolete inventory
• Supervise periodic physical inventories
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Benefits and Costs of Carrying
Adequate Inventory
• Benefits
 Reduces stockouts and backorders
 Makes operations run more smoothly, improves customer
relations and increases sales
• Carrying Costs
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Interest on funds used to acquire inventory
Storage and security
Insurance
Taxes
Shrinkage
Spoilage
Breakage
Obsolescence
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Inventory Ordering Costs
• Inventory ordering costs
 Expenses of placing orders with suppliers,
receiving shipments, and processing
materials into inventory
• Excludes vendor charges
 Relate to the number of orders placed
rather than to the amount of inventory held
 Tend to vary inversely with carrying costs
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Economic Order Quantity (EOQ)
Model
• EOQ model recognizes trade-offs between
carrying costs and ordering costs
 Carrying costs increase with amount of inventory
held ( from larger orders)
 Ordering costs increase with the number of orders
placed (from more orders)
• EOQ minimizes total of sum of ordering and
carrying costs
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Inventory Costs and the EOQ
Cost
($)
Total
Cost
Carrying
Cost
Ordering
Cost
EOQ
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Q (Order Size)
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Economic Order Quantity (EOQ)
Model
• EOQ model is:
 
2FD
Q
c
½
where
Q= order size in units
D= annual quantity used in units
F= cost of placing one order
C= annual cost of carrying one unit in stock
½ denotes square root
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Figure 4.7:
Inventory on Hand for a
Steadily Used Item
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Economic Order Quantity (EOQ)
Model
• Other Inventory Formulas
Average Inventory =
Total Carrying Cost: =
Q
2
Q
c 
2
Number of Orders = N =  D 
Q
D
Total Ordering Cost = FN = F
Q
Q
D
Total Ordering and Carrying Cost = TC = c   +F  
2
Q
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Example
Example 4.3:
Economic Order
Quantity
Q: The Galbraith Corp. buys a part that costs $5. The carrying
cost of inventory is approximately 20% of the part’s dollar value
per year. It costs $50 to place, process and receive an order.
The firm uses 900 of the $5 parts per year.
What ordering quantity minimizes inventory costs?
How many orders will be placed each year if that order quantity
is used?
What inventory costs are incurred for the part with this ordering
quantity?
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Example 4.3:
Economic Order
Quantity
A: Annual carrying cost per unit is 20% x $5 = $1
Example
Q 

2  50  900
1

½
EOQ = 300 units
The annual number of reorders is 900 300 = 3
Ordering costs are $50 x 3 = $150 per year
Average inventory is 300  2 = 150 units
Carrying costs are 150 x $1 = $150 a year
Total inventory cost of the part is $300
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Safety Stocks, Reorder Points and
Lead Times
• Safety stock provides insurance against
unexpectedly rapid use or delayed
delivery
 Additional supply of inventory that is carried
at all times to be used when normal working
stocks run out
 Rarely advisable to carry so much safety
stock that stockouts never happen
• Carrying costs would be excessive
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Safety Stocks, Reorder Points and
Lead Times
• Ordering lead time—advance notice
needed so that an order placed will arrive
when required
 Usually estimated by item’s supplier
• Reorder point—level of inventory at
which order is placed
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Inventory on Hand
Including Safety Stock
Figure 4.9:
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Economic Order Quantity (EOQ)
Model
• Other Inventory Formulas (with Safety
Stock)
• Average Inventory =
Q
 Safety Stock
2
Q

• Total Carrying Cost: = c   Safety Stock 
2

• Total Ordering and Carrying Cost =
Q

D
TC = c   SafetyStock  +F  
2

Q
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Tracking Inventories—The ABC
System
• Some inventory items (A items) require great
deal of attention
 Very expensive
 Critical to firm’s processes or to those of customers
• Some inventory items do not require great deal
of attention (C items)
 Commonplace, easy to obtain
• B items fall between items A & C
• ABC system segregates items by value and
places tighter control on higher cost (value)
pieces
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Just In Time (JIT) Inventory
System
• Inventory supplied
 At exactly the right time
 In exactly the right quantities
• Theoretically eliminates the need for factory inventory




Shortens operating cycle
Reduces costs
Eliminate wasteful procedures
But: late delivery can stop factory’s entire production line
• Works best with large manufacturers who are powerful
with respect to supplier
 Supplier is willing to do almost anything to keep the
manufacturer’s business
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