The Management
of Working Capital
Chapter 16 (Ch. 15 in 4th edition)
Basics
 Working Capital Basics
 The assets/liabilities that are required to operate a
business on a day-to-day basis
 Cash
 Accounts Receivable
 Inventory
 Accounts Payable
 Accruals
 These assets/liabilities are short-term in nature and
turn over regularly
2
Working Capital, Funding Requirements, and
the Current Accounts
 Gross Working Capital (GWC) represents the
investment in assets
 Working Capital Requires Funds

Maintaining a working capital balance requires
a permanent commitment of funds

Example: Your firm will always have a minimum
level of Inventory, Accounts Receivable, and
Cash—this requires funding
3
Working Capital, Funding Requirements, and
the Current Accounts
 Spontaneous Financing
 Your firm will also always have a minimum
level of Accounts Payable—in effect, money
you have borrowed


Accounts Payable (and Accruals) are generated
spontaneously
Offset the funding required to support assets
 Net working capital is Gross Working Capital –
Current Liabilities (or spontaneous financing)
 Reflects the net amount of funds needed to
support routine operations
4
Objective of Working Capital
Management
 To run the firm efficiently with as little money
as possible tied up in Working Capital

Involves trade-offs between easier operation
and the cost of carrying short-term assets

Benefit of low working capital
 Less capital invested for the level of business (higher
rate of return)

Cost of low working capital
 Lost sales
 risk
5
Objective of Working Capital
Management
Inventory
High Levels
Low Levels
Benefit:
 Happy customers
 Few production delays (always have needed parts on
hand)
Cost:
 Expensive
 High storage costs
 Risk of obsolescence
Cost:
 Shortages
 Dissatisfied customers
Benefit:
 Low storage costs
 Less risk of obsolescence
Cash
High Levels
Benefit:
 Reduces risk
Cost:
 Increases financing costs
Low Levels
Benefit:
 Reduces financing costs
Cost:
 Increases risk
6
Objective of Working Capital
Management
Accounts Receivable
High Levels (favorable credit terms)
Benefit:
 Happy customers
 High sales
Cost:
 Expensive
 High collection costs
 Increases financing costs
Low Levels (unfavorable terms)
Cost:
 Dissatisfied customers
 Lower Sales
Benefit:
 Less expensive
Payables and Accruals
High Levels
Benefit:
 Reduces need for external finance--using a
spontaneous financing source
Cost:
 Unhappy suppliers
Low Levels
Benefit:
 Happy suppliers/employees
Cost:
 Not using a spontaneous
financing source
7
Operations—Cash Conversion
Cycle
 A firm begins with cash which then “becomes”
inventory


Which then becomes a product which is sold
Eventually this will turn into cash again
 The firm’s operating cycle is the time from the
acquisition of inventory until cash is collected
from product sales
8
Figure 15.2: Time Line Representation of the
Cash Conversion Cycle
9
Wal Mart CCC
WAL MART STORES INC
sales per day
COGS per day
RECEIVABLES
INVENTORIES
ACCOUNTS PAYABLE
718558
552075
1,254,000
26,612,000
19,332,000
10
Wally World CCC – 2007 data
ICP
48.2
DSO
+1.7
AP deferrals
CCC
-35
14.2
11
Permanent and Temporary
Working Capital
 Temporary working capital supports seasonal
peaks in business
 Working capital is permanent to the extent
that it supports a constant of minimum level of
sales
12
Figure 15.3: Working Capital
Needs of Different Firms
13
Financing Net Working Capital
 Since working capital is of a short-term
nature, it is often financed with short-term
sources

This is known as the maturity-matching
principle
 Permanent working capital can be financed
either long or short term

Temporary working capital needs should be
supported with short-term funds
14
Short-Term vs. Long-Term
Financing
 Long-term financing
 Safe but expensive
 Safe because you don’t have re-issue risk
 Expensive because long-term rates are generally
higher than short-term rates
 Short-term financing
 Cheap but risky
 Cheap because short-term rates are generally lower
than long-term rates
 Risky because you are continually entering
marketplace to borrow—borrower will face changing
conditions
15
Alternative Policies
 The mix of short- or long-term working capital
financing is a matter of policy

Use of longer term funds reflects conservatism
16
Figure 15.4—Working Capital
Financing Policies
17
Working Capital Policy
 Firm must set policy on following issues:




How much working capital is used
The extent to which working capital is
supported by short- vs. long-term financing
The nature/source of any short-term financing
used
How each component of working capital is
managed
18
Sources of Short-term Financing
 Spontaneous financing

Accounts payable and accruals
 Unsecured bank loans
 Commercial paper
 Secured loans
19
Spontaneous Financing
 Accruals
 Money you owe employees (for example) for work they
have performed but not yet been paid
 Tend to be very short-term
 Accounts payable (AKA trade credit)
 Money you owe suppliers for goods you bought on
credit
 Credit Terms: Terms of trade specify when you are to
repay the debt
 Example of terms of trade: 2/10, net/30
 You must pay the entire amount by 30 days
 If you pay within 10 days, you will receive a 2%
discount
20
Spontaneous Financing
 The prompt payment discount
Example

Passing up prompt payment discounts is
generally a very expensive source of financing
If the terms of trade are 2/10, net 30, and you elect to not pay by
the 10th day, you are essentially paying 2% interest for 20 days’
use of money. There are 18.25 20-day periods in one year (365
days  20). We can convert the 2% foregone discount into an
annual rate by multiplying 2% by 18.25 to obtain 36.5%. Thus,
most prompt payment discounts are very attractive.
21
Spontaneous Financing
 Abuses of Trade Credit Terms
 Trade credit, while originally a service to a firm’s
customers, has become so commonplace it is now
expected
 Companies offer it because they have to
 Stretching payables is a common abuse of trade credit
 Paying payables beyond the due date
 Slow paying companies receive poor credit ratings in
credit reports issued by credit agencies
22
Unsecured Bank Loan
 Represent the primary source of short-term
loans for most companies
 Promissory note (AKA Notes Payable)

Note signed promising to repay the amount
borrowed plus interest

Bank usually credits the amount to borrower’s
checking account
23
Unsecured Bank Loans
 Line of credit
 Informal, non-binding agreement between bank and
firm that specifies the maximum amount firm can
borrow over a specific time frame (usually a year)
 Borrower pays interest only on the amount borrowed
 Revolving credit agreement
 Similar to a line of credit except bank guarantees the
availability of funds up to a maximum amount
(effectively a binding agreement)
 Borrower pays a commitment fee on the unborrowed
funds (whether they are used or not)
24
Unsecured Bank Loans
Example
Q: The Arcturus Company has a $10 million revolving credit agreement with its bank at prime
plus 2.5% based on a calendar year. Prior to the month of June, it had taken down $4
million that was outstanding for the entire month. On June 15, it took down another $2
million (assume the funds were available on June 16). Prime is 9.5% and the bank’s
commitment fee is 0.25% annually. What bank charges will Arcturus incur for the month of
June?
A: Arcturus will have to pay both interest on the money borrowed and a commitment fee on the
unused balance of the revolving agreement.
 Monthly interest rate: (Prime + 2.5%)  12 = 1%
 Monthly commitment fee: 0.25%  12 = 0.0208%
 $4 million was outstanding for the entire month of June and $2 million was
outstanding for 15 days of June, so the total dollar interest charges are:
15 

($4,000,000 x 0.01)   .01 x $2,000,000 x   $50,000
30 


The commitment fee must be paid on an average of $5,000,000 that was unused
during June, or:
• $5,000,000  .000208 = $1,040
• Total interest payment = $51,040
25
Unsecured Bank Loans
 Compensating balances

A minimum amount by which the borrower’s
bank account cannot drop below (therefore it
is unavailable for use)
 Increases the effective interest rate on a
loan

Typically between 10% and 20% of amounts
loaned
26
Example
Unsecured Bank Loans
Q: A firm borrows $100,000 subject to a 20% compensating
balance. The firm will only receive $80,000 in usable funds and
the remaining $20,000 must remain in the firm’s account. If the
stated rate on the loan is 12%, what is the effective rate?
A: The firm must pay the 12% on the entire $100,000 borrowed.
Thus, the firm will pay $12,000 in interest for a year on $80,000
of usable funds. This translates to an effective annual rate of
15%, or $12,000  $80,000.
27
Unsecured Bank Loans
 Clean-Up Requirements

Theoretically a firm can constantly roll-over its
short-term debt

Borrow on a new note to pay off an old note
 Risky for both the firm and the bank

Some banks require that borrowers clean up
short-term loans once a year

Remain out of short-term debt for a certain time
period
28
Commercial Paper
 Notes issued by large, financially-strong firms and
sold to investors

Basically a short-term corporate bond
 Unsecured (usually)
 Buyers are usually other institutions (insurance
companies, mutual funds, banks, pension funds)
 Maturity is less than 270 days
 Considered a very safe investment, therefore pays a
relatively low interest rate
 Rather than paying a coupon rate, interest is
discounted
 Commercial paper market is rigid and formal—no
flexibility in repayment terms
29
Short-Term Credit Secured by
Current Assets
 Debt is secured by the current asset being
financed
 More popular in some industries than in
others

Common in seasonal businesses
30
Short-Term Credit Secured by
Current Assets
 Receivables Financing:
 Accounts receivable represent money that is to be
collected in the near future
 Banks recognize that this money will be collected soon
are are willing to lend money based on this soon-to-becollected money
 Pledging AR: firm promises to use the money paid
from the collected AR to pay off bank loan (but AR still
belong to firm which still collects the accounts)
 If firm doesn’t repay, lender has recourse to borrower

Factoring AR: firm sells AR to lender (at a severe
discount) and the lending firm (factor) takes control of
the accounts
 AR are now paid directly to lender
31
Short-Term Credit Secured by
Current Assets
 Pledging Accounts Receivable


Firm promises to use the money paid from the collected
accounts to pay off bank loan
Accounts Receivable still belong to firm which still collects
the accounts


If firm doesn’t repay, lender has recourse to borrower
Lender can provide

General line of credit tied to all receivables
 Lender likely to advance at most 75% of the balance of accounts

Specific line of credit tied to individual accounts receivable
 Evaluates based on creditworthiness of account
 Lender likely to advance as much as 90% of the balance of
accepted accounts

Expensive form of financing
32
Short-Term Credit Secured by
Current Assets
 Factoring Accounts Receivable
 Firm sells Accounts Receivable to lender (at a severe
discount) and the lending firm (factor) takes control of
the accounts
 Accounts Receivable are now paid directly to lender
 Factor usually reviews accounts and only accepts
accounts it deems creditworthy
 Factors offer a wide range of services
 Perform credit checks on potential customers
 Advance cash on accounts it accepts or remit cash
after collection
 Collect cash from customers
 Assume the bad-debt risk when customers don’t pay
34
Short-Term Credit Secured by
Current Assets
 Inventory Financing


Use a firm’s inventory as collateral for a short-term loan
Popular but subject to a number of problems



Lenders aren’t usually equipped to sell inventory
Specialized inventories and perishable goods are difficult to market
Types of methods used



Blanket liens—lender has a lien (claim) against all inventories of the
borrower but borrower remains in physical control of inventory
Chattel mortgage agreement—collateralized inventory is identified by
serial number and can’t be sold without lender’s permission (but
borrower remains in physical control of inventory)
Warehousing—collateralized inventory is removed from borrower’s
premises and placed in a warehouse (borrower’s access controlled by
third party)
 When inventory is sold a paper trail is generated and copy sent to lender
(signaling lender to expect money from borrower soon)
35
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)
 Compensating balances
36
Objective of Cash Management
 Cash doesn’t earn a return
 Want to maintain liquidity without losing too
much in return

Can place a portion of cash balance into
marketable securities (AKA: near cash or
cash equivalents)

Liquid investments that can be held instead of
cash and earn a modest return
 Examples include Treasury bills, commercial paper
37
Check Disbursement and
Collection Procedures
 When you pay a bill, the process generally works like this:
You write a check and place it in the mail to payee (2-3 days
of mail float)
 Payee receives check and performs internal processing (1
day of processing float)
 Payee deposits check in its own bank (1 day of processing
float)
 Payee’s bank sends check into Federal Reserve’s interbank
clearing system which processes the check (2 days of transit
float)
 As a payer, you want to extend this time period
 As a payee, you want to reduce this time period

38
Accelerating Cash Receipts
 Lock-box systems

A post office box(es) located near customers in order to
shorten mail and processing float


Payee rents post office box(es) in strategic locations and hires
a bank to check the box and deposit payments received into
account
After deposits are made, copies are send to payee’s office and
internal processing completed
 Concentration Banking

A single concentration bank manages balances in multiple
remote accounts, sweeping excess cash into a central
location for investment in marketable securities

Funds can be moved electronically or via a depository transfer
check
40
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
45
Managing Accounts Receivable
 Objective: Maximize profitability (not Sales)
 Questions that need to be answered:
 Credit Policy—what type of customer will you lend to?
How financially viable must that customer be?
 Terms of sale (Trade)—What terms will the firm offer to
credit customers?
 Collections Policy—How will the firm collect from those
customers who don’t pay?
46
Credit Policy
 Must examine the creditworthiness of potential credit customers




Credit report
Customer’s financial statements
Bank references
Customer’s reputation among other vendors
 Having a tight credit policy means you’ll probably have lower Sales
 Having a loose credit policy means you’ll probably have high bad debts
 Conflicts often arise between the sales and credit departments

Sales department’s job is to generate sales and if salespeople are paid
on commission it can get personal
47
Terms of Sale
 Credit sales are made according to specified terms of
sales


Example: 2/10, net 30 means the customer receives a
2% discount if payment is made within 10 days,
otherwise the entire amount is due by 30 days
Prompt payment discount is usually an effective tool for
managing receivables
 Customers pay quickly to save money
 Generally follow industry standard
48
Collections Policy
 Collections department’s function is to follow up on overdue
receivables (called dunning)
 Mail a polite letter
 Follow up with additional dunning letters
 Phone calls
 Collection agency
 Lawsuit
 A firm’s collection policy is the manner and aggressiveness with
which a firm pursues payment from delinquent customers
 Being overly aggressive can damage customer relations
49
Receivables Monitoring
1. Days Sales Outstanding (DSO)


The average length of time required to collect
accounts receivable
Also called the average collection period
50
Receivables Monitoring
2. Aging Schedule


Report showing how long accounts receivable
have been outstanding
The report divides receivables into specified
periods, which provides information about the
proportion of receivables that are current and
proportion that are past due for given lengths of
time
51
Aging Schedule
Age of Account
(in days)
0-30
31-60
61-90
Over 90
Net Amount
Outstanding
$ 72,000
90,000
10,800
7,200
$ 180,000
Fraction of
Total Receivables
Average Days
40%
50%
6%
4%
100%
18
55
77
97
DSO = 0.40 (18 days) + 0.50 (55 days) + 0.06 (77 days) + 0.04 (97 days)
= 43.2 days
52
Inventory Management
 Mismanagement of inventory has the
potential to ruin a company
 Inventory is not the direct responsibility of the
finance department


Usually managed by a functional area such as
manufacturing or operations
However, finance department has an oversight
responsibility for inventory management


Monitor level of lost of obsolete inventory
Supervise periodic physical inventories
Benefits and Costs of Carrying
Adequate Inventory
 Benefits


Reduces stockouts and backorders
Makes operations run more smoothly, improves customer
relations and increases sales
 Costs








Interest on funds used to acquire inventory
Storage and security
Insurance
Taxes
Shrinkage
Spoilage
Breakage
Obsolescence
Inventory Control and
Management
 Inventory management refers to the overall
way a firm controls inventory and its cost


Define an acceptable level of operating
efficiency with regard to inventory
Try to achieve that level with the minimum
inventory cost
Economic Order Quantity (EOQ)
Model
 EOQ model recognizes trade-offs between
carrying costs and ordering costs


Carrying costs increase with the amount of
inventory held
Ordering costs increase with the number of
orders placed
 EOQ minimizes the sum of ordering and
carrying costs
Economic Order Quantity (EOQ)
Model
 The EOQ model is:
 2  Fixed Cost per Order  Annual Demand 
EOQ = 

Annual
Carrying
Cost
per
Unit


1
2
Economic Order Quantity (EOQ)
Model—Example
Example
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 $45 to place,
process and receive an order. The firm uses 1,000 of the $5 parts per year.
What ordering quantity minimizes inventory costs and 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?
A: Since the unit carrying cost is 20% of the part’s price, the annual carrying cost
per unit in dollars is $1, or 20% x $5. Substituting the known information into the
EOQ equation, we have:
1
 2  $45  1,000  2
EOQ = 
 = 300 units
$1


The annual number of reorders is 1,000  300, or 3.33. Carrying costs are
$150 a year, or (300  2) x $5 x 20%; and ordering costs are $45 x 3.333, or
$150. The total inventory cost of the part is $300.
Safety Stocks, Reorder Points and
Lead Times
 Safety stock provides a buffer against
unexpectedly rapid use or delayed delivery


An 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
 Ordering lead time is the advance notice
needed so that an order placed will arrive at
the needed time

Usually estimated by the item’s supplier
Figure 15.9: Pattern of Inventory
on Hand
Tracking Inventories—The ABC
System
 Some inventory items warrant a great deal of
attention


Are very expensive
Are critical to the firm’s processes or to those of
customers
 Some inventory items do not warrant a great
deal of attention

Commonplace, easy to obtain
 An ABC system segregates items by value
and places tighter control on higher cost
(value) pieces
Just In Time (JIT) Inventory
Systems
 Suppliers deliver goods to manufacturers just
in time (JIT)
 Theoretically eliminates the need for factory
inventory
 A late delivery can stop a factory’s entire
production line
 JIT works best with large manufacturers who
are powerful with respect to the supplier

Supplier is willing to do almost anything to keep
the manufacturer’s business
63