Chapter 14
Working Capital
and Current
Asset
Management
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Learning Goals
1. Understand short-term financial management,
net working capital, and the related trade-off
between profitability and risk.
2. Describe the cash conversion cycle, its funding
requirements, and the key strategies for
managing it.
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14-2
Learning Goals (cont.)
3. Explain the credit selection process and the
quantitative procedure for evaluating changes in credit
standards.
• Review the procedures for quantitatively considering
cash discount changes, other aspects of credit terms,
and credit monitoring.
• Understand the management of receipts and
disbursements, including float, speeding up
collections, slowing down payments, cash
concentration, zero balance accounts, and investing in
marketable securities.
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14-3
Long & Short Term Assets & Liabilities
Current Assets:
Cash
Marketable Securities
Prepayments
Accounts Receivable
Inventory
Current Liabilities:
Accounts Payable
Accruals
Short-Term Debt
Taxes Payable
Fixed Assets:
Investments
Plant & Machinery
Land and Buildings
Long-Term Financing:
Debt
Equity
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Net Working Capital
• Working Capital includes a firm’s current assets,
which consist of cash and marketable securities in
addition to accounts receivable and inventories.
• It also consists of current liabilities, including accounts
payable (trade credit), notes payable (bank loans), and
accrued liabilities.
• Net Working Capital is defined as total current assets
less total current liabilities.
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The Tradeoff Between
Profitability & Risk
• Positive Net Working Capital (low return and low risk)
low
return
Current
Assets
Net Working
Capital > 0
Current
Liabilities
Long-Term
Debt
low
cost
high
cost
high
return
Fixed
Assets
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Equity
highest
cost
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The Tradeoff Between
Profitability & Risk (cont.)
• Negative Net Working Capital (high return and high risk)
low
return
Current
Assets
high
return
Fixed
Assets
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Current
Liabilities
Net Working
Capital < 0
low
cost
Long-Term
Debt
high
cost
Equity
highest
cost
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The Tradeoff Between
Profitability & Risk (cont.)
Table 14.1 Effects of Changing Ratios
on Profits and Risk
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14-8
The Cash Conversion Cycle
• Short-term financial management—managing current
assets and current liabilities—is on of the financial
manager’s most important and time-consuming activities.
• The goal of short-term financial management is to
manage each of the firms’ current assets and liabilities to
achieve a balance between profitability and risk that
contributes positively to overall firm value.
• Central to short-term financial management is an
understanding of the firm’s cash conversion cycle.
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14-9
Calculating the Cash Conversion Cycle
The Operating Cycle (OC) is the time between
ordering materials and collecting cash from
receivables.
The Cash Conversion Cycle (CCC) is the time
between when a firm pays it’s suppliers (payables)
for inventory and collecting cash from the sale of the
finished product.
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Calculating the Cash
Conversion Cycle (cont.)
• Both the OC and CCC may be computed as
shown below.
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14-11
Calculating the Cash
Conversion Cycle (cont.)
MAX Company, a producer of paper dinnerware, has
annual sales of $10 million, cost of goods sold of 75% of
sales, and purchases that are 65% of cost of goods sold.
MAX has an average age of inventory (AAI) of 60 days,
an average collection period (ACP) of 40 days, and an
average payment period (APP) of 35 days.
Using the values for these variables, the cash conversion
cycle for MAX is 65 days (60 + 40 - 35) and is shown on
a time line in Figure 14.1.
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14-12
Calculating the Cash
Conversion Cycle (cont.)
Figure 14.1 Time Line for MAX Company’s Cash
Conversion Cycle
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14-13
Calculating the Cash
Conversion Cycle (cont.)
The resources MAX has invested in the cash
conversion cycle assuming a 365-day year are:
Obviously, reducing AAI or ACP or lengthening APP will
reduce the cash conversion cycle, thus reducing the amount
of resources the firm must commit to support operations.
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Funding Requirements of the CCC
• Permanent vs. Seasonal Funding Needs
– If a firm’s sales are constant, then its investment in operating
assets should also be constant, and the firm will have only a
permanent funding requirement.
– If sales are cyclical, then investment in operating assets will
vary over time, leading to the need for seasonal funding
requirements in addition to the permanent funding
requirements for its minimum investment in operating assets.
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Funding Requirements
of the CCC (cont.)
• Permanent vs. Seasonal Funding Needs
Nicholson Company holds, on average, $50,000 in cash and
marketable securities, $1,250,000 in inventory, and $750,000
in accounts receivable. Nicholson’s business is very stable
over time, so its operating assets can be viewed as
permanent. In addition, Nicholson’s accounts payable of
$425,000 are stable over time. Nicholson has a permanent
investment in operating assets of $1,625,000 ($50,000 +
$1,250,000 + $750,000 - $425,000). This amount would also
equal the company’s permanent funding requirement.
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Funding Requirements
of the CCC (cont.)
• Permanent vs. Seasonal Funding Needs
In contrast, Semper Pump Company, which produces bicycle pumps, has
seasonal funding needs. Semper has seasonal sales, with its peak sales
driven by purchases of bicycle pumps. Semper holds, at minimum,
$25,000 in cash and marketable securities, $100,000 in inventory, and
$60,000 in accounts receivable. At peak times, Semper’s inventory
increases to $750,000 and its accounts receivable increase to $400,000.
To capture production efficiencies, Semper produces pumps at a
constant rate throughout the year. Thus, accounts payable remain at
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Funding Requirements
of the CCC (cont.)
• Permanent vs. Seasonal Funding Needs
$50,000 throughout the year. Accordingly, Semper has a permanent
funding requirement for its minimum level of operating assets of
$135,000 ($25,000 + $100,000 + $60,000 - $50,000) and peak
seasonal funding requirements of $900,000 [($125,000 + $750,000 +
$400,000 - $50,000) - $135,000]. Semper’s total funding
requirements for operating assets vary from a minimum of $135,000
(permanent) to a a seasonal peak of $1,125,000 ($135,000 +
$900,000) as shown in Figure 14.2.
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14-18
Funding Requirements
of the CCC (cont.)
• Permanent vs. Seasonal Funding Needs
Figure 14.2
Semper Pump
Company’s
Total Funding
Requirements
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14-19
Funding Requirements
of the CCC (cont.)
• Aggressive vs. Conservative Funding Strategies
Semper Pump has a permanent funding requirement of $135,000 and
seasonal requirements that vary between $0 and $990,000 and
average $101,250. If Semper can borrow short-term funds at 6.25%
and long term funds at 8%, and can earn 5% on any invested surplus,
then the annual cost of the aggressive strategy would be:
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14-20
Funding Requirements
of the CCC (cont.)
• Aggressive vs. Conservative Funding Strategies
Alternatively, Semper can choose a conservative strategy under which
surplus cash balances are fully invested. In Figure 13.2, this surplus would
be the difference between the peak need of $1,125,000 and the total need,
which varies between $135,000 and $1,125,000 during the year.
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14-21
Funding Requirements
of the CCC (cont.)
• Aggressive vs. Conservative Funding Strategies
Clearly, the aggressive strategy’s heavy reliance on short-term
financing makes it riskier than the conservative strategy because of
interest rate swings and possible difficulties in obtaining needed
funds quickly when the seasonal peaks occur.
The conservative strategy avoids these risks through the locked-in
interest rate and long-term financing, but is more costly. Thus the
final decision is left to management.
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14-22
Strategies for Managing the CCC
1. Turn over inventory as quickly as possible without
stock outs that result in lost sales.
2. Collect accounts receivable as quickly as possible
without losing sales from high-pressure collection
techniques.
3. Manage, mail, processing, and clearing time to reduce
them when collecting from customers and to increase
them when paying suppliers.
4. Pay accounts payable as slowly as possible without
damaging the firm’s credit rating.
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14-23
Accounts Receivable Management
• The second component of the cash conversion cycle is
the average collection period – the average length of
time from a sale on credit until the payment becomes
usable funds to the firm.
• The collection period consists of two parts:
– the time period from the sale until the customer mails
payment, and
– the time from when the payment is mailed until the firm
collects funds in its bank account.
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14-24
Accounts Receivable Management:
The Five Cs of Credit
• Character: The applicant’s record of meeting past
obligations.
• Capacity: The applicant’s ability to repay the requested
credit.
• Capital: The applicant’s debt relative to equity.
• Collateral: The amount of assets the applicant has
available for use in securing the credit.
• Conditions: Current general and industry-specific
economic conditions.
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14-25
Accounts Receivable Management:
Credit Scoring
• Credit scoring is a procedure resulting in a
score that measures an applicant’s overall credit
strength, derived as a weighted-average of
scores of various credit characteristics.
• The procedure results in a score that measures
the applicant’s overall credit strength, and the
score is used to make the accept/reject decision
for granting the applicant credit.
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14-26
Accounts Receivable Management:
Credit Scoring (cont.)
• The purpose of credit scoring is to make a
relatively informed credit decision quickly and
inexpensively.
• For a demonstration of credit scoring, including
the use of a spreadsheet for that purpose, see the
book’s Web site at www.aw.com/gitman.
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14-27
Accounts Receivable Management:
Changing Credit Standards
• The firm sometimes will contemplate changing its
credit standards to improve its returns and generate
greater value for its owners.
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14-28
Accounts Receivable Management:
Changing Credit Standards
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Changing Credit Standards Example
Dodd Tool, a manufacturer of lathe tools, is currently selling a product
for $10/unit. Sales (all on credit) for last year were 60,000 units. The
variable cost per unit is $6. The firm’s total fixed costs are $120,000.
Dodd is currently contemplating a relaxation of credit standards that is
anticipated to increase sales 5% to 63,000 units. It is also anticipated
that the ACP will increase from 30 to 45 days, and that bad debt
expenses will increase from 1% of sales to 2% of sales. The
opportunity cost of tying funds up in receivables is 15%.
Given this information, should Dodd relax its credit standards?
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14-30
Changing Credit
Standards Example (cont.)
• Additional Profit Contribution from Sales
Dodd Tool Company
Analysis of Rexaxing Credit Standards
Additional Profit Contribution from Sales
Old Sales Level
60,000 Price/Unit
$
10.00
New Sales Level
63,000 Variable Cost/Unit
$
6.00
$
4.00
Increase in Sales
3,000 Contribution Margin/Unit
Additional Profit Contribution from Sales
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(sales incr x cont margin)
$ 12,000
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Changing Credit
Standards Example (cont.)
Cost of marginal investment in A/R:
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Changing Credit
Standards Example (cont.)
Cost of marginal investment in A/R:
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Changing Credit
Standards Example (cont.)
Cost of marginal bad debts:
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Changing Credit
Standards Example (cont.)
Cost of marginal investment in A/R:
Table 14.2
Effects on Dodd
Tool of a
Relaxation of
Credit Standards
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14-35
Changing Credit Terms
• A firm’s credit terms specify the repayment terms
required of all of its credit customers.
• Credit terms are composed of three parts:
– The cash discount
– The cash discount period
– The credit period
• For example, with credit terms of 2/10 net 30, the
discount is 2%, the discount period is 10 days, and the
credit period is 30 days.
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Changing Credit Terms Example
MAX Company has an average collection period of 40
days (turnover = 365/40 = 9.1). In accordance with the
firm’s credit terms of net 30, this period is divided into 32
days until the customers place their payments in the mail
(not everyone pays within 30 days) and 8 days to receive,
process, and collect payments once they are mailed.
MAX is considering initiating a cash discount by changing
its credit terms from net 30 to 2/10 net 30. The firm
expects this change to reduce the amount of time until the
payments are placed in the mail, resulting in an average
collection period of 25 days (turnover = 365/25 = 14.6).
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Changing Credit
Terms Example (cont.)
Table 14.3
Analysis of
Initiating a Cash
Discount for MAX
Company
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Credit Monitoring
• Credit monitoring is the ongoing review of a firm’s
accounts receivable to determine whether customers are
paying according to the stated credit terms.
• Slow payments are costly to a firm because they
lengthen the average collection period and increase the
firm’s investment in accounts receivable.
• Two frequently used techniques for credit monitoring
are the average collection period and aging of accounts
receivable.
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14-39
Credit Monitoring:
Average Collection Period
• The average collection period is the average number of
days that credit sales are outstanding and has two parts:
– The time from sale until the customer places the payment in
the mail, and
– The time to receive, process, and collect payment.
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14-40
Credit Monitoring:
Aging of Accounts Receivable
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Credit Monitoring:
Collection Policy
• The firm’s collection policy is its procedures for
collecting a firm’s accounts receivable when they are
due.
• The effectiveness of this policy can be partly evaluated
by evaluating at the level of bad expenses.
• As seen in the previous examples, this level depends
not only on collection policy but also on the firm’s
credit policy.
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