Working Capital
Management
Chapter 15
Working Capital
Terminology
 Working capital management
 the management of short-term assets
(investments) and liabilities (financing
sources)
Working Capital
Terminology
 Working capital
 a firm’s investment in short-term assets
 cash
 marketable securities
 inventory
 accounts receivable
Working Capital
Terminology
 Net working capital
 Current assets minus current liabilities
 the amount of current assets financed by
long-term liabilities
Working Capital
Terminology
 Working capital policy
 target levels for each current asset account
 how current assets will be financed
Working Capital
Terminology
 Working capital only includes current
liabilities that are specifically used to
finance current assets
Working Capital
Terminology
 Working capital does not include current
liabilities that may be due in the current
period if they are due from long-term
capital decisions, even though these must
be considered when assessing the firm’s
ability to meet its current obligations
Working Capital
Terminology
 Not working capital:
 current maturities of long-term debt
 financing associated with a construction
program that will be funded with the
proceeds of a long-term security issue after
the project is completed
 use of short-term debt to finance fixed
assets
The Requirement for
External Working Capital
Financing
 Seasonal variations
 Business cycles
 Expansion requires more
working capital
The Cash Conversion Cycle
 The length of time from the payment for
the purchase of raw materials to
manufacture a product until the
collection of accounts receivable
associated with the sale of the product
The Cash Conversion Cycle
 1. The inventory conversion period
 length of time required to convert materials
into finished goods and then to sell those
goods
 the amount of time the product remains in
inventory in various stages of completion
The Cash Conversion Cycle
 1. The inventory conversion period
Inve ntory
Inve ntory
Inve ntory
conversion 

 Cost of goods  Annual costof goods sold 
period

 

360

 sold per day  
The Cash Conversion Cycle
 2. The receivables collection period
 average length of time required to convert
the firm’s receivables into cash
 also called days sales outstanding (DSO)
The Cash Conversion Cycle
Receivables
Receivables
Receivables


collectionperiod Averagedaily credit sales  Annual credit sales


360


The Cash Conversion Cycle
 3. The payables deferral period
 average length of time between the
purchase of raw materials and labor and
the payment of cash for them
Payables
Accounts payable
Accounts payable
defe rral 

Cre dit purchases per day  Cost of goods sold 
period


360


The Cash Conversion Cycle
 4. The cash conversion cycle
 net the three periods
 average length of time a dollar is tied up in
current assets
Cash
Inventory
Receivables Payables
conversion = conversion + collection _ deferral
cycle
period
period
period
Working Capital Investment
and Financing Policies
 Two basic questions:
 1. What is the appropriate level for current
assets, both in total and by specific
accounts?
 2. How should current assets be financed?
Alternative Current Asset
Investment Policies
 Relaxed current asset investment policy
 relatively large amounts of cash and
marketable securities and inventories are
carried and sales are stimulated by a
liberal credit policy that results in a high
level of receivables
Alternative Current Asset
Investment Policies
 Restricted current asset investment
policy
 holdings of cash and marketable securities
and inventories are minimized
Alternative Current Asset
Investment Policies
 Moderate current asset investment policy
 a policy that is between the relaxed and
restricted policies
Current Assets
 Permanent current asset
 current asset balances that do not change
due to seasonal or economic conditions
 these balances exist even at the trough of a
firm’s business cycle
Current Assets
 Permanent current asset
Permanent current assets
Current Assets
 Temporary current asset
 current assets that fluctuate with seasonal
or economic variations in a firm’s business
Current Assets
 Temporary current asset
Temporary current assets
Alternative Current Asset
Financing Policies
 Maturity matching, or “self-liquidating”
approach
 a financing policy that matches asset and
liability maturities
 this would be considered a moderate
current asset financing policy
Alternative Current Asset
Financing Policies
 Aggressive approach
 a policy where all of the fixed assets of a
firm are financed with long-term capital,
but some of the firm’s permanent current
assets are financed with short-term
nonspontaneous sources of funds
Alternative Current Asset
Financing Policies
 Conservative approach
 a policy where all of the fixed assets, all of
the permanent current assets, and some of
the temporary current assets of a firm are
financed with long-term capital
Advantages and Disadvantages of
Short-Term Financing
 Speed
 a short-term loan can be obtained much
faster than long-term credit
 Flexibility
 for cyclical needs, avoid long-term debt
 cost of issuing long-term debt is higher
 penalties for payoff prior to maturity
 restrictive covenants
Advantages and Disadvantages of
Short-Term Financing
 Cost of long-term versus short-term debt
 yield curve is generally upward sloping
 short term interest rates are generally
lower than long-term rates
Advantages and Disadvantages of
Short-Term Financing
 Risk of long-term versus short-term debt
 short-term debt subjects the firm to more
risk than long-term debt
 short-term interest expenses fluctuate
 firm may not be able to repay short-term
debt, thus might be forced into bankruptcy
Short-Term Credit
 Any liability originally scheduled for
repayment within one year
Sources of Short-Term
Financing
 Accruals
 continually recurring short-term liabilities
 liabilities such as wages and taxes that
increase spontaneously with operations
 Accounts payable (trade credit)
 credit created when one firm buys on credit
from another firm
Sources of Short-Term
Financing
 Short-term bank loans
 maturity typically 90 days
 promissory note specifies terms and
conditions
 amount, interest rate, repayment schedule,
collateral, and any other agreements
Sources of Short-Term
Financing
 Short-term bank loans (cont.)
 compensating balances of 10 to 20 percent
may be required to be maintained in a
checking account
 line of credit may be arranged
 specified maximum amount of funds
available
Sources of Short-Term
Financing
 Short-term bank loans (cont.)
 revolving credit agreement
 line of credit where funds are committed,
or guaranteed
 commitment fee
 fee charged on the unused balance of a
revolving credit agreement
Sources of Short-Term
Financing
 Commercial paper
 unsecured short-term promissory notes
issued by large, financially sound firms to
raise funds
Sources of Short-Term
Financing
 Secured loans
 loan backed by collateral
 for short-term loans, the collateral is often
either inventory or receivables
 factoring is the sale of receivables
 the lender may seek recourse (payment)
from the borrowing firm for uncollectible
receivables used to secure a loan
Computing the Cost of
Short-Term Credit
 Interest rate
=
Dollar cost of borrowing
Amount of usable funds
m
  Interest rate 
Effective
  1.0
 EAR  1  
annual rate
  per period 
Annual
 Inte re strate 
  m  i SIMPLE
 APR  
pe rce ntagerate
 pe r pe riod 
Computing the Cost of
Short-Term Credit
 Discount interest loan
 a loan in which the interest, which is
calculated on the amount borrowed
(principal), is paid at the beginning of the
loan period
 interest is paid in advance
Managing Cash and
Marketable Securities
 Cash management
 goal of minimizing the amount of cash the
firm must hold for use in conducting its
normal business activities, but sufficient to:
 pay suppliers
 maintain its credit rating
 meet unexpected cash needs
Firms Hold Cash For:
 1. Transaction balance
cash balance necessary for day-to-day
operations
the balance associated with routine payments
and collections
 2. Compensating balance
deposit to meet bank loan requirements
Firms Hold Cash For:
3. Precautionary balance
cash balance held in reserve for unforeseen
fluctuations in cash flows
access to line of credit can reduce the need
for precautionary balances
4. Speculative balance
cash balance that is held to enable the firm to
take advantage of any bargain purchases
that might arise
easy access to borrowed funds can reduce the
need for speculative balances
Cash Management
Techniques
 Cash forecasts
 predict the timing of cash flows
 Synchronized cash flows
 cash inflows coincide with cash outflows,
permitting a firm to hold low transaction
balances
Cash Management
Techniques
 Float
 the difference between the balance shown
in a checkbook and the balance on the
bank’s records
 Disbursement float
 the value of checks that have been written
and disbursed but that have not fully
cleared through the banking system and
thus have not been deducted from the
account on which they were written
Cash Management
Techniques
Collection float
 the amount of checks that have been
received and deposited but that have not yet
been credited to the account in which they
were deposited, because they have not
cleared through the banking system
Cash Management
Techniques
 Net float
 the difference between disbursement float
and collection float
 the difference between the balance shown
in the checkbook and the balance shown on
the bank’s books
Cash Management
Techniques
 Acceleration of receipts
 lockbox arrangement
 reduce float by having payments sent to
post office boxes located near customers
– faster mail delivery
– faster check clearing within the same
Federal Reserve district
Cash Management
Techniques
 Acceleration of receipts
 preauthorized debit system
 allows a customer’s bank to periodically
transfer funds from that customer’s
account to a selling firm’s bank account for
the payment of bills
Cash Management
Techniques
 Acceleration of receipts
 concentration banking
 a technique used to move funds from many
bank accounts to a more central cash pool
in order to more effectively manage cash
Cash Management
Techniques
 Disbursement control
 centralized disbursement system
 more control, but can delay payments
Cash Management
Techniques
 Disbursement control
 centralized disbursement system
 more control, but can delay payments
 zero-balance account (ZBA)
 special account used for disbursements
that has a balance of zero when there is no
disbursement activity
Cash Management
Techniques
 Disbursement control
 controlled disbursement accounts (CDA)
– checking accounts in which funds are not
deposited until checks are presented for
payment, usually on a daily basis
Cash Management
Techniques
 Marketable securities
 securities that can be sold on short notice
without loss of principal or original
investment
 substitute for cash balances
 temporary investment
– finance seasonal or cyclical operations
– amass funds to meet financial requirements
in the near future
Credit Management
 Credit policy
 a set of decisions that include a firm’s
credit standards, credit terms, methods
used to collect credit accounts, and credit
monitoring procedures
Credit Management
 Credit standards
 standards that indicate the minimum
financial strength a customer must have to
be granted credit
Credit Management
 Terms of credit
 the payment conditions offered to credit
customers
 length of credit period and any cash
discounts offered
Credit Management
 Credit period
 the length of time for which credit is
granted
 after that time, the credit account is
considered delinquent
Credit Management
 Cash discount
 a reduction in the invoice price of goods
offered by the seller to encourage early
payment
Credit Management
 Collection policy
 the procedures followed by a firm to collect
its accounts receivables
Credit Management
 Receivables monitoring
 the process of evaluating the credit policy
to determine if a shift in the customers’
payment patterns occurs
Credit Management
 Receivables monitoring
 1. Days sales outstanding (DSO)
 the average length of time required to
collect accounts receivable
 also called the average collection period
Credit Management
 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 is
current and the proportion that is past due
for given lengths of time
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
Credit Management
 Analyzing proposed changes in credit
policy
 Use NPV analysis the same as for capital
budgeting analysis (Chapter 13)
 Timing of the cash inflows and cash
outflows is important to the analysis
Inventory Management
 Raw materials
 inventories purchased from suppliers that
will ultimately be transformed into finished
goods
 Work in-process
 inventory in various stages of completion
Inventory Management
 Finished goods
 inventories that have completed the
production process and are ready for sale
 Optimal inventory level
 sustain operations at the lowest possible
cost
Inventory Management
 Stockout
 when a firm runs out of inventory and
customers arrive to purchase the product
Inventory Management
 Inventory costs
 carrying costs
 storage, insurance, use of funds,
depreciation, etc…
 ordering costs
 costs of placing an order
 the cost of each order is generally fixed
regardless of the average size of inventory
Inventory Management
 Total inventory costs (TIC)
=
Total
carrying
costs
+
Total
ordering
costs
 Carrying cost  Ave rageunits   Cost pe r  Numbe r of 
  
  
  

 
 pe r unit   in inve ntory   orde r   orde rs 

C  PP 

Q
 
2

O

T
 
Q
Inventory Management
 Economic order quantity (EOQ)
 the optimal quantity that should be
ordered
 it is the quantity that will minimize the
total inventory costs
Inventory Management
 EOQ model
 formula for determining the order quantity
that will minimize total inventory costs
2O T
EOQ 
C  PP
Inventory Management
 EOQ model extensions
 reorder point
 the level of inventory at which an order
should be placed
Inventory Management
 EOQ model extensions
 reorder point
 the level of inventory at which an order
should be placed
 safety stocks
 additional inventory carried to guard
against changes in sales rates or
production/shipping delays
Inventory Management
 EOQ model extensions
 quantity discount
 a discount from the purchase price offered
for inventory ordered in large quantities
 seasonal adjustments
 EOQ computed separately for each season
to account for sales variations
Inventory Management
 Inventory control systems
 red-line method
 an inventory control procedure in which a
red line is drawn around the inside of an
inventory-stocked bin to indicate the
reorder point level
Inventory Management
 Inventory control systems
 computerized inventory control system
 a system of inventory control in which a
computer is used to determine reorder
points and to adjust inventory balances
Inventory Management
 Inventory control systems
 just-in-time system
 a system of inventory control in which a
manufacturer coordinates production with
suppliers so that raw materials or
components arrive just as they are needed
in the production process
Inventory Management
 Inventory control systems
 out-sourcing
 the practice of purchasing components
rather than making them in-house
Multinational Working
Capital Management
 Cash management
 speed up collections and slow down
disbursements
 shift cash as rapidly as possible to those
areas where it is needed
 put temporary cash balances to work
earning positive returns
Multinational Working
Capital Management
 Credit management
 credit policy is more important
 risk of default
 political and legal collection constraints
 exchange rate changes between sale and
time receivable is collected
Multinational Working
Capital Management
 Inventory management
 concentrate inventory or distribute ?
 costs versus distribution schedules
 exchange rates affect inventory
 threat of expropriation
 tax effects
End of Chapter 15
Working Capital
Management