CHAPTER 17

Working Capital Management

n Alternative working capital policies
n Cash management
n Inventory and A/R management
n Trade credit
n Bank loans
16-1
Working capital terminology
n Gross working capital – total current assets.
n Net working capital – current assets minus
non-interest bearing current liabilities.
n Working capital policy – deciding the level
of each type of current asset to hold, and
how to finance current assets.
n Working capital management – controlling
cash, inventories, and A/R, plus short-term
liability management.
16-2
Selected ratios for SKI Inc.
SKI Ind Avg
Current ratio 1.75x 2.25x
Debt/Assets 58.76% 50.00%
Turnover of cash & securities 16.67x 22.22x
Days sales outstanding 45.63 32.00
Inventory turnover 4.82x 7.00x
Fixed assets turnover 11.35x 12.00x
Total assets turnover 2.08x 3.00x
Profit margin 2.07% 3.50%
Return on equity 10.45% 21.00%
16-3
Current Asset Investment
Policy
n Relaxed – relatively large amounts of cash,
marketable securities and inventories and
liberal credit policy results in high level of
receivables
n Restricted – holdings of cash, marketable
securities, inventories and receivables are
constrained
n Moderate – between relaxed and
restricted.
16-4
Working capital financing policies
n Moderate – Match the maturity of the
assets with the maturity of the
financing.
n Aggressive – Use short-term financing
to finance permanent assets.
n Conservative – Use permanent capital
for permanent assets and temporary
assets.

16-5
Moderate financing policy
$ Temp. C.A.
S-T
Loans

Perm C.A. L-T Fin:

Stock,
Bonds,
Fixed Assets Spon. C.L.

Years
Lower dashed line would be more aggressive.
16-6
Conservative financing policy
Marketable
$ securities
Zero S-T
Debt

L-T Fin:
Perm C.A. Stock,
Bonds,
Spon. C.L.
Fixed Assets
Years
16-7
 Cash conversion cycle
n The cash conversion cycle focuses on the
length of time between when a company
makes payments to its creditors and when a
company receives payments from its
customers.

Inventory Receivables Payables

CCC = conversion + collection – deferral .
period period period

16-8
 Cash conversion cycle
Inventory Receivables Payables
CCC = conversion + collection deferral
period period period
Payables
Days per year Days sales
CCC = + deferral
Inventory turnover outstanding period
365
CCC = + 46 - 30
4.82
CCC = 76 + 46 - 30 = 92 days.

16-9
Cash doesn’t earn a profit, so
why should the firm hold it?
1. Transactions – must have some cash to
operate.
2. Precaution – “safety stock”. Reduced by
line of credit and marketable securities.
3. Compensating balances – for loans and/or
services provided.
4. Speculation – to take advantage of
bargains and to take discounts. Reduced
by credit lines and marketable securities.

16-10
The goal of cash management
n To meet the above objectives,
especially to have cash for
transactions, yet not have any excess
cash.
n To minimize transactions balances in
particular, and also needs for cash to
meet other objectives.

16-11
Case in Point – First Farms
Corporation
n Group activity: - In groups of 4, analyze
the financial statements of First Farms
corporation from 1993 – 1995. Answer
the questions that follow.

16-12
First Farms Corporation

16-13
First Farms Corporation

16-14
First Farms Corporation

16-15
First Farms Corporation

16-16
First Farms Corporation

16-17
First Farms Corporation

16-18
First Farms Corporation

16-19
First Farms Corporation

16-20
Management of Cash and
Marketable Securities

16-21
Cash and Cash Equivalents
n Currency
n Demand Deposits
n Float (refer to problem 17 -9)
n Marketable Securities

16-22
Cash budget
n Forecasts cash inflows, outflows, and
ending cash balances.
n Used to plan loans needed or funds
available to invest.
n Can be daily, weekly, or monthly,
forecasts.
n Monthly for annual planning and daily for
actual cash management.

16-23
Managing Receipts and
Disbursements
n Receipts
n Cash must be deposited to the bank account
at the shortest time with the minimum cost
n Internal controls
n Efficient reporting system that allows real time
updating
n Disbursements
n Centralization of payments
n Playing the float
n Cross checking of all payments

16-24
Minimizing cash holdings
n Use a lockbox
n Insist on wire transfers from customers
n Synchronize inflows and outflows
n Reduce need for “safety stock” of cash
n Increase forecast accuracy
n Hold marketable securities
n Negotiate a line of credit

16-25
Cash Management System

Disbursements

Financing of
shortages Firm Investments of
excess funds

Receipts

16-26
Determining Optimum Cash
Balance
n Baumol Model
n Expenditures occur evenly throughout the
period.
n Holding cost for cash is the income
foregone on the cash held or the cost of
financing the cash balance.
n Short term investments are alternatives to
cash

16-27
Baumol Model
𝟏
𝟐𝒃𝑻 𝟐
𝑪=
𝒊
n

16-28
Baumol Model
n

16-29
Illustration
n UP Foundation pays honorarium to 500
faculty members at P30,000 per year per
faculty. Investments in short term
securities earn 13% and cost per transfer
is estimated at P500.
a. How much should be the optimal size of
cash transfer?
b. How much is the total cost of cash
transfer?
16-30
Miller-Orr Model
n Does not set a single valued target cash but
rather a range within which the cash balance is
to be maintained.
n Seeks to minimize the expected cost of holding
cash by making sure that cash balance does
not exceed the upper limit nor fall below the
lower limit.
n Cash Return Point is the level to which cash is
to be adjusted whenever cash holdings falls
below the lower limit or exceeds the upper
limit.

16-31
Miller Orr Model

16-32
Determining Optimum Cash
Balance
n Miller-Orr Model
n The distribution of the daily cash changes is at
least approximately normal.
n The transfer cost between cash and the
portfolio is at a given fixed cost
n The transfer between cash and the portfolio
can be implemented instantaneously
n The minimum cash balance is determined
outside the model and depends on the ability
of the firm to source funds externally as
required.

16-33
Miller-Orr Model
n

16-34
Miller-Orr Model
n UL = 3z + LL
n Illustration

16-35
Miller-Orr Model Illustration
n The minimum cash balance of $20,000 is required
at ABC Co, and transferring money to or from the
bank costs $50 per transaction. Inspection of daily
cash flows over the past year suggests that the
standard deviation is $3,000 per day, and hence
the variance (standard deviation squared) is $9
million. The interest rate is 0.03% per day.
n Calculate:
n the spread between the upper and lower limits
n the upper limit
n the return point (target cash balance)

16-36
Inventory costs
n Types of inventory costs
n Carrying costs – storage and handling costs,
insurance, property taxes, depreciation, and
obsolescence.
n Ordering costs – cost of placing orders, shipping,
and handling costs.
n Costs of running short – loss of sales or
customer goodwill, and the disruption of
production schedules.
n Reducing inventory levels generally reduces
carrying costs, increases ordering costs, and
may increase the costs of running short.
16-37
Fixed-order quantity models

n Determine order quantity to minimize

inventory costs
n Economic order quantity model (EOQ)
n Economic production quantity model (EPQ)
n Quantity discount model (QD)

16-38
 EOQ assumptions
n Demand is known & constant - no safety stock
is required
n Lead time (time between order placement and
arrival) is known & constant – no back order is
considered
n No quantity discounts are available
n Ordering (or setup) costs are constant
n All demand is satisfied (no shortages)
n The order quantity arrives in a single shipment

16-39
EOQ inventory profile

16-40
EOQ total costs
Total annual costs = annual ordering costs + annual holding costs

16-41
EOQ: Total cost equation
Q
Annual holding cost = H
2
D
Annaul ordering/setup cost = S
Q
D Q
Total cost at Q, TC Q = S + H
Q 2
where D : Annual Demand
S : Ordering/Setup cost per order
H : Holding cost per unit per year
D EOQ
Minimal cost at EOQ, TC EOQ = S + H
EOQ 2
2DS
where EOQ =
H
16-42
EOQ: reorder point

16-43
 EOQ example
Given:
n Annual demand = 60,000
n Ordering cost = $25 per order
n Holding cost = $3 per item per year
n Number of working days per year = 240
(a) What is the EOQ?
(b) What is the total cost at EOQ?
(c) What is the total number of orders placed in a year?
(d) What is the time between orders?
(e) What is the reorder point if lead time is 3 days?
(f) What is the reorder point if lead time is 5 days?

16-44
EOQ example continued

2DS 2 × 60000 × 25
(a) EOQ = = = 1000
H 3
EOQ D
(b) Total cost at EOQ = × H + × S
2 EOQ
1000 60000
= × 3 + × 25 = $3000
2 1000
Annual demand
(c) Total number of orders placed in a year =
EOQ
60000
= = 60
1000
Number of workings days in a year
(d) Time between orders =
Total number of orders placed in a year
240
= = 4 days
60
16-45
EOQ example continued

(e) If lead time is 3 days (lead time < time between orders)
Reorder point = Daily demand × Lead time
Annual demand 60000
Daily demand = = = 250
Number of working days in a year 240
Reorder point = 250 × 3 = 750
(f) If lead time is 5 days (lead time > time between orders)
Reorder point = Daily demand × Lead time - EOQ
Annual demand 60000
Daily demand = = = 250
Number of working days in a year 240
Reorder point = 250 × 5 1000 = 1250 1000 = 250

16-46
Elements of credit policy
1. Credit Period – How long to pay? Shorter
period reduces DSO and average A/R, but it
may discourage sales.
2. Cash Discounts – Lowers price. Attracts new
customers and reduces DSO.
3. Credit Standards – Tighter standards tend to
reduce sales, but reduce bad debt expense.
Fewer bad debts reduce DSO.
4. Collection Policy – How tough? Tougher
policy will reduce DSO but may damage
customer relationships.
16-47
Short-term credit
n Debt scheduled for repayment within 1 year.
n Major sources of short-term credit
n Accounts payable (trade credit)
n Bank loans
n Commercial loans
n Accruals
n From the firm’s perspective, S-T credit is
riskier than L-T debt.
n Always a required payment around the corner.
n May have trouble rolling over loans.

16-48
Advantages and disadvantages
of using short-term financing
n Advantages
n Speed
n Flexibility
n Lower cost than long-term debt
n Disadvantages
n Fluctuating interest expense
n Firm may be at risk of default as a result of
temporary economic conditions

16-49
What is trade credit?
n Trade credit is credit furnished by a
firm’s suppliers.
n Trade credit is often the largest source of
short-term credit, especially for small
firms.
n Spontaneous, easy to get, but cost can
be high.

16-50
Terms of trade credit
n A firm buys $3,000,000 net ($3,030,303
gross) on terms of 1/10, net 30.
n The firm can forego discounts and pay on
Day 40, without penalty.

Net daily purchases = $3,000,000 / 365

= $8,219.18

16-51
Breaking down trade credit
n Payables level, if the firm takes discounts
n Payables = $8,219.18 (10) = $82,192
n Payables level, if the firm takes no discounts
n Payables = $8,219.18 (40) = $328,767
n Credit breakdown
Total trade credit $328,767
Free trade credit - 82,192
Costly trade credit $246,575

16-52
Nominal cost of trade credit
n The firm loses 0.01($3,030,303)
= $30,303 of discounts to obtain
$246,575 in extra trade credit:

rNOM = $30,303 / $246,575

= 0.1229 = 12.29%

n The $30,303 is paid throughout the year,

so the effective cost of costly trade credit
is higher.
16-53
 Nominal cost of trade credit formula

Discount % 365 days

rNOM = ×
1 - Discount % Days taken - Disc. period
1 365
= ×
99 40 - 10
= 0.1229
= 12.29%

16-54
Effective cost of trade credit
n Periodic rate = 0.01 / 0.99 = 1.01%
n Periods/year = 365 / (40-10) = 12.1667
n Effective cost of trade credit
n EAR = (1 + periodic rate)N – 1
= (1.0101)12.1667 – 1 = 13.01%

16-55
Bank loans
n The firm can borrow $100,000 for 1
year at an 8% nominal rate.
n Interest may be set under one of the
following scenarios:
n Simple annual interest
n Installment loan, add-on, 12 months

16-56
Simple annual interest
n “Simple interest” means no discount or
add-on.

Interest = 0.08($100,000) = $8,000

rNOM = EAR = $8,000 / $100,000 = 8.0%

For a 1-year simple interest loan, rNOM = EAR

16-57
 Add-on interest
n Interest = 0.08 ($100,000) = $8,000
n Face amount = $100,000 + $8,000 = $108,000
n Monthly payment = $108,000/12 = $9,000
n Avg loan outstanding = $100,000/2 = $50,000
n Approximate cost = $8,000/$50,000 = 16.0%
n To find the appropriate effective rate, recognize
that the firm receives $100,000 and must make
monthly payments of $9,000 (like an annuity).

16-58
Add-on interest
From the calculator output below, we have:

rNOM = 12 (0.012043)
= 0.1445 = 14.45%

EAR = (1.012043)12 – 1 = 15.45%

INPUTS 12 100 -9 0
N I/YR PV PMT FV
OUTPUT 1.2043

16-59
Other Examples
n Coverall Carpets Inc. is planning to borrow
$12,000 from the bank. The bank offers the
choice of a 12 percent discount interest loan or
a 10.19 percent add-on, 1-year installment
loan, payable in 4 equal quarterly payments.
n What is the approximate (nominal) rate of interest
on the 10.19 percent add-on loan?
n What is the effective interest rate of the 10.19%
add- on loan?
n What is the effective rate of interest on the 12
percent discount loan?

16-60
Other Examples
n Suppose you borrow $2,000 from a
bank for one year at a stated annual
interest rate of 14 percent, with interest
prepaid (a discounted loan). Also,
assume that the bank requires you to
maintain a compensating balance equal
to 20 percent of the initial loan value.
n What effective annual interest rate are you
being charged?
16-61