Professional Documents
Culture Documents
Learning Objectives:
Upon completing this unit, you will be able to
define the operating and cash cycles, explain how they are used
understand the concept of working capital
distinguish between permanent and temporary working capital
identify the components of working capital
understand the need and determinants of working capital
identify the three current asset financing strategies
1.1 Introduction
Every running business needs working capital. Even a business which is fully equipped
with all types of fixed assets required is bound to collapse without (i) adequate supply of
raw materials for processing; (ii) cash to pay for wages, power and other costs; (iii)
creating a stock of finished goods to feed the market demand regularly; and, (iv) the
ability to grant credit to its customers. All these require working capital. Working capital
is thus like the lifeblood of a business. The business will not be able to carry on day-to-
day activities without the availability of adequate working capital.
Since current assets typically earn a lower return than long-term fixed assets, an overly
strong liquidity position could lower firm profitability. An effective working capital
policy carefully balances the need to have sufficient liquidity with the need to earn an
attractive return on invested capital. Firms may adopt more aggressive working capital
management policies that have less of a drag on firm profitability, but at higher levels of
risk.
Working capital management involves determining the firm’s policy for managing its
working capital, i.e., the firm’s current assets and current liabilities. The basic goal of
working capital management is to ensure that a firm is able to continue its operations and
that it has sufficient ability to satisfy both maturing short-term debt and upcoming
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operational expenses. It involves managing the firm’s cash, marketable securities,
receivables, inventories, accounts payable, and other short-term payables. Gross working
capital refers to the firm’s current assets used in operations, including such items as cash,
marketable securities, accounts receivable, and inventory. Net working capital refers to a
firm’s current assets minus its current liabilities.
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Working capital consists of four main components: cash, marketable securities,
inventory, and accounts receivables. For each type of asset, firms face a fundamental
trade-off: Current assets (that is, working capital) are necessary to conduct business and
the greater the holdings of current assets, the smaller the danger of running out, hence the
lower the firm’s operating risk. However, holding working capital is costly-if inventories
are too large, then the firm will have assets that earn a zero or even negative return if
storage and spoilage costs are high. And, of course, firms must acquire capital to buy
assets such as inventory; this capital has a cost, and this increase the downward drag from
excessive inventories (or receivables or even cash). So there is a pressure to hold the
amount of working capital to the minimum consistent with running the business without
interruption.
SELF-TEST QUESTIONS
1. Define the following terms: gross working capital and net working capital.
1.4
2. Define days sales outstanding (DSO). What can be learned from it? How it is
affected by sales fluctuation?
3. What is the cash conversion period? What is its equation?
4. What are the principal components of working capital?
5. Selam Corporation has a DSO of 17 days. The company average Br 3,500 in
credit sales each day. What is the company’s average account receivable?
The operating cycle creates the need for current assets (working capital). However, the
need does not come to an end after the cycle is completed. It continues to exist. To
explain this continuing need of current assets, a distinction should be made between
permanent and temporary working capital.
Permanent working capital. This component represents the value of the current
assets required on a continuing basis over the entire year, and for several years.
Permanent working capital is the minimum amount of current assets, which is
needed to conduct a business even during the dullest season of the year. The
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minimum level of current assets is called permanent or fixed working capital as
this part is permanently blocked in current assets. This amount varies from year to
year, depending upon the growth of the company and the stage of the business
cycle in which it operates. It is the amount of funds required to produce the goods
and services, which are necessary to satisfy demand at a particular point of time. It
represents the current assets, which are required on a continuing basis over the
entire year. It is maintained as the medium as to continue the operations at any
time.
Permanent
Working Capital
DO LL AR AM O UNT
TIME
Temporary working capital: Contrary to the above you will find that
temporary working capital represents a certain amount of fluctuations in the
total current assets during a short period. These fluctuations are increased or
decreased and are generally cyclical in nature. Variable working capital is the
amount of additional current asset that are required to meet the seasonal needs
of a firm, so is also called as the seasonal working capital. For example:
additional inventory will be required for meeting the demand during the period
of high sales When the peak period is over variable working capital starts
decreasing or very little during the normal period. It is temporarily invested in
Temporary
Working Capital
The amount of current assets that varies
DOLLAR AM OUNT
TIME
current assets. Say for an example a shopkeeper invests more money during
winter season because he/ she require to keep more amount of stock of woolen
cloths. The same happens in a sugar factory how: the factory manager buys
more quantity of sugarcane during the harvesting season and they continuously
stops for some time.
The need for working capital to run the day-to-day business activities cannot be
overemphasized. We will hardly find a business firm, which does not require any amount
of working capital. Indeed, firms differ in their requirements of the working capital. We
know that a firm should aim at maximizing the wealth of its shareholders. In its endeavor
to do so, a firm should earn sufficient return from its operations. Earning a steady amount
of profit requires successful sales activities. The firm has to invest enough founds in
current for generating sales. Current assets are needed because sales do not convert into
cash instantaneously. There is always an operating cycle involved in the conversion of
sales into cash.
A firm should plan its operations in such away that it should have neither too much nor
too little working capital. The total working capital requirement is determined by a
variety of factors. These factors, however, affect different enterprises differently. They
also vary from time to time. In general, the following factors are involved in a proper
assessment of the quantum of working capital required.
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hand require sizable working capital along with fixed investments, as they have to
build up the inventories.
Terms of sales and purchases. Credit sales granted by the concerns to its
customers as well as credit terms granted by the suppliers also affect the working
capital. If the credit terms of the purchases are more favorable and at the same
time those of sales less liberal, less cash will be invested in the inventory. With
more favorable credit terms, working capital requirements can be reduced.
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Seasonal variation. The inventory of raw materials, spares and stores depends on
the condition of supply. If the supply is prompt and adequate the firm can manage
with small inventory. However, if the supply were unpredictable and scant then
the firm, to ensure the continuity of production, would have to acquire stocks as
and when they are available and carry larger inventory on an average.
Market conditions. The degree of competition prevailing in the market place has
an important bearing on working capital needs. When competition is keen, a larger
inventory of finished goods is required to promptly serve customers who may not
be inclined to wait because other manufacturers are ready to meet their needs.
The assessment of the working capital should be accurate even in the case of small and
micro enterprises where business operation is not very large. We know that working
capital has a very close relationship with day-to-day operations of a business. Negligence
in proper assessment of the working capital, therefore, can affect the day-to-day
operations severely. It may lead to cash crisis and ultimately to liquidation. An inaccurate
assessment of the working capital may cause either under-assessment or over-assessment
of the working capital and both of them are dangerous.
SELF-TEST QUESTIONS
1. What is meant by the term “permanent current assets”?
2. What is meant by the term “temporary current assets”?
3. List at least four factors affecting the level of working capital
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requirement.
Consequences of under assessment of working capital
Growth may be stunted. It may become difficult for the enterprise to undertake
profitable projects due to non-availability of working capital.
Implementation of operating plans may become difficult and consequently the
profit goals may not be achieved.
Cash crisis may emerge due to paucity of working funds.
Optimum capacity utilization of fixed assets may not be achieved due to non-
availability of the working capital.
The business may fail to honor its commitment in time, thereby adversely
affecting its credibility. This situation may lead to business closure.
The business may be compelled to buy raw materials on credit and sell finished
goods on cash. In the process it may end up with increasing cost of purchases and
reducing selling prices by offering discounts. Both these situations would affect
profitability adversely.
Non-availability of stocks due to non-availability of funds may result in
production stoppage.
While underassessment of working capital has disastrous implications on business,
over assessment of working capital also has its own dangers.
Working capital is very essential for success of a business and, therefore, needs efficient
management and control. Each of the components of the working capital needs proper
management to optimize profit.
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1.7 Efficiency of Working Capital Management
With the financial manager’s goal being to maximize the value of the firm, each of the
decisions related to working capital is intended to shorten the cash conversion cycle and
improve the firm’s liquidity.
Two commonly used tools to measure the working capital management efficiency are the
operating cycle and the cash conversion cycle.
Operating Cycle: The operating cycle is the average period of time required for a
business to make an initial outlay of cash to produce goods, sell the goods, and receive
cash from customers in exchange for the goods
The operating cycle begins when the firm receives the raw materials it purchased and
ends when the firm collects cash payments on its credit sales. Two measures—days’
sales outstanding and days’ sales in inventory—help determine the operating cycle.
Days’ sales in inventory (DSI). It shows how long the firm keeps its inventory
before selling it. It is the ratio of the inventory balance to the daily cost of goods
sold. The quicker a firm can move out its raw materials as finished goods, the
shorter the duration that the firm holds it inventory, and the more efficient it is in
managing its inventory. This ratio is also called inventory conversion period or
average age of inventory.
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Days’ sales outstanding (DSO). It estimates how long it takes on average for the
firm to collect its outstanding accounts receivable balance. This ratio is also called
the average collection period (ACP). An efficient firm with good working capital
management should have a low average collection period compared to its industry.
The operating cycle is calculated by summing the days’ sales outstanding and the days’
sales in inventory.
Operating Cycle DSO DSI
Cash Conversion Cycle. The cash conversion cycle is related to the operating cycle, but
it does not start until the firm actually pays for its inventory. The cash conversion cycle is
the length of time between the cash outflow for materials and the cash inflow from sales.
To measure the cash conversion cycle, we need another measure called the day’s
payables outstanding.
Days’ payable outstanding (DPO) shows how long a firm takes to pay off its
suppliers for the cost of inventory.
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Payables Turnover = Net Credit Purchases
Average Payables
The cash conversion cycle is then calculated by summing the days’ sales
outstanding and the days’ sales in inventory and subtracting the days’ payables
outstanding.
CashConversionCycle DSO DSI DPO
Example 1. Consider the following financial statement information for the Z Corporation
(all in 000’s)
The company bought and sold off inventory 3.28 times during the year.
Instruction:
a. What is the length of the firm’s cash conversion cycle?
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b. If the Company’s annual sales are Br 3,375,000 and all sales are on credit, what
is the firm’s investment in accounts receivable?
c. How many times per year does Dynamic turn over its inventory? Calculate the
average investment in inventory.
Solution
a. Cash cycle = Operating cycle –Payable period
= (75 days +38 days) – 30 days
=113 days – 30 days
= 83 days
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ITO= COGS or Net sales
Inventory Inventory
ITO= Net sales
Inventory
Inventory = Net sales = Br 3,375,000/4.8 = Br 703,125
ITO
Managers can reduce their firm’s cash conversion cycle and free up cash for other
activities by collecting receivables more promptly, reducing the inventory processing
time, or lengthening the time taken to pay suppliers.
A firm can reduce its accounts receivables collection period by more
aggressively collecting outstanding receivables or by tightening its credit
policy.
A firm can reduce its inventory processing period by employing more effective
inventory management techniques that involve better forecasting of future
demand and by working more closely with its suppliers.
A firm can increase the accounts payable payment period by delaying payment
to its suppliers or by increasing its disbursement float. The firm must balance
any delays in paying its suppliers with potential damages in its relationships
with suppliers and with the loss of any discounts received by paying sooner.
When managing working capital accounts, financial managers want to do the following:
Delay paying accounts payable as long as possible without suffering any
penalties.
Maintain minimal raw material inventories without causing manufacturing
delays.
Use as little labor as possible to manufacture the product while producing a
quality product.
Maintain minimal finished goods inventories without losing sales.
Offer customers the most attractive credit terms possible on trade credit to
maximize sales while minimizing the risk of nonpayment.
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Collect cash payments on accounts receivable as fast as possible to close
the loop.
The nature of many businesses may cause seasonal variations in a firm’s current assets.
Working capital management approaches differ in terms of how the firm finances these
seasonal variations in current assets. Three common ways of dealing with such seasonal
variations are the maturity-matching, conservative, and aggressive approaches.
Aggressive Approach: All current assets, both temporary and permanent, are
financed with short-term financing. This approach relies more heavily on
short-term financing than do the other approaches. Only fixed assets are
financed with long-term debt and equity funds. This could result in liquidity
problems if sales decline in the future.
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Conservative Approach: Except for automatic or “spontaneous” financing
provided by accounts payable and accrued liabilities. All financing is done
through long-term debt and equity funds. This approach relies more heavily on
long-term financing than do the other approaches. At times, firms will have
excess liquidity, when available funds exceed necessary current asset levels.
During this time the firm will have large cash balances and will probably seek
to invest the excess cash in marketable securities.
How would an increase in short-term interest rates affect a firm under the conservative,
maturity-matching, and aggressive approaches to managing working capital?
Under the maturity-matching approach, the firm has essentially hedged against
unexpected changes in short-term interest rates. If short-term interest rates
increase, the increases in the return earned on an equal amount of short-term
current assets should offset the increased cost of short-term funds.
Under the aggressive approach, increases in short-term interest rates will
require the firm to refinance more current assets at the new higher rates. The
firm could be in jeopardy of being shutoff by suppliers.
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Under the conservative approach, the firm uses more long-term financing and
less short-term financing to finance current assets and is therefore less
vulnerable to increases in short-term rates than under the other approaches. If
short-term interest rates rise, the firm has fewer short-term sources that it will
need to refinance at the higher rates.
Discussion Questions
1. Distinguish between permanent and temporary working capital.
2. Define the following terms: inventory conversion period, receivables conversion
period, and payables deferral period. Give the equation for each term.
3. What are some actions the firm can take to shorten its cash conversion cycle?
4. What are the factors involved in the assessment of the quantum of working capital
required?
5. What is the fundamental trade-off that managers face when managing working
capital?
Exercises
1. Shalom Industries sells on terms of 3/10, net 30. Total sales for the year are Br
900,000. Forty percent of customers pay on the 10th day and take discounts; the other
60% pay, on average, 40 days after their purchases. Assume 360 days per year.
Instruction:
a. What is the days sales outstanding (DSO)?
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c. What would happen to average receivables if Shalom toughened up on its
collection policy with the result that all non-discount customers paid on the
30th day?
Instruction:
a. What is the length of Dynamic’s cash conversion cycle?
c. By what amount Dynamic reduces its working capital financing needs if it was
able to stretch its payables deferral period to 35 days?
3. Zenith Corporation is trying to determine the effect of its inventory turnover ratio and
days sales outstanding (DSO) on its cash flow cycle. Zenith’s 2006 sales (all on
credit) were Br 150,000, and it earned a net profit of 6 percent, or Br 9,000. It turned
out its inventory 6 times during the year, and its DSO was 36 days. The firm had fixed
assets totaling Br 40,000. Zenith’s payables deferral period is 40 days. Assume 360
days per year.
Instruction:
a. Calculate Zenith’s cash conversion cycle.
c. Suppose Zenith’s managers believe that the inventor turnover can be raised to
8 times. What would Zenith’s cash conversion cycle, total assets turnover, and
ROA have been if the inventory turnover had been 8 for 2006?
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