Working Capital Management

Glossary

Working Capital Concept

Working Capital: Difference between current assets and current liabilities. It is an indication of
liquidity and the ability to meet current obligations.
Gross Working Capital: The Firm’s investment in current assets.
Net Working Capital: Current Assets – Current Liabilities. Net working capital is the amount
of current assets not financed by long term liabilities.
Working Capital Management: The administration of the firm’s current assets and the
financing needed to support current assets.
Working Capital Policy: It refers the target levels for each category current asset account and
how current assets will be financed.
Working Capital Includes: A firm’s investment in short term assets includes
 Cash
 Marketable Securities
 Inventory
 Accounts Receivables
Working capital doesn’t include:
 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
Impact of Liquidity: Greater current asset levels generate more liquidity remaining all other
factors constant.
Return on Investment = Net Profit /Total Assets
Current Assets = Cash + Rec. + Inv.
Return on Investment = Net Profit / (Current + Fixed Assets)
Impact on Expected Profitability: As current asset levels decline, total assets will decline and
the ROI will rise.
Impact on Risk: Risk increases as the level of current assets are reduced.
 Decreasing cash reduces the firm’s ability to meet its financial obligations. More risk!
 Stricter credit policies reduce receivables and possibly lose sales and customers. More
risk!
 Lower inventory levels increase stockouts and lost sales. More risk!
  Profitability varies inversely with liquidity.
 Profitability moves together with risk. (risk and return go hand in hand!)
The Requirement for External Working Capital Financing
 Seasonal variations
 Business cycles
 Expansion requires more working capital

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.
Restricted current asset investment policy: holdings of cash and marketable securities and
inventories are minimized.
Moderate current asset investment policy: a policy that is between the relaxed and restricted
policies.
Permanent current asset: current asset balances that do not change due to seasonal or economic
conditions. These balances exist even at the difficult conditions of a firm’s business cycle.
Temporary current asset: current assets that fluctuate with seasonal or economic variations in a
firm’s business.
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 non-
spontaneous sources of funds.
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.
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.
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.
Cash conversion cycle = Inventory conversion period + Receivables collection period -
Payables deferral period

Managing Cash Inflow and Outflow

The 3 temporary reasons to hold cash –
 The purpose of Speculation.
 The purpose of Precaution.
 The Purpose of making Transactions.
Expectation Theory: Expectation theory holds that the differences in per-period required
returns among securities of various maturity dates reflect expectations that inflation will change
overtime.
Market Segmentation Theory: This theory holds that investors have preferences for securities
of different maturity & the yield curve levels & shape reflect the availability of maturities
relative to those preferences.
Market Preference Theory: This theory holds that the shape of the yield curve is merely a
reflection of the differences in interest rate risk among maturities.
A list of Money Market Instruments
 Treasury Bill
 Commercial Paper
 Certificate of Deposit
 Bankers Acceptance
 Repurchase Agreements (repos)
 Eurodollars
Float: Float is defined as the difference between the book balance & the bank balance of an
account.
Float = Bank Balance – Book Balance of an Account.
Transfer cost per year = Transfer per year × Cost per transfer
Total Float = Daily deposit × Days available or total delay
Opportunity cost per year = Total Float × Rate of Required return
Total cost per year = Transfer cost per year + Opportunity cost per year
Days available or Total delay = Total Duration of processing

Inventory Management
Raw material: Raw materials are purchased material or goods required for production.
Work-in-progress: It takes time to convert raw material into finished product.
Finished product: Finished product is stocked to be ready for customer sales.
Spares: Spares are held as an after-sales service for products supplied to customers.
Holding/Carrying Costs: Holding or carrying costs are associated with keeping stock over time.
Holding or carrying costs includes interest, insurance, taxes, depreciation, obsolescence,
deterioration, spoilage, pilferage, breakage, warehousing, opportunity costs etc.
Ordering Costs: Ordering costs includes determining how much to order, cost of invoices,
clerical labor costs of processing orders, temporary storage, inspection and return of poor quality
products, transport costs, handling costs etc.
Stockout/Shortage Costs: A stockout occurs when we have insufficient stock to supply
customers.
Set-up Costs: Set-up costs results when changing over from one fixture type to another,
involved with product changes, cost of labour and fixture.
First-In-First-Out (FIFO): This method assumes that the first unit making its way into
inventory is the first sold. FIFO gives us a better indication of the value of ending inventory (on
the balance sheet), but it also increases net income because inventory that is several
months/years old is used to value cost of goods sold. Increasing net income is good, but at the
same time it also has the potential to increase the amount of taxes that a company must pay.
Last-In-First-Out (LIFO): This method assumes that the last unit making its way into
inventory is sold first. The outdated inventory is therefore left over at the end of the accounting
period. LIFO is not a good indicator of ending inventory value because the left over inventory
might be extremely old and perhaps obsolete. This results in a valuation that is much lower than
today's prices. LIFO results in lower net income because cost of goods sold is higher.
Average Cost (AVECO): This method is quite straight forward, it takes the weighted average
of all units available for sale during the accounting period and then uses that average cost to
determine the value of cost of goods sold and ending inventory. Average cost produces results
are somewhere in the middle between FIFO and LIFO. In the absence of inflation, all of the three
inventory valuation methods will produce the exact same results.
Just-in-time control system: JIT is also known as stockless production or lean production
system. The idea behind the system is that the firm should keep a minimum level of inventory on
hand, relying on suppliers to furnish inventory just in time' when required. This is contrary to the
traditional inventory philosophy, which is sometimes referred to as a 'Just-In-Case' system,
which keeps high levels of safety stocks to ensure that production will not be interrupted.
Raw Materials Turnover = Raw Materials Used in Production /Average Inventory of Raw
Material Annual Work-in-Progress Turnover = Volume of Finished Goods /Average
Inventory of Work -in -Progress
Finished Goods Turnover = Cost of Goods Sold /Average Inventory of Finished Goods
Re-Order Time: 'Re-order Time' or simply what is the time required to be re-supplied the
stock. The longer the time the greater is the amount of inventory a firm has to carry. The re-order
time begins at the moment a firm determines that it needs more inventory.
Variable Costs: Variable costs (VC) are those costs which vary directly with the volume of
production, such as raw materials and direct labour and production costs included in costs of
goods sold, as well as selling expenses, freight, and other costs that increase as' volume
increases.
Fixed Costs: Fixed costs are those business costs that are not directly related to the level of
production or output. In other words, even if the business has a zero output or high output, the
level of fixed costs will remain the same. Fixed costs (FC) are normally unavoidable, such as
rent, staff salary, insurance, depreciation, research and development expenses, general and
administrative expenses etc.
Semi-Variable Costs: Practically, there are some costs which are fixed in nature but which
increase when output reaches certain levels. These are largely related to the overall scale and
complexity of the business. These costs have both, a fixed and a variable portion, such as
overheads, cost of utilities, advertising expenses etc. They are separated in their constituent parts
and are termed as Semi-Variable" costs.
Opening Inventory + Purchases = Goods available for sale- Closing inventory = COGS

Economic order quantity (EOQ)

Economic order quantity (EOQ): It is the ideal order quantity a company should purchase to
minimize inventory costs such as holding costs, shortage costs, and order costs. 
EOQ = Square Root (2 S x D)/C)
D= number of units sold, consumed or depleted per year
S= cost per order
C= unit carrying cost
Q= quantity ordered each time
D/Q= number of orders per year
Q/2 = average inventory (i.e. maximum inventory = Q, minimum = 0)
TC = Annual ordering cost + Annual carrying cost
TC = (No. of orders x cost per order) + (average inventory x unit carrying cost)
TC = ((D/Q) x S) + ((Q/2) x C)

Current Liabilities Management

Spontaneous Liabilities: Spontaneous liabilities arise from the normal course of business. The
two major spontaneous liability sources are accounts payable and accruals.
Accounts payable: Accounts payable are the major source of unsecured short-term financing for
business firms.
Payment float time: The time it takes after the firm mails its payment until the supplier has
withdrawn spendable funds from the firm’s account. The firm’s goal is to pay as slowly as
possible without damaging its credit rating.
Credit Sale: Credit sale is the way to transfer of ownership of goods and services to a customer
in which the amount owed will be paid at a later date. In other words, credit sales are those
purchases made by the customers who do not render payment in full at the time of purchase.
Credit terms offered by suppliers allow a firm to delay payment for its purchases.
Cash Discount: A cash discount is a reduction in the amount of an invoice that the seller allows
the buyer. This discount is given in exchange for the buyer paying the invoice earlier than its
normal payment date.
Stretching accounts payable simply involves paying bills as late as possible without damaging
credit rating.
Accrued revenue is a sale that has been recognized by the seller, but which has not yet been
billed to the customer.
A line of credit is an agreement between a commercial bank and a business specifying the
amount of unsecured short-term borrowing the bank will make available to the firm over a given
period of time.
Revolving Credit: A RCA is nothing more than a guaranteed line of credit.
Commitment Fee: The bank guarantees the funds will be available, they typically charge a
commitment fee which applies to the unused portion of the borrower’s credit line.
A compensating balance is simply a certain checking account balance equal to a certain
percentage of the amount borrowed (typically 10 to 20 percent).

Cash—Credit and Short‐Term Financial Instruments

Banker’s acceptance: A banker’s acceptance (BA) is an instrument created when a bank
guarantees an international transaction using a letter of credit. The bank sells the BA to investors
at a discount and accepts the responsibility for repaying the loan, protecting the investor from
default risk. BAs are generally issued for up to six months.
Repos: A repo (repurchase agreement) is an investment contract between a brokerage firm or
bank and an investor (usually a financial institution or large corporation). The repo is sold with
an agreement for repurchase at a future date at a set price, with most settling overnight.
Commercial paper (CP): Commercial paper involves unsecured notes issued by companies
with high credit ratings. Maturities are from a few days to 270days. Most issuers use CP as a
continuing financing source and reissue the CP at the time of redemption.
Money market mutual funds (MMFs): Money market mutual funds are pools of various types
of short‐term investments that offer shares to corporate investors. A significant benefit of MMFs
is that relatively small units of funds can be placed, allowing the earning of some yield even to
the small corporate investor.
U.S. Treasury securities: Securities of the U.S. government include Treasury bills and notes
(those with maturities from 1to 10 years); and Treasury bonds, with maturities from 10 to 30
years. These instruments are highly liquid and risk‐free, although the longer the maturity, the
greater the risk that inflation could impact the real return.
US.Agencies: Although not generally well known, there are various federal agencies that issue
securities to fund their operations.
Municipal securities: State and local government municipal securities ( munis ) have the
attraction of having their interest payment exempt from taxes, although yields are less than those
of other instruments.
Asset‐based financing uses a company’s accounts receivable and/or inventory as collateral in
situations where the lender is uncertain of the borrower’s creditworthiness.
Factoring of receivables involves the direct collection from the borrower’s customers, who are
instructed on the invoice to remit to a specifi ed address controlled by the lender.
Inventory financing is used in industries with expensive equipment and medium‐length sales
cycles. The lender uses the equipment as collateral, and the loan is paid as sales are made to
customers of the borrower.
Sweep: A sweep automatically moves any DDA (demand deposit account or checking account)
balances into an interest‐bearing account outside of the bank.

Cash and Liquidity Management

Disbursement Float: Checks written by a firm generate disbursement float, causing a decrease
in the firm’s book balance but no change in its available balance.
Disbursement Float =Firm’s available balance - Firm’s book balance
Float: Firm’s available balance - Firm’s book balance
Checks received by the firm create collection float. Collection float increases book balances but
does not immediately change available balances.
Collection float: Firm’s available balance - Firm’s book balance
Cost of the Float: The basic cost of collection float to the firm is simply the opportunity cost of
not being able to use the cash.
Cash Concentration: It is the practice of and procedures for moving cash from multiple banks
into the firm’s main accounts.

Credit and Inventory Management

Trade Credit: When credit is granted, an account receivable is created such as receivables
include credit to other firms, called trade credit.
Consumer Credit: Credit granted consumers, called consumer credit. Consumer credit
is personal debt taken on to purchase goods and services.
Credit analysis: It refers the process of determining the probability that customers will not pay.
Collection policy: The procedures followed by a firm in collecting accounts receivable.
Lockbox: A lockbox is a post office box number to which some/all of the firm’s customers are
instructed to send their cheques.
Depository transfer Cheque (DTC): This document instructs to send funds from one bank to
another.
ACH(Automatic Clearing House) Electronic transfer: It is an electronic version of the
depository transfer cheque.

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