Management of Working Capital a LEARNING OBJECTIVES At the end of this chapter, you should be able to: Explain what working capital is and the risk-return trade- off involved in managing a firm’s working capital % Describe the alternative working capital financing policies. % Explain the cash conversion cycle and how it is used to iency of working capital management. INTRODUCTION Managing the firm's working capital, that is its current assets and current liabilities, is one of the financial manager’s main functions, as working capital represents a significant Proportion of total assets. Current assets comprise mainly inventory, accounts receivable, marketable securities and cash while current liabilities comprise mainly accounts payable, accruals, creditors for expenses and bank overdraft. Working capital, or often referred to as net current assets, is usually defined as current assets minus current liabilities, For a firm to be liquid, or solvent, itis imperative that net current assets are positive. 101102 Financial Management for Beginners THE RISK-RETURN TRADE-OFF IN WORKING orking capital is related 10 a trade op ys : period 2 days) (64 +40 ~ 26 «78 days) Receive raw Pay cash Collection of materials, for purchased materials accounts receivable ‘EXAMPLE 2 Hydro Sdn Bhd settles its accounts payable on the 20th day after purchase. The average collection period is 30 days, and the average age of inventory is 60 days, The firm currently spends RM21.6 million on operating cycle investments annually. The firm is considering a plan that would stretch its accounts payable by another 20 days. IF the firm pays 10% per year for its financing, what annual savings can it realize by this plan, assuming no discount for early payment of accounts payable and a 360-day year. CCc = ICP +RCP - PDF = 60 days + 30 days ~ 20 days = 70 days4110 Financial Management for Beat Pe +30 days - 40 days Proposed CCC = 60 days bid | = 50 days ninccc = 70-50 Reduction i a aie perating cycle investment = RM21-6 million Annual of : RM21.6 million Daily expenditure = 360 days = RM60,000 | 6 = RM5g,000 x 20 days n in financing e ae . RM1.2 million 10% x RM1.2 million ;nual increase in profit i = RMI120,000 How to Reduce Cash Conversion Cycle ‘There are four ways in which the CCC can be shortened: 1. Increase inventory turnover but without causing any stockouts that result in lost sig ‘This will reduce the inventory conversion period. Improve debt collection procedures so as to collect cash outstanding faster but witha: ° pressurizing customers so sales will not be lost. This will reduce the receivable collection period. 3. Settle accounts payable in the slowest possible way but without damaging the fim credit rating, This will lengthen the payables deferral period. 4. Manage mail, processing and clearing time in such a way as to reduce them whe collecting from customers and to increase them when paying suppliers. CONCEPT QUESTIONS “ 1. Define working capital. 2. Explain risk-return trade-off 3. What are the commonly used working capital financing policies? 4. Define the cash conversion cycle, SUMMARY In managing off, which isCHAPTER 4 Management of Working Capital 111 not necessarily profitability, whereas a higher investment in current liabilities and the use fpf short-term funds increase profitability but not liquidity. Therefore, a balance must be ensured between liquidity and profitability which would contribute positively to firm value. ‘There are three commonly applied working capital financing policies: 1, Hedging principle, where assets are matched with liabilities 2, Conservative approach, where fixed and part of current assets are financed by long-term funds. 3. Aggressive approach, where short-term funds are used to a higher degree in financing current and even fixed assets. Financial managers must also compute the cash conversion cycle, which represents the length of time funds are tied up in working capital. The shorter the cycle the better the management of working capital. )) EXERCISES True or False 1. | management ofa firm's liquidity involves managementof the firm's investment | T in fixed and current assets and the financing ofthese assets. F 2. | The hedging principle involves matching the cash flow from an asset with the | T cash fiw requirements ofthe financing used. F 3. | Curent assets consist of cash, marketable securities, accounts receivable, | T notes payabie and inventories. | 4. | curent liabilities are represented by accounts payable, accruals, short-term | T investments and short-term loans. F 5. Working capital is commonly referred to as net current assets. 7. : 6. | The greater the firm's investment in current assets, the less the liquidity. iu 7. Current liabilities can reduce the risk of insolvency of the firm. 7 a 8. | Temporary current assets are assets that fluctuate with seasonal or cjcical | T variations in a firm's business, F 9. | Spontaneous sources of financing consist offnancingthathas been scheduled | in the fms day-to-day operations. F ee