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Week 10 – Working Capital Management (chapter 19) This topic concerns short term management o
assets and liabilities:
 Concept behind topic - If you don't manage your inventories and accounts receivables like th
short term assets, short term liabilities well on a daily basis you won't be able to make your lo
term project a success
Measures used in quantitative used in working
capital management decisions:
Notations:
 EAR=Effective Annual Rate
 CA=Current Assets
 CL=Current Liabilities
 COGS=Cost of Goods Sold
 A/R=Accounts Receivables
 A/P=Accounts Payables
 CCC=Cash Conversion Cycle
Balance Sheet:
 Assets = Liabilities + Shareholders equity
 Assets ordered in descending order of
liquidity
 Liabilities & Equity listed in ascending
order of when due to be paid
 Previous weeks only dealt with the evaluation
long term assets
 Remember that capital is – anything the
company owns that has monetary value and c
be contributed to its wealth, e.g. assets,
inventory, accounts receivable
 Working capital management decisions – D
with day-to-day financial matters and affect
current assets, current liabilities and net work
capital
 Net working capital – the difference between
current assets and current liabilities
Terminology of Working Capital:
 Current Assets (CA) - Cash and other assets t
the firm expects to convert into cash in a year
less
 Current liabilities (CL) - Obligations that the
firm expects to pay off in a year or less
 Working capital = amount of $ invested in CA
 Net working capital =$ CA -$CL:
o (This goes back to week 7 or 8 with t
graph/ need for investment for free ca
flows) (When CA > CL) Difference
means that current liability alone is n
enough to finance current assets so so
other source of capital will have to be
coming through the current assets, so
CA minus CL indicates the needs of
investment in current assets) The
difference indicates the amount of lef
over assets that you can invest in,
because if your current assets and
liabilities are already equal then your
short term obligations are met, theref
invest the rest in capital, otherwise it’
waste.
 Working capital management:
o Making decisions regarding the use a
sources of CA
 Working capital efficiency:
o How long it takes to convert raw
materials received into cash (where y
collect it from customers)
o They would also be interested in the
time it takes.
o From the time that you paid for the ra
material up to the point where you
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Measuring Operating cycle & Cash conversion
cycle for Working Capital efficiency:
 4 different points in timeline:
o 1. Receiving raw materials
o 2. Paying for the raw materials
o 3. Selling finished goods
o 4. Collecting cash for finished
goods
 Inventory Days (from period 1 to 3) –
Measure how long the firm keeps its
Inventory before selling it = Inventory
/(COGS/365) where COGS/365 = average
daily COGS
 Accounts receivables days (from period 3
to 4) – Measures how long it takes on
average for the firm to collect its A/Rs
=Average collection period
o = Account Receivable/
(Sales/365) where Sales/365 =
average daily sales
 Accounts payable days (from period 1 to
2) – Measures how long a firm takes to
pay off its suppliers for the cost of
inventory
o = Accounts Payable/ (COGS/365)
With the Cash conversion cycle, operating cycle
and 3 different ratios, you compare it with the
values of the industry average to assess where
your company is at
Where Cash Conversion is negative:
 For a negative CCC, paying for the raw
materials doesn't happen until after you
collect cash for the finished goods, so you
are able to extend the time so much that
you can pay for your materials after you
collect cash for your finished goods.
 A negative CCC of e.g. -4.56 means that
you will receive accounts receivable 4.56
collect the cash from your customers.
o And the more quickly you can transfo
these raw materials into cash, you wo
be considered more liquid.
 Liquidity - liquidity is company's ability to
convert the assets, whether real or financial in
cash quickly enough without suffering a
financial loss.
 Necessary tools to measure working capital
efficiency & liquidity:
o 1. Operating cycle
o 2. Cash conversion cycle
 Higher or lower value which is better?
 For inventory days and accounts receivabl
days, the lower the value, the better it is beca
it means the more quickly, you are converting
your assets into cash and.
 For accounts payable days – the higher the
value, the better because you hold onto the ca
for longer and can use that for something else
 Using those 3 ratios – Operating & Cash
conversion cycle can be calculated:
 Operating cycle = Inventory Days + Accou
receivable days
o The average length of time between a
firm originally receives its inventory
when it receives the cash back from
selling its product.
 Cash conversion Cycle = Operating cycle –
Accounts payable days OR Inventory Days +
Accounts receivable days – Accounts payable
days
o Measure of cash cycle which is the
length of time between when a firm p
cash to purchase its initial inventory a
when it receives cash from the sale of
the output produced from that invento
o How long it takes for cash inflows to
enter from your previous cash outflow
 Make sure to understand how to interpret
positive CCC and negative CCC from the t
solutions
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days before you pay accounts payable,

meaning you are more efficient
 For CCC to be negative,
o Inventory days + A/R days < A/P
days
 Example - Woolworths has a negative
cash conversion cycle:
 meaning that it generally receives cash
from its customers before it pays its
suppliers for the goods.
 Short Accounts receivable days
o A large portion of a retail grocery
store's customers pay cash when
they buy their groceries
 Long Accounts payable days
o Because of Woolworths' position
and bargaining power, its
suppliers allow it to wait more
than 45 days before paying them!
Trade credit and A/R management: To compare the 20 days interest rate with interest rate
 WHEN DOING THESE available from other financing sources, we convert it
CALCULATIONS ALWAYS ASSUME an EAR:
A PRICE OF $100  APR/m = 2/98 (=20-day rate)
 Trade credit – When a firm allows a  M = the number of 20 day periods in a year
customer to pay for goods at some date therefore 365/20
later than the date of purchase, it creates  Note that APR/m = the periodic rate calculat
an account receivable for the firm and from just the interests which is 2/98 or 2.04%
account payable for the customer. Th
 The credit that the firm is extending to its  𝐸𝐴𝑅 = (1 + 𝐴𝑃𝑅/m)m−1
customer is known as trade credit.  𝐸𝐴𝑅 = (1 + 0.0204)365/20- 1 = 44.6%
 Trade credit is just another form of  By not taking the discount, the firm is
financing. – It’s a loan from the selling effectively paying 2.04% to borrow the mone
firm to its customer. for 20 days, which translates to an EAR of
 Price discount (the 2/10 discount) 44.6%. The EAR means that if you continue
represents an interest rate: use the suppler’s money until day 30, the cos
o Therefore we can calculate the you pay per year is 44.6%
interest rate on the trade credit:  You can then compare EAR’’s with other to
o How does this work? (refer to see what to do with the funds (slide 28)
slide 25)  The EAR represents the amount you would
 The period that has the discount is known be charged as an annual rate taking into
as the zero interest loan for that period account compounding, example EAR of 56
(2/10 = the 2% if paid within 10 days, means you would be charged 56% per eve
where n = 30 days) dollar you borrow
 After the 10 day period, it is the net 
period, you have 20 more days until n 30,
This is where you did not take advantage APR m
of the discount, you are essentially EAR=(1+ ¿ −1)
m
borrowing the lender/supplier’s money
that you owe them for the 20 days left of
the trade credit
 During day 10 today 30 you are making
the use of $98 at some cost and that cost
is calculated as $100 minus 98 divided by
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98 because you are borrowing $98 for the

promise of paying $100 at day 30.
 Therefore calculating interest rate: non-
discount amount = discount amount/
discount amount: Example:
o 100 – 98/98 = 2.04% per 20
days
o Meaning you interest rate
associated in the net period is 2
over 98 so it's 2.04% for 20 days
so once again if you don't take
the discount it's equivalent to
borrowing $98 for additional 20
days at an interest rate of 2.04%.

Receivables Management: Receivables Management: The A/R & Aging Schedul

 Part of this is to understand how to
manage your receivables. This involves
determining your credit policy:
 1. Establishing credit standards:
o Extend credit to anyone or be
selective to ones that have low
credit risk
o Companies management may
choose to extend the credit
strategically when dealing with
potentially important customers.
o So the companies would be more
likely to extend the credit, and if
their customers tend to be long
term customers and also repeat
customers, so the companies will
be strategic about who they
extend their credit to.
 2. Establishing credit terms:
o Determine X/Y net Z
o X: Discount percentage, Y:
Discount period
o Z: The length of the period before
payment must be
o made.
 3. Establishing a collection policy
(Determining what to if customers are late
for payment):
o Will you send a letter of inquiry
o Charge interest on payments
extending beyond a specified
period
o Threaten legal action at the first
late payment
Accounts Payable & Inventory Management:
 Firms should monitor their accounts
payable to ensure that they are making
 An Aging schedule is a tool that credit manag
commonly use to monitor their accounts
receivable
 Identify and track delinquent accounts receiva
 Analyse the quality of a company’s receivabl
 Organise the firm’s accounts receivables by th
age.
 Age of accounts (days) represent the period in
which a portion of the accounts receivable is
received/collected
 Using this schedule you can calculate the
average A/R days (A/R days = the average
number of days that it takes a firm to collect o
its sales):
o Age of accounts (days) x % of total
value = 10x0.5 + 30x0.3 + 45x0.15 +
60x0.05 = 23.75days
 Depending on whether the company is over th
supposed period to make payments, the firm m
terminate their relationship or improve on the
credit policy
Stretching accounts payables:
 When a firm ignores payment due period and
pays later
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their payments at an optimal time  Usually involves a calculation of EAR, it will

 When paying for accounts payable, you give you the implicit costs associated with a
want to delay your payment as long as trade credit of %
possible because cash inflow is better than  Principle - if you are in a position to stretch
cash outflow, e.g terms of 2/15, net 40. accounts payables you can reduce your costs
The optimal time would be either to pay at associated with the trade credit. Longer pay
15 or 40 (if you forgo the 15 discount day period results in reduced EAR cost
period).
 TO determine if the firm is managing its
accounts payable well – calculate the
accounts payables days and compare with
the credit terms. If they aren’t delaying
their payments until day 40 or 15, they are
not managing their accounts well
Benefits of holding inventory: Just-in-time Inventory Management:
 Inventory helps minimise the risk that the  When a firm acquires inventory precisely whe
firm will not be able to obtain an input it needed so that its inventory balance is always
needs for production and helps avoid zero or very close to it
stock-outs. (When issues arise with Advantages:
suppliers)  Essentially no raw inventory costs (Affects
 Factors such as seasonality in demand Inventory Days)
mean that customer purchases do not  No chance of obsolescence or loss to theft
perfectly match the most efficient  If the system works for a firm, cuts down
production cycle. investment in working capital dramatically (a
Costs of holding inventory you have less funds in inventory, you can use
 Acquisition costs: the cost of inventory that money elsewhere for e.g. high yielding
itself project)
 Order costs: the cost of placing an order Disadvantage
 Carrying costs: Storage costs, insurance,  If the supplier fails to make the needed
taxes, spoilage, obsolescence and the deliveries, the production shuts down.
opportunity cost (goods in inventory could
be invested in high yielding projects that
could give you a higher return) of the
funds tied up in the inventory.
Cash Management: Alternative investment – short term securities that firm
 There are 3 reasons for holding cash: with excess cash can invest – they have to decide on
 1. Transactions balance - The amount of whether:
cash a firm needs to be able to pay its bills  How much risk they are willing to accept in
o To meet its day-to-day needs. return for a higher yield
 2. Precautionary balance - The amount of  A financial manger who wants to invest the
cash a firm holds to counter the firm’s funds in the least risk security will inve
uncertainty surrounding its future cash in Treasury notes
flows
o Greater uncertainty associated
with the future cash flows, the
more difficult it is for the firm to
predict the transaction balance,
therefore, the higher
precautionary balance would be
required to counter those negative
circumstances.
 3. Compensating balance - An amount a
firm’s bank may require the firm to
maintain in an account at the bank as
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compensation for services the bank may

perform
o Purely to satisfy bank
requirements, not for any other
reason