WORKING CAPITAL

MANAGEMENT
Let’s look at two companies
Company A Company B
Inventories 3,263.70 8,886.01
Payables 1,202.60 7,199.26
Cash 23.50 4,654.03
Total CA 4,489.80 48,886.32
Receivables 13,914.70 15,544.60
Total CL 13,914.70 39,883.11
Sales 76,140.80 46,427.13
COGS 42,629.60 20,913.11

Which firm has a better working capital? Which firm do you think could be in
trouble? Which firm should have better return?
And returns are…
Company A Company B
Return on Capital 19.43 13.23
Return on Assets 14.38 10.05
Return on Equity 20.28 15.40

Companies in which negative working capital exist,

profitability is more and shareholders are getting more
dividend and capital appreciation, which maximizes the
shareholders’ value in the long run [Panigarhi A]
Simple Cycle of Operations
Cash Conversion Cycle
Working Capital and the Cash Conversion
Cycle
• Cash Conversion Cycle
= operating cycle – accounts payable period
= (inventory period + receivables period) – accounts
payable period
CCC for Company A and B
Company A Company B

Average inventory
period 27.94421 155.089
Average receivables
period

10.29681 125.6499
Average payables
period 66.7036 122.2083
Cash Conversion Cycle
-28 158
Cash Conversion Cycle,
Selected Companies
Time & Money Concepts in
Working Capital Cycle

Each component of working capital (namely

inventory, receivables and payables) has two
dimensions ........TIME ......... and MONEY,
when it comes to managing working capital
 TIME IS MONEY
 You can get money to move faster around the cycle or
reduce the amount of money tied up. Then, business
will generate more cash or it will need to borrow less
money to fund working capital.
 As a consequence, you could reduce the cost of bank
interest or you'll have additional free money available to
support additional sales growth or investment.
 Similarly, if you can negotiate improved terms with
suppliers e.g. get longer credit or an increased credit
limit, you effectively create free finance to help fund
future sales.
 If you Then ......

Collect receivables (debtors) You release cash from the

faster cycle
Collect receivables (debtors) Your receivables soak up cash
slower
Get better credit (in terms of You increase your cash
duration or amount) from resources
suppliers
Shift inventory (stocks) faster You free up cash

Move inventory (stocks) You consume more cash

slower
Inventories
• Components of Inventory
• Raw materials
• Work in progress
• Finished goods

• Goal: Minimize amount of cash tied up in

inventory
• Tools used to minimize inventory
• Just-in-time
• Lean manufacturing
Inventories
• As Order Size Increases

• Number of orders decreases

• Order cost decreases

• Average amount in inventory increases

• Carrying cost of inventory increases

Managing Inventories
Determining Optimal
Order Size
 Inventories
• Economic Order Quantity
• Order size that minimizes total inventory costs

2  annual sales  cost per order

Economic order quantity =
carrying cost
Credit Management
• Terms of Sale
• Credit, discount, and payment terms offered on sale

• Example: 5/10 net 30

• 5: Percent discount for early payment
• 10: Number of days discount is available
• Net 30: Number of days before payment due
Credit Management
• Terms of Sale
• Firm that buys on credit borrows from supplier

• Save cash today, pay later (implicit loan)

• Cost of implicit loan:

Effective annual rate


 1+ discount
discountedprice

365/extra days credit
1
Credit Management
• Example
• Calculate implied interest rate on Rs.100 sale with terms 5/10 net
60

Effective annual rate


 1+ discount
discountedprice

365/extra days credit
1
 1 + 
5 365/50
95  1 = .454, or 45.4%
Credit Management
• What If
• The number of days are 30 instead of 60
• So, the are terms 5/10 net 30

Effective annual rate


 1+ discount
discounted price
365/extra days credit
1
 1 + 
5 365/20
95  1 = 1.55, or 155.0%
Credit Management
• Collection Policy
• Procedure to collect and monitor receivables
• Aging Schedule
• Classification of accounts receivable by time outstanding
• Factoring
• Financial institution buys company’s accounts receivable and
collects debt
Optimum Credit Policy
 Optimum Credit Policy

• Estimation of incremental
profit
• Estimation of incremental
investment in receivable
• Estimation of incremental
rate of return (IRR)
• Comparison of incre-mental
rate of return with required
rate of return (RRR)
• Optimum credit policy: IRR
= RRR
Costs of Credit Policy

23
Cost- Benefit Analysis Credit Policy
Tisca Furniture shows following figures
Total Sales : Rs.900 Lacs
After tax profit : Rs. 103.5 Lacs

They want to analyze the impact of discounting sales to

the some of their customers who are financially not very
strong. Such customers are 10% of their total sales.
 Fixed Cost (%) Variable Cost(%) Total Cost(%)
COGS 81.5 81.5
Administrative 2.0 4.00 6.0
Cost
Selling Cost 2.5 5.8 8.3
Bad-Debt Losses 0.06 0.06
Collection Cost 0.03 0.03
4.5 91.39 95.89

Tisca’s variables production, administrative and selling cost are 91.3% of

Sales

Contribution = 100-91.3=8.7%

Tightening of Credit Policy : Lose Sale of 10% = Rs. 90 Lacs

Change in contribution = Change in Sales X
contribution ratio

Δ CONT = -90X .087 = -7.83

Change in operating Profit = change in contribution –

Additional Cost

Δ OP = Δ CONT – Sales(b+c)
= -7.83- [ -90(0.0009)]
= -7.83+ 0.081
= -7.749
Finding the investment in Accounts receivables
Average Collection period : 25 days
ACP of Marginal Account : 60 days
70% of sales to marginal account is on credit
Required rate of return for average risk
project is 20%
Investment in Accounts Receivables = Credit Sales /Day X Average Collection period

Δ INVST = Sales *fraction X ACP

365

= 90(0.7) X 60
360
= Rs10.5 Lacs

If we take only variable cost = 10.5X 0.9139

= 9.595

𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥

𝑟𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 =
𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑖𝑛 𝑎𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠

∆𝑂𝑃(1−𝑇𝑎𝑥)
r= = 53.29%
∆𝐼𝑁𝑉𝑆𝑇

Tax rate :34%

Rate of return
• If the sales value is used in determining the investment in
accounts receivables, the rate of return works out as
53.29%
• Is this an Adequate return?
• The required rate of return for average risk project for the
firm is 20% and given that marginal accounts are more
risky, we can add 5% for risk premium.
Net Contribution
Marginal account make a net contribution to operating
profit:
= (Expected return – required return) * Investment in
receivables
= (.5329-0.25) * 10.5
=2.71
CASH MANAGEMENT
Cash
• Cash Does Not Pay Interest

• Move money from cash accounts to short-

term securities
• Sweep programs
• Concentration banking
• Lock-box system
Cash Management
• Cash doesn’t pay interest
• Cash management—determining:
• Optimal size of firm’s liquid asset balance
• Appropriate types and amounts of
short-term investments
• Most efficient methods of controlling collection and disbursement
of cash
Four Facets of Cash Management

• Cash planning
• Managing the cash flows
• Optimum cash level
• Investing surplus cash
Cash Management
• Motives for holding Cash?
• Transactions demand: need money to pay bills
(employees, suppliers, utility/phone, etc.)

• Precautionary demand: to handle emergencies

(unforeseen expenses)

• Speculative demand: to take advantage of

unexpected opportunities (purchase of raw materials
that are on sale)
Permanent and Temporary Working
Capital

• Working capital is permanent to the extent that it

supports constant or minimum level of sales

• Temporary working capital supports seasonal peaks in

business
Financing Net Working Capital
• According to maturity matching principle
• Temporary (seasonal) should be financed with short-term
borrowing
• Permanent working capital should be financed with long-term
sources, such as long-term debt and/or equity

• In practice, firms may use more or less short-term funds

to finance working capital