MF Working Capital

Working Capital Management
Dr. C. Bulent Aybar

Professor of International Finance
Long & Short Term Assets & Liabilities
Current Assets: Current Liabilities:

Cash Accounts Payable
Marketable Securities Accruals
Prepayments Short-Term Debt
Accounts Receivable Taxes Payable
Inventory
Fixed Assets: Long-Term Financing:

Investments Debt
Plant & Machinery Equity
Land and Buildings
Net Working Capital
• Working Capital includes a firm’s current assets,

which consist of cash and marketable securities in
addition to accounts receivable and inventories.
• It also consists of current liabilities, including
accounts payable (trade credit), notes payable (bank
loans), and accrued liabilities.
• Net Working Capital is defined as total current
assets less total current liabilities.
© Dr. C. Bulent Aybar

The Tradeoff Between Profitability & Risk
Positive Net Working Capital (low return, low risk)
Current Current
Liabilities low
Assets
low cost
Net Working
return Capital > 0
Long-Term
Debt high
cost
Fixed
high Assets
return Equity
highest
cost
The Tradeoff Between Profitability & Risk
Negative Net Working Capital (high return and high risk)
low Current Assets Current

return Liabilities low
Net Working cost
Capital < 0
Fixed Assets Long-Term

high Debt high
return cost
Equity
highest
cost
Effects of Changing Ratios on Profits and Risk
The Cash Conversion Cycle
• Short-term financial management—managing current

assets and current liabilities—is on of the financial
manager’s most important and time-consuming activities.
• The goal of short-term financial management is to
manage each of the firms’ current assets and liabilities to
achieve a balance between profitability and risk that
contributes positively to overall firm value.
• Central to short-term financial management is an
understanding of the firm’s cash conversion cycle.

Cash Conversion Cycle
• The Operating Cycle (OC) is the time between ordering

materials and collecting cash from receivables.
– OC=Average Age of Inventory+Average Collection Period
– OC=AAI+ACP
• The Cash Conversion Cycle (CCC) is the time between

when a firm pays it’s suppliers (payables) for inventory and
collecting cash from the sale of the finished product.
– CCC=Average Age of Inventory-Average Collection Period-Average
Payment Period
– CCC=(AAI+ACP)-APP
– CCC=OC-APP

Example: Max’s Cash Conversion Cycle
MAX Company, a producer of paper dinnerware, has annual sales of $10 million, cost
of goods sold of 75% of sales, and purchases that are 65% of cost of goods sold. MAX
has an average age of inventory (AAI) of 60 days, an average collection period (ACP)
of 40 days, and an average payment period (APP) of 35 days.
Using the values for these variables, the operating cycle for MAX is
60 + 40=100 days. Cash Conversion or Net Operating Cycle is
100-35=65 days.
Max’s Net Investment in the Cash Conversion Cycle
• The resources MAX has invested in the cash conversion

cycle assuming a 365-day year are:
• Obviously, reducing AAI or ACP or lengthening APP will

reduce the cash conversion cycle, thus reducing the amount
of resources the firm must commit to support operations.
Permanent vs. Seasonal Funding Needs
– If a firm’s sales are constant, then its investment in

operating assets should also be constant, and the firm will
have only a permanent funding requirement.
– If sales are cyclical, then investment in operating assets
will vary over time, leading to the need for seasonal
funding requirements in addition to the permanent
funding requirements for its minimum investment in
operating assets.

Seasonal vs Permanent Funding Requirements: Semper
• Semper Pump Company, which produces bicycle pumps, has
seasonal funding needs. Semper holds, at minimum, $25,000 in
cash and marketable securities, $100,000 in inventory, and
$60,000 in accounts receivable. At peak times, Semper’s
inventory increases to $750,000 and its accounts receivable
increase to $400,000. To capture production efficiencies, Semper
produces pumps at a constant rate.
• Semper’s accounts payable remains at $50,000 throughout the
year. Accordingly, Semper has a permanent funding requirement
for its minimum level of operating assets of $135,000 ($25,000 +
$100,000 + $60,000 - $50,000) and peak seasonal funding
requirements of $900,000 [($125,000 + $750,000 + $400,000 -
$50,000) - $135,000].

Funding Requirements of the CCC
Semper’s total funding requirements for operating assets vary from a

minimum of $135,000 (permanent) to a seasonal peak of $1,125,000
($135,000 + $900,000) .
Aggressive Funding Strategy
• Semper Pump has a permanent funding requirement of $135,000 and

seasonal requirements that vary between $0 and $990,000 and average
$101,250 (this was calculated from monthly funding requirements).
• If Semper can borrow short-term funds at 6.25% and long term funds at
8%, and can earn 5% on any invested surplus, then the annual cost of the
aggressive strategy would be:

Aggressive Strategy
• An aggressive strategy finances a firm’s seasonal needs, and

possibly some of its permanent needs, with short-term funds,
including trade credit as well as bank lines of credit or
commercial paper.
• This approach seeks to increase profit by using as much of
the less expensive short-term financing as possible, but
increases risk since the firm operates with minimum net
working capital, which could become negative.
• Another factor contributing to risk is the potential need to
quickly arrange for long-term funding, which is generally
more difficult to negotiate, to cover shortfalls in seasonal
needs.
Conservative Funding Strategy
• Alternatively, Semper can choose a conservative strategy

under which peak need are financed long term and surplus
cash balances are fully invested.
• Average Surplus = (1,125,000-135,000-101,250 ) =888,750

Conservative Strategy
• The conservative strategy finances all expected fund

requirements with long-term funds, while short-term funds
are reserved for use in the event of an emergency.
• This strategy results in relatively lower profits, since the firm
uses more of the expensive long-term financing and may pay
interest on unneeded funds.
• The conservative approach has less risk because of the high
level of net working capital (i.e., liquidity) that is
maintained; the firm has reserved short-term borrowing
power for meeting unexpected fund demands

Assessment of Strategies
• Clearly, the aggressive strategy’s heavy reliance on short-

term financing makes it riskier than the conservative strategy
because of interest rate swings and possible difficulties in
obtaining needed funds quickly when the seasonal peaks
occur.
• The conservative strategy avoids these risks through the
locked-in interest rate and long-term financing, but is more
costly.

Strategies for Managing the CCC
• Turn over inventory as quickly as possible without stock

outs that result in lost sales.
• Collect accounts receivable as quickly as possible without
losing sales from high-pressure collection techniques.
• Manage, mail, processing, and clearing time to reduce them
when collecting from customers and to increase them when
paying suppliers.
• Pay accounts payable as slowly as possible without
damaging the firm’s credit rating.

Inventory Management
• Inventory is an investment because managers must purchase

the raw materials and make expenditures for the production
of the product such as paying labor costs.
• Until cash is received through the sale of the finished goods
the cash expended for creation of the inventory, in any of its
forms, is an investment by the firm.
• Classification of inventories:
– Raw materials: items purchased for use in the manufacture of a
finished product
– Work-in-progress: all items that are currently in production
– Finished goods: items that have been produced but not yet sold

Inventory Management: Differing Views About Inventory
• The different departments within a firm (finance, production,

marketing, etc.) often have differing views about what is an
“appropriate” level of inventory.
• Financial managers would like to keep inventory levels low
to ensure that funds are wisely invested.
• Marketing managers would like to keep inventory levels
high to ensure orders could be quickly filled.
• Manufacturing managers would like to keep raw materials
levels high to avoid production delays and to make larger,
more economical production runs.
Inventory Management Systems: Economic Order Quantity
• The EOQ looks at all of the various costs of inventory and

determines what order size minimizes total inventory cost.
• The model analyzes the tradeoff between order cost and
carrying cost and determines the order quantity that
minimizes the total inventory cost.
• The model Parameters:
– S= Usage in units per period
– O=Order Cost per Order
– C=Carrying Cost per unit per period
– Q=Order Quantity per Period

Economic Order Quantity
• Order Cost=O x (S/Q)

• Carrying Cost=C x (Q/2)
• Total Cost=Order Cost + Carrying Cost
• TC =[O x (S/Q)]+[ C x (Q/2)]
• Economic Order Quantity is the order quantity that
minimizes the total cost. Minimum point for TC is the point
where its slope is equal to zero.
• EOQ  dTC/dQ =0
• EOQ=√{(2 x S x O)/C}
Inventory, thousands of units
Managing Inventories
Inventory
400
Average
200 Inventory
0 3 6 9 12
Weeks

Determination of optimal order size
Total costs
Carrying
Inventory costs, dollars
costs
Total order costs
Optimal Order size

order size

Example: RLB Inc. EOQ and Cost of Inventory
• Assume that RLB, Inc., a manufacturer of electronic test

equipment, uses S=1,600 units of an item annually. Its order
cost is O=$50 per order, and the carrying cost is C=$1 per
unit per year.
• EOQ={(2x50x1,600)/1}1/2=400 units
• Assuming that company orders 400 units at a time the total
cost of inventory will be:
• TC=Order Cost +Carrying Cost
• ={50 x(1,600/400)}+ {$1 x (400/2)}=$400

Reorder Point
• Once a company has calculated its EOQ, it must determine

when it should place its orders.
• More specifically, the reorder point must consider the lead
time needed to place and receive orders
• If we assume that inventory is used at a constant rate
throughout the year (no seasonality), the reorder point can be
determined by using the following equation:
– Reorder point = lead time in days x daily usage
– Daily Usage=Annual Usage/360

RIB Reorder Point
• Using the RIB example above, if they know that it requires

10 days to place and receive an order, and the annual usage
is 1,600 units per year, the reorder point can be determined
as follows:
• Daily Usage=1600/360=4.444
• Reorder Point=Lead Time x Daily Usage =10x 4.444
=44.44 or 45 units
• Thus, when RIB’s inventory level reaches 45 units, it should
place an order for 400 units. However, if RIB wishes to
maintain safety stock to protect against stock outs, they
would order before inventory reached 45 units.
Techniques for Managing Inventory
• Just-In-Time (JIT) System

– The JIT inventory management system minimizes the inventory
investment by having material inputs arrive exactly at the time they
are needed for production.
– For a JIT system to work, extensive coordination must exist between
the firm, its suppliers, and shipping companies to ensure that material
inputs arrive on time.
– In addition, the inputs must be of near perfect quality and consistency
given the absence of safety stock.

Computerized Systems for Resource Control
– Manufacturing Resource Planning (MRP) Systems are used to

determine what to order, when to order, and what priorities to assign
to ordering materials. MRP uses EOQ concepts to determine how
much to order using computer software.
– It simulates each product’s bill of materials structure all of the
product’s parts, inventory status, and manufacturing process.
– Like the simple EOQ, the objective of MRP systems is to minimize a
company’s overall investment in inventory without impairing
production.
– MRP II is an extension of MRP that integrates data from numerous
areas such as finance, accounting, marketing, engineering, and
manufacturing using a sophisticated computer system.
– This system generates production plans as well as numerous financial
and management reports.
Enterprise Resource Planning Systems
– Unlike MRP and MRP II, which tend to focus on internal operations,
enterprise resource planning (ERP) systems can expand the focus
externally to include information about suppliers and customers.
– ERP electronically integrates all of a firm’s departments so that, for
example, production can call up sales information and immediately
know how much must be produced to fill certain customer orders.

International Context
• International inventory management is typically much more

complicated for exporters and MNCs.
• The production and manufacturing economies of scale that
might be expected from selling globally may prove elusive if
products must be tailored for local markets.
• Transporting products over long distances often results in
delays, confusion, damage, theft, and other difficulties.

Accounts Receivable Management
• The second component of the cash conversion cycle is the

average collection period – the average length of time from a
sale on credit until the payment becomes usable funds to the
firm.
• The collection period consists of two parts:
– the time period from the sale until the customer mails payment, and
– the time from when the payment is mailed until the firm collects
funds in its bank account.

Accounts Receivable Management: The Five Cs of Credit
• Character: The applicant’s record of meeting past

obligations.
• Capacity: The applicant’s ability to repay the requested
credit.
• Capital: The applicant’s debt relative to equity.
• Collateral: The amount of assets the applicant has available
for use in securing the credit.
• Conditions: Current general and industry-specific economic
conditions.

Accounts Receivable Management: Credit Scoring
• Credit scoring is a procedure resulting in a score that

measures an applicant’s overall credit strength, derived as a
weighted-average of scores of various credit characteristics.
• The procedure results in a score that measures the
applicant’s overall credit strength, and the score is used to
make the accept/reject decision for granting the applicant
credit.

Accounts Receivable Management: Credit Scoring (cont.)
• The purpose of credit scoring is to make a relatively

informed credit decision quickly and inexpensively.
• For a demonstration of credit scoring, including the use of a
spreadsheet for that purpose, see the book’s Web site at
www.prenhall.com/gitman.

A/R Management: Changing Credit Standards
Average Investment in A/R=Total VC of Annual Sales/Turnover of A/R
Turnover of A/R=(365/Average Collection Period)
• The firm sometimes will contemplate changing its credit

standards to improve its returns and generate greater value
for its owners.

Changing Credit Policy
• Dodd Tool, a manufacturer of lathe tools, is currently selling

a product for $10/unit. Sales (all on credit) for last year were
60,000 units. The variable cost per unit is $6. The firm’s
total fixed costs are $120,000.
• Dodd is currently contemplating a relaxation of credit
standards that is anticipated to increase sales 5% to 63,000
units. It is also anticipated that the ACP will increase from
30 to 45 days, and that bad debt expenses will increase from
1% of sales to 2% of sales. The opportunity cost of tying
funds up in receivables is 15%.
• Given this information, should Dodd relax its credit
standards?
Change in Credit Standards and Investment in A/R
• Current investments in A/R=TVC/A/R Turnover

• TVC=6 x 60,000=360,000
• A/R Turnover=365/30=12.16
• Average Inv. In A/R=360,000/12.16=$29,589
• Investment in A/R Under Proposed Policy
• TVC=6 x 63,000=378,000
• A/R Turnover=365/45=8.11
• Average Inv. In A/R=378,000/8.11=$46,602

Net Benefit of New Policy
• Marginal Investment=46,602-29,589=17,014
– Cost of Marginal Investment=17,014 x 0.15=$2,552
• Other Costs arising from Credit Relaxation:

– Bad Debts under old policy=6,000
– Bad Debts under new policy=12,600
– Marginal Increase in Bad Debt=$6,600
• Marginal Contribution : 3,000 ($10-$6)=$12,000

• Net Benefit of New Policy: 12,000-2,552-6,600=$2,848

Changing Credit Terms
• A firm’s credit terms specify the repayment terms

required of all of its credit customers.
• Credit terms are composed of three parts:
– The cash discount
– The cash discount period
– The credit period
• For example, with credit terms of 2/10 net 30, the

discount is 2%, the discount period is 10 days, and
the credit period is 30 days.
Changing Credit Terms Example
• MAX Company has an average collection period of 40 days

(turnover = 365/40 = 9.1). In accordance with the firm’s
credit terms of net 30, this period is divided into 32 days
until the customers place their payments in the mail (not
everyone pays within 30 days) and 8 days to receive,
process, and collect payments once they are mailed.
• MAX is considering initiating a cash discount by changing
its credit terms from net 30 to 2/10 net 30. The firm expects
this change to reduce the amount of time until the payments
are placed in the mail, resulting in an average collection
period of 25 days (turnover = 365/25 = 14.6).
Changing Credit Terms Example (cont.)
Credit Monitoring
• Credit monitoring is the ongoing review of a firm’s

accounts receivable to determine whether customers
are paying according to the stated credit terms.
• Slow payments are costly to a firm because they
lengthen the average collection period and increase
the firm’s investment in accounts receivable.
• Two frequently used techniques for credit
monitoring are the average collection period and
aging of accounts receivable.

Credit Monitoring: Average Collection Period
• The average collection period is the average number of days

that credit sales are outstanding and has two parts:
– The time from sale until the customer places the payment in the mail,
and
– The time to receive, process, and collect payment.
– Average Collection Period=(A/R)/(Average Sales per Day)

Credit Monitoring: Aging of Accounts Receivable
Credit Monitoring: Collection Policy
• The firm’s collection policy is its procedures for collecting a

firm’s accounts receivable when they are due.
• The effectiveness of this policy can be partly evaluated by
evaluating at the level of bad expenses.
• As seen in the previous examples, this level depends not
only on collection policy but also on the firm’s credit policy.

Popular Collection Techniques
Management of Receipts & Disbursements: Float
• Collection float is the delay between the time when a payer

deducts a payment from its checking account ledger and the
time when the payee actually receives the funds in spendable
form.
• Disbursement float is the delay between the time when a
payer deducts a payment from its checking account ledger
and the time when the funds are actually withdrawn from the
account.
• Both the collection and disbursement float have three
separate components.

Management of Receipts & Disbursements: Float (cont.)
• Mail float is the delay between the time when a payer places
payment in the mail and the time when it is received by the
payee.
• Processing float is the delay between the receipt of a check
by the payee and the deposit of it in the firm’s account.
• Clearing float is the delay between the deposit of a check by
the payee and the actual availability of the funds which
results from the time required for a check to clear the
banking system.

Management of Receipts & Disbursements: Speeding Up Collections
• Lockboxes
– A lockbox system is a collection procedure in which payers send
their payments to a nearby post office box that is emptied by the
firm’s bank several times a day.
– It is different from and superior to concentration banking in that the
firm’s bank actually services the lockbox which reduces the
processing float.
– A lockbox system reduces the collection float by shortening the
processing float as well as the mail and clearing float.

Management of Receipts & Disbursements: Slowing Down Payments
• Controlled Disbursing
– Controlled Disbursing involves the strategic use of mailing points
and bank accounts to lengthen the mail float and clearing float
respectively.
– This approach should be used carefully, however, because longer
payment periods may strain supplier relations.

Management of Receipts & Disbursements: Cash Concentration
• Direct Sends and Other Techniques

– Wire transfers is a telecommunications bookkeeping device that
removes funds from the payer’s bank and deposits them into the
payees bank—thereby reducing collections float.
– Automated clearinghouse (ACH) debits are
pre-authorized electronic withdrawals from the payer’s account that
are transferred to the payee’s account via a settlement among banks
by the automated clearinghouse.
– ACHs clear in one day, thereby reducing mail, processing, and
clearing float.

Management of Receipts & Disbursements: Zero-Balance Accounts
• Zero-balance accounts (ZBAs) are disbursement accounts

that always have an end-of-day balance of zero.
• The purpose is to eliminate non-earning cash balances in
corporate checking accounts.
• A ZBA works well as a disbursement account under a cash
concentration system.

Current Money Market Rates (5/12/09)
International rates Latest Wk ago High Low

Prime rates [ U.S. Effective Date: 12/16/2008 ]
U.S. 3.25 3.25 5.00 3.25
Canada 2.25 2.25 4.75 2.25
Euro zone 1.00 1.25 4.25 1.00
Japan 1.475 1.475 1.875 1.475
Switzerland 0.53 0.52 4.09 0.51
Britain 0.50 0.50 5.00 0.50
Australia 3.00 3.00 7.25 3.00
Hong Kong 5.00 5.25 5.50 5.00
Overnight repurchase
U.S. 0.28 0.18 2.30 0.08
U.K. (BBA) 0.500 0.510 5.742 0.483
Euro zone 0.66 0.49 4.50 0.48
Government Rates
Discount [ Effective Date: 12/16/2008 ]

0.50 0.50 2.25 0.50
Federal funds
Effective rate 0.17 0.19 3.47 0.12
Target rate 0-0.25 0-0.25 2.00 0-0.25
High 0.2500 0.3750 7.0000 0.2500
Low 0.0500 0.1250 2.0000 0.0000
Bid 0.1250 0.1250 3.0000 0.0000
Offer 0.2500 0.1875 4.0000 0.0500
Treasury Yields
Yield
US Treasuries
(%)
1-Month Bill* 0.107
3-Month Bill* 0.165
6-Month Bill* 0.269
1-Year Note* 0.471
2-Year Note* 0.859
3-Year Note* 1.303
5-Year Note* 2.002
10-Year Note* 3.134
30-Year Bond* 4.086
Casa De Desano
• A Southern California furniture manufacturer in a niche market.
• Company is in the process of reviewing its cash management practice.
Treasurer gathers facts and identifies the following:
– Company purchases on open account, there are volume discounts (due to its
order size), Suppliers also do not offer any cash discounts , currently
company buys on net 30 terms. Its average payment period (APP) is 30
days. This is shorter than industry average of 39 days.
– Average ages of inventory for the firm is 110 days. This is well above the
industry average of 83 days.
– Company sales are on net 60 basis which is the industry standard. Average
collection period is 75 days. If company used cash discounts (eg 3/10 net
60) ACP could be reduced by 40%.
– CdD’s operating cycle investment is currently $26.5m. This is the minimum
projected disbursement until 2010 and cost of this investment is about 15%.

Issues
• The treasurer of the company (Ms. Leal) is concerned about

the efficiency n cycle. The treasurer wants to see the current
operating cycle, cash conversion cycle and resource
investment need. Assuming a constant rate of purchases
calculate OC and CCC.
• If Leal can optimize Casa de Disenos operations according
to industry standards, what will Casa de Disenos operating
cycle ( OC), cash conversion cycle ( CCC), and resource
investment need to be under these more efficient conditions?
• In terms of resource investment requirements, what is the
cost of Casa de Disenos operational inefficiency?
• ( 1) If in addition to achieving industry standards for payables and
inventory, the firm can reduce the average collection period by offering
credit terms of 3/ 10 net 60, what additional savings in resource
investment costs will result from the shortened cash conversion cycle,
assuming that the level of sales remains constant?
• ( 2) If the firms sales ( all on credit) are $ 40,000,000 and 45% of the
customers are expected to take the cash discount, by how much will the
firms annual revenues be reduced as a result of the discount?
• ( 3) If the firms variable cost of the $ 40,000,000 in sales is 80%,
determine the reduction in the average investment in accounts receivable
and the annual savings that will result from this reduced investment,
assuming that sales remain constant.

• ( 4) If the firms bad- debts expenses decline from 2% to
1.5% of sales, what annual savings will result, assuming that
sales remain constant?
• ( 5) Use your findings in parts ( 2) through ( 4) to assess
whether offering the cash discount can be justified
financially. Explain why or why not.

• On the basis of your analysis in previous parts what
recommendations would you offer Teresa Leal?
• Review for Teresa Leal the key sources of short- term
financing (secured and unsecured), other than accounts
payable, that she may consider to finance Casa de Disenos
resource investment need .

Operating Cycle , Cash Conversion and Resources Needed
• Operating cycle (OC)= average age of inventory + average collection
period
– = 110 days + 75 days = 185 days
• Cash conversion cycle(CCC)= OC - average payment period
– = 185 days - 30 days
– = 155 days
• Resources needed = (Total Annual Outlays/365)xCCC=
$26,500,000
 155
365
• = $11,253,425

OC, CCC and Resource Need at Industry Standards
• Industry OC= 83 days + 75 days

= 158 days
• Industry CCC= 158 days - 39 days
= 119 days
• Industry resources needed
– (26,500,000/365)x119= $8,639,726
• Overinvestment in Operations=$11,253,425-8,639,726
= $2,613,699
• Cost of inefficiency=$2,613,699 x 0.15 = $392,055
Offering 3/10 net 60 to Clients
• Reduction in collection period =75 days  (1 - 0.4)=45 days

• OC = 83 days + 45 days = 128 days
• CCC =128 days - 39 days
• =89 days
• Resources needed = (26,500.000/365)x89=$6,461,644
• Additional savings =$8,639,726 - $6,461,644 = $2,178,082
=$2,178,082  0.15 = $326,712

Discount and Reduction in Sales
• If the firms sales ( all on credit) are $ 40,000,000 and 45% of

the customers are expected to take the cash discount, by how
much will the firms annual revenues be reduced as a result of
the discount?
– Reduction in sales: $40,000,000  0.45  0.03 = $540,000

• ( 3) If the firms variable cost of the $ 40,000,000 in sales is 80%, determine the
reduction in the average investment in accounts receivable and the annual
savings that will result from this reduced investment, assuming that sales remain
constant.
– Average investment in accounts receivable assuming cash discount:
– New average collection period = 45 days
– ($40,000,000  0.80)  (365  45) = $3,945,205
– Average investment in accounts receivable assuming no cash discount:
– (40,000,000  0.80)  (365  75) = $6,575,342
– Reduction in investment in accounts receivable:
– $6,575,342 - $3,945,205 = $2,630,137
– Annual savings: $2,630,137  0.15= $ 394,521

• ( 4) If the firms bad- debts expenses decline from 2% to 1.5% of sales,
what annual savings will result, assuming that sales remain constant?
– Reduction in bad debt expense:
– $40,000,000  (0.02 - 0.015)= $ 200,000
• ( 5) Use your findings in parts ( 2) through ( 4) to assess whether offering
the cash discount can be justified financially. Explain why or why not.
– Cost of offering cash discount ($ 540,000)
– Annual savings from reduction in investment in accounts receivable 394,521
– Annual savings from reduction in bad debt expense: 200,000
– Savings due to cash discount $ 54,521

Unsecured Sources
• Short-term self-liquidating bank loans—usually used to help with
seasonal needs where the loan is repaid as receivables are collected
• Single payment bank notes—normally a short-term (30 days to 9
months) loan to be repaid on the end of the loan period.
• Line of credit—a loan much like a credit card in that the borrower can
draw down the money as needed and make various payments. The loan
must often be paid in full at some point within
each year.
• Revolving credit agreement—a guaranteed amount of funds available to
the borrower. The borrower usually pays a commitment fee to the bank
to compensate them for having the funds available “on demand.”
• Commercial paper—a 3 day to 270 day loan sold as a security to the
lender.

Secured Sources
• Pledging accounts receivable—a lender loans money on the basis of the credit
worthiness of the borrower’s customers who bought on account. The lender
advances the money to the borrower in an amount discounted from the book
value of the receivables. When the borrower collects the receivables payments
the money is remitted to the lender.
• Factoring accounts receivable—selling the firms accounts receivable to a lender
at a discount to the book value of the receivables. The factor normally receives
the payment directly from the customer when they make payment.
• Floating inventory liens—when inventory is used as collateral for a loan.
• Trust receipt inventory loans—a loan against relatively expensive and easily
identifiable assets, such as automobiles. The loan is repaid when the asset is sold.
• Warehouse receipt loans—when assets in a warehouse are pledged against a
loan. The lender takes control of the inventory items that are normally stored in a
public warehouse.

Kanton Company’s Financing Strategy
• Kanton Company’s CFO Mercado developed the total fund

requirements for the firm as follows:
Month Funding Requirement Month Funding Requirement

January $1,000,000 July 6,000,000
February 1,000,000 August 5,000,000
March 2,000,000 September 5,000,000
April 3,000,000 October 4,000,000
May 5,000,000 November 2,000,000
June 7,000,000 December 1,000,000

Financing Strategies
• Morton expects short term financing cost of about 10 and LT

financing cost of 14% during this period. He developed
three possible financing strategies:
– Strategy 1/Aggressive: Finance seasonal needs with short- term funds
and permanent needs with long- term funds.
– Strategy 2 /Conservative: Finance an amount equal to the peak need
with long-term funds and use short- term funds only in an
emergency.
– Strategy 3 /Tradeoff: Finance $ 3,000,000 with long- term funds and
finance the remaining funds requirements with short- term funds.

Alternative Strategies
• Using the data on the firms total funds requirements, Morton estimated
the average annual short- term and long- term financing requirements for
each strategy in the coming year, as shown in the following table.
Type of Financing Strategy-1 Strategy-2 Strategy-3
Short Term 2,500,000 - 1,166,667
Long Term 1,000,000 7,000,000 300,000
• To ensure that adequate short- term financing will be available, Morton

plans to establish an unsecured short- term borrowing arrangement with
its local bank. The bank has offered either a line- of- credit agreement or
a revolving credit agreement. The terms for a line of credit are an interest
rate of 2.50% above the prime rate, and the borrowing must be reduced
to zero for a 30- day period during the year.
• On an equivalent revolving credit agreement, above prime
with a commitment fee of 0.50% on the average unused
balance.
• Under both loans, a compensating balance equal to 20% of
the amount borrowed would be required.
• The prime rate is currently 7%. Both the line- of- credit
agreement and the revolving credit agreement would have
borrowing limits of $ 1,000,000.
• For purposes of his analysis, Morton estimates that Kanton
will borrow $ 600,000 on the average during the year,
regardless of which financing strategy and loan arrangement
it chooses.
• Determine the total annual cost of each of the three possible financing
strategies.
• Assuming that the firm expects its current assets to total $ 4 million
throughout the year, determine the average amount of net working capital
under each financing strategy. ( Hint: Current liabilities equal average
short- term financing.)
• Using the net working capital found in part b as a measure of risk,
discuss the profitability risk tradeoff associated with each financing
strategy. Which strategy would you recommend to Morton Mercado for
Kanton Company? Why? d. Find the effective annual rate under: ( 1) The
line- of- credit agreement. ( 2) The revolving credit agreement. ( Hint:
Find the ratio of the dollars that the firm will pay in interest and
commitment fees to the dollars that the firm will effectively have use of.)
e. If the firm does expect to borrow an average of $ 600,000, which
borrowing arrangement would you recommend to Kanton? Explain why.
Annual Cost of Each Financing Strategy
• Strategy I—Aggressive
– Amount required: $2,500,000 short-term and $1,000,000 long-term
– Cost: (10%  $2,500,000) + (14%  $1,000,000) = $390,000
• Strategy 2—Conservative
– Amount required: $7,000,000 long-term and $0 short-term
– Cost: (14%  $7,000,000) = $980,000
• Strategy-3- Tradeoff
– Monthly average permanent component is $3m
– Monthly Average Seasonal Component: 14,000,000/12=1,666,667
– Cost: 0.1 x 1,666,667 + 0.14 x 3,000,000=536,667
Strategy 3/Trade off: Calculation of Seasonal Requirements
Total Funds Permanent Seasonal
Month Requirements Requirements Requirements
January $1,000,000 $3,000,000 $0

February 1,000,000 3,000,000 0
March 2,000,000 3,000,000 0
April 3,000,000 3,000,000 0
May 5,000,000 3,000,000 2,000,000
June 7,000,000 3,000,000 4,000,000
July 6,000,000 3,000,000 3,000,000
August 5,000,000 3,000,000 2,000,000
September 5,000,000 3,000,000 2,000,000
October 4,000,000 3,000,000 1,000,000
November 2,000,000 3,000,000 0
December 1,000,000 3,000,000 0
•Monthly average permanent component is $3m

•Monthly Average Seasonal Component: 14,000,000/12=1,666,667
•Cost: 0.1 x 1,666,667 + 0.14 x 3,000,000=536,667
Assuming $4m Current Assets Estimate NWC for each Strategy
• Net working capital = Current assets - Current liabilities

– Aggressive = $4,000,000 - $2,500,000 = $1,500,000
– Conservative = $4,000,000 - $0 = $4,000,000
– Tradeoff = $4,000,000 - $1,166,667 = $2,833,333

Assessment of Strategies
• The aggressive strategy is the most profitableit has the lowest cost, $390,000because
it uses the largest amount of the less-expensive short-term financing. It also pays interest
only on needed financing. The aggressive strategy is also the most risky, relying heavily on
short-term financing, which may have more limited availability. Net working capital is
lowest, also increasing risk.
• Because the conservative strategy funds the highest amount in any month for the whole
year with more-expensive long-term financing, it is the most expensive ($980,000) and the
least profitable. It is the lowest-risk strategy, however, reserving short-term financing for
emergencies. The high level of working capital also reduces risk.
• The tradeoff strategy falls between the two extremes in terms of both profitability and risk.
The cost ($536,667) is higher than the aggressive strategy because the permanent funds
requirement of $3,000,000 is financed with more costly long-term funds. In five months
(January, February, March, November, and December), the company pays interest on
unneeded funds. The risk is less than with the aggressive strategy; some short-term
borrowing capacity is preserved for emergencies. Because a portion of short-term
requirements is financed with long-term funds, the firm’s ability to obtain short-term
financing is good.

Effective Interest Rates
• Effective interest, line of credit:

– Interest on borrowing: $600,000  (7% + 2.5%) = $57,000
– Effective Cost: 57,000/[(600,000)(1-0.2)]=11.88%
• Effective interest, revolving credit agreement:

– Cost of borrowing:
– Interest: $600,000  (7% + 3.0%) $60,000
– Commitment Fee: $400,000  0.5% 2,000
– Total $62,000
– 62,000/[(600,000)(0.8)]=12.92%

• The line of credit arrangement seems better, since its annual
cost of 11.88% is less than the 12.92% cost of the revolving
loan arrangement.
• Kanton will save about 1% in terms of annual interest cost
(11.88% versus 12.92%) by using the line of credit.
• The only negative is that if Third National lacks loanable
funds, Kanton may not be able to borrow the needed funds.
Under the revolving credit agreement, funds availability
would be guaranteed

MF Working Capital

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MF Working Capital

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Working Capital Management

Dr. C. Bulent Aybar

Current Assets: Current Liabilities:

Fixed Assets: Long-Term Financing:

• Working Capital includes a firm’s current assets,

© Dr. C. Bulent Aybar

Positive Net Working Capital (low return, low risk)

Negative Net Working Capital (high return and high risk)

low Current Assets Current

Fixed Assets Long-Term

• Short-term financial management—managing current

© Dr. C. Bulent Aybar

• The Operating Cycle (OC) is the time between ordering

• The Cash Conversion Cycle (CCC) is the time between

© Dr. C. Bulent Aybar

• The resources MAX has invested in the cash conversion

• Obviously, reducing AAI or ACP or lengthening APP will

– If a firm’s sales are constant, then its investment in

© Dr. C. Bulent Aybar

© Dr. C. Bulent Aybar

Semper’s total funding requirements for operating assets vary from a

• Semper Pump has a permanent funding requirement of $135,000 and

© Dr. C. Bulent Aybar

• An aggressive strategy finances a firm’s seasonal needs, and

• Alternatively, Semper can choose a conservative strategy

• Average Surplus = (1,125,000-135,000-101,250 ) =888,750

© Dr. C. Bulent Aybar

• The conservative strategy finances all expected fund

© Dr. C. Bulent Aybar

• Clearly, the aggressive strategy’s heavy reliance on short-

© Dr. C. Bulent Aybar

• Turn over inventory as quickly as possible without stock

© Dr. C. Bulent Aybar

• Inventory is an investment because managers must purchase

© Dr. C. Bulent Aybar

• The different departments within a firm (finance, production,

• The EOQ looks at all of the various costs of inventory and

© Dr. C. Bulent Aybar

• Order Cost=O x (S/Q)

© Dr. C. Bulent Aybar

Total order costs

Optimal Order size

© Dr. C. Bulent Aybar

• Assume that RLB, Inc., a manufacturer of electronic test

© Dr. C. Bulent Aybar

• Once a company has calculated its EOQ, it must determine

© Dr. C. Bulent Aybar

• Using the RIB example above, if they know that it requires

• Just-In-Time (JIT) System

© Dr. C. Bulent Aybar

– Manufacturing Resource Planning (MRP) Systems are used to

© Dr. C. Bulent Aybar

• International inventory management is typically much more

© Dr. C. Bulent Aybar

• The second component of the cash conversion cycle is the

© Dr. C. Bulent Aybar

• Character: The applicant’s record of meeting past

© Dr. C. Bulent Aybar

• Credit scoring is a procedure resulting in a score that

© Dr. C. Bulent Aybar

• The purpose of credit scoring is to make a relatively

© Dr. C. Bulent Aybar

• The firm sometimes will contemplate changing its credit