Working Capital Management

Session # 11

.
 .

11.1 Working Capital Terminologies and Importance

11.2 Working Capital Policies, Planning and Financing

11.3 Cash Management and Cash Conversion Cycle

.
 Working Capital Terminologies and Importance

• Working capital: Gross current assets.

• Net working capital: current assets minus current
liabilities.
• Current assets investment policy: deciding the
level of each type of current asset to hold, and
how to finance current assets.
• Current assets are divided into two categories,
1. operating and 2. nonoperation.

16-3
 Working Capital Terminologies and Importance

• Working capital management (WCM) : controlling cash,

inventories, and A/R, plus short-term liability managemen
t

• WCM is important because it assess the company’s ability

to pay off short-term obligations.

16-4
Working Capital Financing

16-5
 Working Capital Financing Policies

• Moderate: Match the maturity of the assets

with the maturity of the financing.
• Aggressive: Use short-term financing to
finance permanent assets.
• Conservative: Use permanent capital for
permanent assets and temporary assets.

16-6
 Selected Ratios for Ski Cement Inc. Example
Ski Ind Avg

Current ratio 1.75x 2.25x

Debt/Assets 58.76% 50.00%
Turnover of cash & securities 16.67x 22.22x
Days sales outstanding 45.63 32.00
Inventory turnover 4.82x 7.00x
Fixed assets turnover 11.35x 12.00x
Total assets turnover 2.08x 3.00x
Profit margin 2.07% 3.50%
Return on equity 10.45% 21.00%
16-7
How does Ski’s cement current assets investment policy compare with its industry?

• Current assets investment policy is reflected in the

current ratio, turnover of cash and securities, inventor
y turnover, and days sales outstanding.
• These ratios indicate that SKI has large amounts of
working capital relative to its level of sales.
• Ski is either very conservative or inefficient.

16-8
 Ski inefficient or conservative?

• A conservative (relaxed) policy may be appropriate if

it leads to greater profitability.

• However, Ski is not as profitable as the average firm

in the industry.
– This suggests the company has excessive current assets.

16-9
 Management of Cash

• Cash management is used in two senses:

1. In narrow sense, it is used to cover currency and generally
equivalents of cash, such as cheques and demand deposits
in bank.
2. In broad sense, cash also includes near cash assets, such a
s marketable securities and time deposits into bank. They s
erve as a reserve pool of liquidity that provides cash quickly
when needed.
 Motives for holding Cash

1. Transaction Motive.
• Cash payment for purchases
• Wages
• Operating expenses
• Financial charges, like interest, taxes.
 Motives for holding Cash

2. Precautionary Motive.
• Flood, strike and failure of important customers
• Unexpected slow down in collection of receiva
bles.
• Cancelation of some order for goods as the cu
stomer is not satisfied.
• Sharp increase in cost of raw material.
 Motives for holding Cash

3. Speculative Motive.
• An opportunity to purchase raw materia
l at a reduced price on payment of imm
ediate cash.
• Delay in purchase of raw materials on t
he anticipation of decline in prices.
 Motives for holding Cash

4. Compensating Motive.
• It is a minimum account balance that a
bank requires as compensation, either
for services provided or as part of a loa
n payment
 Cash Conversion Cycle

• The cash conversion cycle focuses on the length of

time between when a company makes payments to
its creditors and when a company receives payments
from its customers.

Inventory Average Payables

CCC  conversion  collection  deferral
period period period

16-15
Cash Conversion Cycle

16-16
 Cash Conversion Cycle

• Assume that Ahsan is just starting in business, buying device

s from a manufacturer in china and selling them through
distributors all over world. The business plan calls for it to
purchase 100 Million of merchandise at the start of each
month and have it sold within 50 days. The company will
have 40 days to pay its suppliers, and it will give its customer
s 60 days to pay for their purchases.
• This information can be used to calculate Ahsan’s, cash
conversion cycle, which “nets out” the three time periods:

16-17
 Cash Conversion Cycle
• 1. Inventory conversion period. For Ahsan, this is the 50 days it
expects to take to sell the cement, converting it from raw material
to accounts receivable
• 2. Average collection period (ACP). The ACP is also called the
days sales outstanding (DSO). It is total time that customers gets
to to pay for goods following a sale. Ahsan’s business plan calls for
an ACP of 60 days based on its 60-day credit terms. This is also
called the receivables conversion period, as it is supposed to take
60 days to collect and thus convert receivables to cash.
• 3. Payables deferral period. This is the length of time Ahsan
suppliers give it to pay for its purchases, which in our example is
40 days.
16-18
Cash Conversion Cycle

16-19
Computing the Actual CCC from Financial Statements

The following data taken from GBM financial statements, in millions:

a) What is inventory conversion period?

The 50.4 period shows that it takes GBM around 50 days to convert sells
its merchandise.
16-20
Computing the Actual CCC from Financial Statements

The following data taken from GBM financial statements, in

millions:

b) What is average collection period?

The 133.5 days period shows that it takes GBM around 134
days after sales to receive cash. 16-21
Computing the Actual CCC from Financial Statements

The following data taken from GBM financial statements, in

millions:

c) What is average payable period?

GBM pays its suppliers 41 days after purchase.

16-22
Computing the Actual CCC from Financial Statements
The following data taken from GBM financial statements, in millions:

d) What is cash conversion cycle?

We can now combine the three periods: inventory conversion, average collection
period, and payable deferral period to compute the cash conversion cycle.

GBM has a CCC of 143 days.

16-23
 Class Practice Exercise/Activities

• Question 1 Define each of the following terms:

• a. Working capital; net working capital.
• b. Aggressive financing policy; Moderate (maturity
matching) financing policy; conservative financing
policy

» Cont..
16-24
 Class Practice Exercise/Activities

• Question 2 Based on the following financial data

of Ahsan Cement: compute the cash conversion
cycle.
Annual Sales 1100 Million
Inventories 120 Million
Cost of Goods Sold 910 Million
Account Receivable 380 Million
Account Payable 110 Million

16-25
 .

Question
 A) You are required to download the financial statement of any firm of
your choice in the cement sector and compute the cash conversion cycle
based on the financial information in the financial statements.
• b) Compare the inventory conversion, average collection, and payable
deferral period with the cement industry average. Assume that the indu
stry average of cement sector is:
– Inventory conversion period = 25 Days
– Average collection period = 35 Days
– Average Payable period is = 15 Days
 

16-26
 Video Lecture Link

• https://www.youtube.com/wa
tch?v=W9LkrCGTxfU

16-27