Working Capital

Basic Concepts
Working Capital
Management -
DEFINITION
• Management of current assets and
liabilities
• To achieve a balance between
profitability and risk that
contributes positively to the firm’s
value.

Working capital management is all

about RISK AND RETURN TRADE-OFF.
 To understand the relationship between profitability and
risk, we need to understand the nature of current assets.

Working Capital CURRENT ASSETS are the least profitable assets of the
Management - company.
• Investment in working capital involves lower return.
DEFINITION • The lower the return, the lower the risk
• Lower default risk
• Investment in working capital more has given the
company a greater liquidity.
• PROFITABILITY is INVERSELY related to LIQUIDITY.
 The length of time in which the firm purchase
inventories, sell it and receive cash from sale.
Purchase of Sell Collecting
Inventories Inventories Cash

Ave. Conversion/Sale Ave. Collection Period or

OPERATING
Period or Age of Inventory Age of Receivables

CYCLE
Operating Cycle

Inventory days Receivable days

Credit Purchases Credit Sale Cash Receipt

 The length of time between paying for working capital
and collecting cash from sale of inventory.

Purchase of Payment for Collecting

Inventories Purchases Cash

CASH Ave. Payable Deferral

CONVERSION
CASH CONVERSION CYCLE
Period or Age of Payables

CYCLE
Operating Cycle

Inventory days Receivable days

Credit Purchases Credit Sale Cash Receipt

Cash Payment

Cash Conversion Cycle

 The length of time the funds are tied up in working
CASH capital

CONVERSION NOTE: Cash Conversion cycle is the basis for how much
CYCLE the company should invest in working capital.
 ILLUSTRATION
APR. 1 – Purchased inventories on account, P20,000.

CASH
APR. 4 – Sold inventories on account, P25,000.
APR. 6 – Paid the purchases on account
CONVERSION APR. 10 – Collected cash from sales on account

CYCLE CCC = Days Inventory + Days AR – Days AP

3 + 6 - 5
= 4 DAYS
 GOAL OF THE COMPANY:
To shorten the cash conversion cycle
(Lower CCC = Lower Investment in WC)
CASH
CONVERSION Decrease Days
Inventories or

CYCLE Decrease Cash

Conversion Cycle
Days AR

Increase Days
Accounts Payable

CCC = Days AR + Days Inventory – Days AP

 Elaine Corp., a leading producer of cellphone cases,
turns out 2,000 cases a day at a cost of 750.00 per case.
It takes the firm 20 days to convert raw materials into
cellphone cases. Elaine allows its customers 25 days to
pay for the cellphone cases, and then it pays supplier on
a 15-day basis.

Sample Exercise REQUIREMENTS:

1. How long is ELAINE’s operating cycle and cash
conversion cycle, respectively?
2. Assuming the production of cases is steady, what
amount of working capital must ELAINE finance?
 Working
Capital Policy

Working Investment
Policy
Financing
Policy
Capital Policy
Where the
Where to
finances
invest?
came from?
 Type of Conservativ
Aggressive
Policy e

Description Relaxed Restricted

Working Capital Working

High Low
Capital
Investment Policy
Profitability Low High

Liquidity High Low

Default Risk Low High

Working Capital
Financing Policy

Asset classification for WC

management purposes:

• Permanent – are current and

fixed assets that remain
unchanged over the year.
• Temporary (seasonal assets) –
are current assets that vary
over the year.
Working Capital
Financing Policy
ILLUSTRATION:
A company has the following balances on its current
assets:
• Permanent current assets –
100,000 January 100,000
• Temporary current assets – February 120,000
• Jan = 0 March 130,000
• Feb = 20,000 April 110,000
• March = 30,000 May 105,000
• April = 10,000
• May = 5,000
 Maturity
CLASSIFICATION OF ASSETS Aggressive Conservative
Matching

Temporary Short Term Debt

Working Capital Current Assets
Assets
Short Term Debt
Short Term Debt

Financing Policy Permanent

Assets

Long Term Debt

Long Term Debt
Permanent Long Term Debt
Fixed Assets Assets
 • Carrying Cost – cost associated with having current assets.
• Opportunity Costs – benefit foregone
• Storage Costs
Relevant costs in • Shortage cost – costs associated with NOT having current
Investment of assets.
• Transaction costs
Current Assets • Stock-out costs