WORKING CAPITAL

MANAGEMENT
Delivered by:
Dr. Shakeel Iqbal Awan
Working Capital Management
• Alternative Working Capital Policies
• Cash Management
• Inventory and A/R Management
• Trade Credit
• Bank Loans

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Working Capital Terminology
Working capital: current assets.
Net working capital: current assets minus current
liabilities.
Net operating working capital: current assets
minus (current liabilities less notes payable).
Current assets investment policy: deciding the
level of each type of current asset to hold, and
how to finance current assets.
Working capital management: controlling cash,
inventories, and A/R, plus short-term liability
management.

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Alternative Current Asset (CA) Investment Policies

Relaxed CA Investment Policy: Relatively large amounts of cash ,

marketable securities, and inventories are carried, and a liberal credit
policy results in a high level of receivables.
Restricted CA Policy: Holdings of cash marketable securities,
inventories and receivables are constrained.
Moderate CA Policy: Between the relaxed and restricted policies.

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 Zero Working Capital
Zero Working Capital = Inventory + A/R – Payables =
0
Negative working capital: Dell computers and
Amazon.com
Payment is received in advance before the product is
shipped or payment to suppliers.
These companies are able to use other people’s money
to run much of their day to day business.

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 Selected Ratios for SKI Inc.
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%

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How does SKI’s current assets investment
policy compare with its industry?
Current assets investment policy is reflected in
the current ratio, turnover of cash and
securities, inventory turnover, and days sales
outstanding.
These ratios indicate SKI has large amounts of
working capital relative to its level of sales.
SKI is either very conservative or inefficient.

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Is 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.

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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.

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Moderate Financing Policy
$ Temp. C.A.
S-T
Loans

Perm C.A. L-T Fin:

Stock,
Bonds,
Spon. C.L.
Fixed Assets
Years
Lower dashed line would be more aggressive.
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Conservative Financing Policy
Marketable
$ securities Zero S-T
Debt

L-T Fin:
Stock,
Perm C.A. Bonds,
Spon. C.L.

Fixed Assets
Years

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Choosing Between the Approaches
Short Term Loan
Lower interest rates (Advantage)
Faster processing (Advantage)
More flexible (Advantage) :
Switching to long term loan is
possible.
No restrictions from the lenders.
More risk for borrower (Disadvantage):
Increase in interest rates over time
In case of recession the borrower
might find it difficult to renew the loan
contract.
Long Term Loan
Higher interest rates (Disadvantage)
Slower Processing due to detailed
scrutiny (Disadvantage)
Less flexible (Disadvantage)
Switching to lower rates is not
possible
Sometimes restrictions are imposed
by the lenders.
Low risk (Advantage):
Not affected by rising interest rates.
No need to renew before maturity.
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WORKING CAPITAL MANAGEMENT
PART II

Delivered by:
Dr. Shakeel Iqbal Awan
 Cash Conversion Cycle (CCC)
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

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Cash Conversion Cycle
Inventory Average Payables
CCC  conversion  collection  deferral
period period period
Payables
Days per year Days sales
CCC    deferral
Inventory turnover outstandin g
period
365
CCC   46  30
4.82
CCC  76  46  30  92 days

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 Cash Budget
Forecasts cash inflows, outflows, and ending
cash balances.
Used to plan loans needed or funds available
to invest.
Can be daily, weekly, or monthly, forecasts.
Monthly for annual planning and daily for
actual cash management.

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SKI’s Cash Budget for January and
February
January February
Collections
$67,651.95 $62,755.40
Purchases 44,603.75 36,472.65
Wages 6,690.56 5,470.90
Rent
2,500.00 2,500.00
Total payments
$53,794.31 $44,443.55
Net cash flows $18,311.85
$13,857.64

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 SKI’s Cash Budget
January February
Cash at start if no borrowing $ $16,857.64
3,000.00
Net cash flows 18,311.85
13,857.64
Cumulative cash $35,169.49
$16,857.64
Less: Target cash
1,500.00 1,500.00
Surplus
$15,357.64 $33,669.49

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 Minimizing Cash Holdings
Use a lockbox
Insist on wire transfers and debit/credit cards
from customers
Synchronize inflows and outflows
Reduce need for “safety stock” of cash
Increase forecast accuracy
Hold marketable securities
Negotiate a line of credit

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How could bad debts be worked into the
cash budget?
Collections would be reduced by the amount
of the bad debt losses.
For example, if the firm had 3% bad debt
losses, collections would total only 97% of
sales.
Lower collections would lead to higher
borrowing requirements.

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 Inventory Costs
Types of inventory costs
 Carrying costs: storage and handling costs,
insurance, property taxes, depreciation, and
obsolescence.
 Ordering costs: cost of placing orders, shipping,
and handling costs.
 Costs of running short: loss of sales or customer
goodwill, and the disruption of production schedules.
Reducing inventory levels generally reduces
carrying costs, increases ordering costs, and may
increase the costs of running short.

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Is SKI holding too much inventory?
SKI’s inventory turnover (4.82x) is
considerably lower than the industry average
(7.00x).
The firm is carrying a large amount of
inventory per dollar of sales.
By holding excessive inventory, the firm is
increasing its costs, which reduces its ROE.
Moreover, this additional working capital
must be financed, so EVA is also lowered.

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 WC and EVA
EVA = NOPAT – (WACC * Total Operating Capital)
A reduction in WC decreases total operating capital
which increases EVA

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 WCM and ROE
ROE = Profit Margin * Total Assets Turnover * Equity
Multiplier
= NI/Sales * Sales/TA * Assets/Equity
I fWC and hence total assets can be
reduced without seriously affecting the
PM this will increase the total asset
turnover and consequently ROE.

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 WC and FCF
FCF = NOPAT – Net Investment in Operating Capital
If a company reduce its inventories, cash holdings or
receivables then its net investment in operating capital
will decline.
Less operating capital will lead to increase in FCF and
hence the stock price.

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END OF PART II

26
WORKING CAPITAL MANAGEMENT
Part III
Delivered by:
Dr. Shakeel Iqbal Awan
 If SKI reduces its inventory without adversely
affecting sales, what effect will this have on the
cash position?
Short run: Cash will increase as inventory purchases
decline.
This will reduce financing or target cash balance.
Long run: Company is likely to take steps to reduce its
cash holdings and increase its EVA.
The “excess” cash can be used to make investments in more
productive assets such as plant and equipment resulting in an
increase in operating income increasing its EVA.
Alternately, can distribute “excess” cash to its shareholders
through higher dividends or repurchasing shares resulting in a
lower cost of capital increasing its EVA.
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 Do SKI’s customers pay more or less
promptly than those of its competitors?
SKI’s DSO (45.6 days) is well above the
industry average (32 days).
SKI’s customers are paying less promptly.
SKI should consider tightening its credit
policy in order to reduce its DSO.

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 Elements of Credit Policy
1. Credit Period: How long to pay? Shorter period
reduces DSO and average A/R, but it may
discourage sales.
2.Cash Discounts: Lowers price. Attracts new
customers and reduces DSO.
3.Credit Standards: Restrictive standards tend to
reduce sales, but reduce bad debt expense. Fewer
bad debts reduce DSO.
4.Collection Policy: How tough? Restrictive
policy will reduce DSO but may damage customer
relationships.

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 Business Credit Report
A typical business credit report would include the
following:
1. A summary balance sheet and income statement.
2. A number of key ratios, with trend information.
3. Referrals from other parties offering credit to this firm.
4. A verbal description of the physical conditions of the firm’s
operations
5. A verbal description of the backgrounds of the firms
owners including any bankruptcies, lawsuits, divorce
settlement problems and the like.
6. A summary rating ranging from A the best credit risk
down to F for those that are deemed likely to default.
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Does SKI face any risk if it restricts its credit
policy?
Yes, a restrictive credit policy may discourage
sales.
Some customers may choose to go elsewhere if they
are pressured to pay their bills sooner.
SKI must balance the benefits of fewer bad debts
with the cost of possible lost sales.

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 If SKI reduces its DSO without adversely
affecting sales, how would this affect its cash
position?
Short run: If customers pay sooner, this increases
cash holdings. This will reduce financing or target
cash balance needed.
Long run: Over time, the company would
hopefully invest the cash in more productive assets,
or pay it out to shareholders. Both of these actions
would increase EVA.

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Reflecting Uncollectible Accounts in the
Financial Statements
At
Atthe
theend
endof
ofeach
eachperiod,
period,record
recordan
anestimate
estimateof
of the
the
uncollectible
uncollectibleaccounts.
accounts.

GENERAL JOURNAL
P
Date Account Titles and Explanation R Debit Credit
Uncollectible Accounts Expense $$$$
Allowance for Doubtful Accounts $$$$

Selling
Selling expense
expense Contra-asset
Contra-assetaccount
account
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The Allowance for Doubtful Accounts
The net realizable value is the amount of accounts
receivable that the business expects to collect.

Accounts receivable
Less: Allowance for doubtful accounts
Net realizable value of accounts receivable

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Writing Off an Uncollectible Account Receivable

When
When anan account
account is is determined
determined toto be
be
uncollectible,
uncollectible, itit no
no longer
longerqualifies
qualifies
as
as an
an asset
asset and
and should
should be be written
written off.
off.

GENERAL JOURNAL
P
Date Account Titles and Explanation R Debit Credit
Jan. 5 Allowance for Doubtful Accounts 500
Accounts Receivable (J. Clark) 500

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Writing Off an Uncollectible Account
Receivable
Before After
Write-Off Write-Off
Accounts receivable $ 10,000 $ 9,500
Less: Allow. for doubtful accts. 2,500 2,000
Net realizable value $ 7,500 $ 7,500

Notice that the $500 write-off did not change

the net realizable value nor did it affect any
income statement accounts.
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Monthly Estimates of Credit Losses

At
At the
theend
end of
of each
each month,
month,
management
managementshould
should
estimate
estimate the
the probable
probable
amount
amountof of uncollectible
uncollectible
accounts
accounts and
and adjust
adjust the
the
Allowance
Allowance for
for Doubtful
Doubtful
Accounts
Accounts toto this
this new
new
estimate. Two Approaches to Estimating
estimate. Credit Losses:
1. Balance Sheet Approach
2. Income Statement Approach

38
Estimating Credit Losses — The Balance Sheet
Approach

Year-end
Year-endAccounts
AccountsReceivable
Receivableis
is
broken
brokendown
downinto
intoage
ageclassifications.
classifications.


Each
Eachage
agegrouping
groupinghas
hasaadifferent
different
likelihood
likelihoodof
of being
beinguncollectible.
uncollectible.

Compute
Computeaaseparate
separateallowance
allowancefor
for
each
eachage
agegrouping.
grouping.

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Estimating Credit Losses — The Balance Sheet
Approach
At December 31, the receivables for EastCo, Inc. were
categorized as follows:
EastCo, Inc.
Schedule of Accounts Receivable by Age
December 31, 2009
Accounts Estimated Estimated
Receivable Bad Debts Uncollectible
Days Past Due Balance Percent Amount
Current $ 45,000 1% $ 450
1 - 30 15,000 3% 450
31 - 60 5,000 5% 250
Over 60 2,000 10% 200
 $ 67,000  $  1,350

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Estimating Credit Losses — The Balance
Sheet Approach
EastCo’s
EastCo’sunadjusted
unadjusted Allowance for
balance Doubtful Accounts
balancein
inthe
theallowance
allowance 500
account
accountis
is$500.
$500. 850
Per
Perthe
theprevious
previous 1,350
computation,
computation,the
thedesired
desired
balance
balanceis
is$1,350.
$1,350.

GENERAL JOURNAL
P
Date Account Titles and Explanation R Debit Credit
Dec. 31 Uncollectible Accounts Expense 850
Allowance for Doubtful Accounts 850

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Estimating Credit Losses — The Income
Statement Approach
Uncollectible accounts’ percentage is based on
actual uncollectible accounts from prior years’
credit sales.

Net Credit Sales

 % Estimated Uncollectible
Amount of Journal Entry

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Estimating Credit Losses — The Income Statement
Approach
In
In 2009,
2009, EastCo
EastCo had
had credit
credit sales
sales of
of $60,000.
$60,000.
Historically,
Historically, 1%
1% of
of EastCo’s
EastCo’s credit
credit sales
sales has
has
been
been uncollectible.
uncollectible. For
For 2009,
2009, the
the estimate
estimate
of
of uncollectible
uncollectible accounts
accounts expense
expense is is $600.
$600.
($60,000
($60,000 ×× .01
.01 == $600)
$600)

GENERAL JOURNAL
P
Date Account Titles and Explanation R Debit Credit
Dec. 31 Uncollectible Accounts Expense 600
Allow ance for Doubtful Accounts 600

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Recovery of an Account Receivable Previously
Written Off
Subsequent
Subsequentcollections
collectionsrequire
requirethat
thatthe
theoriginal
originalwrite-off
write-off
entry
entrybe
bereversed
reversed before
beforethe
thecash
cashcollection
collectionis
isrecorded.
recorded.

GENERAL JOURNAL
P
Date Account Titles and Explanation R Debit Credit
Accounts Receivable (X Customer) $$$$
Allowance for Doubtful Accounts $$$$

Cash $$$$
Accounts Receivable (X Customer) $$$$

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 Direct Write-Off Method
This method makes no attempt to
match revenues with the expense of
uncollectible accounts.

GENERAL JOURNAL
P
Date Account Titles and Explanation R Debit Credit
June 15 Uncollectible Accounts Expense $$$$
Accounts Receivable (X Customer) $$$$

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Internal Controls for Receivables
Separate the following duties:

Maintenance
Maintenanceof of the
theaccounts
accountsreceivable
receivable
subsidiary
subsidiaryledger.
ledger.

Custody
Custodyofofcash
cashreceipts.
receipts.
Authorization
Authorizationof
ofaccounts
accountsreceivable
receivablewrite-offs.
write-offs.

46
Management of Accounts Receivable
Extending credit encourages customers to
buy from us but it ties up resources in
accounts receivable.

Factoring
Credit Card
Accounts
Sales
Receivable

47
END OF LECTURE

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