CORPORATE FINANCIAL

MANAGEMENT AND
MODELLING
Week 10/ Session 14
WORKING CAPITAL MANAGEMENT
 Acknowledgement
These slides have been adapted from:
Lawrence J. Gitman, Chad J. Zutter (2015)
Principles of Managerial Finance. Pearson.
Global Edition. 14th Edition. ISBN 978 1 292
01820 1.

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 Learning Goals
LG
1
Students understand working capital
management, net working capital and
risk and profitability trade off
LG
2 Students understand Cash Conversion
Cycle, its funding requirements, funding
strategy and strategy to manage it
LG
3 Students understand various Inventory
Management systems
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 Learning Goals
LG
4
Students understand Credit Selection
process and Credit Standards
LG
5
Students understand about credit terms,
cash discounts and credit monitoring
LG
6 Students understand Investment in
Marketable Securities

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WORKING CAPITAL
 Overview
• Working Capital Management is management of
firm’s current assets and current liabilities. It
covers the management of each current assets
and liabilities such as account receivable,
inventory and account payables
• Net Working Capital is firm’s current assets
minus current liabilities. When a firm has
predictable cash flows high net working capital is
not a necessity
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 Profitability and Risk
 Firms aim to have a balance between risk and profitability
 Risk in working capital management, risk is a possibility of insolvency,
firm inability to pay bills
 Profitability is relationship between revenue and costs.
 Table below illustrate impact on increase and decrease of current assets
and liabilities towards firm’s risk and profit

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 CASH CONVERSION CYCLE

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 Overview
 Cash Conversion Cycle (CCC) is amount of
time required for a firm to convert cash
invested in oprations to cash received as a
result from operations
 Operating Cycle (OC) is time required from
beginning of operation process to ending of
operation process when firm collects cash
from sale of its products
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 Calculating Cash
Conversion Cycle (CCC)
 How we calculate firm’s CCC?
CCC = OC – APP
where
OC = AAI + ACP
therefore we can calculate CCC as follows:
CCC = AAI + ACP – APP
AAI Average Age of Inventory amount of time inventory is held
ACP Average Collection Period the time takes to collect Account Receivable

APP Average Payment Period the time takes to pay Account Payable

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 Resorcess Invested in CCC
In 2007, International Business Machines Corp. (IBM) had annual revenues of
$98.786 million, cost of revenue of $57,057 million, and account payable of
$8,054 million. IBM had an Average Age of Inventory (AAI) of 17,5 days, and
Average Collection Period (ACP) of 44.8 days, and an Average Payment Period
(APP) of 51.2 days. (IBM’s purchases were $57,416 million). Thus the cash
conversion cycle for IBM was 11.1 days.

The resources IBM has invested in cash conversion cycle (1 year = 365 days) were:

Inventory = $57,057 million x (17,5/365) = $ 2,735,609,589

+ Account Receivable = $98,786 million x (44.8/365) = $12,124,966,575
- Account Payable = $57,416 million x (51,2/365) = $ 8,053,970,411
Resources Invested = $ 6,806,605,753

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Thank You
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 Funding Requirements
and Strategy for CCC
 Permanent Funding Requirenent: firm’s constant investment
in operating assets due to constant sales
 Seasonal Funding Requirement: firm’s investment in
operating assets varies over time atributed to cyclical nature
of sales
 Agressive Funding Strategy: firm funding strategy under
which it funds seasonal funding requirement with short term
debt and permanent fnding requirement with long term debt
 Conservative Funding Strategy: under this strategy firm uses
long term debt only for both permanent and seasonal funding
requirement
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Thank You
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 Calculating Agressive vs
Conservative Funding Strategy
 Semper Pump Company has a permanent funding
requirement of $135,000 in operating assets and seasonal
funding requirements that vary between $0 and $990,000
and average $101,250. If Semper can borrow short-term
funds at 6.25% and long-term funds at 8%, and if it can earn
5% on the investment of any surplus balances, then the
annual cost of an aggressive strategy for seasonal funding
will be: Cost of short-term financing = 0.0625  $101,250 = $  6,328.13
+ Cost of long-term financing = 0.0800  135,000 = 10,800.00
– Earnings on surplus balances = 0.0500  0 = 0
Total cost of aggressive strategy = $17,128.13

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 Calculating Agressive vs
Conservative Funding Strategy
 Alternatively, Semper can choose a conservative strategy,
under which surplus cash balances are fully invested. (In
Figure 15.3, this surplus will be the difference between the
peak need of $1,125,000 and the total need, which varies
between $135,000 and $1,125,000 during the year.) The
cost of the conservative strategy will be:
Cost of short-term financing = 0.0625  $ 0 = $  0

+ Cost of long-term financing = 0.0800  1,125,000 = 90,000.00

– Earnings on surplus balances = 0.0500  888,750 = 44,437.50

Total cost of conservative strategy = $45,562.50

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 In management of CCC the strategy is to
operate efficiently by minimizing the length
of CCC. This strategy can be achieved by
turnover inventory as quickly as possible,
collect account receivable as fast as possible
and pay account payable as long as it is
permitted.

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 INVENTORY MANAGEMENT

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 Inventory Management
Techniques
 ABC System: differentiate inventory into 3 categories A, B and
C on the basis of dollar investment. Category A represent
highest dollar investment, while category C represent lowest
dollar investment. Firm’s intensity of monitoring and
management of inventory differ for each category
 Economic Order Quantity (EOQ) Model: Inventory
management system that determine the optimum order
quantity which minimize order cost and carrying cost for the
year. Formula for calculating EOQ:
S = Usage per period
O = Order Cost
C = Carrying Cost
Q = Order Quantity per Unit

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 Inventory Management
Techniques
 Order Cost: Fixed cost for placing and receiving order
 Carrying Cost: variable cost per unit for holding an
inventory for specific period
Order Cost = O x (S/Q)
Carrying Cost = C x (Q/2)
 Reorder Point: the point in which firm must make an
inventory order.
Reorder point = lead time x usage per day
 Safety Stock: extra inventory held by firm
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 Inventory Management
Techniques
 Just in Time system: inventory management
that focus in efficiency under which raw
materials arrive just in time before
production starts.
 Computerized Inventory Management
• Materials Requirement Planning (MRP)
• Manufacturing Resource Planning II (MRPII)
• Enterprise Resource Planning (ERP)
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ACCOUNT RECEIVABLE
MANAGEMENT
 Credit Selection
 The strategy in management of CCC is to
minimize length of CCC. One way to realize it
is by collection of account receivables as fast
as possible or speed the Average Collection
Period
 To ensure smooth credit collection firm must
have good credit selection and credit
standard procedure
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 Credit Selection
 5 C’s of Credit
1. Character: The applicant’s record of meeting past
obligations.
2. Capacity: The applicant’s ability to repay the
requested credit.
3. Capital: The applicant’s debt relative to equity.
4. Collateral: The amount of assets the applicant has
available for use in securing the credit.
5. Conditions: Current general and industry-specific
economic conditions.
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 Credit Selection
 Credit scoring is a procedure resulting in a
score that measures an applicant’s overall
credit strength.
 This method is used for small dollar credit
request
 The purpose of credit scoring is to make a
relatively informed credit decision quickly
and inexpensively
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 Credit Standard
 The firm sometimes will change its credit
standards by relaxing the standard in an
effort to improve its sales, returns and create
greater value for its owners.

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 Credit Standard
 Example:
Dodd Tool is currently selling a product for $10 per 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.The firm is currently
contemplating a relaxation of credit standards that is expected to
result in the following:
• a 5% increase in unit sales to 63,000 units;
• an increase in the average collection period from 30 days (the current level)
to 45 days;
• an increase in bad-debt expenses from 1% of sales (the current level) to 2%.
The firm’s required return on equal-risk investments, which is the
opportunity cost of tying up funds in accounts receivable, is 15%.
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Thank You
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 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:
1. The cash discount
2. The cash discount period
3. 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.

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 Credit Terms
 A firm may consider to change it credit terms to increase sales,
such as initiating discount.
 Example:
MAX Company has annual sales of $10 million and 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).
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Thank You
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 Credit Monitoring
 Average Collection Period (ACP)
 One of Credit monitoring techniques is by
calculating firm’s ACP. ACP will give
ilustration to the firm on when on average
customers pays receivables.

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 Credit Monitoring
 Aging of Account Receivable: technique in
monitoring Account Receivable that breaks
down AR into groups according to time of
origin

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 MARKETABLE SECURITIES

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 Summary
 Firm’s working capital management is
management of current asset and current
liabilities of the firm covering cash, inventory,
account receivable, account payable, etc
 Firm must maintain balance between profitability
and risk by having an appropriate number of
current assets and current liabilities. High level of
net working capital to minimize risk but low
enough to increase profitability
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 Summary
 Firm must target minimizing length of Cash Conversion
Cycle by turning inventory quickly, collecting receivable
quickly and paying payables as slowly as allowed.
 By minimizing length of CCC firm can reduce amount of
resources invested in operations
 Good management of working capital might reduce
resources investment in operations creating more
funds for expansion and reducing financing cost. This
at the end will cause positive impact in maximizing
owner’s wealth
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Thank You
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