Working Capital Management: Fourth Edition

Fundamentals of Corporate
Finance
Fourth Edition
Robert Parrino, Ph.D.; David S. Kidwell, Ph.D.; Thomas W. Bates,
Ph.D.; Stuart Gillan, Ph.D.
Chapter 14
Working Capital Management

Chapter 14: Working Capital
Management
Copyright ©2018 John Wiley & Sons, Inc. 2

Learning Objectives (1 of 2)
1. Define net working capital, discuss the importance of
working capital management, and compute a firm’s net
working capital
2. Define the operating and cash conversion cycles, explain
how they are used, and compute their values for a firm
3. Discuss the relative advantages and disadvantages of
pursing (1) flexible and (2) restrictive current asset
management strategies
4. Explain how accounts receivable are created and managed,
and compute the cost of trade credit

Learning Objectives (2 of 2)
5. Explain the trade-off between carrying costs and reorder
costs, and compute the economic order quantity for a firm’s
inventory costs
6. Define cash collection time, discuss how a firm can
minimize this time, and compute the economic costs and
benefits of a lock box
7. Describe three current asset financing strategies and discuss
the main sources of short-term financing

Working Capital Basics (1 of 4)
• Working capital management involves two key issues
o What is the appropriate amount and mix of current assets
for the firm to hold?
o How should these current assets be financed?

Exhibit 14.1 Apple Inc. Financial Statements, Fiscal Year Ended September 24, 2016 ($ millions)
This exhibit shows the balance sheet and income statement for Apple Inc. for the fiscal year ended September 24, 2016.
We use this information in illustrating various elements of working capital management.
Balance Sheet as of September 24, 2016
Assets
Cash $20,484
Short-term investments 46,671
Accounts receivable 15,754
Inventory 2,132
Other current assets 21,828
Total current assets $106,869
Property, plant, and equipment 61,245
Less: Accum. depreciation 34,235
Net plant and equipment 27,010
Investments 170,430
Other noncurrent assets 17,377
Total Assets $321,686
Balance Sheet as of September 24, 2016
Liabilities and equity

Accounts payable $37,294
Deferred revenue 8,080
Accrued expenses 22,027
Other current liabilities 11,605
Total current liabilities $79,006
Long-term debt 75,427
Other noncurrent liabilities 39,004
Total liabilities $193,437
Preferred stock 0
Common stock 31,251
Retained earnings 96,364
Other stockholder equity 634
Less: Treasury stock 0
Total common equity $128,249
Total liabilities and stockholder’s
equity $321,686
Income Statement for the fiscal year ended September 24, 2016
Net sales $215,639

Cost of goods sold 131,376
Operating expenses 24,239
Earnings before interest and taxes (EBIT) $ 60,024
Interest and other income 1,348
Earnings before taxes (EBT) $ 61,372
Taxes 15,685
Net income $ 45,687
Common stock dividend $ 12,188
Stock repurchases 29,000
Addition to retained earnings $ 4,080

Working Capital Basics: Terms and
Concepts (1 of 2)
• Current assets are cash and other assets that the firm expects
convert into cash in a year or less
• Current liabilities (or short-term liabilities) are obligations that
the firm expects to pay off in a year or less
• Working capital (also called gross working capital) are the funds
invested in a company’s cash account, account receivables,
inventory, and other current assets

Working Capital Basics: Terms and
Concepts (2 of 2)
• Net working capital (NWC) refers to the difference between
current assets and current liabilities; it is important because it is a
measure of liquidity and represents the net short-term investment
the firm keeps in the business
• Working capital management involves making decisions
regarding the use and sources of current assets
• Working capital efficiency refers to the length of time between
when a working capital asset is acquired and when it is converted
into cash
• Liquidity is the ability of a company to convert real or financial
assets into cash quickly and without loss of value

Working Capital Accounts and Trade-Offs
• Working capital accounts

o Cash includes cash and other highly liquid short-term money
market instruments, such as U.S. Treasury securities
o Receivables represent the amount owed by customers who
have availed themselves of the firm’s trade credit facility
o Firms maintain inventory of raw materials, work in process,
and finished goods
o Payables represent the amount owed to the firm’s vendors and
suppliers for materials purchased on credit
• Increasing working capital costs money, but should lead to
increased sales and better relationships with vendors,
suppliers, and employees
Operating and Cash Conversion
Cycles (1 of 5)
• The cash conversion cycle is the length of time from the point at
which a company pays for raw materials until the point at which
it receives cash from the sale of finished goods made from those
materials
• Sequence of events in the cash conversion cycle:
o The firm uses cash to pay for the cost of raw materials and the costs
of conversion
o Finished goods are held in finished goods inventory until they are
sold
o Finished goods are sold on credit to the firm’s customers
o Customers repay the credit the firm has extended them and the firm
receives the cash
Cycles (2 of 5)
Exhibit 14.2 The Cash Conversion Cycle

A typical cash conversion cycle begins with cash outflows for raw materials and conversion costs and goes through
several stages before these resources are turned back into cash. The cash conversion cycle reflects the average time
from the point that cash is used to pay for raw materials until cash is collected on the accounts receivable associated
with the product produced with those raw materials. One of the main goals of a financial manager is to optimize the
time between the cash outflows and the cash inflows.

Cycles (3 of 5)
• Goals of financial managers in managing the cycle:
o To delay paying accounts as long as possible without suffering
any penalties
o To maintain minimal raw material inventories without causing
manufacturing delays
o To use as little labor as possible to manufacture the product
while maintaining quality

Cycles (4 of 5)
• Goals of financial managers in managing the cycle:
o To maintain minimal finished good inventories without losing
sales
o To offer customers the most attractive credit terms possible on
trade credit to maximize sales while minimizing the risk of
non-payment
o To collect cash payments on accounts receivable as fast as
possible to close the loop

Cycles (5 of 5)
Exhibit 14.3 Time Line for Operating and Cash Conversion Cycles for Apple Inc. in 2016
The exhibit shows the cash inflows and outflows and other key events in a firm’s operating cycle and
cash conversion cycle, along with computed values for Apple. Both of these cycles are used for
measuring working capital efficiency.

Operating Cycle (1 of 2)
• The operating cycle begins when the firm uses its cash to
purchase raw materials and ends when the firm collects cash
payments on its credit sales
o Days sales in inventory (DSI) shows how long the firm keeps
its inventory before selling it, the ratio of the inventory balance
to the daily cost of good sold
365 days 365 days

DSI  
Inventory turnover COGS / Inventory

Operating Cycle (2 of 2)
Exhibit 14.4 Selected Financial Ratios for Apple Inc. and the Computer Industry in 2016
When we compare working capital ratios for Apple with average ratios for the computer industry, we
see that Apple is outperforming its peers on all metrics. Apple holds less inventory, collects on its
outstanding balances more quickly than competitors, and is able to defer its cash payments to suppliers
longer than competitors. These three facts combined ensure that Apple’s operating and cash conversion
cycles are significantly shorter than is the norm in the computer industry. Note that a negative cash
conversion cycle of −71.11 days means that Apple collects cash from its customers before it has to pay
its suppliers. Thus, Apple’s suppliers are financing all of Apple’s working capital and then some.
Financial Ratio Apple Computer Industry

Days’ sales in inventory (D SI) 5.92 54.25
Days’ sales outstanding (DSO) 26.66 58.10
Days’ payables outstanding (D PO) 103.69 72.41
Operating cycle (days) 32.58 112.35
Cash conversion cycle (days) −71.11 39.93

Operating Cycle: Days Sales Outstanding
• Days sales outstanding (DSO) estimates how long it takes on
average for the firm to collect its outstanding accounts receivable
balances; also called the Average Collection Period (ACP)
365 days
DSO 
Accounts receivable turnover
365 days
 Net sales
Accounts receivable
Equation 14.1
Operating Cycle  DSI  DSO

Cash Conversion Cycle (1 of 5)
• The cash conversion cycle does not start until the firm
actually pays for its inventory
o It represents the length of time between the cash outflow for
materials and the cash inflow from sales
o Days payables outstanding (DPO) tells how long a firm takes
to pay off its suppliers for the cost of inventory
365 days 365 days

DPO  
Accounts payable turnover COGS / Accounts payable

• We can now calculate the cash conversion cycle using one of two
methods:
Equation 14.2
Cash Conversion Cycle  DSI  DSO  DPO

Equation 14.3
Cash Conversion Cycle  Operating Cycle  DPO

Exhibit 14.5 Kernel Mills Financial Statements, Fiscal Year Ended December 31, 2017 ($ millions)
The exhibit shows the balance sheet and income statement for Kernel Mills for the fiscal year ended December 31, 2017,
as well as some ratios from the food industry. Use the data to work through and support your analysis in Learning by
Doing Application 14.1.
Balance Sheet as of December 31, 2017
Assets
Cash $175,000
Short-term investments 165,000
Accounts receivable 690,000
Inventory 660,000
Total current assets $1,690,000
Plant and equipment 2,400,000
Less: Accum. depreciation (800,000)
Net plant and equipment 1,600,000
Investments 210,000
Total Assets $3,500,000

Balance Sheet as of December 31, 2017
Liabilities and equity

Accounts payable $ 550,000
Deferred revenue 400,000
Accrued expenses 85,000
Taxes payable 80,000
Total current liabilities $1,115,000
Long-term debt $1,100,000
Total liabilities $2,215,000
Common stock 600,000
Retained earnings 685,000
Total common equity $1,285,000
Total liabilities and stockholder’s equity $3,500,000

Income Statement
Net sales $5,200,000
Cost of goods sold 3,325,000
Operating expenses 1,500,000
Earnings before interest and taxes (EBIT) $ 375,000
Investment and other income 40,000
Interest expense 116,500
Earnings before taxes (EBT) $ 298,500
Taxes 148,000
Net income $ 150,500
Common stock dividend $ 15,500
Addition to retained earnings $ 135,000
Selected food industry ratios: Days’ sales in inventory = 71.59, Days’ sales outstanding = 44.77, Days’ payables
outstanding = 58.33, Cash conversion cycle = 58.03 days

Strategies (1 of 4)
• Financial managers use two types of strategies for current
assets: flexible and restrictive
o The flexible current asset management strategy has a high
percent of current assets to sales, whereas a restrictive policy
has a low percent of current assets to sales

Strategies (2 of 4)
• Flexible current asset management strategy
o Calls for management to invest large amounts in cash,
marketable securities, and inventory
o Is considered low-risk and low-return
o The advantage of this strategy is large working capital
balances
o The downside of this strategy is the high carrying cost
associated with owning a high level of inventory and providing
liberal credit terms to customers

Strategies (3 of 4)
• The restrictive current asset management strategy is a
high-risk high-return alternative to the flexible strategy
o The high risk comes in the form of shortage costs, both
financial and operating
• Operating shortage costs result from lost production and
sales
• Financial shortage costs arise mainly from illiquidity,
shortage of cash, and a lack of marketable securities to sell
for cash

Working Capital Management Strategies
(4 of 4)
• The working capital trade-off: management will try to find

the level of current assets that minimizes the sum of the
carrying costs and shortage costs
o The optimal current assets investment strategy will depend on
the relative magnitudes of carrying costs and shortage costs;
this conflict is often referred to as the working capital trade-off
o Financial managers need to balance shortage costs against
carrying costs to define an optimal strategy
o If carrying costs are larger than shortage costs, then the firm
will maximize value by adopting a more restrictive strategy
o On the other hand, if shortage costs dominate carrying costs,
the firm will need to move towards a more flexible policy
Accounts Receivables
• Companies frequently make sales to customers on credit by
delivering goods in exchange for the promise of a future payment
• The promise is an account receivable from the firm’s point of
view
• Offering credit to customers can help a firm attract customers by
differentiating the firm and its products from its competitors

Terms of Sale (1 of 2)
• Whenever a firm sells a product, the seller spells out the terms
and conditions of the sale in a document called the terms of sale
o The agreement specifies when payment is due and the amount of any
discount if early payment is made
• The simplest offer is cash on delivery (COD), with no credit
offered
• When credit is part of the sale, the terms of sale spell out the
credit agreement between the buyer and seller
o Trade credit, which is short-term financing, is typically made with a
discount for early payment rather than an explicit interest charge

Terms of Sale (2 of 2)
• Trade credit is a loan from the supplier and is usually a very
costly form of credit
• We can find the effective annual rate (EAR) for trade credit using
the following formula:
Equation 14.4
365
 Discount  days credit
EAR for accounts receivable  EARR  1   1
 Discounted price 

Aging Accounts Receivables (1 of 2)
• A common tool that credit managers use is called an aging
schedule
o The aging schedule shows the breakdown of the firm’s accounts
receivable by their date of sale, how long the account has not been
paid
o Its purpose is to identify and then track delinquent accounts and to
see that they are paid
• Aging schedules are also an important tool for analyzing the
quality of a firm’s receivables
o The aging schedule reveals patterns of delinquency and shows where
collections efforts should be concentrated

Aging Accounts Receivables (2 of 2)
Exhibit 14.6 Aging Schedule of Accounts Receivable
An aging schedule shows the breakdown of a firm’s accounts receivable by their date of sale; it tells managers how long
the accounts have gone unpaid. This exhibit shows the aging schedules for three different firms: Minnow, which is
extremely effective in collecting on its accounts receivable, and Rooney and Hastings, which are not performing as well.
Minnow Corporation Rooney, Inc. Hastings Corporation

Age of Value of % of Total Value of % of Total Value of % of Total
Account(days) Account Value Account Value Account Value
0–10 $436,043 60% $363,370 50% $319,765 44%
11–30 290,696 40 218,022 30 181,685 25
31–45 0 0 109,011 15 116,278 16
46–60 0 0 36,336 5 72,674 10
Over 60 0 0 0 0 36,337 5
Total $726,739 100% $726,739 100% $726,739 100%

Inventory Management
• Inventory management is largely a function of operations
management, not financial management
• Manufacturing companies generally carry three types of
inventory: raw materials, work in process, and finished goods
o Investment in inventory is costly
• Capital invested in inventory provides no direct return, but
running out of raw materials can cause manufacturing to shut
down at a greater cost to the firm
o A shortage of finished goods can mean lost sales

Economic Order Quantity (EOQ)
• The EOQ mathematically determines the minimum total inventory
cost taking into account reorder costs and inventory carrying costs
• The optimal order size strikes the balances between these two
costs
Equation 14.5
2  Reorder costs  Sales per period
EOQ 
Carrying costs

Just-in-Time Inventory Management
• In this system the exact day-by-day, or even hour-by-hour raw
material needs are delivered by the suppliers, who deliver the
goods “just in time” for them to be used on the production line
o A big advantage in this system is that there are essentially no raw
material inventory costs and no chance of obsolescence or loss to
theft
o On the other hand, if the supplier fails to make the needed deliveries,
then production shuts down
• If this system works for a firm effectively, it cuts down their
investment in working capital dramatically

Cash Management and Budgeting
• There are three main reasons for holding a cash balance
o First, it facilitates transactions with suppliers, customers, and
employees
o Second, for precautionary or strategic reasons
o The third reason for holding cash is simply that most banks require
firms to hold compensating balances, minimum cash balances in
exchange for services

Cash Collection
• Collection time, or float, is the time between when a customer
makes a payment and when the cash become available to the firm
• Collection time can be broken down into three components:
o Delivery, or mailing, time: when a customer mails a payment it may
take several days before that payment arrives
o Processing delay: once the payment is received it must be opened,
examined, accounted for, and deposited at the firm’s bank
o Finally, there is a delay between the time of the deposit and the time
the cash is available for withdrawal

Lockboxes
• A system allows geographically dispersed customers to send their
payments to a post office box close to them
• With a concentration account, a post office box is replaced by a
local branch which receives the mailings, processes the
payments, and makes the deposits
• Either approach will reduce the collection time to an extent but
there is a cost associated with it

Electronic Funds Transfers
• Another increasingly popular means of reducing cash collection
time is through the use of electronic funds transfers. Such
payments reduce cash collection times in every phase
o First, mailing time is eliminated
o Second, processing time is reduced or eliminated since no data entry
is necessary
o Finally, electronic funds transfers typically have little or no delay in
funds availability
• Using PayPal eliminates float

Financing Working Capital (1 of 4)
• The minimum level of working capital is viewed as permanent
working capital
• Exhibit 14.7 shows the three basic strategies that a firm can
follow to finance its working capital and fixed assets
• Each of the three panels show:
o The total long-term financing needed, consisting of long-term and
equity
o The seasonal needs for working capital that fluctuates with the level
of sales

Exhibit 14.7 Working Capital Financing Strategies

Three alternative strategies for financing working capital and fixed assets are (1) a maturity matching strategy, which
matches the maturities of assets and the sources of funding; (2) a long-term funding strategy, which relies on long-term
debt to finance both working capital and fixed assets; and (3) a short-term funding strategy, which uses short-term debt to
finance all seasonal working capital needs and a portion of permanent working capital and fixed assets.

• Strategies for financing working capital
o The maturity matching strategy is one of the most basic
techniques used by financial managers to reduce risk when
financing assets (Exhibit 14.7 Panel A)
• All seasonal working capital is funded with short-term
borrowing and, as the level of sales varies seasonally, short-term
borrowing fluctuates between some minimum and maximum
level

• Strategies for financing working capital
o The long-term funding strategy is shown in Panel B of
Exhibit 14.7
• All permanent working capital and fixed assets are funded with
long-term financing
• This strategy relies on long-term debt to finance both capital
assets and working capital
o The short-term funding strategy is shown in Panel C of
Exhibit 14.7
• This strategy relies on short-term debt to finance all seasonal
working capital, a portion of the permanent working capital and
fixed assets

Financing Working Capital in Practice
• Matching Maturities
o Nearly all financial managers try to match the maturities of
assets and liabilities when funding the firm
o Short-term assets are funded with short-term financing and
long-term assets are funded with long-term financing
• Permanent Working Capital
o Most financial managers like to fund some of their current
assets with long-term debt as shown in Panel B of Exhibit 14.7
o Some large firms with the highest credit standing prefer to
fund some of their long-term fixed assets with short-term debt
sold in the commercial paper market

Sources of Short-Term Financing (1 of 4)
• Accounts Payable
o Accounts payable (trade credit), bank loans, and commercial
paper are common sources of short-term financing
o The buyer decides whether to take advantage of the cash
discount or wait and pay in full when the account is due

• Short-term Bank Loans
o If the firm backs the loan with an asset the loan is defined as secured,
otherwise the loan is unsecured
o Secured loans should allow the borrower to borrow at a lower interest rate
o An informal line of credit is a verbal agreement between the firm and the
bank, allowing the firm to borrow up to an agreed-upon upper limit
• In exchange for providing the line of credit, a bank may require that the firm
hold a compensating balance with them
o A formal line of credit is also known as revolving credit
• Under this type of agreement, the bank has a legal obligation to lend an amount
of money up to a pre-set limit; the firm pays a yearly fee in addition to the
interest expense on the amount they borrow

• Commercial Paper
o Commercial paper is a promissory note issued by large
financially secure firms that have high credit ratings
o Commercial paper is not secured (the issuer is not pledging
any assets to the lender in the event of default), but most
commercial paper is backed by a credit line from a commercial
bank
o The default rate on commercial paper is very low, resulting in
an interest rate that is usually lower than what a bank would
charge on a direct loan

• Accounts Receivable Financing
o A company can secure a bank loan by pledging the firm’s
accounts receivable as security
o Accounts receivable financing is an important source of
funds for medium-size and small businesses
o A second way for a business to finance itself with accounts
receivables, called factoring, is to sell the receivables to a
factor at a discount; the firm that sells the receivables has no
further legal obligation to the factor

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Copyright © 2018 John Wiley & Sons, Inc.
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from the use of the information contained herein.

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Fundamentals of Corporate

Working Capital Management

Copyright ©2018 John Wiley & Sons, Inc. 2

Copyright ©2018 John Wiley & Sons, Inc. 3

Copyright ©2018 John Wiley & Sons, Inc. 4

Copyright ©2018 John Wiley & Sons, Inc. 5

Liabilities and equity

Net sales $215,639

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• Working capital accounts

Exhibit 14.2 The Cash Conversion Cycle

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365 days 365 days

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Financial Ratio Apple Computer Industry

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Operating Cycle  DSI  DSO

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365 days 365 days

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Cash Conversion Cycle  DSI  DSO  DPO

Cash Conversion Cycle  Operating Cycle  DPO

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Balance Sheet as of December 31, 2017

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Liabilities and equity

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• The working capital trade-off: management will try to find

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Minnow Corporation Rooney, Inc. Hastings Corporation

11–30 290,696 40 218,022 30 181,685 25

31–45 0 0 109,011 15 116,278 16

46–60 0 0 36,336 5 72,674 10

Total $726,739 100% $726,739 100% $726,739 100%

Copyright ©2018 John Wiley & Sons, Inc. 33

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Exhibit 14.7 Working Capital Financing Strategies

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