Working Capital Management

Chapter 16
Working Capital Management
Alternative Working Capital Policies

Cash Management
Inventory and A/R Management
Trade Credit
Bank Loans
16-1
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.
Working Capital Terminology
• Working capital: current assets often as they turn over( used

and then replaced during the year).
• Net working capital: current assets minus current liabilities.
• Net operating working capital (NOWC): operating current
assets minus operating current liabilities.
• NOWC = cash + accounts receivable + inventories – (accounts
payables + accruals).
• 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.
16-2
Current Asset Investment Policies
• Relaxed: Relatively large amounts of cash,

marketable securities, and inventories are carried;
and a liberal credit policy results in a high level of
receivables.
• Restricted: Holdings of cash, marketable securities,
inventories, and receivables are constrained.
• Moderate: Between the relaxed and restricted
policies.
16-3
Chapter 16: Working Capital Management
16-4
ROE & Current Asset Investment Policies
• The DuPont Equation can be used to analyze ROE.

• ROE= PM*TAT* EM
= (NI/Sales)* (Sales/TA)* (TA/ Equity)
• Restricted: Low level of assets => a high total assets turnover ratio => a
high ROE.
– This policy also exposes the firm to risks because shortages can lead
to work stoppages, unhappy customers, and serious long-run
problems.
• Relaxed: Minimizes such operating problems; but it results in a low
turnover (and more bad debts) => low ROE. Trade-off between liquidity
and profitability.
• The optimal strategy is the one that maximizes the firm’s long-run
earnings and the stock’s intrinsic value.
16-5
Current Assets
• Businesses experience seasonal/or cyclical fluctuations.

• They must build up current assets when economy is
strong, but sell off all the inventories and reduce
receivables when the economy slacks off.
• However, current assets rarely drop to zero.
– Permanent current assets: CA needed at the low point of the
business cycle
– Temporary current assets: Extra CA needed to finance
seasonal or cyclical increase/fluctuations in sale.
• Current asset financing policy: the manner in which the
permanent and temporary current assets are financed.
16-6
Cash Conversion Cycle
• Generally, companies follow a typical cycle in which

they purchase inventory, sell this inventory on
credit and then collect accounts receivable.
• 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
16-7
• Real Time Computers Corp. (RTC) is introducing a new

minicomputer that performs 100 billion instructions per
second and sells for $250,000.
• The company expects to sell 40 such computers in its
first year of production.
• The effect on RTC’s working capital position will be as
follows:
• Firstly, RTC will order and receive the materials needed
to produce the 40 computers. As RTC purchases
materials on credit, this transaction will create an
account payable. Hence, the purchase will have no
immediate cash flow effect.
16-8
• Secondly, labour will be used to convert the materials

into finished computers. However, wages will not be paid
at the time the work is done, so, similar to account
payable, accrued wages will also build up.
• Thirdly, the finished computers will be sold on credit.
Hence, sales will create receivables, not immediate cash
flows.
• Fourthly, at some point before receivables are collected,
RTC must pay off its accounts payable and accrued
wages.
• Lastly, the cycle is completed when RTC’s receivables are
collected.
16-9
Inventory Conversion Period
• This is the average time required to convert

materials into finished goods and then to sell those
goods.
Inventory
Inventory Conversion Period 
Cost of goods sold/365
• If inventories are $2 million and cost of goods sold are

$8 million, then the inventory conversion period is
[2/(8/365)] = 91 days.
16-10
Average Collection Period
• The average length of time required to convert the

firm’s receivables into cash, that is, to collect cash
following a sale.
Receivables
Average Collection Period 
Sales/365
• If receivables are $657,534 and sales are $10 million,

the receivables collection period is [0.657/(10/365)] =
24 days.
16-11
Payables Deferral Period
• The average length of time between the purchase of

materials and labor and the payment of cash for
them.
Payables
Payables Deferral Period 
Cost of goods sold/365
• If the company’s cost of goods sold is $8 million per

year, and its accounts payable $657,534, then its
payables deferral period is [0.657/(8/365)] = 30 days.
16-12
Inventory Average Payables

CCC  conversion  collection  deferral
period period period
 91  24  30
 85 days
16-13
Shortening the CCC
• RTC knows when its starts to produce a computer, it

will have to finance the manufacturing costs for a
85-day period.
• The company’s goal should be to shorten its CCC as
much as possible without hurting its operations.
• This would increase RTC’s value, since the shorter
the CCC, the lower the required net operating
working capital and the higher the shareholders’
wealth.
16-14
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.
16-15
Cash Budget: An Example
Collections during month of sale 20%

Collection during 1st month after sale 70%
Collection during 2nd month after sale 10%
Discount on first month collections 2%
Purchases as a % of next month’s sales 70%
Lease payments $15 m
Construction cost for new plant (Oct) $100 m
Tax payment (Sept) $30 m
Tax payment (Dec) $20 m
Target cash balance $10 m
16-16
Wages & Other

Sales
Salaries Expenses
May $200 m - -
June $250 m - -
July $300 m $30 m $10 m
Aug $400 m $40 m $15 m
Sept $500 m $50 m $20 m
Oct $350 m $40 m $15 m
Nov $250 m $30 m $10 m
Dec $200 m $30 m $10 m
16-17
16-18
Should depreciation be explicitly included in the cash
budget?
• No. Depreciation is a noncash charge. Only cash

payments and receipts appear on cash budget.
• However, depreciation does affect taxes, which appear
in the cash budget.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly19
accessible website, in whole or in part.
What are some other potential cash inflows besides
collections?
• Proceeds from the sale of fixed assets.

• Proceeds from stock and bond sales.
• Interest earned.
• Court settlements.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly20
accessible website, in whole or in part.
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.
16-21
Why might a company want to maintain a
relatively high amount of cash?
• If sales turn out to be considerably less than

expected, the company could face a cash shortfall.
• A company may choose to hold large amounts of
cash if it does not have much faith in its sales
forecast, or if it is very conservative.
• The cash may be used, in part, to fund future
investments.
16-22
If a firm 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 value.
– 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 and increasing
its overall value.
– Alternately, can distribute “excess” cash to its shareholders
through higher dividends or repurchasing shares resulting
in a lower cost of capital.
16-23
Accounts Receivables
• Accounts receivables are determined by the volume

of credit sales and the average length of time
between sales and collections.
• Suppose Boston Lumber Company (BLC) has sales

of $1,000 per day (all on credit) and it requires
payment after 10 days.
• Accounts receivables = 1000 x 10 = $10,000
16-24
Days Sales Outstanding (DSO)
• DSO is the same as average collection period (ACP).

• It represents the average length of time the firm must
wait after making a sale before receiving cash.
• The DSO is used for monitoring and can be compared to

the firm’s own credit terms. If a company sells on terms
of net 30, so its DSO should be no greater than 30 days.
16-25

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Chapter 16

Working Capital Management

Alternative Working Capital Policies

• Working capital: current assets often as they turn over( used

• Relaxed: Relatively large amounts of cash,

• The DuPont Equation can be used to analyze ROE.

• Businesses experience seasonal/or cyclical fluctuations.

• Generally, companies follow a typical cycle in which

Inventory Average Payables

• Real Time Computers Corp. (RTC) is introducing a new

• Secondly, labour will be used to convert the materials

• This is the average time required to convert

• If inventories are $2 million and cost of goods sold are

• The average length of time required to convert the

• If receivables are $657,534 and sales are $10 million,

• The average length of time between the purchase of

• If the company’s cost of goods sold is $8 million per

Inventory Average Payables

• RTC knows when its starts to produce a computer, it

• Forecasts cash inflows, outflows, and ending cash

Collections during month of sale 20%

Wages & Other

• No. Depreciation is a noncash charge. Only cash

• Proceeds from the sale of fixed assets.

• Collections would be reduced by the amount of the

• If sales turn out to be considerably less than

• Short run: Cash will increase as inventory purchases

• Accounts receivables are determined by the volume

• Suppose Boston Lumber Company (BLC) has sales

• DSO is the same as average collection period (ACP).

• The DSO is used for monitoring and can be compared to

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