WORKING CAPITAL

MANAGEMENT
Let’s look at two companies
Company A Company B
Inventories 3,263.70 8,886.01
Payables 1,202.60 7,199.26
Cash 23.50 4,654.03
Total CA 4,489.80 48,886.32
Receivables 13,914.70 15,544.60
Total CL 13,914.70 39,883.11
Sales 76,140.80 46,427.13
COGS 42,629.60 20,913.11

Which firm has a better working capital? Which firm do you think could be in
trouble? Which firm should have better return?
And returns are…
Company A Company B
Return on Capital 19.43 13.23
Return on Assets 14.38 10.05
Return on Equity 20.28 15.40

Companies in which negative working capital exist,

profitability is more and shareholders are getting more
dividend and capital appreciation, which maximizes the
shareholders’ value in the long run [Panigarhi A]
Simple Cycle of Operations
Cash Conversion Cycle
Working Capital and the Cash Conversion Cycle
• Cash Conversion Cycle
= operating cycle – accounts payable period
= (inventory period + receivables period) – accounts
payable period
CCC for Company A and B
Company A Company B

Average inventory
period 27.94421 155.089
Average receivables
period

10.29681 125.6499
Average payables
period 66.7036 122.2083
Cash Conversion Cycle
-28 158
Cash Conversion Cycle,
Selected Companies
Time & Money Concepts in
Working Capital Cycle

Each component of working capital (namely

inventory, receivables and payables) has two
dimensions ........TIME ......... and MONEY,
when it comes to managing working capital
 TIME IS MONEY
 You can get money to move faster around the cycle or
reduce the amount of money tied up. Then, business
will generate more cash or it will need to borrow less
money to fund working capital.
 As a consequence, you could reduce the cost of bank
interest or you'll have additional free money available
to support additional sales growth or investment.
 Similarly, if you can negotiate improved terms with
suppliers e.g. get longer credit or an increased credit
limit, you effectively create free finance to help fund
future sales.
 If you Then ......

Collect receivables (debtors) You release cash from the

faster cycle
Collect receivables (debtors) Your receivables soak up cash
slower
Get better credit (in terms of You increase your cash
duration or amount) from resources
suppliers
Shift inventory (stocks) faster You free up cash

Move inventory (stocks) You consume more cash

slower
Inventories
• Components of Inventory
• Raw materials
• Work in progress
• Finished goods

• Goal: Minimize amount of cash tied up in

inventory
• Tools used to minimize inventory
• Just-in-time
• Lean manufacturing
Inventories
• As Order Size Increases

• Number of orders decreases

• Order cost decreases

• Average amount in inventory increases

• Carrying cost of inventory increases

Managing Inventories
Determining Optimal
Order Size
 Inventories
• Economic Order Quantity
• Order size that minimizes total inventory costs

2  annual sales  cost per order

Economic order quantity =
carrying cost
Credit Management
• Terms of Sale
• Credit, discount, and payment terms offered on sale

• Example: 5/10 net 30

• 5: Percent discount for early payment
• 10: Number of days discount is available
• Net 30: Number of days before payment due
Credit Management
• Terms of Sale
• Firm that buys on credit borrows from supplier

• Save cash today, pay later (implicit loan)

• Cost of implicit loan:

Effective annual rate


 1+ discount
discountedprice

365/extradays credit
1
Credit Management
• Example
• Calculate implied interest rate on Rs.100 sale with terms 5/10 net
60

Effective annual rate


 1+ discount
discountedprice

365/extradays credit
1
 1 + 
5 365/50
95  1 = .454, or 45.4%
Credit Management
• What If
• The number of days are 30 instead of 60
• So, the are terms 5/10 net 30

Effective annual rate


 1+ discount
discounted price
365/extra days credit
1
 1 + 
5 365/20
95  1 = 1.55, or 155.0%