Working Capital

Management

1
Topics in Chapter
■ Working Capital
■ Cash conversion cycle
■ Cash management
■ Cash budget
■ Receivables management
■ Trade credit

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Basic Definitions
■ Gross working capital:
Total current assets used in operations.
■ Net working capital:
Current assets - Current liabilities.
■ Net operating working capital (NOWC):
Operating CA – Operating CL =
(Cash + Inv. + A/R) – (Accruals + A/P)

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Definitions (Continued)
■ Working capital management:
Includes both establishing working
capital policy and then the day-to-day
control of cash, inventories, receivables,
accruals, and accounts payable.
■ Working capital policy:
■ The level of each current asset.
■ How current assets are financed.

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 Cash Conversion Cycle
All firms follow a “working capital cycle” in which they
purchase or produce inventory, hold it for a time, and
then sell it and receive cash. This process is known as
the cash conversion cycle (CCC).
The cash conversion cycle focuses on the time
between payments made for materials and labor and
payments received from sales:

Cash Inventory Receivables Payables

Conversion = Conversion + Collection - Deferral .
Cycle Period Period Period
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Cash Conversion Cycle (Cont.)

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 Importance of Cash Management
■ Transactions: Cash balances are necessary in business
operations. Payments must be made in cash, deposited in
the cash account. Cash balances associated with routine
payments and collections.
■ Precaution: Firms need to hold some cash to meet
random, unforeseen fluctuations in inflows and outflows.
These “safety stocks” are called precautionary balances.
■ Compensating balances: For loans and/or services
provided.
■ Speculation: To take advantage of bargains, to take
discounts, and so on. Reduced by credit line, marketable
securities.
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 Cash Management Techniques
■ Use lockboxes - In a lockbox system, incoming
checks are sent to post office boxes rather than to
the firm’s corporate headquarters.
■ Insist on wire transfers from customers - Firms are
increasingly demanding payments of larger bills by
wire or by automatic electronic debits. Under an
electronic debit system, funds are automatically
deducted from one account and added to another.
■ Synchronize inflows and outflows.
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Cash Budget: The Primary
Cash Management Tool
■ Purpose: Uses forecasts of cash inflows,
outflows, and ending cash balances to predict
loan needs and funds available for temporary
investment.
■ Timing: Daily, weekly, or monthly, depending
upon budget’s purpose. Monthly for annual
planning, daily for actual cash management.

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Data Required for Cash
Budget
■ Sales forecast.
■ Information on collections delay.
■ Forecast of purchases and payment
terms.
■ Forecast of cash expenses: wages,
taxes, utilities, and so on.
■ Initial cash on hand.
■ Target cash balance.
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Sources of Cash Inflow
■ Proceeds from fixed asset sales.
■ Proceeds from stock and bond sales.
■ Interest earned.
■ Court settlements.

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How could bad debts be
worked into the cash budget?
■ Collections would be reduced by the
amount of 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 lower
surpluses and higher borrowing
requirements.

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Inventory Management
■ Financial managers have a responsibility for
raising the capital needed to carry inventory
and for overseeing the firm’s overall
profitability.
■ The twin goals of inventory management are
■ to ensure that the inventories needed to
sustain operations are available.
■ to hold the costs of ordering and carrying
inventories to the lowest possible level
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Inventory Management:
Categories 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,
loss of customer goodwill, and the
disruption of production schedules.
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 Elements of Credit Policy
■ Credit policy is a set of guidelines that: Are
used to determine which customers are
extended credit and billed. Set the payment
terms for parties to whom credit is
extended. Define the limits to be set on
outstanding credit accounts. It consists of:
■ Cash Discounts
■ Credit Period
■ Credit Standards
■ Paying Accounts
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 Credit Policy (Continued)
■ Cash Discounts: Lowers price. Attracts new
customers and reduces DSO.
■ If the credit terms are stated as “2/10, net 30,”
then buyers may deduct 2% of the purchase price
if payment is made within 10 days; otherwise, the
full amount must be paid within 30 days. Thus,
these terms allow a discount to be taken.
■ Credit Period: How long to pay? Shorter period
reduces DSO and average A/R, but it may discourage
sales.
■ A firm might sell on terms of “net 30,” which means
that the customer must pay within 30 days.
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Credit Policy (Continued)
■ Credit Standards: How much financial strength must
a customer show to qualify for credit?
■ Lower credit standards boost sales, but they also increase
bad debts. Fewer bad debts reduces DSO.
■ Collection Policy: How tough or lax is a company in
attempting to collect slow paying accounts?
■ A tough policy may speed up collections, but it might also
anger customers and cause them to take their business
elsewhere and reduce DSO.

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What is trade credit?
■ Trade credit (Accounts payable) is
credit provided by a firm’s suppliers.
■ Trade credit is often the largest source
of short-term credit, especially for small
firms.
■ Spontaneous, easy to get, but cost can
be high.

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 Free and Costly Trade Credit
■ Trade credit can be divided into two
components:
1) free trade credit, which involves credit received during the
discount period.
2) costly trade credit, which involves credit in excess of the
free trade credit and whose cost is an implicit one based
on the forgone discounts.
Firms should always use the free component, but they should
use the costly component only after analyzing the cost of
this capital to make sure it is less than the cost of funds
that could be obtained from other sources.
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SKI buys $506,985 net, on terms of
1/10, net 30, and pays on Day 40.
Find free and costly trade credit.
Net daily purchases = $506,985/365
=
$1,389.
Payables level if take discount:
Payables = $1,389(10) = $13,890.
Payables level if don’t take discount:
Payables = $1,389(40) =
$55,560.
Total trade credit = $55,560
Free trade credit = 13,890
Costly trade credit = $41,670 20
 Nominal Cost Formula, 1/10,
net 40
Nominal cost
of trade credit = Cost per period × Number of periods per year

rNom = Discount % × 365 days

100 - Discount % *Days Discount
Taken
- Period
1 365
= × = 0.0101 × 12.1667
99 30

= 0.1229 = 12.29%
Pays 1.01% 12.167 times per year.
*Days credit is outstanding 21