Working Capital Management

• Knowledge of working capital patterns improves a manager’s awareness of the

dynamics affecting the firm’s cash flows.
• Exhaustion of liquid resources can leave the firm unable to pay it’s obligations as they come due.

• Firms can run out of liquidity by pursuing a rapid expansion of production and sales
which could leave it with illiquid assets like inventories, receivables, and PPE.
• A firm may be profitable (net income) but verging on bankruptcy due to a cash shortage.

• To help avoid such problems, it is best to construct a cash budget to forecast cash
inflows and outflows (usually monthly, but weekly budgets are sometimes useful).
• By mapping out cumulative inflows and outflows, managers can forecast the timing, magnitude
and duration of cash deficits and surpluses, allow them to plan for future deficits and surpluses.
Monthly Cash Budgeting
• In this example the firm has no fixed assets, just current ones.
• As sales increase, so does the cash used to finance inventory and receivables.

• Starting cash of $2000

• Begins with monthly sales of $1000, which grow at $500 per month
• Has 25% profit margin
• Wants to maintain a cash balance equal to 20% of monthly sales
• Pays its bills immediately (no accounts payable)
• Takes one month to collect its receivables
• Maintains one month worth of sales as inventory
A 6-Month Cash Budget (Rapid Straight-Line Growth)
• Note how cash is consumed most rapidly in months when the growth rate (%) in
sales is high (operating cash is “most” negative)
1 2 3 4 5 6
Sales 1,000 1,500 2,000 2,500 3,000 3,500
Cash inflow 0 1,000 1,500 2,000 2,500 3,000
Cash outflow            
Current sales -750 -1,125 -1,500 -1,875 -2,250 -2,625
Inventory 0 -375 -375 -375 -375 -375
Operating cash -750 -500 -375 -250 -125 0
Start cash 2,000 1,250 750 375 125 0
End cash 1,250 750 375 125 0 0
Required cash 200 300 400 500 600 700
Surplus/deficit 1,050 450 -25 -375 -600 -700
 A 12-Month Cash Budget (same example)
• Cash deficits start in month 3, end in month 10, and the maximum drawdown is $700.

1 2 3 4 5 6 7 8 9 10 11 12
Sales 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500 5,000 5,500 6,000 6,500
Cash inflow 0 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500 5,000 5,500 6,000
Cash outflow                        
Current sales -750 -1,125 -1,500 -1,875 -2,250 -2,625 -3,000 -3,375 -3,750 -4,125 -4,500 -4,875
Inventory 0 -375 -375 -375 -375 -375 -375 -375 -375 -375 -375 -375
Operating cash -750 -500 -375 -250 -125 0 125 250 375 500 625 750
Start cash 2,000 1,250 750 375 125 0 0 125 375 750 1,250 1,875
End cash 1,250 750 375 125 0 0 125 375 750 1,250 1,875 2,625
Required cash 200 300 400 500 600 700 800 900 1,000 1,100 1,200 1,300
Surplus/deficit 1,050 450 -25 -375 -600 -700 -675 -525 -250 150 675 1,325
Current Liabilities
• When firms face such shortfalls, what options do they have?

• Small deficit persisting for a short period of time (30-90 days)

• Delay purchases or speed collections; try to synchronize cash flows
• Negotiate an operating line of credit with the financial institution

• Large deficit forecast to last 30-90 days

• Operating line of credit with a syndicate of lenders
• Issue commercial paper if deficit is recurrent.

• Firms facing longer-term deficits should issue additional long-term capital

• Bonds and shares are the most common instruments for raising long-term funds.
• More on issuing long-term securities in 4 weeks
Synchronizing Cash Flows
• Trying to match up the timing of in and outflows can free up cash and reduce the
amount of working capital a firm requires.

• This is done by speeding up cash inflows:

• Bill clients earlier each month
• Increase cash sales through incentives
• Encourage customers to pay using electronic payments systems

• Or by delaying outflows to match them up chronologically:

• Arrange with suppliers for more liberal credit terms (net 40 rather than net 30 for example)
• Paying employees once a month rather than twice.
Accounts Payable
• Accruals and accounts payable (trade credit) are ‘spontaneous’ liabilities that are
flexible, easy to access, and usually carry no restrictive covenants.
• Trade credit is simple and convenient to use, and it therefore has lower transaction costs than
alternative sources of funds.
• Accounts payable from suppliers is generally collateralized by inventory.

• Other sources of financing must be negotiated and the firm must evaluate the
effectiveness of alternative financing mechanisms.
• Accounts payable are generally a flexible source of funds that can be used as needed (provided
that resource hasn’t already been exhausted).
• In some cases it many be the only source of funding available.
Discounts on Early Payments
• Stretching accounts payable (paying later) as a source of funding can come with a
high implicit cost if there is a discount provided for prompt payment.
• A discount on early payments represents a premium the firm is willing to pay for cash
now – in other words, the rate at which it is offering to “borrow” from customers.

• If this rate is higher than the rate at which a customer borrows, they will pay
early and take the discount.
• Firms offered discounts on accounts payable should compare the implied rate of its cost of
debt (it is usually much higher than people expect!)
The Implied Cost of a Discount
• As example, consider the foregone benefits to a firm that forgoes discounts on early
payment such as 2/10 Net 30
• For a $100 item, the firm is effectively being charged $2 of interest on $98 for the use of
funds from day 10 to day 30 (20 days) if it foregoes the discount.
• Such discounts are expensive for firms offering them but they may be able to secure greater market share
by doing so, or may be desperate for short-term financing.

ANNUALLY

• If the firm can obtain a bank loan at a lower interest rate, it would be better off borrowing at
the lower rate on day 10 and taking advantage of the discount.
Lines of Credit
• Firms often maintain access to flexible short-term bank financing options to help
manage their working capital flows (usually cheaper than foregoing discounts)
• Secured by accounts receivable to a maximum percent of those assets.
• May be used to purchase inventory when trade credit is unavailable/unattractive.
• Interest only payments (no principal payments required).
• Balance can often be retired at the firm’s discretion.

• A committed LoC is a legally binding agreement that obligates a bank to provide

funds to a firm (up to a stated credit limit) as long as the firm satisfies any
restrictions in the agreement
• They usually carry stand-by fees (capital must be committed whether tapped or not) as well as
the stipulation that at some point in time the outstanding balance must be zero.
• LoC’s can be revolving (for a specific period of time), or evergreen (no maturity)
Money Market Instruments
• Large firms with good credit may be able to sidestep banks and borrow directly from the
money markets via commercial paper or banker’s acceptances.
• These are short-term debts sold at a discount from face value rather than bearing regular interest.
• They typically have face amount of $100,000 or more and maturities of 30, 60, or 90 days

• Commercial Paper
• A short-term unsecured, negotiable promissory note which by-passes banks and allows the firm direct
access to the money market

• Banker’s Acceptance
• An alternative to commercial paper for smaller firms that don’t have the credit-worthiness to secure
commercial paper financing.
• The bank “accepts” the promissory note by stamping it “accepted”....the note therefore is secured by the
Bank’s promise to pay.
Money Market Default Risk
• Suppose the default free yield on a one year note is 1% and there is a 1%
chance of default and you get nothing, what is the break-even interest rate?

Probability 99%
get (1+K)

Probability 1%
get nothing

• Answer: 0.99*(1+X) + 0.01*0 = 1.01  X = 2.02%, a 1.02% risk

premium.
Factoring (Selling Receivables)
• In a pinch, a firm might consider factoring arrangements, which are the sale of
receivables at a discount to a financial company (called a factor) which
specializes in collections, or the out-sourcing of all collections to a factor.

• The factoring institution receives a credit approval slip and does a credit check.
If approved, shipment is made and the buyer is instructed to make payment
directly to the factor.

• This way, the firm that sells its receivables eliminates the need for an accounts
receivable department while receiving a cash payment immediately from the
factor following the sale.
• Cash up front, but less than the sale price (less profit).
Factoring (Selling Receivables)
• For example, if a firm sells its goods on net 30 terms, then the factor will pay the
firm the face value of its receivables, less a factor’s fee, at the end of 30 days.
• The firm may be able to borrow as much as 80% of the face value of its receivables, thereby
receiving its funds in advance.

• In such a case, the lender will charge interest on the loan in addition to a fee.
• These fees typically range from 0.75% to 1.50% of the face value of the accounts receivable,
whether or not the firm borrows any of the available funds.

• Receivables may be factored with (or without) recourse, meaning that the lending
can (or cannot) seek payment from the borrower should the customer default.
Securitization
• If the firm is large enough, it may consider performing the function of the factor itself
by securitizing its receivables with the help of an investment bank.
• This involves setting up another company (a “special purpose vehicle”) which sell bonds to investors,
uses the funds to purchase a portfolio of receivables from the issuer, and then bundles them into
portfolios which back the bonds. As they arrive, cash receipts are used to make interest payments.
• Credit enhancements are actions taken to reduce credit risk, such as requiring collateral, insurance or
other agreements.

• Asset-backed commercial paper (ABCP) is an example but as the 2008 financial crisis
showed, this source of funding can be risky to rely upon as the market has disappeared
for some of these instruments on occasion.
• Investors became concerned about the underlying asset values (packages of receivables) and their
price collapsed. The market for some of these instruments subsequently vanished.
• The issue in 2008 was bad risk modelling which led financial engineers to ignore geographic
diversification (not a problem with car loans, but a big one for mortgages)
• https://www.wired.com/2009/02/wp-quant/
Basic Securitization Structure
Originator sells loans to SIV:
A/R loans, residential and
commercial mortgages, credit cards,
auto loans and leases, equipment loans
and leases, corporate loans

Sells Receives
Assets cash

Special SIV I
ssue
s&S
ells s
Investment SIV g
ets c
ecur
ities
sale as h
Vehicle of se f
curit rom
(SIV) Cas
h
pay flow fr
i es
Investors
sP
& I o om ass buy Securities
n se et
curi s (ABCP)
ties
Dealing with Cash Surpluses
• While surpluses are less of a problem than deficits, knowing their magnitude,
timing, and duration allows management to create value with resources which
might otherwise sit idle:

• Small surplus available (ie. less than $100,000)

• Short-term (30-90 days): keep it in cash
• Long-term: consider dispersing as cash dividends, or retiring flexible debt

• Large surplus (ie. greater than $100,000)

• Short-term (30-90 days): invest in money market securities such as T-bills
• Long-term: disperse excess funds as cash dividends, or investing in longer-lived higher-
yielding projects
Optimal Cash Balances
• Despite earning no return, most firms retain some cash balances in their accounts
for different reasons:
1. To complete expected transactions
2. To ensure emergency liquidity (precautionary)
3. It is due to be paid out as dividends or used as investment capital
4. To be able to take advantage of unexpected bargains

• The optimal cash level is the amount that balances the risks of illiquidity against
the sacrifice in expected return (it therefore differs substantially across firms)
• Firms with predictable cash flows will have lower optimal cash balance requirement
• Firms with excess borrowing capacity (unused line of credit for example) can hold less cash.
Marketable Securities
• Large firms typically retain marketable securities instead of sizable cash balances
in order to earn some return on these otherwise idle resources.

• When selecting marketable securities, several things should be kept in mind:

• default risk vs. the overall rate of return
• interest rate risk
• liquidity or marketability risk

• The most common choice for this are government issued Treasury-Bills but
commercial paper may offer a reasonable, if riskier, substitute.
• If CP is chosen, its likely financing another firm’s working capital needs with your surplus.
Working Capital Assets
• In addition to long-term assets, firms must often invest capital in short-term assets
like inventory and accounts receivable.

• Although each individual receivable or item of inventory passes through the firm
quickly, rolling over such assets on a continuing basis makes them (more or less) a
“structural” part of a firm’s balance sheet which can have significant impact on
NPV
• Firms with permanent working capital needs can finance these aggressively with short-term
instruments (regularly exposed to funding risk, but lower interest rates) or conservatively with
long-term debt (lower interest rate risk, but higher overall rates).
Inventory
• Like the optimal cash balance, the level of inventory a firm holds is a trade off
between benefits and costs
• PRO: Take advantage of large-volume discounts, reduce the probability of production
disruptions because of lack of inventory, minimize lost sales because of stock-outs
• CON: Financing costs associated with inventory investment as well as costs related to storage,
handling, insurance, spoilage and obsolescence costs.

• Numerous approaches exist (ABC, EOQ, MRP, JIT). More on these models can
be learned from most Operations texts or courses but the specific choice between
them is determined by the firm’s operating environment and its risks.
Accounts Receivable
• In a competitive environment, firms often don’t have a choice about whether or
not to extend sales on credit.
• In some cases, a supplier may have an ongoing business relationship with its customer and thus
more information about the credit quality of the customer than a bank does.

• The considerations for specific acceptance of credit (and the terms of repayment)
are determined by:
• Capacity – the customer’s ability to pay
• Character – the customer’s willingness to pay
• Collateral – the security that could be seized to satisfy payment
• Conditions – the state of the economy.
Credit and Collections
• Once a firm has decided to extend credit, it must determine which customers will
be granted credit and under what terms.
• Cash on delivery (COD); Cash before delivery (CBD)
• Net 30, net 40 - no incentive for early payment
• 2/10 net 30 - a 2% discount for early payment

• Finally, a collection process must be implemented (and payments monitored)

• It is a good practice to monitor the age of receivables and encourage payment through a mix of
friendly notices and high interest rates on outstanding balances.
• Long-outstanding payments might trigger a variety of responses, depending on the nature of
the client, the amount, and the cost of legal action:
• Cut off access to further credit sales, take them to court, sell the receivable to a factor, write off the debt.
NPV of Credit Policy Changes
• When considering a policy change, it is important to focus on the net
incremental costs and benefits associated with that choice.
• The benefits of increased sales from some policy will usually be offset by the financing
costs associated with maintaining a larger investment in A/R (modelled as a time 0 cash
flow) as well as the increased risk of non-payment (increased bad debts expenses).
• Inventories might need to increase as well.

• The cost of financing is NOT explicitly modelled as it is already captured by the

discount rate applied to any eventual working capital recovery.
Old Working Capital Exam Question

• Megathuselah, is considering a change in its accounts receivable policy which it

believes will increase the firm’s sales and thus bottom line. The company has total
annual credit sales of $144 million with a gross margin of 28% (no growth).
• To encourage early payment the firm offers payment terms on accounts receivable of 1/10 net
30 which it finances with its line of credit carrying an after-tax cost of 3.5% annually.
• Presently, one in ten accounts is settled ten days after the purchase, the rest pay 30 days after
purchase. The firm’s tax rate is 30%.

a) If credit terms are changed to 1/10 net 40 and the collection pattern is unchanged, cash inflows
to the firm will be disrupted for the next 10 days as accounts due take advantage of the later due
date. How much borrowing will be required to finance this? hint: calculate daily credit sales
b) If credit terms are changed as in part a) how much additional sales (annually) will be required to
offset this cost and keep the NPV of the proposed change at 0? (assume the same fixed costs).
Old Working Capital Exam Question - SOLUTION

A. avg daily sales = $144 million / 365 = $394,520

• 90% of receipts are delayed an additional 10 days so we need to borrow an additional:
• Extra working capital required = $394,520/day * 10 days * 90% = $3,550,680
• ALT SOLN: avg age of A/R rises from 28 days (.1*10 + .9*30) to 37 days (.1*10 + .9*40)
which requires $394,520 per day so our needs are: $394,520 / day * 9 days = $3,550,680

B. PV of incremental flows must equal $3,550,680

• $3,550,680 = ∆ after-tax cash flows / 0.035  ∆ Annual ATCF = $124,274
• But this still has to be converted in revenue!
• ∆ Annual ATCF = ∆ Annual Sales * (gross margin) * (1-tax rate)
• ∆ Annual Sales = $124,274 / [(.28)(0.7)]
• = Additional $634,050 in sales needed each year to overcome the upfront cost of W/C expansion
How Working Capital Affects Firms
• Firm valuation is tied to earnings growth, which in turn is tied to working capital
management as funds tied up in receivables or inventory which may not be
yielding sufficient returns.
• Reducing the amounts invested in these assets can enable a firm to grow faster organically
without having to pay the fees to access external capital.

• It is important to remember that maximizing potential growth may not maximize

actual NPV!!
• The goal is not to make the firm as large as possible, it is to efficiently invest each dollar of
capital.
A Simple Model

• The impact of sales growth on the firm’s cash can be estimated analytically by
building up a function which expresses the change in cash between periods

• Where:
g = monthly sales growth
b = the cash production cost and (1 – b ) = unit contribution margin, and
St-1 = Sales from the previous month

• The maximum (internally-financed) sustainable growth rate can be calculated

by substituting St for [(St-1 )*(1+g)], setting the change in cash to 0, and solving
for g
A Complex Model
• We can create more sophisticated models exploring how the firm’s cash position
changes with respect to the firm’s credit, inventory and payables policies as well.
• This model uses payments and receipts over 2 months

α = the percentage of sales collected this month

1 – α = the balance of sales collected in the month following sales
β = the proportion of this month’s production costs paid in this month
1 - β= the proportion of production costs paid next month.
γ = percentage of the firm’s monthly sales tied up in inventory

• Solving for “g” reveals that, faster growth results from: lower production
costs, faster collections, slower payments, and less inventory.
Internally Sustainable Growth Rate

• Using the earlier cash budget example, we find the sustainable monthly growth
rate for sales to be 16.7% ($500/$3000)
• Note that the month in which this occurs, that the cash balance in the firm does not change.
1 2 3 4 5 6 7 8 9 10 11 12
Sales 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500 5,000 5,500 6,000 6,500
Cash inflow 0 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500 5,000 5,500 6,000
Cash outflow                        
Current sales -750 -1,125 -1,500 -1,875 -2,250 -2,625 -3,000 -3,375 -3,750 -4,125 -4,500 -4,875
Inventory 0 -375 -375 -375 -375 -375 -375 -375 -375 -375 -375 -375
Operating cash -750 -500 -375 -250 -125 0 125 250 375 500 625 750
Start cash 2,000 1,250 750 375 125 0 0 125 375 750 1,250 1,875
End cash 1,250 750 375 125 0 0 125 375 750 1,250 1,875 2,625
Required cash 200 300 400 500 600 700 800 900 1,000 1,100 1,200 1,300
Surplus/deficit 1,050 450 -25 -375 -600 -700 -675 -525 -250 150 675 1,325
Monitoring Working Capital
• Ratios built from a firm’s accounting data are commonly used to assess or to
summarize its working capital management.
• Current Ratio = current assets / current liabilities
• Quick Ratio = (current assets – inventory) / current liabilities
• Average age of Receivables = (balance sheet amount / sales from same year) * 365 days
• Average age of Inventory = (balance sheet amount / CoGS from same year) * 365 days
• Average age of Payables = (balance sheet amount / CoGS from same year) * 365 days

• Combining the average age of inventory and receivables, then subtracting the
average age of payables yields the cash conversion cycle.
• This is the average number of days worth of sales that a firm must finance outside the use of
trade credit. The longer it is, the more capital is required.
• Table 26.1 in the text shows that the CCC can be negative or positive.
The Cash Conversion Cycle
Good Working Capital Management

1. Make use of trade credit where possible.

• Low cost but is generally collateralized by inventory
2. Maintain an appropriate level of short-term financing
• Using the least expensive and most flexible source possible
3. Work to maintain optimal cash balances
• Invest any excess liquid funds in marketable securities
4. Set up an efficient inventory management system
• Tradeoff costs and benefits of investing
5. Properly manage accounts receivable
• Regular monitoring and collection
A Short Video and a Reminder

• A VERY good talk on the topic of working capital management from two INSEAD
professors and its link to employees incentives:
• https://www.youtube.com/watch?v=1zcfq-lnGxU

• Also note their discussion of benchmarking and the dangers of being too heavily
focused on profits instead of cash flows.

• Remember, your first group case is due in two weeks. If you haven’t started
looking into the problems at Butler Lumber, you should soon.