Working Capital Management

Chapter 6
Working Capital
Management
Learning Goals
1. Understand short-term financial management,

net working capital, and the related trade-off
between profitability and risk.
2. Describe the cash conversion cycle, its funding
requirements, and the key strategies for
managing it.
3. Discuss inventory management: differing
views, common techniques, and international
concerns.
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Learning Goals (cont.)
4. Explain the credit selection process and the

quantitative procedure for evaluating changes
in credit standards.
5. Review the procedures for quantitatively
considering cash discount changes, other
aspects of credit terms, and credit monitoring.
6. Understand the management of receipts and
disbursements, including float, speeding up
collections, slowing down payments, cash
concentration, zero balance accounts, and
investing in marketable securities.
Long & Short Term Assets & Liabilities
Current Assets: Current Liabilities:

Cash Accounts Payable
Marketable Securities Accruals
Prepayments Short-Term Debt
Accounts Receivable Taxes Payable
Inventory
Fixed Assets: Long-Term Financing:

Investments Debt
Plant & Machinery Equity
Land and Buildings

Net Working Capital
• Working Capital includes a firm’s current

assets, which consist of cash and marketable
securities in addition to accounts receivable
and inventories.
• It also consists of current liabilities, including
accounts payable (trade credit), notes payable
(bank loans), and accrued liabilities.
• Net Working Capital is defined as total current
assets less total current liabilities.

The Tradeoff Between
Profitability & Risk
• Positive Net Working Capital (low return and low risk)
Current Current
low
Assets Liabilities cost
low
return Net Working
Capital > 0
high
Long-Term cost
Debt
high
return
highest
Fixed cost
Assets Equity
Profitability & Risk (cont.)
• Negative Net Working Capital (high return and high risk)
Current Current
low Assets Liabilities
return low
Net Working
cost
Capital < 0
high Long-Term high

return Debt cost
Fixed highest
Assets Equity cost
Profitability & Risk (cont.)

The Cash Conversion Cycle
• Short-term financial management—managing current

assets and current liabilities—is on of the financial
manager’s most important and time-consuming
activities.
• The goal of short-term financial management is to
manage each of the firms’ current assets and liabilities
to achieve a balance between profitability and risk that
contributes positively to overall firm value.
• Central to short-term financial management is an
understanding of the firm’s cash conversion cycle.

Calculating the Cash Conversion Cycle
The Operating Cycle (OC) is the time between ordering

materials and collecting cash from receivables.
The Cash Conversion Cycle (CCC) is the time between

when a firm pays it’s suppliers (payables) for inventory
and collecting cash from the sale of the finished product.

Calculating the Cash
Conversion Cycle (cont.)
• Both the OC and CCC may be computed
as shown below.

MAX Company, a producer of paper dinnerware, has
annual sales of $10 million, cost of goods sold of 75% of
sales, and purchases that are 65% of cost of goods sold.
MAX has an average age of inventory (AAI) of 60 days,
an average collection period (ACP) of 40 days, and an
average payment period (APP) of 35 days.
Using the values for these variables, the cash

conversion cycle for MAX is 65 days (60 + 40 - 35) and
is shown on a time line in Figure 14.1.

The resources MAX has invested in the cash
conversion cycle assuming a 365-day year are:
Obviously, reducing AAI or ACP or lengthening APP will

reduce the cash conversion cycle, thus reducing the amount
of resources the firm must commit to support operations.
Funding Requirements of the CCC
• Permanent vs. Seasonal Funding Needs

– If a firm’s sales are constant, then its investment
in operating assets should also be constant,
and the firm will have only a permanent
funding requirement.
– If sales are cyclical, then investment in operating
assets will vary over time, leading to the need for
seasonal funding requirements in addition to the
permanent funding requirements for its minimum
investment in operating assets.

Funding Requirements
of the CCC (cont.)
Nicholson Company holds, on average, $50,000 in cash and
marketable securities, $1,250,000 in inventory, and $750,000
in accounts receivable. Nicholson’s business is very stable
over time, so its operating assets can be viewed as
permanent. In addition, Nicholson’s accounts payable of
$425,000 are stable over time. Nicholson has a permanent
investment in operating assets of $1,625,000 ($50,000 +
$1,250,000 + $750,000 - $425,000). This amount would also
equal the company’s permanent funding requirement.
of the CCC (cont.)
In contrast, Semper Pump Company, which produces bicycle pumps,
has seasonal funding needs. Semper has seasonal sales, with its peak
sales driven by purchases of bicycle pumps. Semper holds, at minimum,
$25,000 in cash and marketable securities, $100,000 in inventory, and
$60,000 in accounts receivable. At peak times, Semper’s inventory
increases to $750,000 and its accounts receivable increase to $400,000.
To capture production efficiencies, Semper produces pumps at a
constant rate throughout the year. Thus, accounts payable remain at

of the CCC (cont.)
$50,000 throughout the year. Accordingly, Semper has a permanent

funding requirement for its minimum level of operating assets of
$135,000 ($25,000 + $100,000 + $60,000 - $50,000) and peak
seasonal funding requirements of $900,000 [($125,000 + $750,000 +
$400,000 - $50,000) - $135,000]. Semper’s total funding
requirements for operating assets vary from a minimum of $135,000
(permanent) to a a seasonal peak of $1,125,000 ($135,000 +
$900,000) as shown in Figure 14.2.

of the CCC (cont.)

of the CCC (cont.)
• Aggressive vs. Conservative Funding Strategies
Semper Pump has a permanent funding requirement of $135,000 and

seasonal requirements that vary between $0 and $990,000 and
average $101,250. If Semper can borrow short-term funds at 6.25%
and long term funds at 8%, and can earn 5% on any invested surplus,
then the annual cost of the aggressive strategy would be:

of the CCC (cont.)
Alternatively, Semper can choose a conservative strategy under which

surplus cash balances are fully invested. In Figure 13.2, this surplus would
be the difference between the peak need of $1,125,000 and the total need,
which varies between $135,000 and $1,125,000 during the year.

of the CCC (cont.)
Clearly, the aggressive strategy’s heavy reliance on short-term

financing makes it riskier than the conservative strategy because of
interest rate swings and possible difficulties in obtaining needed
funds quickly when the seasonal peaks occur.
The conservative strategy avoids these risks through the locked-in

interest rate and long-term financing, but is more costly. Thus the
final decision is left to management.

Strategies for Managing the CCC
1. Turn over inventory as quickly as possible

without stock outs that result in lost sales.
2. Collect accounts receivable as quickly as
possible without losing sales from high-
pressure collection techniques.
3. Manage, mail, processing, and clearing time to
reduce them when collecting from customers
and to increase them when paying suppliers.
4. Pay accounts payable as slowly as possible
without damaging the firm’s credit rating.
Inventory Management:
Inventory Fundamentals
• Classification of inventories:
– Raw materials: items purchased for use in
the manufacture of a finished product
– Work-in-progress: all items that are currently
in production
– Finished goods: items that have been
produced but not yet sold

Differing Views About Inventory
• The different departments within a firm (finance,
production, marketing, etc.) often have differing views
about what is an “appropriate” level of inventory.
• Financial managers would like to keep inventory levels
low to ensure that funds are wisely invested.
• Marketing managers would like to keep inventory levels
high to ensure orders could be quickly filled.
• Manufacturing managers would like to keep raw
materials levels high to avoid production delays and to
make larger, more economical production runs.

Techniques for Managing Inventory
• The ABC System

– The ABC system of inventory management divides
inventory into three groups of descending order of
importance based on the dollar amount invested
in each.
– A typical system would contain, group A would consist
of 20% of the items worth 80% of the total dollar
value; group B would consist of the next largest
investment, and so on.
– Control of the A items would intensive because of the
high dollar investment involved.

Techniques for Managing
Inventory (cont.)
• The Economic Order Quantity (EOQ) Model
EOQ = 2 x S x O
C
• Where:
– S = usage in units per period (year)
– O = order cost per order
– C = carrying costs per unit per period (year)
– Q = order quantity in units

Inventory (cont.)
Assume that RLB, Inc., a manufacturer of electronic test

equipment, uses 1,600 units of an item annually. Its order
cost is $50 per order, and the carrying cost is $1 per unit per
year. Substituting into the above equation we get:
EOQ = 2(1,600)($50) = 400

$1
The EOQ can be used to evaluate the total cost of inventory
as shown on the following slides.
Inventory (cont.)
Ordering Costs = Cost/Order x # of Orders/Year

Ordering Costs = $50 x 4 = $200
Carrying Costs = Carrying Costs/Year x Order Size
2
Carrying Costs = ($1 x 400)/2 = $200
Total Costs = Ordering Costs + Carrying Costs

Total Costs = $200 + $200 = $400
Inventory (cont.)
• The Reorder Point
– Once a company has calculated its EOQ, it must
determine when it should place its orders.
– More specifically, the reorder point must consider
the lead time needed to place and receive orders.
– If we assume that inventory is used at a constant rate
throughout the year (no seasonality), the reorder
point can be determined by using the
following equation:
Reorder point = lead time in days x daily usage

Daily usage = Annual usage/360
Inventory (cont.)
• The Reorder Point
Using the RIB example above, if they know that it requires 10 days to
place and receive an order, and the annual usage is 1,600 units per
year, the reorder point can be determined as follows:
Daily usage = 1,600/360 = 4.44 units/day
Reorder point = 10 x 4.44 = 44.44 or 45 units
Thus, when RIB’s inventory level reaches 45 units, it should place an

order for 400 units. However, if RIB wishes to maintain safety stock
to protect against stock outs, they would order before inventory
reached 45 units.
Inventory (cont.)
• Just-In-Time (JIT) System
– The JIT inventory management system minimizes
the inventory investment by having material inputs
arrive exactly at the time they are needed
for production.
– For a JIT system to work, extensive coordination
must exist between the firm, its suppliers, and
shipping companies to ensure that material inputs
arrive on time.
– In addition, the inputs must be of near perfect quality
and consistency given the absence of safety stock.

Inventory (cont.)
• Computerized Systems for
Resource Control
– MRP systems are used to determine what to
order, when to order, and what priorities to
assign to ordering materials.
– MRP uses EOQ concepts to determine how
much to order using computer software.
– It simulates each product’s bill of materials
structure all of the product’s parts), inventory
status, and manufacturing process.
Inventory (cont.)
• Computerized Systems for Resource Control
– Like the simple EOQ, the objective of MRP systems
is to minimize a company’s overall investment in
inventory without impairing production.
– Manufacturing resource planning II (MRP II) is an
extension of MRP that integrates data from numerous
areas such as finance, accounting, marketing,
engineering, and manufacturing suing a sophisticated
computer system.
– This system generates production plans as well as
numerous financial and management reports.

Inventory (cont.)
• Computerized Systems for Resource Control
– Unlike MRP and MRP II, which tend to focus on
internal operations, enterprise resource planning
(ERP) systems can expand the focus externally to
include information about suppliers and customers.
– ERP electronically integrates all of a firm’s
departments so that, for example, production can call
up sales information and immediately know how
much must be produced to fill certain
customer orders.

International Inventory Management
• International inventory management is
typically much more complicated for exporters
and MNCs.
• The production and manufacturing economies of
scale that might be expected from selling
globally may prove elusive if products must be
tailored for local markets.
• Transporting products over long distances often
results in delays, confusion, damage, theft, and
other difficulties.
Accounts Receivable Management
• The second component of the cash conversion

cycle is the average collection period – the
average length of time from a sale on credit until
the payment becomes usable funds to the firm.
• The collection period consists of two parts:
– the time period from the sale until the customer mails
payment, and
– the time from when the payment is mailed until the
firm collects funds in its bank account.

Accounts Receivable Management:
The Five Cs of Credit
• Character: The applicant’s record of meeting
past obligations.
• Capacity: The applicant’s ability to repay the
requested credit.
• Capital: The applicant’s debt relative to equity.
• Collateral: The amount of assets the applicant
has available for use in securing the credit.
• Conditions: Current general and industry-
specific economic conditions.
Credit Scoring
• Credit scoring is a procedure resulting in a
score that measures an applicant’s overall credit
strength, derived as a weighted-average of
scores of various credit characteristics.
• The procedure results in a score that measures
the applicant’s overall credit strength, and the
score is used to make the accept/reject decision
for granting the applicant credit.

Credit Scoring (cont.)
• The purpose of credit scoring is to make a
relatively informed credit decision quickly
and inexpensively.
• For a demonstration of credit scoring,
including the use of a spreadsheet for that
purpose, see the book’s Web site at
www.aw.com/gitman.

Changing Credit Standards
• The firm sometimes will contemplate changing
its credit standards to improve its returns and
generate greater value for its owners.

Changing Credit Standards Example
Dodd Tool, a manufacturer of lathe tools, is currently selling a product

for $10/unit. Sales (all on credit) for last year were 60,000 units. The
variable cost per unit is $6. The firm’s total fixed costs are $120,000.
Dodd is currently contemplating a relaxation of credit standards that is

anticipated to increase sales 5% to 63,000 units. It is also anticipated
that the ACP will increase from 30 to 45 days, and that bad debt
expenses will increase from 1% of sales to 2% of sales. The
opportunity cost of tying funds up in receivables is 15%.
Given this information, should Dodd relax its credit standards?

Changing Credit
Standards Example (cont.)
Dodd Tool Company
Analysis of Relaxing Credit Standards
Relevant Data
Present Sales Level (units) 60,000
Proposed Sales Level (units) 63,000
Price/unit ($) $ 10.00
Variable Cost/unit ($) $ 6.00
Contributin Margin/unit ($) $ 4.00
Old Receivables Level (days) 30.0
New Receivables Level (days) 45.0

Present A/R Turnover (365/AR) 12.2
Proposed A/R Turnover (365/AR) 8.1
Present Bad Debt Level (% of sales) 1.0%
Proposed Bad Debt Level (% of sales) 2.0%
Opportunity Cost (%) 15.0%
Changing Credit
• Additional Profit Contribution from Sales
Dodd Tool Company

Analysis of Rexaxing Credit Standards
Additional Profit Contribution from Sales
Old Sales Level 60,000 Price/Unit $ 10.00
New Sales Level 63,000 Variable Cost/Unit $ 6.00
Increase in Sales 3,000 Contribution Margin/Unit $ 4.00
Additional Profit Contribution from Sales (sales incr x cont margin) $ 12,000

Changing Credit
Dodd Tool Company
Analysis of Rexaxing Credit Standards
Cost of Marginal Investment in Accounts Receivable
Cost of Marginal Investment in A/R = Total VC/Turnover of A/R
Total VC = VC/Unit X # of Units
Total VC Under the Present Plan $ 360,000
Total VC Under the Proposed Plan $ 378,000
Average Investment Under Present Plan $ 29,508
Average Investment Under Proposed Plan $ 46,667
Marginal Investment in Accounts Receivable $ 17,158
Opportunity Cost 15.0%
Cost of Marginal Investment in Accounts Receivable $ 2,574
Changing Credit
Dodd Tool Company
Cost of Marginal Bad Debt
Cost of Bad Debt = Bad Debt % x Total Sales
Total Sales under Present Plan $ 600,000
Total Sales under Proposed Plan $ 630,000
Bad Debt % under Present Plan 1.0%
Bad Debt % under Proposed Plan 2.0%
Cost of Bad Debt under Present Plan $ 6,000

Cost of Bad Debt under Proposed Plan $ 12,600
Cost of Marginal Bad Debts $ 6,600
Changing Credit
Dodd Tool Company

Making the Credit Standard Decision
Additional Profit Contribution from Sales $ 12,000
Cost of Marginal Investment in Accounts Receivable (2,574)
Cost of Marginal Bad Debts (6,600)
Net Profit From Implementation of Proposed Plan $ 2,826

Changing Credit Terms
• A firm’s credit terms specify the repayment

terms required of all of its credit customers.
• Credit terms are composed of three parts:
– The cash discount
– The cash discount period
– The credit period
• For example, with credit terms of 2/10 net 30,
the discount is 2%, the discount period is 10
days, and the credit period is 30 days.

Changing Credit Terms Example
MAX Company has an average collection period of 40
days (turnover = 365/40 = 9.1). In accordance with the
firm’s credit terms of net 30, this period is divided into 32
days until the customers place their payments in the mail
(not everyone pays within 30 days) and 8 days to receive,
process, and collect payments once they are mailed.
MAX is considering initiating a cash discount by changing

its credit terms from net 30 to 2/10 net 30. The firm
expects this change to reduce the amount of time until the
payments are placed in the mail, resulting in an average
collection period of 25 days (turnover = 365/25 = 14.6).
Changing Credit
Terms Example (cont.)
Insert Table 14.3 here

Credit Monitoring
• Credit monitoring is the ongoing review of a

firm’s accounts receivable to determine whether
customers are paying according to the stated
credit terms.
• Slow payments are costly to a firm because
they lengthen the average collection period
and increase the firm’s investment in
accounts receivable.
• Two frequently used techniques for credit
monitoring are the average collection period and
aging of accounts receivable.
Credit Monitoring:
Average Collection Period
• The average collection period is the average
number of days that credit sales are outstanding
and has two parts:
– The time from sale until the customer places the
payment in the mail, and
– The time to receive, process, and collect payment.

Credit Monitoring:
Aging of Accounts Receivable

Credit Monitoring:
Collection Policy
• The firm’s collection policy is its
procedures for collecting a firm’s accounts
receivable when they are due.
• The effectiveness of this policy can be
partly evaluated by evaluating at the level
of bad expenses.
• As seen in the previous examples, this
level depends not only on collection policy
but also on the firm’s credit policy.
Collection Policy

Management of Receipts
& Disbursements: Float
• Collection float is the delay between the time
when a payer deducts a payment from its
checking account ledger and the time when
the payee actually receives the funds in
spendable form.
• Disbursement float is the delay between the
time when a payer deducts a payment from its
checking account ledger and the time when the
funds are actually withdrawn from the account.
• Both the collection and disbursement float have
three separate components.
Management of Receipts
& Disbursements: Float (cont.)
• Mail float is the delay between the time when a
payer places payment in the mail and the time
when it is received by the payee.
• Processing float is the delay between the
receipt of a check by the payee and the deposit
of it in the firm’s account.
• Clearing float is the delay between the deposit
of a check by the payee and the actual
availability of the funds which results from
the time required for a check to clear the
banking system.
Management of Receipts & Disbursements:
Speeding Up Collections
• Lockboxes
– A lockbox system is a collection procedure in which
payers send their payments to a nearby post office
box that is emptied by the firm’s bank several times
a day.
– It is different from and superior to concentration
banking in that the firm’s bank actually services the
lockbox which reduces the processing float.
– A lockbox system reduces the collection float by
shortening the processing float as well as the mail
and clearing float.

Slowing Down Payments
• Controlled Disbursing
– Controlled Disbursing involves the strategic
use of mailing points and bank accounts to
lengthen the mail float and clearing
float respectively.
– This approach should be used carefully,
however, because longer payment periods
may strain supplier relations.

Management of Receipts &
Disbursements: Cash Concentration
• Direct Sends and Other Techniques
– Wire transfers is a telecommunications bookkeeping
device that removes funds from the payer’s bank and
deposits them into the payees bank—thereby
reducing collections float.
– Automated clearinghouse (ACH) debits are
pre-authorized electronic withdrawals from the
payer’s account that are transferred to the payee’s
account via a settlement among banks by the
automated clearinghouse.
– ACHs clear in one day, thereby reducing mail,
processing, and clearing float.
Zero-Balance Accounts
• Zero-balance accounts (ZBAs) are

disbursement accounts that always have an
end-of-day balance of zero.
• The purpose is to eliminate non-earning cash
balances in corporate checking accounts.
• A ZBA works well as a disbursement account
under a cash concentration system.

Investing in Marketable Securities

Investing in Marketable
Securities (cont.)

Investing in Marketable
Securities (cont.)

Working Capital Management

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Chapter 6

1. Understand short-term financial management,

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 13-2

4. Explain the credit selection process and the

Current Assets: Current Liabilities:

Fixed Assets: Long-Term Financing:

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• Working Capital includes a firm’s current

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high Long-Term high

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• Short-term financial management—managing current

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The Operating Cycle (OC) is the time between ordering

The Cash Conversion Cycle (CCC) is the time between

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 13-10

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 13-11

Using the values for these variables, the cash

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 13-13

Obviously, reducing AAI or ACP or lengthening APP will

• Permanent vs. Seasonal Funding Needs

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 13-15

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 13-17

$50,000 throughout the year. Accordingly, Semper has a permanent

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 13-18

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 13-19

Semper Pump has a permanent funding requirement of $135,000 and

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 13-20

Alternatively, Semper can choose a conservative strategy under which

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 13-21

Clearly, the aggressive strategy’s heavy reliance on short-term

The conservative strategy avoids these risks through the locked-in

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 13-22

1. Turn over inventory as quickly as possible

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 13-24

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 13-25

• The ABC System

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Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 13-27

Assume that RLB, Inc., a manufacturer of electronic test

EOQ = 2(1,600)($50) = 400

Ordering Costs = Cost/Order x # of Orders/Year

Carrying Costs = ($1 x 400)/2 = $200

Total Costs = Ordering Costs + Carrying Costs

Reorder point = lead time in days x daily usage

Daily usage = 1,600/360 = 4.44 units/day

Reorder point = 10 x 4.44 = 44.44 or 45 units

Thus, when RIB’s inventory level reaches 45 units, it should place an

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Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 13-34

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 13-35

• The second component of the cash conversion

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Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 13-40

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 13-41

Dodd Tool, a manufacturer of lathe tools, is currently selling a product

Dodd is currently contemplating a relaxation of credit standards that is

Given this information, should Dodd relax its credit standards?

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 13-42

New Receivables Level (days) 45.0

Dodd Tool Company

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Cost of Bad Debt under Present Plan $ 6,000