Lecture 2: 1

Working Capital
Management
Outline 2

0. Motivation

1. Economic Framework

2. Working Capital Components

 Motivation
Problem: Working capital management is a key driver of value and growth; 3
it has become especially important recently due to high interest rates and
poor economic conditions
 Motivation 4
These events give rise to many questions:
• How can firms improve their working capital mgt?
• What factors impact WC? What should be ignored?
• How to measure the gains and costs of improved WC mgt?
• What tools are available to firms to manage their WC?
• What are recent innovations and examples of WC mgt?

Why should I care about answering these questions?

1. Relevant for many careers
 Operations / Consulting – helping companies manage their operations,
particularly in times of tight credit
 Buy side (equity, debt analyst, private equity) – assessing ability to manage
projects with internal funding
 Sell side (banking) – Modeling firms and selling securities
2. Helpful for forming your own views on many world events
 Motivation 5
These events give rise to many questions:
• How can firms design the optimal working capital policy?
• What factors impact WC? What should be ignored?
• How to measure the gains and costs of improved WC mgt?
• What tools are available to firms to manage their WC?
• What are recent innovations and examples of WC mgt?

Can we answer these questions using intuition alone?

 Intuition is helpful for thinking about the general tradeoffs associated with WC
components. For example, intuition is sufficient for understanding that inventory
helps meet uncertain consumer demand, but ties up cash in the firm. However,
intuition alone is insufficient for quantifying the value gains from improved
working capital management.

Can we rely on statistical approaches to managing WC?

 It is quite common to use statistics to compare WC management across similar
firms. For example, cash conversion cycle lengths within an industry can help
identify WC mgt inefficiencies. Again though, statistics don’t give us the how
and why of WC mgt practices.
Economic Framework
6

Because intuition and statistics are helpful, but not fully insufficient for
understanding working capital management, we will try using economics
to help guide us.

We will develop a theoretical framework to think about working capital

and how it impacts the firm and its stakeholders (such as creditors,
equity holders, employees, etc.).

We will construct this framework in stages, by first starting with

working capital management in the simplest setting: frictionless markets.

(This is similar to our approach to thinking about optimal financial

policy, and many other issues in economics/finance: we usually start
with the simplest model possible, then build up from there to incorporate
important features of reality).
 Definitions
7
To ensure that we have the right terminology in place:
Working capital is the internal funds that the firm needs to conduct day-to-
day operations.
Typically: WC = Cash + Inventory +A/R – A/P

The operating cycle (OC) of the firm is the length of time between when the
firm purchases inventory and when it receives cash for its sales.
OC = Inventory + A/R

The cash conversion cycle (CCC) is the length of time between when cash
flows first go out of the firm during the operating cycle and then last come in
during the operating cycle.
CCC = Inventory – A/P + A/R

* Note: cycles & their individual components are quoted in days

What are examples of firms with long vs. short CCC?
 Perfect Markets
8
Each component of working capital can be thought of as a production
input that is determined by supply (S) and demand (D).

Cash, A/R, and A/P are essentially financial assets. Under perfect capital
markets, any choice of these inputs is equivalent in terms of NPV.

Inventory is a non-financial asset that is determined by perfect

competition; there will be an optimal level of inventory given S and D.
 Imperfect Markets
9
When markets are imperfect, for example, if capital markets are imperfect, then
the firm’s choice of cash, A/R, and A/P matters for value.

What frictions would matter for these WC components?

Solution: liquidity constraints and costly external financing will make cash
holdings relevant.

If customers or suppliers are financially constrained, A/R and A/P terms will
reflect these constraints.

Firms’ inventory decisions will also be affected by market imperfections. For

example, if firms have market power, they can likely afford to maintain lower
levels of inventory. Why?

 Therefore, if markets have frictions, there is an optimal WC policy!

 Cash
10
Definition: Cash used for operations has many functions: to meet daily business
requirements, to mitigate uncertainty, to satisfy bank terms. Accordingly, cash
balances are sometimes called transactional, precautionary, or compensating.

Quick ratio is a common metric used to assess cash balances: Current assets
(minus inventory) / current liabilities

Equilibrium: What are the tradeoffs firms face when managing cash?
Solution: There is a clear tradeoff between the benefits listed above, and the
opportunity costs of holding cash (foregoing investment returns and facing
double taxation)

Question: How have cash holdings for U.S. publicly traded firms been evolving
since 2000? What are the reasons for this?
Solution: Internal cash has been increasing steadily since 2000. The reasons for
this include offshore tax rule changes, increases in the desire for financial
flexibility (and avoid costly external financing), and a shift away from capital
intensive production to knowledge based production.
 Inventory
11
Definition: Inventory refers to products that the firm intends to use for production within
the next year. These products can encompass raw materials, in process goods, and final
sales items.

Equilibrium: Inventory is determined by supply and demand for these products. What’s
the tradeoff?

Question: How did Inventories and Sales look for firms before, during and immediately
after the pandemic?
Solution: During the pandemic, inventories soared while sales dropped; in the aftermath
of the pandemic, many firms experienced depleted inventories.

Question: What are some recent trends in inventory management?

Solution: Technological change has led to greater Just-in-Time inventory management
practices. Firms are also using technology to better forecast sales and prepare more
accurate inventory levels in advance.

Question: What types of industries maintain high vs. low inventory stocks?
 A/R and A/P
Definition: A/R (A/P) refer to sales (payments) that are recorded before cash
12
actually changes hands.

To understand these items, it is helpful to first define Trade Credit (TC).

When a seller sells a good to a buyer, the buyer can pay immediately, or can pay
later at terms that have been negotiated between the two parties. By offering
later payment to the buyer, the seller is giving trade credit to the buyer (akin to
giving a loan).

A common convention for TC terms is {Discount % / Early Day, Net Last

Day}.

For example: 2/10 Net 30 means you offer a 2% discount if the buyer pays
within 10 days, otherwise they have to pay full price in 30 days. What is the
effective interest rate that the buyer is being offered by the seller?
Solution: for a $100 sale, the discount is $2 if paid by day 10. The 20 day delay
means that the buyer is foregoing a $98 payment in order to pay 100 later, or 98
= 100/(1+r). r = 2.04%. Annualized, (1+r)^(365/20) – 1 = 44.6%. Expensive
loan!
 A/R and A/P
13
Equilibrium: What determines the equilibrium level of A/R and A/P that a
firm is willing to take on?

What are the tools available to firms to manage A/R and A/P?

What types of firms have high vs low A/R? What about A/P?

What are alternative ways of dealing with the problems that A/R and A/P
are trying to solve? How do store credit cards work?
 Political Issues
14
Working capital policies are often times subject to political debate.

For example, large firms may impose their market power and use their
bargaining power to get better terms from smaller suppliers.

What are the pros and cons of policies that aim to address these issues?
 Summary
Working capital management is an important component of value creation15

Intuition and statistics are very helpful when thinking about optimal WC
policies.

Economics also helps to quantify the costs and benefits of individual WC

component levels, and helps to give intuition for why high or low WC
components may be suitable for the firm