Notes On Working Capital Management

Notes on Working Capital Management
All that capital; which changes its form very speedily like currency into raw material then raw
material into product then product sold and again we get currency
Working Capital Management= Current Assets – Current Liabilities

You have enough current assets to meet your current liabilities or obligation.
Bankruptcy vs Insolvency
If company is unable to pay its financial leverage interest expenses or Debt is called bankruptcy
Insolvency when you are unable to meet your operating leverage daily operating expenses
Profitability
Suppose you have 1 lac cash

1. Purchase raw material of 1.5 lac with 1 lac cash and 50 thousand ac payable
2. Transfer that raw material into finished goods
3. Finsihed goods sale for 2 lac jis main sa 1.25lac cash and remaning 75 thousand apko
credit sales a/c recievables
4. You recive your cash from sales (a/c recievable)
When you complete this stage so its called Operating cycle
5. You paid for the raw material (a/c payable)
When you complete this stage so its called Cash Conversion Cycle
 A/ c receivable creates when u sales something
 A/c Payables when you purchase something
 Inventory important analyze what cost we bear
Operating Cycle = Inventory Turnover in days + Average collection period in days

Cash Conversion Cycle = Operating Cycle - Average payment Period in days
Cash Conversion Cycle = Inventory Turnover in days + Average collection period in days -
Average payment Period in days
Inventory Turnover in days

inventory
IT ∈days=
CGS
365
Average collection period in days
Ac Receivables
ACP∈days=
Sales
365
Average payment Period in days
Ac Payables
APP∈days=
Purchases
365
Types of funding
Permanent funding requirement

A constant investment in operating assets resulting from constant sales over time.
Seasonal funding requirement

An investment in operating assets that varies over time as a result of cyclic sales.
Funding strategy
Aggressive funding strategy

A funding strategy under which the firm funds its seasonal requirements with short-term debt
and its permanent requirements with long-term debt.
Conservative funding strategy

A funding strategy under which the firm funds both its seasonal and its permanent requirements
with long-term debt.
Goal of Cash Conversion Cycle for Owners Wealth Maximization

This goal can be realized through use of the following strategies:
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.
Accounts Receivable Management
Credit selection technique is the five C’s of credit, which provides a framework for in-depth
credit analysis. The five C’s are as follow:
1. Character: The applicant’s record of meeting past obligations.

2. Capacity: The applicant’s ability to repay the requested credit, as judged in terms of
financial statement analysis focused on cash flows available to repay debt obligations.
3. Capital: The applicant’s debt relative to equity.
4. Collateral: The amount of assets the applicant has available for use in securing the credit.
The larger the amount of available assets, the greater the chance that a firm will recover funds if
the applicant defaults.
5. Conditions: Current general and industry-specific economic conditions, and any unique
conditions surrounding a specific transaction.
Credit scoring
A credit selection method commonly used with high volume/ small-dollar credit requests; relies
on a credit score determined by applying statistically derived weights to a credit applicant’s
scores on key financial and credit characteristics.
Credit Standards
The firm sometimes will contemplate changing its credit standards in an effort to improve its
returns and create greater value for its owners.
Effects of Relaxation of Credit Standards

Variable Direction of change Effect on profits
Sales volume Increase Positive/ Negative
Investment in accounts receivable Increase Negative
Bad-debt expenses Increase Negative
CREDIT TERMS
The terms of sale for customers who have been extended credit by the firm.
Terms of net 30 mean the customer has 30 days from the beginning of the credit period (typically
end of month or date of invoice) to pay the full invoice amount.
Cash discount
A percentage deduction from the purchase price; available to the credit customer who pays its
account within a specified time.
Cash discount period

The number of days after the beginning of the credit period during which the cash discount is
available.
Credit period
The number of days after the beginning of the credit period until full payment of the account is
due.
Credit monitoring
The ongoing review of a firm’s accounts receivable to determine whether customers are paying
according to the stated credit terms.
Aging schedule
A credit-monitoring technique that breaks down accounts receivable into groups on the basis of
their time of origin; it indicates the percentages of the total accounts receivable balance that have
been outstanding for specified periods of time.
Cost of the Marginal Investment in Accounts Receivable
To determine the cost of the marginal investment in accounts receivable, Dodd must find the
difference between the costs of carrying receivables under the two credit standards. Because its
concern is only with the out-of-pocket costs, the relevant cost is the variable cost. The average
investment in accounts receivable can be calculated by using the following formula:
365
Turnover of accounts receivable=
Average collection period
Total Variable Cost

Average investment under proposed /actual plan=
Turnover of accountsreceivable
Cost of marginal investment ∈ A /Recivebales=Marginal investment ∈accounts receivable∗Cost of funds tied up∈
bad debts=Total Sales∗bad debt expenses
Additional profit contribution from sales
Average investment in A/R under proposed plan:
- Average investment in A/R under present plan:
= Marginal investment in A/R
Cost of marginal investment in A/R
Bad debts under proposed plan
- Bad debts under present plan
=Cost of marginal bad debts
= Net profit from implementation of proposed plan

Practice Question:
Dodd Tool, a manufacturer of lathe tools, is currently selling a product for $10 per
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. The firm is currently
contemplating a relaxation of credit standards that is expected to result in the
following: a 5% increase in unit sales to 63,000 units; an increase in the average
collection period from 30 days (the current level) to 45 days; an increase in bad-
debt expenses from 1% of sales (the current level) to 2%. The firm determines that
its cost of tying up funds in receivables is 15% before taxes. To determine whether
to relax its credit standards, Dodd Tool must calculate its effect on the firm’s
additional profit contribution from sales, the cost of the marginal investment in
accounts receivable, and the cost of marginal bad debts.
Selling Price= 10
Present plan sales unit = 60,000
VC per unit= 6
Proposed Sales units= 63000
Bad Debt Expense under present plan= 1% of Sales
Bad Debt Expense under proposed plan= 2% of Sales
Cost of tying up funds in receivables = 15% of Marginal Receivables
Average collection period under present plan =30 days
Average collection period under proposed plan = 45 days
Additional Profit from sales = 3000 (10 is Selling price - 6 is VC) = 12000
Marginal Investment in A/C Rec = Investment in A/C Rec Proposed – Present
plan
Investment in A/C Rec Proposed = Total Variable Cost/ A/C Receivables turnover
= 6*63000 / 365/45
= 378000/8.1
= 46667
Investment in A/C Rec Present = Total Variable Cost/ A/C Receivables turnover
= 6*60,000/ 365/30
= 360000/ 12.1
= 29752
Marginal Investment in A/C Rec = Investment in A/C Rec Proposed – Present
plan
= 46667-29752
= 17159
Cost of Marginal Investment in A/C Rec = Cost of tying up funds in
receivables * Marginal Investment in A/C Rec
= 0.15*17159 = 2574
Bad Debt Expense = Bad Debt Exp Proposed – Present
Bad Debt Exp Proposed= Sales Proposed * its bad debt %
= 63000*10 * 0.02
= 12600
Bad Debt Exp Present = Sales Present * its bad debt %
= 60000*10 * 0.01
= 6000
Sales = Price * no of units sold
Cost of Bad Debt Expense = Bad Debt Exp Proposed – Present
= 12600- 6000
= 6600
Total Profit = Additional Profit from sales - Cost of Marginal Investment in A/C
Rec - Cost of Bad Debt Expense
= 12000 – 2574 – 6600
= 2826
We have to relax our credit
standards
Parker Tool is considering lengthening its credit period from 30 to 60 days. All
customers will continue to pay on the net date. The firm currently bills $450,000
for sales and has $345,000 in variable costs. The change in credit terms is expected
to increase sales to $510,000. Bad-debt expenses will increase from 1% to 1.5% of
sales. The firm has a required rate of return on equal-risk investments of 20%.
(Note: Assume a 365-day year.)
a. What additional profit contribution from sales will be realized from the proposed
change?
b. What is the cost of the marginal investment in accounts receivable?
c. What is the cost of the marginal bad debts?
d. Do you recommend this change in credit terms? Why or why not?

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Notes on Working Capital Management

Working Capital Management= Current Assets – Current Liabilities

Suppose you have 1 lac cash

Operating Cycle = Inventory Turnover in days + Average collection period in days

Inventory Turnover in days

Permanent funding requirement

Seasonal funding requirement

Aggressive funding strategy

Conservative funding strategy

Goal of Cash Conversion Cycle for Owners Wealth Maximization

1. Character: The applicant’s record of meeting past obligations.

Effects of Relaxation of Credit Standards

Cash discount period

Total Variable Cost

bad debts=Total Sales∗bad debt expenses

Additional profit contribution from sales

Average investment in A/R under proposed plan:

- Average investment in A/R under present plan:

= Marginal investment in A/R

Cost of marginal investment in A/R

Bad debts under proposed plan

- Bad debts under present plan

=Cost of marginal bad debts

= Net profit from implementation of proposed plan

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