Topic 10: Working Capital Management

Learning Objectives

After successful completion of this topic, you should be able to:

 Explain how different amounts of current assets and current liabilities affect firms’ profitability and thus
their stock prices.
 Discuss how the cash conversion cycle is determined, how the cash budget is constructed, and how each is
used in working capital management.
 Explain how companies decide on the proper amount of each current asset—cash, marketable securities,
accounts receivable, and inventory.
 Discuss how companies set their credit policies and explain the effect of credit policy on sales and profits.
 Describe how the costs of trade credit, bank loans, and commercial paper are determined and how that
information impacts decisions for financing working capital.
 Explain how companies use security to lower their costs of short-term credit.

Presentation of Contents

Working Capital
The capital of a business which is used in its day-by-day trading operations, calculated as the current assets
minus the current liabilities. Working capital is also called operating assets or net current assets.
WC = CA – CL

Working Capital Management

Working capital management refers to a company’s managerial accounting strategy designed to monitor and
utilize the two components of working capital, current assets and current liabilities, to ensure the most
financially efficient operation of the company.

Need of Working Capital Management

Cash Receivable Inventory

Management Management Management

Factors Affecting Working Capital

1. Nature of business 8. Business
2. Production policy 9. Taxation policy
3. Credit policy 10. Dividend policy
4. Inventory policy 11. Operating efficiency
5. Abnormal factor 12. Price level changes
6. Market conditions 13. Depreciation policy
7. Conditions of supply 14. Availability of raw material

How much Working Capital is Needed?

It depends on the following factors
1. Size of the firm
2. Activities of the firm
3. Availability of credits
4. Attitude towards profit
5. Attitude toward risk

Financial Management Module 1

Importance of Adequate Working Capital (Optimum WC)
1. Smooth running of business
2. Profitability with manage risk
3. Growth and development possibility
4. Smooth payment
5. Increase in Goodwill
6. Better trade relationship

Business Cycle
2 Processes in Managing
Working Capital

Forecasting Fund
Requirement

Arrangement of Fund

Some Important Issues

A. Monetary level of cash, receivable and inventory
i. Current asset / Current Liability
ii. Current asset / Total Liability
iii. (Current asset – inventory) / Liability
iv. (Cash + marketable securities) / Current assets
B. To have understanding of percentage of fund in current account
C. Recording time spent in managing current account

Current Asset Investment Policies

Financial Management Module 2

Relaxed Current Asset Investment Policy - Relatively large amounts of cash, marketable securities, and
inventories are carried; and a liberal credit policy results in a high level of receivables.

Moderate Current Asset Investment Policy - Between the relaxed and restricted policies.

Restricted Current Asset Investment Policy - Holdings of cash, marketable securities, inventories, and
receivables are constrained.

A restricted (lean-and-mean) policy means a low level of assets (hence, a high total assets turnover ratio), which
results in a high ROE, other things held constant. However, this policy also exposes the firm to risks because
shortages can lead to work stoppages, unhappy customers, and serious long-run problems. The relaxed policy
minimizes such operating problems; but it results in a low turnover, which in turn lowers ROE. The moderate
policy falls between the two extremes. The optimal strategy is the one that maximizes the firm’s long-run
earnings and the stock’s intrinsic value.

DuPont Equation

Current Assets Financing Policies

Investments in current assets must be financed; and the primary sources of funds include bank loans, credit from
suppliers (accounts payable), accrued liabilities, long-term debt, and common equity. Each of those sources has
advantages and disadvantages, so each firm must decide which sources are best for it.

 Current Assets Financing Policy - The way current assets are financed.
 Permanent Current Assets - Current assets that a firm must carry even at the trough of its cycles.
 Temporary Current Assets - Current assets that fluctuate with seasonal or cyclical variations in sales.
 Maturity Matching, or “Self-Liquidating,” Approach - A financing policy that matches asset and liability
maturities. This is a moderate policy.

Working Capital Cycle

The duration of working capital cycle may vary depending upon the nature of business. The duration of
operating cycle (working capital cycle) is equal to the sum of duration of each of above events less the credit
period allowed by the supplier.

Financial Management Module 3

 Cash

Raw Material,
Debtors
Labor,
(Customers)
Overhead

Finished
Work in
goods
progress
(Inventory)

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.
 Cash Conversion Cycle - The length of time funds are tied up in working capital or the length of time
between paying for working capital and collecting cash from the sale of the working capital.
1) Inventory Conversion Period - The average time required to convert raw materials into finished goods
and then to sell them.
2) Average Collection Period (ACP) - The average length of time required to convert the firm’s receivables
into cash, that is, to collect cash following a sale.
3) Payables Deferral Period - The average length of time between the purchase of materials and labor and
the payment of cash for them.

Example:
On Day 1, Abu Sado buys merchandise and expects to sell the goods and thus convert them to accounts
receivable in 60 days. It should take another 60 days to collect the receivables, making a total of 120 days
between receiving merchandise and collecting cash. However, Abu Sado is able to defer its own payments for
40 days.
Illustration:

Although GFI must pay $100,000 to its suppliers after 40 days, it will not receive any cash until 60 + 60 = 120
days into the cycle. Therefore, it will have to borrow the $100,000 cost of the merchandise from its bank on
Day 40, and it will not be able to repay the loan until it collects on Day 120. Thus, for 120 – 40 = 80 days—
which is the cash conversion cycle (CCC)—it will owe the bank $100,000 and will be paying interest on this
debt. The shorter the cash conversion cycle, the better because that will lower interest charges.
Note that if Abu Sado could sell goods faster, collect receivables faster, or defer its payables longer without
hurting sales or increasing operating costs, its CCC would decline, its interest charges would be reduced, and its
profits and stock price would be improved.

Cash Conversion Cycle

Calculating the Cash Conversion Cycle

Financial Management Module 4

Sample Financial Statement
Annual sales $1,216,666
Cost of goods sold 1,013,889
Inventory 250,000
Accounts receivable 300,000
Accounts payable 150,000

Cash Budget - A table that shows cash receipts, disbursements, and balances over some period.
Target Cash Balance - The desired cash balance that a firm plans to maintain in order to conduct business.

Cash and Marketable Securities

 Also called “cash and cash equivalents”
 currency and demand deposits in addition to very safe, highly liquid marketable securities that can be sold
quickly at a predictable price and thus be converted to bank deposits

Demand Deposits - are used for transactions—paying for labor and raw materials, purchasing fixed assets,
paying taxes, servicing debt, paying dividends, and so forth.
The following techniques are used to optimize demand deposit holdings:
1. Hold marketable securities rather than demand deposits to provide liquidity.
2. Borrow on short notice.
3. Forecast payments and receipts better.
4. Speed up payments.
Ex. Lockbox - A post office box operated by a bank to which payments are sent. Used to speed up effective
receipt of cash.
5. Use credit cards, debit cards, wire transfers, and direct deposits.
6. Synchronize cash flows.

Inventories
Inventories, which can include (1) supplies, (2) raw materials, (3) work in process, and (4) finished goods, are
an essential part of virtually all business operations. Optimal inventory levels depend on sales, so sales must be
forecasted before target inventories can be established. Moreover, because errors in setting inventory levels
lead to lost sales or excessive carrying costs, inventory management is quite important. Therefore, firms use
sophisticated computer systems to monitor their inventory holdings.

Accounts Receivable
 Funds due from a customer
Today the vast majority of sales are on credit. Thus, in the typical situation, goods are shipped, inventories are
Financial Management Module 5
reduced, and an account receivable is created. Eventually, the customer pays, the firm receives cash, and its
receivables decline. The firm’s credit policy is the primary determinant of accounts receivable, and it is under
the administrative control of the CFO. Moreover, credit policy is a key determinant of sales, so sales and
marketing executives are concerned with this policy.

Credit Policy
A set of rules that includes the firm’s credit period, discounts, credit standards, and collection procedures
offered.
1. Credit Period - The length of time customers have to pay for purchases.
2. Discounts - Price reductions given for early payment.
3. Credit Standards - The financial strength customers must exhibit to qualify for credit.
4. Collection Policy - refers to the procedures used to collect past due accounts, including the toughness or
laxity used in the process.

Credit Terms - a statement of the credit period and discount policy.

Monitoring Accounts Receivable

The total amount of accounts receivable outstanding at any given time is determined by the volume of credit
sales and the average length of time between sales and collections.
Example:
Boston Lumber Company (BLC), a wholesale distributor of lumber products, has sales of $1,000 per day
(all on credit) and it requires payment after 10 days. BLC has no bad debts or slow-paying customers.
Under those conditions, it must have the capital to carry $10,000 of receivables:

Accounts Payable (Trade Credit)

Firms generally make purchases from other firms on credit and record the debt as an account payable. Accounts
payable, or trade credit, is the largest single category of short-term debt, representing about 40% of the average
corporation’s current liabilities.

Trade Credit - Debt arising from credit sales and recorded as an account receivable by the seller and as an
account payable by the buyer.

Illustration:
Antokers Inc. buys 20 microchips each day with a list price of $100 per chip on terms of 2/10, net 30. Under
those terms, the “true” price of the chips is 0.98($100) = $98 because the chips can be purchased for only $98
by paying within 10 days. Thus, the $100 list price has two components:
List price = $98 “true” price + $2 finance charge

If Antokers decides to take the discount, it will pay at the end of Day 10 and show $19,600 of accounts
payables:
Accounts payable (Take discounts) = (10 days)(20 chips) ($98 per chip)
= $19,600

If it decides to delay payment until the 30th day, its trade credit will be $58,800:
Accounts payable (No discounts) = (30 days)(20 chips)($98 per chip)
= $58,800
Promissory Note
A document specifying the terms and conditions of a loan, including the amount, interest rate, and repayment

Financial Management Module 6

schedule.

Key Features of Promissory Notes

1. Amount
2. Maturity
3. Interest Rate
4. Interest only versus amortized
5. Frequency of interest payments
6. Discount interest
7. Add-on loans
8. Collateral
9. Restrictive covenants
10. Loan guarantees

Line of Credit - An arrangement in which a bank agrees to lend up to a specified maximum amount of funds
during a designated period.

Revolving Credit Agreement - A formal, committed line of credit extended by a bank or another lending
institution.

Cost of Bank Loans

The costs of bank loans vary for different types of borrowers at any given point in time and for all borrowers
over time. Interest rates are higher for riskier borrowers, and rates are higher on smaller loans because of the
fixed costs involved in making and servicing loans
 Prime Rate - A published interest rate charged by commercial banks to large, strong borrowers.

Calculating Banks’ Interest Charges: Regular (or Simple) Interest

 Regular, or Simple, Interest - The situation when only interest is paid monthly.
Assuming a loan of $10,000 at the prime rate (currently 5.25%) with a 360-day year. Interest must be paid
monthly, and the principal is payable “on demand” if and when the bank wants to end the loan.

To find the monthly interest payment, the daily rate is multiplied by the amount of the loan, then by the
number of days during the payment period. For our illustrative loan, the daily interest charge would be
$1.458333333 and the total for a 30-day month would be $43.75:

The effective interest rate on a loan depends on how frequently interest must be paid—the more frequently
interest is paid, the higher the effective rate. If interest is paid once a year, the nominal rate also will be the
effective rate. However, if interest must be paid monthly, the effective rate will be (1 + 0.0525/12)12 – 1 =
5.3782%.

Add-On Interest - Interest that is calculated and added to funds received to determine the face amount of an
instalment loan.

Commercial Paper - Unsecured, short-term promissory notes of large firms, usually issued in denominations
of $100,000 or more with an interest rate somewhat below the prime rate.

Accruals - Continually recurring hort-term liabilities, especially accrued wages and accrued taxes.
Spontaneous Funds - Funds that are generated spontaneously as the firm expands.
Secured Loan - A loan backed by collateral, often inventories or accounts receivable.

Summary
This module discussed the management of current assets, including cash, marketable securities, inventory, and
receivables. Current assets are essential, but there are costs associated with holding them. So if a company can
reduce its current assets without hurting sales, this will increase its profitability. The investment in current
assets must be financed; and this financing can be in the form of long-term debt, common equity, and/or short-
term credit. Firms typically use trade credit and accruals; they also may use bank debt or commercial paper.
Financial Management Module 7
Financial Management Module 8