Lecture 10: Working Capital

Management

Copyright ©2022 John Wiley & Sons, Inc. 1

Learning Objectives (1 of 2)

1. Define net working capital, discuss the importance of

working capital management, and compute a firm’s net
working capital
2. Define the operating and cash conversion cycles, explain
how they are used, and compute their values for a firm
3. Discuss the relative advantages and disadvantages of
pursuing (1) flexible and (2) restrictive current asset
management strategies
4. Explain how accounts receivable are created and managed,
and compute the cost of trade credit

Copyright ©2022 John Wiley & Sons, Inc. 2

Learning Objectives (2 of 2)

5. Explain the trade-off between carrying costs and reorder

costs, and compute the economic order quantity for a firm’s
inventory orders
6. Define cash collection time, discuss how a firm can
minimize this time, and compute the economic costs and
benefits of a lockbox
7. Describe three current asset financing strategies, and
discuss the main sources of short-term financing

Copyright ©2022 John Wiley & Sons, Inc. 3

14.1 Working Capital Basics

• Working capital basics

• Working capital terms and concepts
• Working capital accounts and trade-offs

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Working Capital Basics

• Working capital management involves two key issues

o What is the appropriate amount and mix of current assets for
the firm to hold?
o How should these current assets be financed?

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Apple Inc. Financial Statements -
Assets
Fiscal Year Ended September 26, 2020 ($ millions)
Balance Sheet as of September 26, 2020

Assets
Cash $38,016
Short-term investments 52,927
Accounts receivable 16,120
Inventory 4,061
Other current assets 32,589
Total current assets $143,713
Property, plant, and equipment 103,526
Less: Accum. depreciation 66,760
Net plant and equipment 36,766
Investments 100,887
Other noncurrent assets 42,522
Total Assets $323,888

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Apple Inc. Financial Statements –
Liabilities and Equity
Fiscal Year Ended September 26, 2020 ($ millions)
Liabilities and equity
Accounts payable $42,296
Deferred revenue 6,643
Other current liabilities including accrued expenses 56,453
Total current liabilities $105,392
Long-term debt 98,667
Other noncurrent liabilities 54,490
Total liabilities $258,549
Preferred stock 0
Common stock 50,779
Retained earnings 14,966
Other stockholder equity (406)
Less: Treasury stock 0
Total common equity $65,339
Total liabilities and stockholder’s equity $323,888

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Apple Inc. Financial Statements
Fiscal Year Ended September 26, 2020 ($ millions)
Income Statement for the fiscal year ended September 26, 2020

Net sales $274,515

Cost of goods sold 169,559

Operating expenses 38,668

Earnings before interest and taxes (EBIT) $ 66,288

Interest and other income 803

Earnings before taxes (EBT) $ 67,091

Taxes 9,680

Net income $ 57,411

Common stock dividend $ 14,087

Stock repurchases 72,516

Addition to retained earnings ($30,832)

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Working Capital Basics: Terms and
Concepts (1 of 2)
• Current assets are cash and other assets that the firm
expects to convert into cash in a year or less
• Current liabilities (or short-term liabilities) are obligations
that the firm expects to pay off in a year or less
• Working capital (also called gross working capital) are the
funds invested in a company’s cash account, account
receivables, inventory, and other current assets

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Working Capital Basics: Terms and
Concepts (2 of 2)
• Net working capital (NWC) refers to the difference
between current assets and current liabilities. It is a
measure of liquidity and represents the net short-term
investment the firm keeps in the business
• Working capital management involves making decisions
regarding the use and sources of current assets
• Working capital efficiency refers to the length of time
between when a working capital asset is acquired and when
it is converted into cash
• Liquidity is the ability of a company to convert real or
financial assets into cash quickly and without loss of value
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Working Capital Accounts and
Trade-Offs
• Working capital accounts
o Cash is cash and other highly liquid investments
o Receivables are amounts owed by customers
o Firms maintain inventory of raw materials, work in process,
and finished goods
o Payables represent the amount owed to the firm’s suppliers
• Increasing working capital costs money, but should lead to
increased sales and better relationships with vendors,
suppliers, and employees

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14.2 The Operating and Cash Conversion Cycles

• The operating and cash conversion cycles

• Operating cycle
• Cash conversion cycle

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Operating and Cash Conversion Cycles
• The cash conversion cycle the point a company pays for
raw materials until the point it receives cash from sales
• Sequence of events in the cash conversion cycle:
o Use cash to pay for raw materials and costs of conversion
o Finished goods are held in inventory until they are sold
o Finished goods are sold on credit to the firm’s customers
o Customers repay the credit the firm has extended to them
and the firm receives the cash

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The Cash Conversion Cycle

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Goals of Financial Managers in
Managing the Cycle
• To delay paying accounts as long as possible
• To maintain minimal raw material inventories
• To use as little labor as possible
• To maintain minimal finished good inventories
• To offer customers the most attractive credit terms
• To collect cash payments as fast as possible

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Time Line for Operating and Cash
Conversion Cycles for Apple Inc. in
2020

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Operating Cycle

• The operating cycle begins when the firm uses its cash to
purchase raw materials and ends when the firm collects cash
payments on its credit sales
o Days’ sales in inventory (DSI) shows how long the firm keeps its
inventory before selling it, the ratio of the inventory balance to the
daily cost of good sold

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Selected Financial Ratios for Apple
Inc. and Comparison Companies in
2020
Financial Ratio Apple Comparison Firm Average

Days’ sales in inventory (DSI) 8.74 25.45

Days’ sales outstanding (DSO) 21.43 49.68

Days’ payables outstanding (DPO) 91.05 81.27

Operating cycle (days) 30.18 75.13

Cash conversion cycle (days) −60.87 -6.14

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Days’ Sales Outstanding

• Days’ sales outstanding (DSO) shows how long it takes on

average for the firm to collect its outstanding accounts
receivable balances
• Also called the average collection period (ACP)

Equation 14.1
Operating Cycle=DSI+DSO

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Cash Conversion Cycle

• The cash conversion cycle starts when the firm actually pays for
its inventory
o It represents the length of time between the cash outflow for
materials and the cash inflow from sales
o Days payables outstanding (DPO) tells how long a firm takes to
pay off its suppliers for the cost of inventory

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Calculation of the Cash Conversion
Cycle
• We can now calculate the cash conversion cycle using one
of two methods:
Equation 14.2
Cash Conversion Cycle=DSI+DSO−DPO
Equation 14.3
Cash Conversion Cycle=Operating Cycle−DPO

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Kernel Mills Financial Statements - Assets
Fiscal Year Ended December 31, 2020 ($ millions)
Balance Sheet as of December 31, 2020
Assets

Cash $175,000

Short-term investments 165,000

Accounts receivable 690,000

Inventory 660,000

Total current assets $1,690,000

Plant and equipment 2,400,000

Less: Accum. depreciation (800,000)

Net plant and equipment 1,600,000

Investments 210,000

Total Assets $3,500,000

Selected food industry ratios: Days’ sales in inventory = 71.59, Days’ sales outstanding = 44.77,
Days’ payables outstanding = 58.33, Cash conversion cycle = 58.03 days
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Kernel Mills Financial Statements –
Liabilities and Equity
Fiscal Year Ended December 31, 2020 ($ millions)
Balance Sheet as of December 31, 2020

Liabilities and equity

Accounts payable $ 550,000
Deferred revenue 400,000
Accrued expenses 85,000
Taxes payable 80,000
Total current liabilities $1,115,000
Long-term debt $1,100,000
Total liabilities $2,215,000
Common stock 600,000
Retained earnings 685,000
Total common equity $1,285,000
Total liabilities and stockholder’s equity $3,500,000

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Kernel Mills Financial Statements
Fiscal Year Ended December 31, 2020 ($ millions)
Income Statement
Net sales $5,200,000
Cost of goods sold 3,325,000
Operating expenses 1,500,000
Earnings before interest and taxes (EBIT) $ 375,000
Investment and other income 40,000
Interest expense 116,500
Earnings before taxes (EBT) $ 298,500
Taxes 148,000
Net income $ 150,500
Common stock dividend $ 15,500
Addition to retained earnings $ 135,000

Selected food industry ratios: Days’ sales in inventory = 71.59, Days’ sales outstanding = 44.77,
Days’ payables outstanding = 58.33, Cash conversion cycle = 58.03 days

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14.3 Working Capital Management Strategies

• Working capital management strategies

• Flexible current asset management strategy
• Restrictive current asset management strategy
• The working capital trade-off

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Working Capital Management
Strategies
• Financial managers use two types of strategies for current
assets:
o The flexible current asset management strategy has a high
percent of current assets to sales
o The restrictive policy has a low percent of current assets to
sales

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Flexible Current Asset Management
Strategy
• Invest large amounts in cash, marketable securities, and
inventory
• Considered low-risk and low-return
• Advantage of this strategy is large working capital balances
• The downside of this strategy is the high carrying cost
associated with owning a high level of inventory and
providing liberal credit terms to customers

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Restrictive Current Asset
Management Strategy
• The restrictive current asset management strategy is a
high-risk high-return alternative to the flexible strategy
o The high risk comes from risks of:
• Operating shortage costs result from lost production and
sales
• Financial shortage costs arise mainly from illiquidity,
shortage of cash, and a lack of marketable securities to sell for
cash

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The Working Capital Trade-Off
• Management will try to find the level of current assets that
minimizes the sum of the carrying costs and shortage costs
o The optimal strategy depends on the relative magnitudes of
carrying costs and shortage costs
o This conflict is often referred to as the working capital trade-off
o Financial managers need to balance shortage costs against
carrying costs to define an optimal strategy
o If carrying costs are larger than shortage costs, then the firm will
maximize value by adopting a more restrictive strategy
o On the other hand, if shortage costs dominate carrying costs, the
firm will need to move towards a more flexible policy

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14.4 Accounts Receivable

• Accounts receivable
• Terms of sale
• Aging accounts receivable

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Accounts Receivable

• Companies frequently make sales to customers on credit by

delivering goods in exchange for the promise of a future
payment
• The promise is an account receivable
• Offering credit can help a firm attract customers

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Terms of Sale

• For every sale, the seller spells out the terms of sale
o The agreement specifies when payment is due and any early
payment discount
• The simplest offer is cash on delivery (COD), no credit
• When credit is part of the sale, the terms of sale spell out the
credit agreement between the buyer and seller
o Trade credit, which is short-term financing, is typically made with
a discount for early payment rather than an explicit interest charge
• Trade credit is a loan from the supplier and is usually a very
costly form of credit

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Effective Annual Rate

• We can find the effective annual rate (EAR) for trade credit
using the following formula:

Equation 14.4

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Aging Accounts Receivables

• Aging schedule is a common tool for credit managers

o The aging schedule shows the breakdown of the firm’s
accounts receivable by their date of sale
o It identifies and track delinquent accounts
• Aging schedules are also an important tool for analyzing
the quality of a firm’s receivables
o The aging schedule reveals patterns of delinquency and
shows where collections efforts should be concentrated

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Aging Schedule of Accounts
Receivable
Age of Minnow Minnow Rooney, Rooney, Inc.: Hastings Hastings
Account(days) Corporation: Corporation: Inc.: % of Total Corporation: Corporation:
Value of % of Total Value of Value Value of % of Total
Account Value Account Account Value
0–10 $436,043 60% $363,370 50% $319,765 44%

11–30 290,696 40 218,022 30 181,685 25

31–45 0 0 109,011 15 116,278 16

46–60 0 0 36,336 5 72,674 10

Over 60 0 0 0 0 36,337 5

Total $726,739 100% $726,739 100% $726,739 100%

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14.5 Inventory Management

• Inventory management
• Economic order quantity
• Just-in-time inventory management

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Inventory Management
• Inventory management is operations management
• Manufacturing companies generally carry three types of
inventory: raw materials, work in process, and finished
goods
• Investment in inventory is costly
• Capital invested in inventory provides no direct return
• Running out of raw materials can cause manufacturing to
shut down at a greater cost to the firm
• A shortage of finished goods can mean lost sales

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Economic Order Quantity (EOQ)

• The EOQ mathematically determines the minimum total

inventory cost, allowing for reorder costs and inventory carrying
costs
• The optimal order size strikes the balances between these two
costs

Equation 14.5

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Just-in-Time Inventory Management
• The exact raw material needs are delivered by the suppliers
o Essentially no raw material inventory costs and no chance of
obsolescence or loss to theft
o On the other hand, if the supplier fails to make the needed
deliveries, then production shuts down
• If this system works for a firm effectively, it cuts down
their investment in working capital dramatically

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14.6 Cash Management and Budgeting

• Cash management and budgeting

• Reasons for holding cash
• Cash collection

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Cash Management and Budgeting
• Cash is part of working capital
o Balances earn little or no interest in a commercial bank
account
o Many firms also invest their cash in short-term investments
o Corporate holdings of cash and short-term investments can
be quite large

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Reasons for Holding Cash
• There are three main reasons for holding a cash balance
o First, it facilitates transactions with suppliers, customers,
and employees
o Second, for precautionary or strategic reasons
o The third reason for holding cash is simply that most banks
require firms to hold compensating balances, minimum cash
balances in exchange for services

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Cash Collection
• Collection time, or float, is the time between when a
customer makes a payment and when the cash become
available to the firm
• Collection time can be broken down into three components:
o Delivery, or mailing, time
o Processing delay
o Finally, there is a delay between the time of the deposit and
the time the cash is available for withdrawal

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Lockboxes
• Geographically dispersed customers send their payments to
a post office box close to them
• With a concentration account, a post office box is replaced
by a local branch which receives the mailings, processes
the payments, and makes the deposits
• Either approach will reduce the collection time to an extent
but there is a cost associated with it

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Electronic Funds Transfers
• Electronic funds transfers reduce cash collection times in
every phase
o Mailing time is eliminated
o Processing time is reduced or eliminated since there is no
data entry is necessary
o Electronic funds transfers typically have little or no delay in
funds availability

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14.7 Financing Working Capital

• Financing working capital

• Strategies for financing working capital
• Financing working capital in practice
• Sources of short-term financing

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Financing Working Capital
• Working capital must be funded in some way
• Financial managers can finance working capital with
short-term debt, long-term debt, equity, or a mixture of all
three

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Strategies for Financing Working
Capital
• The minimum level of working capital is viewed as
permanent working capital
• The next slides show the three basic strategies that a firm
can follow to finance its working capital and fixed assets
• Each of the three panels show:
o The total long-term financing
o The seasonal needs for working capital that fluctuates with
the level of sales

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Working Capital Financing Strategies
(1 of 3)

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Working Capital Financing Strategies
(2 of 3)

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Working Capital Financing Strategies
(3 of 3)

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Maturity Matching Strategy
• The maturity matching strategy is one of the most basic
techniques used by financial managers to reduce risk when
financing assets
o All seasonal working capital is funded with short-term
borrowing
o As the level of sales varies seasonally, short-term borrowing
fluctuates between some minimum and maximum level

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Long-term and Short-term Funding
Strategy
• The long-term funding strategy was shown in the second
slide
• All permanent working capital and fixed assets are funded
with long-term financing
• Relies on long-term debt to finance both capital assets and
working capital
o The short-term funding strategy is shown in Panel C of
Exhibit 14.7
• This strategy relies on short-term debt to finance all seasonal
working capital, a portion of the permanent working capital
and fixed assets

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Financing Working Capital in Practice
• Matching Maturities
o Nearly all financial managers try to match the maturities of
assets and liabilities when funding the firm
o Short-term assets are funded with short-term financing and
long-term assets are funded with long-term financing
• Permanent Working Capital
o Most financial managers like to fund some of their current
assets with long-term debt
o Some large firms with the highest credit standing prefer to
fund some of their long-term fixed assets with short-term
debt sold in the commercial paper market

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Sources of Short-Term Financing –
Accounts Payable (Trade Credit)
• Accounts payable (trade credit), bank loans, and
commercial paper are common sources of short-term
financing
• The buyer decides whether to take advantage of the cash
discount or wait and pay in full when the account is due

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Sources of Short-Term Financing –
Short-Term Bank Loans
• A loan backed with an asset is defined as secured, otherwise the
loan is unsecured
• Secured loans usually have a lower interest rate
• An informal line of credit is a verbal agreement between the
firm and the bank, allowing the firm to borrow up to an
agreed-upon upper limit
• In exchange for providing the line of credit, a bank may require
that the firm hold a compensating balance with them
• A formal line of credit is also known as revolving credit
o The bank has a legal obligation to lend up to a pre-set limit
o A yearly fee is paid in addition to the interest expense

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Sources of Short-Term Financing
-Commercial Paper
• Commercial paper is a promissory note issued by large
financially secure firms that have high credit ratings
• It is not secured (the issuer is not pledging any assets to the
lender in the event of default), but most commercial paper
is backed by a credit line from a commercial bank
• The default rate on commercial paper is very low, resulting
in an interest rate that is usually lower than what a bank
would charge on a direct loan

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Sources of Short-Term Financing -
Accounts Receivable Financing
• A company can secure a bank loan by pledging the firm’s
accounts receivable as security
• Accounts receivable financing is an important source
of funds for medium-size and small businesses
• Factoring is when a firm sells receivables to a factor at a
discount. The firm that sells the receivables has no further
legal obligation to the factor

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