Chapter 2

Working Capital Management (WCM)

 Working capital terminology

• Gross working capital – total current assets.

• Net working capital – current assets minus non-interest
bearing current liabilities.
• Working capital policy – deciding the level of each type of
current asset to hold, and how to finance current assets.
• Working capital management – establishing Policies and
strategies for controlling the current assets and short-term
liability.
• It involves investment & financing decisions of current assets
 Components of WCM

• Investment in current assets

• Cash Management
• Account Receivable Management
• Inventory Management
• Short-Term Financing
• Trade Credit
• Bank Loans
• Commercial Paper
 Permanent vs Temporary WC
• Permanent WC: are those current assets that the firm holds
even during slack times
• Working capital is permanent to the extent that it
supports constant or minimum level of sales
• Temporary WC: are the additional current assets that are
needed during seasonal or cyclical peaks.
• Temporary working capital supports seasonal
peaks in business
Permanent vs Temporary WC
 Cash conversion cycle

• The cash conversion cycle is the length of time between

payments for inputs until to collection from its customers.
• Gross operating cycle (GOC) is the sum of inventory
conversion period and receivable collection period

Inventory Receivables Payables

CCC = conversion + collection – deferral .
period period period
Cash conversion cycle
 Cash conversion cycle

• Cash conversion cycle is an important metric for a

business to determine the efficiency at which a company
is able to convert its inventory into sales and then into
cash
• Working capital efficiency is commonly measured by a
firm’s cash conversion cycle
• The shorter is conversion cycle , the more efficient is its
use of working capital.
 Discussion

Is that possible to have

negative CCC? What
does negative CCC
mean?
 Example
• Analyze the cash conversion cycle for Hewlett-Packard
(NYSE: HPQ) and Apple, Inc. (NYSE: AAPL) based on the
information given below (as obtained from Morningstar).
Which company have efficient WCM?
 Example 2
• Data about two companies are given below. Compute the CCC
for each company.

Company A Company B

Inventory $ 3000 $5000

Net Credit Sales 40,000 50,000

Accounts
5,000 6,000
Receivable

Accounts Payable 4,000 3,000

Cost of goods sold 54,000 33,000

 Working capital strategies

Three kinds of working capital

strategies:
1. Flexible current assets strategy
2. Restrictive current asset strategy
3. Moderate current asset strategy
 Working capital strategies
1. Flexible strategy
• Hold large balances of cash, marketable securities and
inventory.
• Such strategy generally followed by company’s that offer
liberal credit terms to customers, which results in high
levels of accounts receivable
• It is generally perceived to be a low risk-low return
course of action
 Working capital strategies
2. Restrictive strategy:
Hold small balances of cash, marketable securities and inventory.
 Involves high risk in the form of exposure to shortage costs
 Does not hold enough raw materials in inventory and leads to production interruption
 A firms may run out of finished goods and sales may be lost.
 Involves highly restrictive credit policies
it is generally perceived to be a high risk-high return course of
action
 Working capital strategies
3. Moderate strategy
• The moderate current asset investment policy is
between the two extremes
• Results in moderate risk and return
 Objectives of WCM

• The main objective in WCM is to:

• Optimize the investment in current assets
• Optimal investment strategy for current assets is determined by:
• Balancing shortage costs against carrying costs.
• The management should try to find the level of current assets that:
• Minimize the sum of carrying costs and shortage costs
 Trade-off of Short-Term Investment
Short-term asset Cost of Carrying Cost of Shortage
Cash & MS Opportunity cost of Illiquidity &
funds solvency Costs
Accounts Cost of investment Opportunity cost of
receivable in acct receivable lost sales due to
Bad debt losses overly restrictive
credit policy
and/or terms
Inventory Carrying cost of Order and setup
inventory including costs associated
financing, with replenishment
warehouse costs and production of
finished goods
 Determinants of WC
requirements
• Nature of business • Scale of Operation
• Manufacturing cycle • Inventory policy
• Business cycle • Credit policy
• Seasonal variation • Supply situation
 Working Capital Financing Policies

• Moderate: Match the maturity of the assets with the maturity of

the financing.
• Aggressive: Use short-term financing to finance permanent
current assets.
• Conservative: Use permanent capital for permanent current
assets and temporary current assets. Short term financing is
used only for contingencies.
 Maturity Matching Principle

• Maturity (due date) of financing should

roughly match duration (life) of asset being
financed
• Then financing /asset combination becomes
self-liquidating
• Cash inflows from asset can be used to pay off
loan
Financing Net Working Capital
• According to maturity matching
principle
• Temporary (seasonal) should be financed
with short-term borrowing
• Permanent working capital should be
financed with long-term sources, such as
long-term debt and/or equity
Conservative policy
Aggressive policy
 Short-term credit

• Any debt scheduled for repayment within

one year.
• Major sources of short-term credit
• Accounts payable (trade credit)
• Bank loans
• Commercial papers
• Accruals
Advantages and disadvantages of using
short-term financing
• Advantages
• Speed
• Flexibility
• Lower cost than long-term debt
• Disadvantages
• Fluctuating interest expense
• Firm may be at risk of default as a result of
temporary economic conditions
 Accrued liabilities
• Continually recurring short-term
liabilities, such as accrued wages or
taxes.
• Is there a cost to accrued liabilities?
• They are free in the sense that no explicit
interest is charged.
• However, firms have little control over the
level of accrued liabilities.
 What is trade credit?

• Trade credit is credit furnished by a

firm’s suppliers.
• Trade credit is often the largest source of
short-term credit, especially for small firms.
• Spontaneous, easy to get, but cost can be
high.
 Commercial paper (CP)
• Short-term notes issued by large, strong companies.
• CP trades in the market at rates just above T-bill
rate.
• CP is usually bought with surplus cash by banks and
other companies, then held as a marketable security
for liquidity purposes.
End of the chapter