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 WORKING CAPITAL MANAGEMENT

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Learning Outcomes

 Understand how firms manage cash and various

collection, concentration, and disbursement
techniques
 Understand how to manage receivables, and the
basic components of credit policy
 Understand various inventory types, different
inventory management systems, and what
determines the optimal inventory level
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Working Capital Management

 Alternative working capital policies

 Cash, inventory, and A/R management
 Accounts payable management
 Short-term financing policies
 Bank debt and commercial paper
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Basic Definitions

 Gross working capital:

Total current assets.
 Net working capital:
Current assets - Current liabilities.
 Net operating working capital (NOWC):
Operating CA – Operating CL =
(Cash + Inv. + A/R) – (Accruals + A/P)
(More…)
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 Working capital management:

Includes both establishing working
capital policy and then the day-to-day
control of cash, inventories,
receivables, accruals, and accounts
payable.
 Working capital policy:
The level of each current asset.
How current assets are financed.
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How does SKI’s working capital policy

compare with the industry?

 Working capital policy is reflected in

a firm’s current ratio, quick ratio,
turnover of cash and securities,
inventory turnover, and DSO.
 These ratios indicate SKI has large
amounts of working capital relative to
its level of sales. Thus, SKI is
following a relaxed policy.
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Cash Conversion Cycle

The cash conversion cycle focuses on the

time between payments made for materials
and labor and payments received from
sales:

Cash Inventory Receivables Payables

conversion = conversion + collection - deferral .
cycle period period period
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Cash Conversion Cycle (Cont.)

Payables
CCC = Days per year + Days sales – deferral
Inv. turnover outstanding
period

365
CCC = 4.82 + 45.6 – 30
CCC = 75.7 + 45.6 – 30
CCC = 91.3 days.
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What’s the goal of cash management?

 To have sufficient cash on hand to

meet the needs listed on the
previous slide.
 However, since cash is a non-earning
asset, to have not one dollar more.
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Cash Budget: The Primary Cash

Management Tool

 Purpose: Uses forecasts of cash

inflows, outflows, and ending cash
balances to predict loan needs and
funds available for temporary
investment.
 Timing: Daily, weekly, or monthly,
depending upon budget’s purpose.
Monthly for annual planning, daily for
actual cash management.
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Data Required for Cash Budget

1. Sales forecast.
2. Information on collections delay.
3. Forecast of purchases and payment
terms.
4. Forecast of cash expenses: wages,
taxes, utilities, and so on.
5. Initial cash on hand.
6. Target cash balance.
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Inventory Management:
Categories of Inventory Costs

 Carrying Costs: Storage and handling

costs, insurance, property taxes,
depreciation, and obsolescence.
 Ordering Costs: Cost of placing orders,
shipping, and handling costs.
 Costs of Running Short: Loss of sales,
loss of customer goodwill, and the
disruption of production schedules.
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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 assets.
 Conservative: Use permanent capital
for permanent assets and temporary
assets.
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What are the advantages of short-term
debt vs. long-term debt?
 Low cost-- yield curve usually slopes
upward.
 Can get funds relatively quickly.
 Can repay without penalty.
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What are the disadvantages of short-
term debt vs. long-term debt?
 Higher risk. The required repayment
comes quicker, and the company
may have trouble rolling over loans.
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An Aging Schedule

 An aging schedule is a summarized

presentation of accounts receivable into
separate time brackets that rank the
receivables based upon the days until
due or the days past due. In other
words, it’s a list of receivables along
with their customer, amount, and age.
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What Does Aging Schedule Mean?

 Generally, the longer the account

balance is overdue, the more likely it will
be uncollectable and will lead to a
doubtful debt. Therefore, many firms
create an aging schedule of accounts
receivables to follow the pattern of
collecting their account receivables and
track the percentage of doubtful debts.
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Aging Schedule

 Example:
 The Fast company has divided its
accounts receivable into five age groups
by preparing the following aging
schedule:
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Aging Schedule

 On the basis of past experience and current

economic conditions, the company has determined
the percentage of expected credit losses in each age
group as follows:
 Not yet due: 1%
 1 – 30 days past due: 3%
 31 – 60 days past due: 10%
 61 – 90 days past due: 20%
 Over 90 days past due: 50%
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Example
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Example
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Reasons for Holding Cash

 Speculative motive – hold cash to take advantage

of unexpected opportunities
 Precautionary motive – hold cash in case of
emergencies
 Transaction motive – hold cash to pay the day-to-
day bills
 Trade-off between opportunity cost of holding
cash relative to the transaction cost of converting
marketable securities to cash for transactions
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Understanding Float

 Float – difference between cash balance recorded in the

cash account and the cash balance recorded at the bank
 Disbursement float
 Generated when a firm writes checks
 Available balance at bank – book balance > 0
 Collection float
 Checks received increase book balance before the bank
credits the account
 Available balance at bank – book balance < 0
 Net float = disbursement float + collection float
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Example: Types of Float

 You have $3,000 in your checking account. You

just deposited $2,000 and wrote a check for
$2,500.
What is the disbursement float?
What is the collection float?
What is the net float?
What is your book balance?
What is your available balance?
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Characteristics of Short-Term
Securities
 Maturity – firms often limit the maturity of short-
term investments to 90 days to avoid loss of
principal due to changing interest rates
 Default risk – avoid investing in marketable
securities with significant default risk
 Marketability – ease of converting to cash
 Taxability – consider different tax characteristics
when making a decision
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Components of Credit Policy

 Terms of sale
 Credit period
 Cash discount and discount period
 Type of credit instrument
 Credit analysis – distinguishing between “good” customers
that will pay and “bad” customers that will default
 Collection policy – effort expended on collecting
receivables
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Terms of Sale

 Basic Form: 2/10 net 45

2% discount if paid in 10 days
Total amount due in 45 days if discount is not
taken
 Buy $500 worth of merchandise with the credit
terms given above
Pay $500(1 - .02) = $490 if you pay in 10 days
Pay $500 if you pay in 45 days
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Example

 Finding the implied interest rate when customers do not

take the discount
 Credit terms of 2/10 net 45 and $500 loan
 $10 interest (.02*500)
 Period rate = 10 / 490 = 2.0408%
 Period = (45 – 10) = 35 days
 365 / 35 = 10.4286 periods per year
 EAR = (1.020408)10.4286 – 1 = 23.45%
 The company benefits when customers choose to forgo
discounts
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Five Cs of Credit

 Character – willingness to meet financial

obligations
 Capacity – ability to meet financial obligations
out of operating cash flows
 Capital – financial reserves
 Collateral – assets pledged as security
 Conditions – general economic conditions related
to customer’s business
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THE OPERATING CYCLE AND THE
CASH CYCLE
 Short-term finance is concerned with
the firm’s short-run operating
activities. A typical manufacturing
firm’s short-run operating activities
consist of a sequence of events and
decisions:
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THE OPERATING CYCLE AND THE
CASH CYCLE
 The cash cycle begins when cash is
paid for materials and ends when
cash is collected from receivables.
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THE OPERATING CYCLE AND THE
CASH CYCLE
 The operating cycle is the time
interval between the arrival of
inventory stock and the date when
cash is collected from receivables.
 The cash cycle begins when cash is
paid for materials and ends when
cash is collected from receivables.
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THE OPERATING CYCLE AND THE
CASH CYCLE
 The cash flow time line consists of
an operating cycle and a cash cycle..
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CASH BUDGETING

 The cash budget is a primary tool of short-

run financial planning. It allows the
financial manager to identify short-term
financial needs (and opportunities). It will
tell the manager the required borrowing
for the short term. It is the way of
identifying the cash-flow gap on the
cashflow time line. The idea of the cash
budget is simple: It records estimates of
cash receipts and disbursements