CHAPTER 16

WORKING CAPITAL MANAGEMENT

16.1 WHAT IS WORKING CAPITAL?

• Current assets – often referred to as working capital

• Working capital policy –deciding the level of each type of current asset to
hold, and how to finance current assets.Z0
• Working capital management –controlling cash, inventories, and A/R, plus
short-term liability management.
• Interest bearing notes payable are considered as financing cost.
Therefore, it is deducted to the current liabilities, which is considered as
operating costs.
• Any current assets not used in normal operations of the business are
deducted and thus not included in the working capital.

Net working
= Current assets - Current liabilities
capital

Net operating Current Current Interest bearing

= - ( - )
working capital assets liabilities notes payable

16.2 DUPONT EQUATION

• Demonstrates how working capital management affects ROE or Return on

equity
• Profit margin – measures operating efficiency
• Asset turnover – measures asset use efficiency or how well assets are
used to generate sales
• Equity multiplier – measures the amount of financial leverage used

✓ If ROE is high due to high or increased profit margin and asset turnover,
then, the company is in a good financial condition.
✓ If ROE is high due to financial leverage, the company has more debt,
which negatively affects the company’s bottom line.

Total assets
ROE = Profit margin x x Equity multiplier
turnover
Net income Sales Assets
= x x
Sales Assets Equity
 Net Income Net Income
ROA = =
Ave. total assets AR + Inv. + FA

16.3 CURRENT ASSET INVESTMENT

1. Relaxed Investment Policy – relatively large amounts of cash,

marketable securities and inventories are carried, and a liberal credit
policy results to high receivables.
• Conservative working capital policy
• Implications:
o Lower ROE
o Low asset turnover
o Minimizes operating risks
o High interest cost, reducing profitability
• The estimation of current assets for achieving targeted revenues
are prepared after carefully considering uncertain events,
contingencies, and provisions.
2. Restricted Investment Policy – holdings of cash, marketable securities,
inventories and receivables are constrained.
• Implications:
o Lower level of assets
o Higher ROE
o High asset turnover
o Increases operating risks
• Does not carefully considering uncertain events, contingencies, and
provisions.
• Exposed to risks due to shortages
3. Moderate Investment Policy – an investment policy that is between the
relaxed and restricted policies.
• Considered as the optimal investment policy
 Relaxed

Moderate

Restricted

16.4 CURRENT ASSET FINANCING POLICES

• Investment in current assets are financed by:

o Bank loans
o Accounts payable/Accrued liabilities
o Long-term debt
o Common equity

• Permanent Current Assets

o Current assets that a firm must carry even at the lowest point of its
cycle
o A constant minimum level of cash, marketable securities, and other
current assets
• Temporary Current Assets
o Current assets that fluctuate with seasonal or cyclical variations in
sales
o The fluctuation amount of inventories and receivables added to the
permanent current assets due to the increase or decrease of sales
in different periods.
• Current Assets Financing Policy
o The manner in which current assets are financed.

1. Maturity Matching, or “Self-Liquidating” Approach

• A financing policy that
matches the maturities
of assets and liabilities.
A moderate policy where
fixed assets plus
permanent current
assets are financed by
long-term capital/debt
 while temporary current assets are financed by short-term debt.
• Two Factors Preventing the Approach
o Uncertainty of the lives of assets
o Common equity financing option
2. Aggressive Approach
• A financing policy where
permanent current assets are
financed by short-term debt.
• Reason:
o Short-term debts have
lower interest rates
o Short-term debts can be
obtained faster compared
to long-term debts
• Consideration:
o Highly risky, especially when a company encounters
temporary financial problems, may lead to bankruptcy.
o Short-term debts interest rates fluctuates
3. Conservative Approach
• A policy where current assets,
both permanent and temporary,
are financed by long-term
capital/debt.
• Reason:
o Long-term debts interest
rates are constant
• Consideration:
o The cost of issuing long-
term debts are higher compared to short-term debts

16.5 CASH CONVERSION CYCLE (CCC)

• The length of time where 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.
• Ways to shorten CCC:
o Speed up sales
o Accelerate collection of payment from sales
o Get longer payment or credit terms

✓ The lower the value of CCC, the better

Inventory Average
Payables
CCC = conversion + collection -
deferral period
period period
 • Inventory conversion cycle (ICP)
o The average time required to convert raw materials into finished
goods and then sell them.

Inventory COGS
ICP = Inv.
=
COGS / 365 turnover
Ave. Inv.

• Average collection period (ACP) or Days’ sales outstanding (DSO)

o The average length of time required to convert the firm’s
receivables into cash, that is, to collect cash following a sale.

ACP Receivables Sales

or = AR
=
DSO Sales / 365 turnover
Ave. AR

• Payables deferral period (PDP)

o The average length of time between the purchase of materials and
labor and the payment of cash for them.

Payables Payables
PDP = =
Purchase per
COGS / 365
day

Total
AP purchases
=
turnover
Ave. AP

16.6 MINIMIZING CASH HOLDINGS

• Use a lockbox
o A post office box operated by a bank to which payments are sent.
o Used to speed up effective receipt of cash
• Insist on wire transfers and debit/credit cards from customers
• Synchronize inflows and outflows
o Match payment terms with maturity dates
 • Reduce need for “safety stock” of cash
o Increase forecast accuracy
o Hold marketable securities
o Negotiate a line of credit

16.7 INVENTORY MANAGEMENT

• Lead time
o Time interval between ordering and receiving the order

Lead stock or Length of time

Safety stock or = from order to x Daily demand
Buffer delivery

• Carrying (holding) costs

o Cost to carry an item in inventory for a length of time, usually a year
o Storage and handling costs, insurance, property taxes, depreciation,
and obsolescence.

Carrying cost Average

Carrying costs = x
per unit Inventory

• Ordering costs
o Costs of ordering and receiving inventory (shipping cost, cost of
preparing how much is needed, preparing invoices, cost of inspecting
goods upon arrival for quality and quantity, moving the goods to
temporary storage)

Ordering cost Number of

Ordering costs = x
per unit orderings

• Shortage costs
o Costs when demand exceeds supply (the opportunity cost of not
making a sale, loss of customer goodwill, late charges, the cost of
disruption of production schedules or downtime)

✓ Reducing inventory levels generally reduces carrying costs, increases

ordering costs, and may increase the costs of running short.
✓ If inventory turnover is considerably lower than the industry average, the firm
is carrying a lot of inventory per dollar of sales.
 ✓ By holding excessive inventory, the firm is increasing its costs, which reduces
its ROE.
✓ Moreover, additional working capital must be financed, so EVA is also
lowered.

1. Economic ordering quantity (EOQ)

• The question of how much to order is frequently determined by using
an Economic Order Quantity (EOQ) model.
• EOQ models identify the optimal order quantity by minimizing the sum
of certain annual costs that vary with order size.
• Three order size models are described:
o The basic economic order quantity model
o The economic production quantity model
o The quantity discount model
• Assumptions of EOQ Model
o Only one product is involved
o Annual demand requirements are known
o Demand is even throughout the year
o Lead time does not vary
o Each order is received in a single delivery
o There are no quantity discounts

𝟐 (𝐀𝐧𝐧𝐮𝐚𝐥 𝐝ⅇ𝐦𝐚𝐧𝐝) (𝐎𝐫𝐝ⅇ𝐫𝐢𝐧𝐠 𝐜𝐨𝐬𝐭 𝐩ⅇ𝐫 𝐮𝐧𝐢𝐭)

𝑬𝑶𝑸 𝒖𝒏𝒊𝒕𝒔 = √
𝐂𝐚𝐫𝐫𝐲𝐢𝐧𝐠 𝐜𝐨𝐬𝐭 𝐩ⅇ𝐫 𝐮𝐧𝐢𝐭

𝟐 (𝐀𝐧𝐧𝐮𝐚𝐥 𝐝ⅇ𝐦𝐚𝐧𝐝) (𝐎𝐫𝐝ⅇ𝐫𝐢𝐧𝐠 𝐜𝐨𝐬𝐭 𝐩ⅇ𝐫 𝐮𝐧𝐢𝐭)

𝑬𝑶𝑸 𝒑𝒓𝒊𝒄𝒆 = √
𝐂𝐚𝐫𝐫𝐲𝐢𝐧𝐠 𝐜𝐨𝐬𝐭 %

16.8 ACCOUNTS RECEIVABLE

• Funds due from a customer

• Credit Policy – a set of rules that include the firm’s credit period, discounts,
credit standards, and collection procedures offered.

1. Variables/Elements of Credit Policy

a) Credit Period is the length of time buyers are given to pay for their
purchases
• How long to pay?
o Shorter period reduces DSO and average A/R, but it may
discourage sales
b) Cash Discounts
• Is the price reductions given for early payment
• Lowers price
• Attracts new customers and reduces DSO.

c) Credit Standards
• The required financial strength of acceptable credit customers
• Tighter standards tend to reduce sales, but reduce bad debt
expense.
• Fewer bad debts reduce DSO.

Credit Standards Factors:

• Customer debt and interest coverage ratios
• Customer’s credit history
• Credit score – is a numerical score from 0 to 10 that indicates
the likelihood that a person or business will pay on time
d) Collection Policy
• Refers to the procedures used to collect past due accounts
• How tough?
o Tougher policy will reduce DSO but may damage
customer relationships.
• Importance:
o It has a major effect on sales
o It influences the amount of funds tied up in receivables
o It affects bad debt losses

Credit Terms is defined as a statement of their credit period and

discount policy like 2/10, net 30

Sales on credit Length of

AR = x
per day collection period

Ave. Daily Sales Annual credit

= x 365
(ADS) sales

DSO = Receivables x ADS

AR Investment = ADS x DSO

Note: DSO should be no greater than the credit period

16.9 ACCOUNTS PAYABLE (TRADE CREDIT)

• Is a debt arising from credit sales and recorded as an accounts receivable by

the seller and as an account payable by the buyer
• 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.

1. Free trade credit – credit received during the discount period

2. Costly trade credit – credit taken in excess of free trade credit, whose cost is
equal to the discount lost.

Nominal
Discount % 365
annual cost
= x
of trade 100 - Discount (Days credit is outstanding - Discount
credit % period)

Effective annual
cost of trade = (1 + rd)N - 1
credit

rd = Discount %

100 - Discount %

N = 365

(Days credit is outstanding - Discount period)

SAMPLE PROBLEM:

CASH CONVERSION CYCLE Primrose Corp has $15 million of sales, $2 million of inventories,
$3 million of receivables, and $1 million of payables. Its cost of goods sold is 80% of sales, and
it finances working capital with bank loans at an 8% rate. What is Primrose’s cash conversion
cycle (CCC)? If Primrose could lower its inventories and receivables by 10% each and increase
its payables by 10%, all without affecting sales or cost of goods sold, what would be the new
CCC, how much cash would be freed up, and how would that affect pretax profits?

1.) COGS = .80 (Sales) Payables

PDP =
= .80 (15,000,000,000) COGS / 365
= 12,000,000,000 1,000,000
=
12,000,000 / 365
= 30.42 days
 Inventory
ICP =
COGS / 365 = ICP + ACP - PDP
2,000,000 CCC = 60.83 +73 - 30.42
=
12,000,000 / 365 = 103.41 days
= 60.83 days

Receivables
ACP =
Sales / 365
3,000,000
=
15,000,000 / 365
= 73 days

Lower inventories and receivables by 10% each and increase payables by 10%.
Sales and COGS remain the same.

2.) Inv. = 2,000,000 (.9) Receivables

ACP =
= 1,800,000 Sales / 365
2,700,000
=
AR = 3,000,000 (.9) 15,000,000 / 365
= 2,700,000 = 65.70 days

AP = 1,000,000 (1.1) Payables

PDP =
= 1,100,000 COGS / 365
1,000,000
=
32,876.7123
Inventory = 33.46 days
ICP =
COGS / 365
1,800,000 New = ICP + ACP - PDP
=
32,876.7123 CCC = 54.75 +65.70 - 33.46
= 54.75 days = 87 days

Cash freed up

Inventory = (60.83 – 54.75) * 32,876.7123 = 199,890.14

Receivables = (73 – 54.75) * 41,095.8904 = 300,000
Payables = (33.46 – 30.42) * 32,876.7123 = 399,945.2055
Cash freed up = 199,890.14 + 300,000 – 399,945.2055 = 400,000
400,000 * .08 = 32,000 increase