LECTURE NOTE OF CHAPTER 5 – FINANCIAL MANAGEMENT COURSE

LECTURE NOTE OF CHAPTER 5: WORKING CAPITAL

MANAGEMENT
After completing this chapter, you are required to understand the following key concepts
and skills:
- The definition of working capital and working capital management
- Working capital investment and financing policies
- Management of major elements of working capital.
- Short-term financing
1. Overview of working capital and working capital (WC) management:
There are two major concepts of working capital – net working capital and gross working
capital (called working capital). From the financial analyst view, working capital is involved in
current assets. Because it does make sense for the financial manager to be involved with
providing the correct amount of current assets for the firm at all times, we will adopt the concept
of working capital
However, when accountants use the term working capital, they are generally referring to
net working capital, which is the dollar difference between current assets and current liabilities.
From a management viewpoint, however, it makes little sense to talk about trying to actively
manage a net difference between current assets and current liabilities, particularly when that
difference is continually changing.
Thus, in this course, we briefly say:
1. Working capital showns as the current assets
2. Net working capital is the difference between current assets and current liabilities
Net working capital is the difference between current assets and current liabilities. It
represents the amount of money that firm must obtain from non-interest source to carry its
current assets
Net working capital = Current asset – Current liabilities
1.1 Working capital management:
Working capital management is the administration of the firm’s current assets and
the financing needed to support current assets.
WC management determines the following:
- The firm’s level of current assets
- The level of investment in each type of current asset
- The proportion of short-term and long-term debt used to finance the firm’s assets.

1.2 The importance of working capital management:

Working capital management is important because of the following reasons:

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- WC management affects the levels of current assets can easily result in a firm realizing
substandard return on investment. However, firms with too few current assets may incur
shortages and difficulties in maintaining smooth operations.
- For small companies, current liabilities are the principal source of external financing. These
firms do not have access to the longer-term capital markets, other than to acquire a mortgage
on a building.
- WC affects the firm’s liquidity and function.
- WC affects the firm’s cash cycle and cash flow from operating activities.
- Net working capital position is also widely used as one measure of the firm’s risk
(probability that a firm will encounter financial difficulties such as the inability to pay
bills on time.
- WC affects the firm’s ability to obtain debt financing.
Working capital management and Cash conversion cycle:
Operating cycle of a firm is equal to the length of the inventory and receivables
conversion periods

Figure 1: Cash conversion cycle of a typical firm

The inventory conversion period is the length of time required to produce and sell the
product.
𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈 𝐭𝐭𝐭𝐭𝐭𝐭𝐭𝐭𝐭𝐭𝐭𝐭𝐭𝐭𝐭𝐭 𝐢𝐢𝐢𝐢 𝐝𝐝𝐝𝐝𝐝𝐝𝐝𝐝 (𝐈𝐈𝐈𝐈𝐈𝐈) or 𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈 𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂 𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏
Days in the year Average Inventory × Days in the year
= =
Inventory Turnover Cost of goods sold
The receivables conversion period or average collection period represents the length
of time required to collect the sales receipts.
𝐑𝐑𝐑𝐑𝐑𝐑𝐑𝐑𝐑𝐑𝐑𝐑𝐑𝐑𝐑𝐑𝐑𝐑𝐑𝐑𝐑𝐑 𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂 𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏 𝐨𝐨𝐨𝐨 𝐚𝐚𝐚𝐚𝐚𝐚𝐚𝐚𝐚𝐚𝐚𝐚𝐚𝐚 𝐜𝐜𝐜𝐜𝐜𝐜𝐜𝐜𝐜𝐜𝐜𝐜𝐜𝐜𝐜𝐜𝐜𝐜𝐜𝐜 𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩
Days in the year Receivables x Days in the year
= =
Accounts Receivable Turnover Net sales
The payables deferral period or average payable period is the length of time the firm
is able to defer payment on its various resource purchases.
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Days in the year

𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏 𝐭𝐭𝐭𝐭𝐭𝐭𝐭𝐭𝐭𝐭𝐭𝐭𝐭𝐭𝐭𝐭 𝐢𝐢𝐢𝐢 𝐝𝐝𝐝𝐝𝐝𝐝𝐝𝐝 (𝐏𝐏𝐏𝐏𝐏𝐏)𝐨𝐨𝐨𝐨 𝐚𝐚𝐚𝐚𝐚𝐚𝐚𝐚𝐚𝐚𝐚𝐚𝐚𝐚 𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩 𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩 =
Payable turnover
Account payable × Days in the year
=
Annual credit purchases
The cash cycle referred to as the long lag time between the date that cash is received and
the date that cash is paid.
𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪 𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄 𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄
= 𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰𝑰 𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄 𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑 + 𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨 𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄 𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑
− 𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨 𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑 𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑
The cash cycle refers to the continual flow of resource through various working capital
accounts such as cash, account receivables, inventory, payables and accruals that working capital
management focus. A well-managed cash cycle result from aggressively monitoring the
receivable balance, from reducing idle inventory, stretching payables to the last day possible
given a term of purchase, and implementation of an effective cash collection and disbursement
system. Even profitable firms can experience cash flow difficulties due to timing difference
receipts and cash disbursement if we don’t have an efficient working capital management.
In conclusion, the shorter this cash cycle period, the more efficient are the working
capital management policies. So managing the cash cycle result in working capital account
management.
Moreover, working capital management monitors the account receivable, payable and
accruals management so that working capital management influences operating cash flows. The
more net operating cash flows if company manage the cash collection and disbursement from
trade credit.
2. Working capital investment policies
The company has to deal with profitability versus risk trade-off for alternative levels of
working capital investment
Three alternative working capital investment policies are as follows:
Policy A represents a conservative approach to working capital management. Under this
policy, the firm holds a relatively large proportion of its total assets in the form of current assets.
This policy results in a lower expected profitability and lower risk.
Policy C represents an aggressive approach. Under this policy, the firm holds a relatively
small proportion of its total assets in the form of current assets and thus has relatively less net
working capital. This policy yields a higher expected profitability and a higher risk that the
company will encounter financial difficulties.
Policy B represent a moderate approach. With this policy, expected profitability and risk
levels fall between those of policy C and A.

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Interestingly, our discussion of working capital policies has just illustrated the two most
basic principles in finance:
1. Profitability varies inversely with liquidity. Notice that for our three alternative working
capital policies, the liquidity rankings are the exact opposite of those for profitability.
Increased liquidity generally comes at the expense of reduced profitability.
2. Profitability moves together with risk (i.e., there is a trade-off between risk and return). In
search of higher profitability, we must expect to take greater risks. Notice how the
profitability and risk rankings for our alternative working capital policies are identical.
Ultimately, the optimal level of each current asset (cash, marketable securities,
receivables, and inventory) will be determined by management’s attitude to the trade-off between
profitability and risk. For now, we continue to restrict ourselves to some broad generalities. In
subsequent chapters, we will deal more specifically with the optimal levels of these assets, taking
into consideration both profitability and risk
3. Working capital financing policies:
Financing needs including frequent needs and temporary needs over time are as follows:

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A firm’s permanent working capital is the amount of current assets required to meet
long-term minimum needs. You might call this “bare bones” working capital. Permanent working
capital is similar to the firm’s fixed assets in two important respects.First, the dollar investment is
long term, despite the seeming contradiction that the assets being financed are called “current.”
Second, for a growing firm, the level of permanent working capital needed will increase over
time in the same way that a firm’s fixed assets will need to increase over time. However,
permanent working capital is different from fixed assets in one very important respect – it is
constantly changing
Temporary working capital (fluctuating curretn assets) is the investment in current
assets that varies with seasonal requirements. Like permanent working capital, temporary
working capital also consists of current assets in a constantly changing form. However, because
the need for this portion of the firm’s total current assets is seasonal, we may want to consider
financing this level of current assets from a source which can itself be seasonal or temporary in
nature. Let us now direct our attention to the problem of how to finance current assets.
3.1 Matching approach
A firm uses long-term debt and equity capital to finance fixed assets and permanent
current assets and uses short-term debt to finance fluctuating current assets

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3.2 Conservative Approach

Firms use long-term debt plus equity capital to finance fixed assets and permanent
current assets (frequent needs of working capital) and a part of fluctuating current assets.That
means firms use more long-term sources of financing

3.3 Aggressive approach

Firms use short-term debt to finance fluctuating current assets (temporary needs of
working capital) and a part of frequent needs of working capital. That means firms use more
short-term sources of financing.

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Short-Term versus Long-Term Financing

4.Management of major elements of working capital

4.1 Cash and marketable securities management
Reasons of holding cash:
- Transactions motive: to meet payments, such as purchases, wages, taxes, and dividends,
arising in the ordinary course of business.
- Speculative motive: to take advantage of temporary opportunities, such as a sudden
decline in the price of a raw material.

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- Precautionary motive: to maintain a safety cushion or buffer to meet unexpected cash

needs. The more predictable the inflows and outflows of cash for a firm, the less cash that
needs to be held for precautionary needs. Ready borrowing pow
Major techniques are used to control the collection and disbursement of cash:
- Expediting collections
- Slowing disbursements
- Float
- Lockboxes
- Wire transfer ad depository transfer check
- Scheduling and centralizing payments
- Drafts
4.2 The management of accounts receivable
Reasons of holding accounts receivable:
- Increase the sale
- Create the relationship with customers
- Avoid the pricing competitions
Credit policy:
When the company have account receivable, it establishes the credit policy. Credit poicy
includes these following components:
- Credit standards: minimally acceptable creditworthy customer defines the selling
business’s credit standards. Based on financial analysis and nonfinancial data, the credit
analyst determines whether each credit applicant exceeds the credit standard and thus
qualifies for credit.
- Credit terms: Credit terms specify the length of time over which credit is extended to a
customer (credit period) and the discount (cash discount), if any, given for early
payment. For example, one firm’s credit terms might be expressed as “2/10, net 30.” The
term “2/10” means that a 2 percent discount is given if the bill is paid within 10 days of
the invoice date., called cash discount period. The term “net 30” implies that if a
discount is not taken, the full payment is due by the 30th day from invoice date. Thus the
credit period is 30 days.
- Collection policy and procedures: The firm determines its overall collection policy by
the combination of collection procedures it undertakes. These procedures include such
things as letters, faxes, phone calls, personal visits, and legal action. One of the principal
policy variables is the amount of money spent on collection procedures. Within a range,
the greater the relative amount expended, the lower the proportion of bad-debt losses, and
the shorter the average collection period, all other things being the same.
Developing credit standards:
The minimum standards a customer must meet to be extended credit are usually base on
the five C’s of credit.
Five C’s of credit: character, capital, capacity, conditions and collateral.
- Character: the most important criterion, refers to moral uprightness, integrity,
trustworthiness and quality of management. Willingness to pay is tested when times are
bad and there is pressure to compromise one’s integrity. Past payment records and

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insights from a customer’s existing suppliers are often all the information the credit has
on which to base an assessment.
- Capital: refers to net worth, or the difference between total assets and total liabilities. If
measure the cushion with which business exists or how much it has in assets over and
above what is necessary to pay creditors. The seller should not place too much confidence
in this figure, however because in a liquidation the assets would generally be sold for less
than a amount shown on the books.
- Capacity: the ability to repay debts when due, as measured by the company’s ability to
generate cash flows. This often includes a subjective analysis of the borrower’s
management and future outlook, both in normal and pessimistic economic conditions.
Critical evaluation of the borrower’s projected cash budget and most recent statement of
cash flow is instrumental here.
- Conditions: General economy and industry environment, as well as the reason for loan
request.
- Collateral: Assets pledged as security to back up a credit sale or loan
5. Short-term financing:
Short-term credit sources can be either spontaneous or negotiated:
- Negotiated sources: bank credit, commercial paper, receivables loan, inventory loans.
- Spontaneous sources: trade credit, accrued expenses, deferred income
5.1 Negotiated sources
Short-term bank credit is available under 3 different arrangements:
- Single loans (notes)
- Lines of credit: is an arrangement that permits the firm to borrow funds up to a
predetermined limit at any time during the life of the agreement.
- Revolving credit arrangement: the bank is legally committed to making loan to a company
up to the predetermined credit limit specified in the agreement. It requires the borrower
to pay a commitment fee on the unused portion of the funds.
Commercial paper consists of short-term unsecured promissory notes issued by major
corporations
Accounts receivable are one of the most commonly used forms of collateral for secured
short-term borrowing. Many companies use accounts receivable as collateral for short-term
financing by either pledging their receivables or factoring them.
Inventories are another commonly used form of collateral for secured short term loans.
5.2 Spontaneous sources
Whenever a business receives merchandise ordered from a supplier and is then permitted
to wait a specified period of time before having to pay, it is receiving trade credit

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The annual financing cost of forgoing a cash discount is calculated as follows:

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