1. Working Capital Management
CHAPTER 21
Working Capital Management

2. Topics in Chapter Working capital policies
Cash, inventory, and A/R management
Accounts payable management
Short-term financing policies
Bank debt and commercial paper 1

3. Basic Definitions Gross working capital: Total current assets
Net working capital (NWC):
Current assets - Current liabilities
Net operating working capital (NOWC):
Operating CA – Operating CL =
(Cash + Inv. + A/R) – (Accruals + A/P) 2

4. Working Capital Management
Day-to-day control
Cash
Inventories
Accounts receivable
Accruals
Accounts payable
Working capital policy
The level of each current asset
How current assets are financed 2

5. Cash Conversion Cycle
The time between payments made for materials and labor and payments received from sales:
Cash
Conversion =
Cycle
Inventory
Conversion +
Period
Receivables
Collection −
Payables
Deferral
(21-4)

6. Inventory Conversion Period
Average time required to convert materials into finished goods and to sell those goods:

7. Receivables Collection Period
Average length of time required to convert the firm’s receivables into cash:
Receivables Collection Period = DSO = Days Sales Outstanding

8. Payables Deferral Period
Average length of time between the purchase of materials and labor and the payment of cash for them:

9. Real Time Computer Cash Conversion Data

10. Inventory Conversion Period

11. Receivables Collection Period

12. Payables Deferral Period

13. Cash Conversion Cycle CCC = 73 days + 24 days – 30 days CCC = 67 days
Inventory
Conversion +
Period
Receivables
Collection −
Payables
Deferral
(21-4)
CCC = days days – 30 days
CCC = days

14. Cash Conversion Cycle
Figure 21-1

15. Cash Conversion Objective
Shorten the cash conversion cycle as much as possible without hurting operations:
Reduce Inventory Conversion period
Process & sell goods quicker
Reduce Receivables Collection period
Speed up collections
Lengthen Payables Deferral Period
Slow firm’s payments

16. Real Time Computer
TABLE 21.1

17. Real Time Computer

18. Alternative NOWC Policies

19. Cash Management: Cash = “Non-earning Asset”
Transactions:
Must have some cash to pay current bills.
Precautionary balances = “Safety stock”
Compensating balances:
For loans and/or services provided.
Speculation:
Take advantage of bargains
Take discounts 6

20. Cash Budget: The Primary Cash Management Tool
Projected cash inflows, outflows, and ending cash balances forecast loan needs and funds available for temporary investment
Daily, weekly, or monthly, depending upon budget’s purpose
Monthly for annual planning
Daily for actual cash management 11

21. Data Required for Cash Budget
Sales forecast
Information on collections delay
Forecast of purchases and payment terms
Forecast of cash expenses: wages, taxes, utilities, and so on
Initial cash on hand
Target cash balance 12

22. MicroDrive Cash Budget

23. Table 21-2

25. $300*20%*98% =
$250*70% =
$200*10% =
$300*70% =

26. MicroDrive Cash Budget

27. Table 21-2

28. Other Cash Budget Line Items
Interest earned or paid
= Interest rate x surplus/loan line of cash budget for preceding month
Interest on any other outstanding loans
Bad debt expense
Collections reduced by bad debt losses.
For example, if 3% bad debt losses, collections would = 97% of sales 17

29. Cash Budget with Adjustments

30. Cash Management Techniques
Synchronize inflows and outflows
Billing cycle = Payment cycle
Use Float
Remote disbursement accounts (+) Net
Collections float (-) Float
Lockbox Plan
Payment by wire transfer or automatic debit
Reduce the need for a cash “safety stock”:
Increase forecast accuracy
Hold marketable securities instead of a cash
Negotiate a line of credit 8

31. Inventory Management Goals
Ensure that the inventory needed to sustain operations is available
Minimize the costs of ordering and carrying inventory
Trade-off to balance goals

32. Inventory Management: Categories of Inventory Costs
Carrying Costs
Storage and handling
Insurance
Property taxes
Depreciation
Obsolescence 21

33. Inventory Management: Categories of Inventory Costs
Ordering Costs
Cost of placing orders
Shipping
Handling costs 21

34. Inventory Management: Categories of Inventory Costs
Costs of Running Short
Loss of sales
Loss of customer goodwill
Disruption of production schedules 21

35. Receivables Management
A/R = Credit sales/day X Collection Period
Depends on volume of credit sales
Average time from credit sale to collection of cash
Credit policy
Receivables monitoring

36. Elements of Credit Policy
Credit Period = How long to pay?
Shorter period reduces DSO
Reduces average A/R
May discourage sales
Cash Discounts
Lowers price
Attracts new customers
Reduces DSO 25

37. Elements of Credit Policy
Credit Standards
Tighter standards reduce bad debt losses,
May reduce sales
Fewer bad debts reduces DSO
Collection Policy
Tougher policy will reduce DSO
May damage customer relationships

38. Receivables Monitoring
Credit sale events:
Inventories reduced by COGS
A/R increased by sales price
Price – COGS = Profit
Profit  Retained Earnings
DSO = Days Sales Outstanding
DSO = Average Collection Period

39. Days Sales Outstanding

40. Receivables Aging Schedule
Breaks down firm’s receivables by age
TABLE 21.3

41. Accruals Accrued wages and accrued taxes Increase spontaneously
Accruals are free in that no explicit interest is charged
Firms have little control over the level of accruals
Levels influenced by industry custom, economic factors, and tax laws

42. Trade Credit Credit furnished by a firm’s suppliers Accounts Payable
Often largest source of short-term credit, especially for small firms
Spontaneously increases
Easy to get, but cost can be high
Example: 2/10, net 30
2% discount if paid within 10 days
Due in 30 days

43. The Cost of Trade Credit
Microchip sells on terms of 2/10, net 30
True price = 98% of selling price
PCC buys $100 of memory chips from Microchip
If paid within 10 days  Cost = $98
If PCC wants 20 extra days to pay  Cost = $100
List price = $98 true cost + $2 finance charge

44. PCC’s Trade Credit Cost
PCC buys an average of $11,923,333 from Microchip
$32, per day
If PCC pays on day 10
PCC A/P average = 10(32,667) = $326,667
PCC is receiving $326,667 credit from Microchip

45. PCC’s Trade Credit Cost
If PCC takes the extra 20 days to pay
PCC A/P average = 30(32,667) = $980,000
PCC is receiving $980, ,667 = $653,333 credit from Microchip
PCC is foregoing a 2% discount
PCC’s total cost = $11,923,333/0.98
= $12,166,666
Annual finance cost = $12,166,666 – 11,923,333 = $243,333 = 37.2%

46. Nominal Cost Formula 2/10, net 30
rNOM =
Discount %
1 - Discount % ×
365 days
Days
Taken
Discount
Period - = 2 98
365 20
= × 18.25
= = 37.2%
PCC Pays 2.04% times per year

47. Effective Annual Rate (EAR) 2/10, net 30
Periodic rate = 0.02/0.98 = 2.04%
Periods/year = 365/(30 – 10)
= 18.25
EAR = (1 + Periodic rate)n – 1.0
= (1.0204)18.25 – 1.0
= 44.6%

48. The Cost of Trade Credit

49. Trade Credit Two components:
Free trade credit = discount period credit
Costly trade credit = cost implied by foregone discount
Firms should always use the free credit
Use the costly credit only after careful analysis and comparison with other sources

50. Working Capital Financing Policies
Moderate = Match the maturity of the assets with the maturity of the financing
“Maturity matching”
“Self-liquidating”
Aggressive = Use short-term financing to finance permanent assets
Conservative = Use permanent capital for permanent assets and temporary assets

51. FIGURE 21.2
Page 751

52. Moderate Financing Policy
Years $
Perm NOWC
Fixed Assets
Temp. NOWC
Lower dashed line, more aggressive. }
S-T
Loans
L-T Fin:
Stock &
Bonds,

53. Conservative Financing Policy
Fixed Assets
Years $
Perm NOWC
L-T Fin:
Stock &
Bonds
Marketable Securities
Zero S-T
debt

54. Short-term Investments
Marketable securities
Lower yields than operating assets
Held for same reasons as cash
Benefits:
Reduces risk and transactions costs
Won’t need to issue securities or borrow as frequently
Ready cash for opportunities = “speculative balances”
Disadvantages
Low after-tax return

55. Short-term Financing Advantages Funds available relatively quickly
Lower cost
Yield curve usually upward sloping
Lower flotation costs
Can repay early without penalty
Less restrictive loan covenants

56. Short-term Financing Disadvantages Higher risk
Interest expense fluctuates
Required repayment comes quicker
Firm may have trouble rolling over loans

57. Short-term Bank Loans = Notes payable Maturity Promissory Note
2/3 are for less than 1 year
Frequently 90 days
Promissory Note
Signed when bank loan approved
Specifies:
Amount
Interest rate
Repayment schedule
Collateral

58. Short-term Bank Loans Compensating Balances Informal Line of Credit
Raises the effective loan rate
Illegal in many states
Informal Line of Credit
Maximum amount bank will extend
Revolving Credit Agreement
Formal line of credit
Periodic commitment fee
Bank legally obligated to honor agreement

59. Commercial Paper (CP)
Short term, unsecured promissory notes issued by large, strong companies
Maturity = 1-9 months; average 5 months
Interest rates fluctuate daily just above the T-bill rate
Less personal than bank relationships

60. Security in Short-term Financing
Commercial paper is never secured
Better to borrow on an unsecured basis
Lower bookkeeping costs
Collateral options:
Marketable securities
Land or buildings
Equipment
Inventory
Receivables