1. Working Capital Management
Chapter 18
Working Capital Management

2. Slide Contents Learning Objectives Principles Used in This Chapter
Working Capital Management and the Risk-Return Tradeoff
Working Capital Policy
Operating and Cash Conversion Cycle
Managing Current Liabilities
Managing the Firm’s Investment in Current Assets
Key Terms

3. Learning Objectives
Describe the risk-return tradeoff involved in managing a firm’s working capital.
Explain the principle of self-liquidating debt as a tool for managing firm liquidity.
Use the cash conversion cycle to measure the efficiency with which a firm manages its working capital.

4. Learning Objectives (cont.)
Evaluate the cost of financing as a key determinant of the management of a firm’s use of current liabilities.
Understand the factors underlying a firm’s investment in cash and marketable securities, accounts receivable, and inventory.

5. Principles Used in This Chapter
There is a Risk-Return Tradeoff.

6. 18.1 Working Capital Management and the Risk-Return Tradeoff

7. Working Capital Management and the Risk-Return Tradeoff
Working capital management encompasses the day-to-day activities of managing the firm’s current assets and current liabilities. Examples of working capital decisions include:
How much inventory should a firm carry?
Who should credit be extended to?
Should inventories be bought on credit or cash?
If credit is used, when should payment be made?

8. Measuring Firm Liquidity
The current ratio (current assets divided by current liabilities) and net working capital (current assets minus current liabilities) are two popular measures of liquidity.
Both measures of liquidity provide the same information. However, current ratio can be more easily used for comparing firms.

9. Measuring Firm Liquidity (cont.)
Here the net working capital for two firms is very different (due to differences in firm sizes) but the current ratio is equal. Current ratio is a better measure of comparison of liquidity among firms.
Firm A
Firm B
Current Assets
$100,000
$10,000
Current Liabilities
$50,000
$5,000
Net Working Capital
Current Ratio
2.0

10. Managing Firm Liquidity
Managing a firm’s liquidity requires balancing the firm’s investments in current assets in relation to its current liabilities.
This can be accomplished by minimizing the use of current assets by efficiently managing its inventories and accounts receivable and by seeking out the most favorable accounts payable terms and monitoring its use of short-term borrowing.

11. Risk-Return Tradeoff
Working capital decisions will change the firm’s liquidity.
For example, a firm can enhance its profitability by reducing its cash and marketable securities as they yield low rates of return. However, the firm will be exposed to a higher risk of default or not being able to pay its bills on time if it does not have adequate cash and marketable securities.

12. Checkpoint 18.1
Measuring Firm Liquidity Ford Motor Company (F) suffered along with all the U.S. automakers with the onset of the recession in The following information from the firm’s financial statements for 2008 and 2006 provide the information needed to assess the firm’s liquidity (Note: all figures below are in $000):

13. Checkpoint 18.1

14. Checkpoint 18.1

15. Checkpoint 18.1

16. Checkpoint 18.1: Check Yourself
Consider the effect on Ford’s liquidity of the firm having the opportunity to enter into a long-term financing arrangement to borrow $20 million, which could be used to reduce the firm’s 2008 accounts payable. What would be the effect of this event on the firm’s liquidity measures?

17. Step 1: Picture the Problem
Liquidity refers to the firm’s ability to pay its bills in a timely fashion.
We can determine the firm’s liquidity by comparing firm’s current assets (assets that can be converted to cash in the coming year) and current liabilities (bills the firm must pay within the year).

18. Step 1: Picture the Problem (cont.)
We are given the following information:
2008
2006
Total Current Assets
$36,832,000
$49,244,000
Total Current Liabilities
$58,158,000
$52,544,000
Note:
$20 million transferred
to long-term debt.

19. Step 1: Picture the Problem (cont.)
2008
Current
Assets
2006
Current
Liabilities
2008
Current
Liabilities
2006
Current
Assets

20. Step 2: Decide on a Solution Strategy
Firm’s liquidity can be measured by computing the following two measures:
Current Ratio = Current Assets ÷ Current Liabilities
Working capital = Current Assets – Current Liabilities

21. Step 3: Solve Current Ratio (2008)
= Current Assets ÷ Current Liabilities
= $36,832,000 ÷ $58,158,000
= 0.63

22. Step 3: Solve (cont.) Working capital
= Current Assets – Current Liabilities
= $36,832,000 - $58,158,000
= -$21,326,000

23. Step 4: Analyze
The long-term financing arrangement for $20 million improves the liquidity measures by increasing the current ratio from 0.47 to However, it is still below the 2006 current ratio of 0.94.

24. 18.2 Working Capital Policy

25. Working Capital Policy
Managing the firm’s net working capital involves deciding on an investment strategy for financing the firm’s current assets and liabilities.
Since each financing source comes with advantages and disadvantages, the financial manager has to decide on the optimal source for the firm.

26. The Principle of Self-Liquidating Debt
This principle states that the maturity of the source of financing should be matched with the length of time that the financing is needed.
Thus a seasonal increase in inventories prior to Christmas season must be financed with short-term loan or current liability.

27. Permanent and Temporary Asset Investments
Temporary investments in assets include current assets that will be liquidated and not replaced within the current year.
For example, cash and marketable securities, accounts receivable, and seasonal fluctuation in inventories.

28. Permanent and Temporary Asset Investments (cont.)
Permanent investments are composed of investments in assets that the firm expects to hold for a period longer than one year.
For example, the firm’s minimum level of current assets such as accounts receivable and inventories, as well as fixed assets.

29. Spontaneous, Temporary, and Permanent Sources of Financing
Spontaneous sources of financing arise spontaneously out of the day-to-day operations of the business and consist of trade credit and other forms of accounts payable (such as wages and salaries payable, tax payable, interest payable).

30. Spontaneous, Temporary, and Permanent Sources of Financing (cont.)
Temporary sources of financing typically consist of current liabilities the firm incurs on a discretionary basis. The firm’s management must make an overt decision to use temporary sources of financing.
For example, unsecured bank loans, commercial paper, short-term loans secured by the firm’s inventories or accounts receivables.

31. Spontaneous, Temporary, and Permanent Sources of Financing (cont.)
Permanent sources of financing are called permanent since the financing is available for a longer period of time than a current liability.
For example, intermediate term loans, bonds, preferred stock and common equity.

33. Spontaneous, Temporary, and Permanent Sources of Financing (cont.)
Figure 18-2 illustrates the use of principle of self-liquidating debt to guide a firm’s financing decision.
We observe that the firm’s temporary or short-term debt rises and falls with the rise and fall in the firm’s temporary investment in current assets.

34. 18.3 Operating and Cash Conversion Cycles

35. Operating and Cash Conversion Cycles
Operating and cash conversion cycles indicate how effectively a firm has managed its working capital.
The shorter these two cycles are, the more efficient is the firm’s working capital management.

36. Measuring Working Capital Efficiency
The operating cycle measures the time period that elapses from the date that an item of inventory is purchased until the firm collects the cash from its sale. If an item is sold on credit, this date is when the accounts receivable is collected.

37. Measuring Working Capital Efficiency (cont.)
When the firm is able to purchase items of inventory on credit, cash is not tied up for the full length of its operating cycle. This is known as the accounts payable deferral period.

38. Measuring Working Capital Efficiency (cont.)
Cash conversion cycle is shorter than the operating cycle as the firm does not have to pay for the items in its inventory for a period equal to the length of the account payable deferral period.

39. Figure 18.3 (Cont.)

40. Calculating the Operating and Cash Conversion Cycle
Figure 18-3 calculations are based on the following information:
Annual credit sales = $15 million
Cost of goods sold = $12 million
Inventory = $3 million
Accounts receivable = $3.6 million
Accounts payable outstanding = $ 2million

41. Calculating the Operating and Cash Conversion Cycle (cont.)
To calculate the operating cycle, we need to compute the inventory conversion period and the accounts receivable collection period.

42. Calculating the Operating and Cash Conversion Cycle (cont.)
The inventory conversion period measures the number of days it takes the firm to convert its inventory to credit sales (i.e. accounts receivable).
The second half of the operating cycle is the number of takes it takes to convert accounts receivable to cash (or average collection period).

43. Calculating the Operating and Cash Conversion Cycle (cont.)
To calculate the cash conversion cycle, we need to calculate the accounts payable deferral period.

44. Calculating the Operating and Cash Conversion Cycle (cont.)
We have now calculated the following:
Inventory conversion period = 91 days
Average collection period = 61 days
Accounts payable deferral period = 61 days

45. Calculating the Operating and Cash Conversion Cycle (cont.)
Cash conversion cycle = 176 days – 61 days
= 116 days

46. Checkpoint 18.2 Analyzing the Cash Conversion Cycle
Financial information for the Dell Computer Corporation (DELL) and Ford Motor Company (F) are found below:
Compute the operating cycle and cash conversion cycle for each of these companies. You may assume for purposes of your analysis that all of the firm sales are credit sales.

47. Checkpoint 18.2

48. Checkpoint 18.2

49. Checkpoint 18.2

50. Checkpoint 18.2: Check Yourself
If GM were to have an average collection period of days, an inventory conversion period of days and accounts payable deferral period of days, what would its operating and cash conversion cycles be?

51. Step 1: Picture the Problem
The operating and cash conversion cycle can be visualized as shown below:

52. Step 2: Decide on a Solution Strategy
The firm’s cash conversion cycle and operating cycle are defined as follows:

53. Step 3: Solve We are given the following for DELL:
Average collection period = days
Inventory conversion period = days
Accounts payable deferral period = days

54. Step 3: Solve (cont.) Operating Cycle = 39.76 days + 18.89 days

55. Step 3: Solve (cont.) Cash conversion cycle = 58.65 days – 60.17 days

56. Step 4: Analyze
We observe that the operating cycle for Dell is days which indicates that days elapse from the date an item of inventory is purchased at Dell until the firm collects the cash from its sale.
The cash conversion cycle is negative as Dell is able to defer making payments on its account payable for days, which is longer than the operating cycle.

57. 18.4 Managing Current Liabilities

58. Managing Current Liabilities
repaid within one year)
(debt obligations to be
Current Liabilities
(trade credit, unsecured bank loans, commercial paper)
Unsecured current liabilities
(loans secured by specific assts like inventories or accounts receivable)
Secured current liabilities

59. Calculating the Cost of Short-term Financing
When evaluating alternative sources of financing, it is critical to consider the cost. The cost of short-term credit is given by:
Interest = principal × rate × time

60. Calculating the Cost of Short-term Financing (cont.)
Example 18.1
What will be the interest payment on a 4-month loan for $35,000 that carries an annual interest rate of 12%?
Interest = principal × rate × time
= $35,000 × .12 × 4/12
= $1,400

61. Calculating the Cost of Short-term Financing (cont.)
The Annual Percentage Rate (APR) is computed as follows:

62. Calculating the Cost of Short-term Financing (cont.)
Example Rio Corporation plans to borrow $35,000 for a 120-day period and repay $35,000 principal amount plus $1,400 interest at maturity. What is the APR?
APR = ($1400/$35000) × (1/120/365)
= %

64. Evaluating the Cost of Credit
Trade credit is given by firm’s suppliers. The credit terms generally include discount for early payment.
For example, credit terms of 3/10, net 30 means that a 3% discount is offered for payment within 10 days or the full amount is due in 30 days. What is the cost of not taking the 3% discount?

65. Evaluating the Cost of Credit (cont.)
The 3% cash discount is the interest cost of extending the payment period an additional 20 days. For a $100 invoice, the cost is computed as follows:
APR = ($3/$97) × (1/20/365)
= or 56.44%

66. Evaluating the Cost of Bank Loans
We can apply equation 18-8 (APR) to estimate the cost of bank loans also.
However, firms generally borrow money from bank by creating a line of credit.

67. Evaluating the Cost of Bank Loans (cont.)
A line of credit entitles the firm to borrow up to the stated amount. In exchange, the firm is generally required to maintain a minimum balance in the bank throughout the loan period (known as compensating balance).
The compensating balance increases the annualized cost of loan to the borrower.

68. Checkpoint 18.3 Calculating the APR for a Line of Credit
M&M Beverage Company has a $300,000 line of credit that requires a compensating balance equal to 10 percent of the loan amount. The rate paid on the loan is 12 percent per annum, $200,000 is borrowed for a six-month period, and the firm does not currently have a deposit with the lending bank. The dollar cost of the loan includes the interest expense as well as the opportunity cost of maintaining an idle cash balance in the compensating balance (which is 10% of the loan). To accommodate the cost of the compensating balance requirement, assume that the added funds will have to be borrowed and simply left idle in the firm’s checking account. What would the annualized rate on this loan be if there was no compensating balance requirement? What is the annual rate on this loan with the compensating balance requirement?

69. Checkpoint 18.3

70. Checkpoint 18.3

71. Checkpoint 18.3

72. Checkpoint 18.3: Check Yourself
Assume that your firm has a $1,000,000 line of credit that requires a compensating balance equal to 20 percent of the loan amount. The rate paid on the loan is 12 percent per annum, $500,000 is borrowed for a six-month period, and the firm does not currently have a deposit with the lending bank. To accommodate the cost of the compensating balances requirement, assume that the added funds will have to be borrowed and simply left idle in the firm’s checking account. What would the annualized rate on this loan be with the compensating balance requirement?

73. Step 1: Picture the Problem
Since there is a compensating balance requirement, the amount actually borrowed (B) will be larger than the $500,000 needed.
$500,000 will constitute 80% of the total borrowed funds because of the 20 percent compensating balance requirement.
Hence, .80B = $500,000

74. Step 1: Picture the Problem (cont.)
If .80B = $500,000
Amount borrowed (B) = $500,000/.80
= $625,000
Thus interest is paid on a $625,000 loan of which only $500,000 is available for use by the firm.

75. Step 2: Decide on a Solution Strategy
We can solve for APR using Equation (18-8),

76. Step 3: Solve Here interest is paid on a loan of $625,000.
Thus, interest for 6-months at 12%
= $625,000 × .12 × ½
= $37,500

77. Step 3: Solve (cont.)
APR = ($37,500 ÷ $500,000) × 2
= 0.15 or 15%

78. Step 4: Analyze
We observe that the presence of a compensating balance requirement increases the cost of credit from 12% to 15%.
This results from the fact that the firm pays interest on $625,000 but it gets the use of $37,500 less, or $500,000 -$37,500 = $462,500.

79. 18.5 Managing the Firm’s Investment in Current Assets

80. Managing the Firm’s Investment in Current Assets
The primary types of current assets that most firms hold are:
Cash,
Marketable securities,
Accounts receivable, and
Inventories.

81. Cash and Marketable Securities
Cash and marketable securities are held to pay the firm’s bills on a timely basis.
Holding too little cash and marketable securities could lead to default.
However, holding excessive cash and marketable securities is costly since they earn little, or very low rates of return.

82. Cash and Marketable Securities (cont.)
There are two fundamental problems of cash management:
Keeping enough cash on hand to meet the firm’s cash disbursal requirements on a timely basis.
Managing the composition of the firm’s marketable securities portfolio.

83. Cash and Marketable Securities (cont.)
Problem #1: Maintaining a Sufficient Balance
To maintain an adequate balance requires an accurate forecast of firm’s cash receipts and disbursements. This is accomplished through a cash budget.

84. Cash and Marketable Securities (cont.)
Once estimates of cash flows have been made, firm may want to find ways to reduces its need for cash.
For example, if the firm is able to accelerate its cash collections or slow down its cash disbursements, it will be able to reduce its need for cash.

85. Cash and Marketable Securities (cont.)
Problem #2: Managing the composition of the firm’s marketable securities portfolio
Firms prefer to hold cash reserves in money market securities as it can be easily and quickly converted to cash at little or no loss. These securities mature in less than 1 year, have low or no default probability, and are highly liquid.

87. Managing Accounts Receivable
Whenever a sale is made on credit, it increases the firm’s account receivable balance. Cash flow from sales cannot be invested until accounts receivable are collected.
Efficient collection policies and procedures will improve firm profitability and liquidity.

88. Determinants of the Size of a Firm’s Investment in Accounts Receivable
The level of credit sales as a percentage of sales. This percentage will vary with the type of business.
The level of sales. Higher the sales, greater the accounts receivable.
The credit and collection policy.

90. Terms of Sale
Terms of sale identify the possible discounts for early payment, the discount period, and the total credit period.
It is generally stated in the form a/b, net c. For example 1/10, net 30, means the customer can deduct 1% if paid within 10 days, otherwise the account must be paid within 30 days.

91. Terms of Sale (cont.)
What is the opportunity cost of passing up this 1% discount in order to delay payment for 20 days?

92. Terms of Sale (cont.) Annualized opportunity cost
= 0.01/(1-.01) × 365/(30-10)
= or 18.43%

93. Customer Quality
It is important to determine the type of customer who should qualify for trade credit. It is critical to understand the customer’s short-run financial well being.
As the quality of customer declines, it increases the costs of credit investigation, default costs, and collection costs.

94. Customer Quality (cont.)
To determine customer quality, firm can analyze the liquidity ratios, other obligations, and overall profitability of the firm.
The firm can also obtain information from credit rating services such as Dun & Bradstreet that provide information on the financial status, operations, and payment history for most firms.

95. Customer Quality (cont.)
Credit score is also a popular way to evaluate the credit risk of individuals and firms.
Credit score is a numerical evaluation of each applicant based on the applicant’s current debts and history of making payments on a timely basis.

97. Collection Efforts
Control of accounts receivables focuses on the control and elimination of past-due receivables. This can be done by analyzing various ratios such as average collection period, the ratio of receivables to assets, accounts receivable turnover ratio, and the amount of bad debt relative to sales over time.

98. Collection Efforts (cont.)
The manager can also perform “aging of accounts receivable” to determine in dollars and percentage the proportion of receivables that are past due.

100. Managing Inventories
Inventory management involves the control of assets that are produced to be sold in the normal course of business. It includes raw materials, work-in-process, and finished goods inventory.
How much inventory a firm carries depends upon the target level of sales, and the importance of inventory.

101. Key Terms Bank transaction loans Cash conversion cycle
Commercial paper
Credit scoring
Factor
Float
Inventory conversion period

102. Key Terms (cont.) Inventory management Line of credit
Money market securities
Operating cycle
Permanent sources of financing
Permanent investments
Principle of self-liquidating debt

103. Key Terms (cont.) Secured current liabilities
Spontaneous sources of financing
Temporary investments in assets
Temporary sources of financing
Terms of sale
Trade credit
Unsecured current liabilities