College of Banking and Financial Studies
UNDERGRADUATE DEGREE PROGRAMME
B.Sc. in Accounting, Auditing and Finance
Bachelor of Business Administration
Semester 2
FINANCIAL MANAGEMENT / PRINCIPLES OF FINANCIAL MANAGEMENT
Course Instructor: Dr. Anand S.
CHAPTER – 6
WORKING CAPITAL MANAGEMENT
Learning Outcome
• To understand the concept of Working Capital
• To know the Operating cycles
• To understand Working Capital Cycle
• To know the management of components of Working capital
• To know the concept of Working Capital Policy
• To understand factors affecting Working Capital Management
Decisions relating Major elements Major elements
to working capital
and short-term Working Capital Needs of Different Firms
Inventories Trade payables
financing are
referred to as Trade receivables Bank overdrafts
working capital
management. Cash (in hand and Outstanding
at bank) Expenses
Net Working = Total Current Less Total Current
capital assets liabilities
equals
Gross Working Capital
Example Company
Balance Sheet
December 31, 2010
• Availability of current or short-term assets of a firm such as cash,
receivables, inventory and marketable securities that are used to finance ASSETS LIABILITIES
Current Assets Current Liabilities
its day-to-day operations. Cash $ 2,100 Notes Payable $ 5,000
Petty Cash 100 Accounts Payable 35,900
• Gross working capital = Total Current assets Temporary Investments 10,000 Wages Payable 8,500
Accounts Receivable - net 40,500 Interest Payable 2,900
Represents investment in current assets Inventory 31,000 Taxes Payable 6,100
Supplies 3,800 Warranty Liability 1,100
Prepaid Insurance 1,500 Unearned Revenues 1,500
• Net working capital = Total Current assets – Total Current liabilities Total Current Assets 89,000 Total Current Liabilities 61,000
-
• Positive working capital is required to ensure that a firm is able to Investments 36,000 Long-term Liabilities
Notes Payable 20,000
continue its operations and that it has sufficient funds to satisfy both Property, Plant & Equipment Bonds Payable 400,000
maturing short-term debt and upcoming operational expenses Land 5,500 Total Long-term Liabilities 420,000
Land Improvements 6,500
Buildings 180,000
• If current assets are less than current liabilities, an entity has a working Equipment 201,000 Total Liabilities 481,000
capital deficiency, also called a working capital deficit. Less: Accum Depreciation (56,000)
Prop, Plant & Equip - net 337,000
-
• An increase in working capital indicates that the business has either Intangible Assets
Goodwill 105,000
STOCKHOLDERS' EQUITY
Common Stock 110,000
increased current assets or has decreased current liabilities. Trade Names 200,000 Retained Earnings 229,000
Total Intangible Assets 305,000 Less: Treasury Stock (50,000)
Total Stockholders' Equity 289,000
• Fundamental principles of working capital management are reducing the Other Assets 3,000
capital employed and improving efficiency in the areas of receivables, -
inventories, and payables Total Assets $770,000 Total Liab. & Stockholders' Equity $770,000
The notes to the sample balance sheet have been omitted.
• Liquidity management is the planned acquisition and utilization of cash – or near cash – resources to ensure that the
company is in a position to meet its cash obligations as they fall due.
• Any predicted cash shortfall may require the raising of additional finance, disposal of fixed assets or tighter control over
working capital requirements in order to avoid a liquidity crisis.
• Following being the most commonly employed to assess corporate liquidity
1. Current Ratio = Current assets divided by current liabilities
• The current ratio is the ratio of current assets to current liabilities.
• A high ratio (relative to the industry) would suggest that the firm is in a relatively liquid position .
• However, if much of the current assets are in the form of raw materials and finished stocks, this may not be the case.
2. Quick (acid test) Ratio =Current assets minus stocks, divided by current liabilities
• The quick or ‘acid test’ ratio recognises that stocks may take many weeks to realise in cash terms.
• Accordingly, it is computed by dividing current liabilities into current assets excluding stock.
Calculate Liquidity Position for the Balance Sheet of previous example
Cash sales
Cash/
Finished goods bank overdraft
Trade
Credit sales receivables Cash
Work in progress Raw materials Trade payables
Cash received from
Purchase of goods Payment for Sale of goods on credit customer
on credit goods credit
Inventories turnover period
Operating cash cycle
The OCC is the time lapse between paying for goods and receiving the cash from the sale of those goods.
The length of the OCC has a significant impact on the amount of funds that the business needs to apply to
working capital.
Average inventories turnover period
plus
Average settlement period for receivables
Debt Collection Period
minus
Average payment period for payables
Creditors Payment Period
equals
Operating cash cycle
EXAMPLE: ABC plc, a manufacturer has the following working capital items in its balance sheet at the start
and end of its financial year:
1 January 31 December
Stock £5,500 £6,500
Debtors £3,200 £4,800
Creditors £3,000 £4,500
Turnover for the year, all on credit, is £50,000 and cost of sales is £30,000. For how many days is working
capital tied up in each item? What is the cash operating cycle period?
1. Average settlement period for payables:
(Opening payables + Closing payables)/2
X 365
Credit purchases or cost of sales
= 46 days
2. Average settlement period for receivables:
(Opening receivables + Closing receivables)/2
Credit Sales X 365
= 29 days
3. Average inventories holding period: =
(Opening inventories + Closing inventories)/2
Cost of sales X 365
= 73 days
The cash operating cycle is therefore: (73 + 29 - 46) = 56 days
Cash conversion cycle
Why corporate holds cash? Practical points on cash management
• Transactions: Must have some cash to pay ➢ establish a policy;
current bills.
➢ plan cash flows;
• Precaution: “Safety stock.” But lessened by
credit line and marketable securities. ➢ make judicious use of bank overdraft finance – it can be
cheap and flexible;
• Compensating balances: For loans and/or
services provided. ➢ use short-term cash surpluses profitably;
• Speculation: To take advantage of bargains, to ➢ bank frequently;
take discounts, and so on.
➢ operating cash cycle (for a retailer) = length of time from
Reduced by credit line, marketable securities.
buying inventories to
• However, since cash is a non-earning asset, to ➢ receiving cash from receivables less payables’ payment
have not one Rial more. period (in days);
➢ transmit cash promptly; 12
Categories of Inventory Costs
• Types of Inventory
• Carrying Costs: Storage and handling costs,
– Raw Materials insurance, property taxes, depreciation, and
obsolescence.
– Work in Progress
– Finished Goods • Ordering Costs: Cost of placing orders, shipping, and
handling costs.
Practical points on inventories management:
• Costs of Running Short: Loss of sales, loss of
customer goodwill, and the disruption of production
▪ identify optimum order size – models can schedules.
help with this;
▪ set inventories reorder levels; • By holding excessive inventory, the firm is increasing
▪ use budgets; its operating costs which reduces its NOPAT.
Moreover, the excess inventory must be financed, so
▪ keep reliable inventories records; EVA is further lowered.
▪ use accounting ratios (for example,
inventories turnover period ratio); • Short run: Cash will increase as inventory purchases
▪ establish systems for security of inventories decline.
and authorisation;
▪ consider just-in-time (JIT) inventories • Long run: Company is likely to then take steps to
management. reduce its cash holdings.
• 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.
Elements in Credit Policy
Practical points on receivables management:
• Cash Discounts: Lowers price. Attracts new ▪ establish a policy;
customers and reduces Days Sales outstanding (DSO)
▪ assess and monitor customer creditworthiness;
• Credit Period: How long to pay? Shorter period
reduces DSO and average A/R, but it may discourage
sales. ▪ establish effective administration of receivables;
• Credit Standards: Tighter standards reduce bad debt
losses, but may reduce sales. Fewer bad debts ▪ establish a policy on bad debts;
reduces DSO.
▪ consider cash discounts;
• Collection Policy: Tougher policy will reduce DSO,
but may damage customer relationships.
▪ use financial ratios (for example, average settlement
• YES! A tighter credit policy may discourage sales. period for receivables ratio);
Some customers may choose to go elsewhere if they
are pressured to pay their bills sooner.
▪ use ageing summaries.
• It is administration of a company's outstanding debts, or liabilities, to vendors for purchases of goods and services made
on credit.
• When an item is purchased on credit, the seller will usually specify a period within which the payment should be made.
• Terms “2/10, net 60” indicate that the buyer will get a 2% discount if he makes the payment within 10 days of
purchase.
• Effectiveness of payables management is measured by the:
• Average days of payables outstanding.
• Average number of times a company pays its suppliers in a particular period (Account Payable Period)
• A short payables period indicates that the company is paying faster because the company is taking advantage of
discounts available for paying early.
• A long payables period indicates that either:
• company is a dominant player and can afford to pay late and take advantage of the extra credit period,
• poor in payables management
• Liquidity problems within the company.
• Practical points on payables management:
• establish a policy; exploit free credit as far as possible; use accounting ratios (for example, average
settlement period ratio).
• Accruals are free in that no explicit interest is charged.
• Accrued Expenses - Amounts owed but not yet paid for wages, taxes, interest, and
dividends.
• The accrued expenses account is a short-term liability.
• Firms have little control over the level of accruals.
• Levels are influenced more by industry custom, economic factors, and tax laws.
Inventory Accounts Receivable
High Levels Low Levels High Levels Low Levels
Benefit: Cost: (favorable credit terms) (unfavorable terms)
• Happy customers • Shortages
Benefit: Cost:
• Few production • Dissatisfied customers
delays (always have • Happy customers • Dissatisfied customers
Benefit:
needed parts on • High sales • Lower Sales
• Low storage costs
hand) Cost: Benefit:
• Less risk of obsolescence
Cost: • Expensive • Less expensive
• Expensive • High collection costs
• High storage costs • Increases financing costs
• Risk of obsolescence
Accounts Payable and Accruals
Cash High Levels Low Levels
High Levels Low Levels Benefit: Benefit:
Benefit: Benefit: • Reduces need for external • Happy suppliers/employees
• Reduces risk • Reduces financing costs finance--using a spontaneous Cost:
Cost: Cost: financing source • Not using a spontaneous
• Increases financing • Increases risk Cost: financing source
costs • Unhappy suppliers
$ Temp. NOWC
S-T
} Loans
Permanent NOWC L-T Fin:
Stock &
Bonds, $ Marketable Securities
Fixed Assets Zero S-T
debt
Years
Lower dashed line, more aggressive.
Permanent NOWC L-T Fin:
Stock &
• Moderate: Match the maturity of the assets with Bonds
the maturity of the financing.
• Aggressive: Use short-term financing to finance Fixed Assets
permanent assets.
• Conservative: Use permanent capital for
permanent assets and temporary assets. Years
1. Nature of the Industry
2. Demand of Industry
3. Cash requirements 13. Credit control
4. Nature of the Business 14. Inflation or price level changes
5. Manufacturing time 15. Profit planning and control
6. Volume of Sales 16. Repayment ability
7. Terms of Purchase and Sales 17. Cash reserves
8. Inventory Turnover 18. Operation efficiency
9. Business Turnover 19. Changes in technology
10. Business Cycle 20. Firm’s finance and dividend policy
11. Current Assets requirements 21. Attitude towards risk
12. Production Cycle
1. Essentials of Corporate Financial Management by Glen Arnold, Prentice Hall
2. Principles of Corporate Finance by Richard A. Brealey & Stewart C. Myers,
McGraw Hill
3. Fundamental of Financial Management by James C. Van Horne & John M
4. Fundamentals of Financial Management by Prasanna Chandra, Tata McGraw Hill
5. Fundamentals of Financial Management by Eugene F. Brigham, Joel F. Houston
6. Fundamentals of Corporate Finance by Ross, Thompson, Christensen, Westerfield
and Jordan, McGraw-Hill
