Working Capital Management
Working capital management is the
management of the short-term investment
and financing of a company.
Internal and External Factors that Affect Working Capital Needs
Internal Factors External Factors
• Company size and growth rates • Banking services
• Organizational structure • Interest rates
• Sophistication of working capital • New technologies and new products
management • The economy
• Borrowing and investing • Competitors
positions/activities/capacities
Bottom line: There are many influences on a company’s need for working capital.
Working Capital and the Current
Accounts
Net Working Capital – the difference
between gross working capital and
spontaneous financing
Generally:
– Gross working capital = current assets
– Net working capital =
current assets – current liabilities
People often say working capital when
they actually mean net working capital
Objective of Working
Capital Management
To run the firm with as little money
tied up in the current accounts as
possible
Working capital elements
– Inventory
– Receivables
– Cash
– Payables
– Accruals
Objectives of Working Capital Management
Inventory
High Levels Low Levels
Benefit: Cost:
Happy customers – supplied quickly Shortages
Few production delays (parts always on hand) Dissatisfied customers –
Cost: product not available
High financing costs Benefit:
High storage costs Low financing and storage
Shrinkage (theft) costs
Less risk of obsolescence
Risk of obsolescence
Cash
High Levels Low Levels
Benefit: Benefit:
Reduces risk of being unable to pay bills Reduces financing costs
Cost: Cost:
Increases financing costs Increases transaction risk
Objective of Working Capital Management
Accounts Receivable
High Levels Low Levels
Benefit: Cost:
Happy customers –can pay slowly Customers unhappy with
High credit sales payment terms
Cost: Lower Credit Sales
More bad debts Benefit:
High collection costs Less financing cost
Increased financing costs
Payables and Accruals
High Levels Low Levels
Benefit: Benefit:
Spontaneous financing reduces need to borrow Happy suppliers/employees
Cost: Cost:
Unhappy suppliers because paid slowly Not using spontaneous financing
Significance of Working Capital
Management
In a typical manufacturing firm, current assets
exceed one-half of total assets.
Excessive levels can result in a substandard
Return on Investment (ROI).
Current liabilities are the principal source of
external financing for small firms.
Requires continuous, day-to-day managerial
supervision.
Working capital management affects the
company’s risk, return, and share price.
The Cash Conversion Cycle
Short-term financial management—managing current
assets and current liabilities—is on of the financial
manager’s most important and time-consuming
activities.
The goal of short-term financial management is to
manage each of the firms’ current assets and liabilities
to achieve a balance between profitability and risk that
contributes positively to overall firm value.
Central to short-term financial management is an
understanding of the firm’s cash conversion cycle.
Operating and Cash Conversion Cycles
Operating Cycle Cash Conversion Cycle
Operating and Cash Conversion Cycles:
Formulas
Calculating the Cash
Conversion Cycle
MAX Company, a producer of paper dinnerware, has annual
sales of $10 million, cost of goods sold of 75% of sales, and
purchases that are 65% of cost of goods sold. MAX has an
average age of inventory (AAI) of 60 days, an average
collection period (ACP) of 40 days, and an average payment
period (APP) of 35 days.
Using the values for these variables, the cash conversion cycle
for MAX is 65 days (60 + 40 - 35) and is shown on a time line 1.
Calculating the Cash
Conversion Cycle (cont.)
Figure 14.1 Time Line for MAX Company’s Cash Conversion Cycle
Calculating the Cash
Conversion Cycle (cont.)
The resources MAX has invested in the cash conversion cycle
assuming a 365-day year are:
Obviously, reducing AAI or ACP or lengthening APP will reduce the
cash conversion cycle, thus reducing the amount of resources the
firm must commit to support operations.
Strategies for Managing the Working Capital
1. Turn over inventory as quickly as possible
without stock outs that result in lost sales.
2. Collect accounts receivable as quickly as
possible without losing sales from high-
pressure collection techniques.
3. Manage, mail, processing, and clearing time
to reduce them when collecting from
customers and to increase them when paying
suppliers.
4. Pay accounts payable as slowly as possible
without damaging the firm’s credit rating.
Cash Management
Motivation for Holding Cash
– Transactions demand
– Precautionary demand
– Speculative demand
– Compensating balances
How to maximize cash flow
Insuring that cash receipts are
deposited daily.
Investing excess cash in short-term
investments until needed.
Longer float(time it takes from the
mailing of check until it is charged to
one’s account)
Restricting minimum cash balances
required by lenders or bank providing
lock-box or other services.
Utilizing lock-boxes
Marketable Securities
Some assets are only slightly less
liquid than cash, and earn a return
– Treasury bills
– Other short term securities issued by
stable organizations
Held as a substitute for cash
Figure 16-5 The Check-Clearing
Process
Check Disbursement and
Collection Procedures
Float: money tied up in the check
clearing process
– Mail float
– Transit float
– Processing float
Use of Cash - Payers versus Payees
– Payers want to extend float periods
– Payees want to reduce float periods
Accelerating Cash Receipts
Lock-box systems
– Service provided by banks to accelerate
collections
Concentration Banking
– Sweep excess balances in distant
depository accounts into central
locations daily
Figure 16-6 A Lock Box System in the
Check-Clearing Process
Accelerating Cash Receipts
Wire Transfers Preauthorized Checks
– Transfers money – Customer gives the payee
electronically signed check-like documents
in advance
– Payee deposits it in its bank
account once product is
shipped
Management responsibilities
relating to cash
Prevent losses from fraud or theft.
Provide accurate accounting of cash
receipts, payments and balances
Maintain sufficient amount of cash at all
times to make necessary payments plus
reasonable balance for emergencies.
Prevent unnecessary large amounts of
cash from being held idle in bank
accounts, which produce no revenues.
Accounts Receivable Management
The second component of the cash conversion
cycle is the average collection period – the
average length of time from a sale on credit
until the payment becomes usable funds to the
firm.
The collection period consists of two parts:
– the time period from the sale until the customer
mails payment, and
– the time from when the payment is mailed until the
firm collects funds in its bank account.
Accounts Receivable Management:
The Five Cs of Credit
Character: The applicant’s record of meeting
past obligations.
Capacity: The applicant’s ability to repay the
requested credit.
Capital: The applicant’s debt relative to equity.
Collateral: The amount of assets the applicant
has available for use in securing the credit.
Conditions: Current general and industry-
specific economic conditions.
Managing Accounts Receivable
Objectives and Policy
– Higher receivables means selling to
financially weaker customers and not
pressuring them to pay promptly
Higher sales but also more bad debts
Objective is to max profit, not revenue
Receivables Policy involves:
– Credit Policy
– Terms of Sale
– Collections Policy
Determinants of
Receivables Balance
Credit Policy
– Examine credit worthiness of potential
credit customers
– Tight credit policy = lower sales
– Loose credit policy = high bad debts
– Conflict between sales and credit
departments
Terms of Sale
Credit sales are subject to specific payment terms
– 2/10, net 30 - The most common terms
2% discount for paying within 10 days,
otherwise entire amount due within 30 days
– Prompt payment discounts are usually effective
tools for managing receivables
Customers pay quickly to save money
May backfire if customers are very cash poor
– Discount taken only by those who pay anyway
Credit Monitoring
Credit monitoring is the ongoing review of a
firm’s accounts receivable to determine
whether customers are paying according to
the stated credit terms.
Slow payments are costly to a firm because
they lengthen the average collection period
and increase the firm’s investment in accounts
receivable.
Two frequently used techniques for credit
monitoring are the average collection period
and aging of accounts receivable.
Credit Monitoring:
Average Collection Period
The average collection period is the average
number of days that credit sales are
outstanding and has two parts:
– The time from sale until the customer places the
payment in the mail, and
– The time to receive, process, and collect payment.
Credit Monitoring:
Aging of Accounts Receivable
Credit Monitoring:
Collection Policy
The firm’s collection policy is its procedures
for collecting a firm’s accounts receivable
when they are due.
The effectiveness of this policy can be partly
evaluated by evaluating at the level of bad
expenses.
As seen in the previous examples, this level
depends not only on collection policy but also
on the firm’s credit policy.
Collections Policy
Collections Department - follows up on overdue
receivables - called dunning
– Mail polite letter
– Follow up with additional increasingly
aggressive dunning letters
– Phone calls
– Collection agency
– Lawsuit
Collection policy: manner and aggressiveness
with which a firm pursues payment from
delinquent customers
Inventory Management
Inventory: product held for sale
– Inventory mismanagement can ruin a
company
Finance department has only an
oversight responsibility
– Monitor level of lost or obsolete
inventory
– Supervise periodic physical inventories
Objectives of Inventory
Management
Reduce inventories while maintaining
customer service levels and quality. The
firm can free needed cash to finance
both internal and external growth.
To establish production and inventory
control.
Economic Order Quantity
Is the order size of the appropriate number of units
that should be ordered.
______
EOQ = √ 2 x D x O
C
D = demand annually for the product
O = Order Cost per order placed
C = Carrying Cost annually per unit of
the product in inventory
Formulas
TIC = TAC + TOC
TAC = Average Inventory level x Annual Carrying Cost per unit
Average Inventory = Order size / 2
TOC = No. of orders x Cost per order
No. of Orders = Annual Demand / Order Size
Formulas
Reorder point- level represents when to place the order for
the order quantity (size).
Delivery Time- is the time interval between placing an order
and receiving delivery.
Safety Stock- are inventory carried over and above the
quantity determined by the EOQ formula to meet
unanticipated demand.
REORDER POINT = Daily Demand x Lead Time
Safety Stock = (Maximum lead time – Normal lead time) demand
Tracking Inventories
The ABC System
The ABC system segregates items by
value and places tighter control on
higher-cost pieces
– “A” items – very expensive or critical
– “B” items – moderate value
– “C” items – cheap and plentiful
Effort and spending on control
diminishes from A to B to C
Just In Time (JIT)
Inventory Systems
JIT virtually eliminates manufacturing
inventory by pushing it back on suppliers
Suppliers deliver goods just in time for use
in production
Works best with large manufacturers
Works poorly where firm has little control
over distant suppliers
Accounts Payable Management
WHY COMPANIES FINANCE THEIR PURCHASES
Purchasing inventory, raw materials, and other goods on
trade credit allows a company to defer its cash outlays,
while accessing resources immediately.
When managed appropriately financing purchases can
contribute to effective working capital management.
A company that employs best practices with regards to
payables management can reap the benefits of stable
operating cycles that provide a stable source of operating
cash flows and place it in a good liquidity position with
respect to its competitors.
MANAGING PAYMENTS
The Accounts Payable department is accountable for this
function, and performs tasks such as communicating with
suppliers, sending payments and reconciling bank records,
as well as updating and performing related accounting
entries
Managing payables also include the expense
administration with respect to the company’s own
employees.
Expenses such as employee travelling, meals,
entertainment, and other costs related to doing business for
the company are administered by the payables department
and must be managed appropriately.
