Working Capital Management

• How can a company lower its DWC?

• Reduced its inventories by adopting
just-in-time manufacturing processes
Working Capital Management
• Working capital management involves two basic
questions:
• (1) What is the appropriate amount of working capital,
both in total and for each specific account, and
• (2) how should working capital be financed?
• basic definitions and concepts.
• 1. Working capital, sometimes called gross working
capital, simply refers to current assets used in
operations.
• 2. Net working capital is defined as current assets minus
all current liabilities.
• 3. Net operating working capital (NOWC) is defined as
current operating assets minus current operating
liabilities.
 CURRENT ASSET HOLDINGS

• Current assets can be divided into two categories,

operating and nonoperating. Operating current assets
consist of cash plus marketable securities held as a
substitute for operating cash, inventories, and accounts
receivable. These are assets that are necessary to
operate the business.
• Nonoperating current assets consist of any other current
assets, principally short-term securities in excess of what
is required in operations,
 CURRENT ASSET HOLDINGS

• relaxed policy
• restricted policy
• moderate policy
 CURRENT ASSET HOLDINGS
• relaxed policy
• restricted policy
• moderate policy
  
CURRENT ASSETS FINANCING POLICIES

• Investments in operating current assets must be

financed, and the primary sources of funds include bank
loans, credit from suppliers (accounts payable), accrued
liabilities, long-term debt, and common equity.
• permanent current operating assets
• temporary current operating assets
• Three alternative policies
• maturity matching, or “self-liquidating,” approach
• Aggressive Approach
• Conservative Approach
  
CURRENT ASSETS FINANCING POLICIES
  
THE CASH CONVERSION CYCLE
• Calculating the Target CCC
• 1. Inventory conversion period.
• 2. Average collection period (ACP)
• 3. Payables deferral period
  
Calculating the Actual CCC from Financial Statements
  
Calculating the Actual CCC from Financial Statements
• if working capital decreases by a given amount while other
things remain constant, then FCF increases by that same
amount
• an improvement in working capital management creates a
large one-time increase in FCF at the time of the improvement
as well as higher FCF in future years.
 THE CASH BUDGET
 
• Firms must forecast their cash flows. If they are likely to need
additional cash then they should line up funds well in
advance, yet if they are likely to generate surplus cash then
they should plan for its productive use. The primary
forecasting tool is the cash budget
• Monthly Cash Budgets
THE CASH BUDGET
 
 Cash Budgets versus Income Statements
and Free Cash Flows

• key differences:
• (1) In an income statement, the focus would be on
sales, not collections.
• (2) An income statement would show accrued taxes,
wages, and so forth, not the actual payments.
• (3) An income statement would show depreciation as
an expense, but it would not show expenditures on new
fixed assets.
• (4) An income statement would show a cost for goods
purchased when those goods were sold, not for when
they were ordered or paid.
 Cash Management and the target Cash Balance

• the goal of the cash manager is to minimize the cash

amount the firm must hold for conducting its normal
business activities while continuing to maintain a
sufficient cash reserve to (1) take trade discounts, (2)
pay promptly and thus maintain its credit rating, and (3)
meet any unexpected cash needs.
• Reasons for Holding Cash
• Transactions, both routine and precautionary
• Compensation to banks for providing loans and services
 CASH MANAGEMENT TECHNIQUES

• a system must be in place to transfer funds from where

they come in to where they are needed, to arrange loans
to cover net corporate shortfalls, and to invest net
corporate surpluses without delay
• synchronization of cash flows provides cash when it is
needed and thus enables firms to reduce their average
cash balances.
• Speeding Up the Check-Clearing Process
• Using Float
• Speeding Up Collections
 INVENTORY MANAGEMENT

• The twin goals of inventory management are (1) to

ensure that the inventories needed to sustain operations
are available, but (2) to hold the costs of ordering and
carrying inventories to the lowest possible level.
• lower inventory levels reduce costs due to storage and
handling, insurance, property taxes, spoilage, and
obsolescence.
• there are costs associated with holding too little
inventory, and these costs can be severe.
• if stocks become depleted then firms can miss out on
profitable sales and also suffer lost goodwill,
 RECEIVABLES MANAGEMENT

• Receivables management begins with the firm’s credit

policy, but a monitoring system is also important to keep
tabs on whether the terms of credit are being observed.
Corrective action is often needed, and the only way to
know whether the situation is getting out of hand is with
a good receivables control system.
• Credit Policy
• 1. Credit period.
• 2. Discounts.
• 3. Credit standards.
• 4. Collection policy.
 RECEIVABLES MANAGEMENT

• The Accumulation of Receivables

• The total amount of accounts receivable outstanding at
any given time is determined by two factors: (1) the
credit sales per day and (2) the average length of time it
takes to collect cash on accounts receivable:
 RECEIVABLES MANAGEMENT

• Monitoring the Receivables Position

When a credit sale is made, these events occur: (1) inventories
are reduced by the cost of goods sold; (2) accounts receivable
are increased by the sales price; and (3) the difference is
reported as a profit, which is adjusted for taxes and then added
to the previous retained earnings balance.
Days Sales Outstanding (DSO).
 RECEIVABLES MANAGEMENT

Aging Schedules. An aging schedule breaks down a firm’s

receivables by age of account
Management should constantly monitor both the DSO and
the aging schedule to detect any trends, to see how the
firm’s collections experience compares with its credit terms,
and to see how effectively the credit department is
operating in comparison with other firms in the industry.
 ACCRUALS AND ACCOUNTS PAYABLE

two major types of operating current liabilities: accruals and

accounts payable
Accruals
Accounts Payable (Trade Credit
The Cost of Trade Credit
The Cost of Trade Credit
 The Cost of Trade Credit

• trade credit can be divided into two

components: (1) free trade credit, which
involves credit received during the
discount period, and (2) costly trade credit,
which involves credit in excess of the free
trade credit and whose cost is an implicit
one based on the forgone discounts.
 SHORT-TERM MARKETABLE SECURITIES
• Short-term marketable securities are held
for two separate and distinct purposes:
• (1) to provide liquidity, as a substitute for
cash; and
• (2) as a nonoperating investment .
 SHORT-TERM FINANCING

• The aggressive policy called for the

greatest use of short-term debt, and the
conservative policy called for using the
least; maturity matching fell in between.
• Advantages of Short-Term Financing
• Disadvantages of Short-Term Debt
 SHORT-TERM FINANCING

• SHORT-TERM BANK LOANS

• Promissory Notes
• Compensating Balances
• Informal Line of Credit
• Revolving Credit Agreement
• Costs of Bank Loans