CHAPTER 21

Working Capital Management

Topics in Chapter

Working capital policies

Cash, inventory, and A/R management
Accounts payable management
Short-term financing policies
Bank debt and commercial paper

21-2

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)
21-3

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
21-4

Cash Conversion Cycle

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

21-5

Inventory Conversion
Period
Average time required to convert
materials into finished goods and to
sell those goods:
Inventory
Inventory Conversion Period
Sales per day

21-6

Receivables Collection
Period
Average length of time required to
convert the firms receivables into
cash:
Receivables
Receivables Collection Period
Sales / 365

Receivables Collection Period =

DSO = Days Sales Outstanding
21-7

Payables Deferral Period

Average length of time between the
purchase of materials and labor and
the payment of cash for them:
Payables
Payable Deferral Period
Purchases per Day
Payables

Cost of goods sold / 365

21-8

Real Time Computer

Cash Conversion Data

21-9

Inventory Conversion
Period

Inventory
Sales per day
$2,000,000
Inventory Conversion Period
73 days
$10,000,00 0 / 365
Inventory Conversion Period

21-10

Receivables Collection
Period

Receivables
Sales / 365
$657,534
Receivables Collection Period
24 days
$10,000,00 0 / 365
Receivables Collection Period

21-11

Payables Deferral Period

Payables
Purchases per Day
Payables

Cost of goods sold / 365

$657,534

30 days
$8,000,000 / 365

Payable Deferral Period

21-12

Cash Conversion Cycle

Cash
Inventory Receivables Payable
Conversion =Conversion +Collection s
Cycle
Period
Period
Deferral
Period

CCC =

73 days + 24 days 30 days

CCC =

67 days

(21-4)

21-13

Cash Conversion Cycle

Figure 21-1

21-14

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 firms payments
21-15

Real Time Computer

TABLE 21.1

21-16

Real Time Computer

21-17

Alternative NOWC Policies

21-18

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
21-19

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 budgets purpose
Monthly for annual planning
Daily for actual cash management
21-20

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
21-21

MicroDrive Cash Budget

21-22

Table 21-2

21-23

21-24

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

$300*70% =

21-25

MicroDrive Cash Budget

21-26

Table 21-2

21-27

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
21-28

Cash Budget with

Adjustments

21-29

Cash Management
Techniques
Synchronize inflows and outflows
Billing cycle = Payment cycle

Use Float
Remote disbursement accounts (+)
Collections float (-)

Net
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

21-30

Inventory Management
Goals
1. Ensure that the inventory needed to
sustain operations is available
2. Minimize the costs of ordering and
carrying inventory
Trade-off to balance goals
21-31

Inventory Management:
Categories of Inventory Costs
Carrying Costs

Storage and handling

Insurance
Property taxes
Depreciation
Obsolescence
21-32

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

21-33

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

21-34

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
21-35

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
21-36

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
21-37

Receivables Monitoring
Credit sale events:
1. Inventories reduced by COGS
2. A/R increased by sales price
3. Price COGS = Profit
Profit Retained Earnings

DSO = Days Sales Outstanding

DSO = Average Collection Period
21-38

Days Sales Outstanding

ADS Average Daily Sales
Annual Sales (Units Sold) (Sales Price)
ADS

365
365

(21 - 6)

Receivables (ADS) (DSO)

(21 - 7)

DSO

Receivables
Receivables

Sales per Day

Sales/365

21-39

Receivables Aging
Schedule
Breaks down firms receivables by age

TABLE 21.3

21-40

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
21-41

Trade Credit
Credit furnished by a firms 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
21-42

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

21-43

PCCs Trade Credit Cost

PCC buys an average of $11,923,333
from Microchip
$32,666.67 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
21-44

PCCs Trade Credit Cost

If PCC takes the extra 20 days to pay
PCC A/P average = 30(32,667) = $980,000
PCC is receiving $980,000 - 326,667 = $653,333
credit from Microchip
PCC is foregoing a 2% discount

PCCs total cost = $11,923,333/0.98

= $12,166,666
Annual finance cost = $12,166,666
11,923,333 = $243,333 = 37.2%
21-45

Nominal Cost Formula

2/10, net 30
365
rNOM = Discount %
days
Days
Discount
1 - Discount
%
Taken Period
2
365
=

= 0.0204 18.25
98
20
= 0.372 = 37.2%

PCC Pays 2.04% 18.25 times per

year

21-46

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%
21-47

The Cost of Trade Credit

21-48

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
21-49

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

21-50

FIGURE 21.2
Page 751

21-51

Moderate Financing Policy

$

Temp. NOWC

}
Perm NOWC

S-T
Loans
L-T Fin:
Stock &
Bonds,

Fixed Assets
Years
Lower dashed line, more aggressive.

21-52

Conservative Financing
Policy
$

Marketable Securities
Zero S-T
debt

Perm NOWC

L-T Fin:
Stock &
Bonds

Fixed Assets
Years 21-53

Short-term Investments
Marketable securities
Lower yields than operating assets
Held for same reasons as cash
Benefits:
Reduces risk and transactions costs
Wont need to issue securities or borrow as
frequently
Ready cash for opportunities = speculative
balances
Disadvantages
Low after-tax return
21-54

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
21-55

Short-term Financing
Disadvantages

Higher risk
Interest expense fluctuates
Required repayment comes quicker
Firm may have trouble rolling over
loans
21-56

Short-term Bank Loans

= Notes payable
Maturity
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

21-57

Short-term Bank Loans

Compensating Balances
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
21-58

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

21-59

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
21-60