CHAPTER 14 Working Capital Management Learning Objectives 1. Define net working capital, discuss the importance of working capital management, and be able to compute a firm’s net working capital. 2. Define the operating and cash cycles, explain how they are used, and be able to compute their values for a firm. 3. Discuss the relative advantages and disadvantages of pursuing (1) flexible and (2) restrictive current asset investment strategies. 4. Explain how accounts receivable are created and managed, and be able to compute the cost of trade credit. 5. Explain the trade-off between carrying costs and reorder costs, and be able to compute the economic order quantity for a firm’s inventory orders. 6. Define cash collection time, discuss how a firm can minimize this time, and be able to compute the cash collection costs and benefits of a lockbox. 7. Identify three current asset financing strategies and discuss the main sources of short-term financing. Prepared by Contessa Petrini 1
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CHAPTER 14Working Capital Management
Learning Objectives
1. Define net working capital, discuss the importance of working capital management, and be able to
compute a firm’s net working capital.
2. Define the operating and cash cycles, explain how they are used, and be able to compute their values for
a firm.
3. Discuss the relative advantages and disadvantages of pursuing (1) flexible and (2) restrictive current
asset investment strategies.
4. Explain how accounts receivable are created and managed, and be able to compute the cost of trade
credit.
5. Explain the trade-off between carrying costs and reorder costs, and be able to compute the economic
order quantity for a firm’s inventory orders.
6. Define cash collection time, discuss how a firm can minimize this time, and be able to compute the cash
collection costs and benefits of a lockbox.
7. Identify three current asset financing strategies and discuss the main sources of short-term financing.
I. Chapter Outline
14.1 Working Capital Basics
Working capital management involves two key issues.
What is the appropriate amount and mix of current assets for the firm to hold?
How should these current assets be financed?
Discussions with CFOs quickly lead to the conclusion that, as important as capital
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budgeting and capital structure decisions are, they are made less frequently, while the
day-to-day complexities involving the management of net working capital (especially
cash and inventory) consume tremendous amounts of management time. Also, it is clear
that while poor long-term investment and financing decisions will adversely impact firm
value, poor short-term financial decisions will impair the firm’s ability to remain
operating. Finally, working capital decisions can also have a major impact on firm value.
Let us review some basic definitions related to working capital.
Current assets are cash and other assets that the firm expects to convert into cash in a year or
less.
Current liabilities (or short-term liabilities) are obligations that the firm expects to pay off in a
year or less.
Working capital, also called gross working capital, includes the funds invested in a company’s
cash account, account receivables, inventory, and other current assets.
Net working capital (NWC) refers to the difference between current assets and current
liabilities.
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o NWC is important because it is a measure of liquidity and represents the net short-term
investment the firm keeps in the business.
Working capital management involves making decisions regarding the use and sources of
current assets.
Working capital efficiency refers to the length of time between when a working capital asset
is acquired and when it is converted into cash.
Liquidity is the ability of a company to convert assets—real or financial—into cash quickly
without suffering a financial loss.
A. Working Capital Accounts and Trade-Offs
The various working capital accounts are:
Cash: This account includes cash and marketable securities like Treasury securities.
o The higher the cash balance, the better the ability of the firm to meet its short-
term financial obligations.
Receivables: These represent the amount owed by customers who have taken advantage
of the firm’s trade credit policy.
Inventory: Firms maintain inventory of raw materials and work in process and finished
goods.
Payables: The payables balance represents the amount owed to the firm’s vendors and
suppliers on materials purchased on credit.
o The accrual accounts are liabilities incurred but not yet paid, such as accrued
wages or taxes.
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14.2 The Operating and Cash Conversion Cycles
The cash conversion cycle begins when the firm invests cash to purchase the raw materials that would be used
to produce the goods that the firm manufactures and ends with the finished goods being sold to customers and
the cash collected on the sales, also taking into account the time taken by the firm to pay for its purchases.
See Exhibit 14.2 for a graphical representation of the cash conversion cycle.
When managing working capital accounts, financial managers want to do the following:
Delay paying accounts payable as long as possible without suffering any penalties.
Maintain minimal raw material inventories without causing manufacturing delays.
Use as little labor as possible to manufacture the product while producing a quality product.
Maintain minimal finished goods inventories without losing sales.
Offer customers the most attractive credit terms possible on trade credit to maximize sales while
minimizing the risk of nonpayment.
Collect cash payments on accounts receivable as fast as possible to close the loop.
With the financial manager’s goal being to maximize the value of the firm, each of the decisions above is
intended to shorten the cash conversion cycle and improve the firm’s liquidity.
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Two tools to measure the working capital management efficiency are the operating cycle and the cash
conversion cycle.
A. Operating Cycle
The operating cycle begins when the firm receives the raw materials it purchased and ends when the
firm collects cash payments on its credit sales.
Two measures—days’ sales outstanding and days’ sales in inventory—help determine the operating
cycle.
Days’ sales in inventory (DSI) shows how long the firm keeps its inventory before selling it.
o It is the ratio of the inventory balance to the daily cost of goods sold.
o The quicker a firm can move out its raw materials as finished goods, the shorter the
duration when the firm holds it inventory, and the more efficient it is in managing its
inventory.
Days'sales in inventory= DSI =365 daysInventory turnover
=365 daysCost of goods sold / Inventory
Days’ sales outstanding (DSO) estimates how long it takes on average for the firm to collect
its outstanding accounts receivable balance.
o This ratio is also called the average collection period (ACP).
o An efficient firm with good working capital management should have a low average
Short-term financial management in a large firm involves coordination between the credit manager, marketing manager, and controller. Potential for conflict may exist if particular managers concentrate on individual objectives as opposed to overall firm objectives.
The cash conversion cycle depends on the inventory, receivables, and payables periods. The cash conversion cycle increases as the inventory and receivables periods get longer. It decreases if the company is able to defer payment of payables and thereby lengthen the payables period. Most firms have a positive cash conversion cycle, and they thus require financing for inventories and receivables. The longer the cash conversion cycle, the more financing is required. Also, changes in the firm's cash conversion cycle are often monitored as an early-warning measure. A lengthening cycle can indicate that the firm is having trouble moving inventory or collecting on its receivables. Such problems can be masked, at least partially, by an increased payables cycle, so both should be monitored.
We can easily see the link between the firm's cash conversion cycle and its profitability by recalling that one of the basic determinants of profitability and growth for a firm is its total asset turnover, which is defined as Sales/Total assets. The higher this ratio is, the greater are the firm's accounting return on assets, ROA, and return on equity, ROE.
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Thus, all other things being the same, the shorter the cash conversion cycle is, the lower is the firm's investment in inventories and receivables. As a result, the firm's total assets are lower, and total turnover is higher.
14.3 Working Capital Investment Strategies
Financial managers use two types of strategies for current assets investments: flexible and restrictive.
A. Flexible Current Asset Investment Strategy
The flexible strategy has a high percent of current assets to sales, whereas a restrictive policy has a low
percent of current assets to sales.
The flexible strategy calls for management to invest large amounts in cash, marketable securities, and
inventory.
The strategy also promotes a liberal trade credit policy for customers, which results in high levels of
accounts receivable.
The flexible strategy is perceived be a low risk and low return course of action for management to
follow.
The advantage of this policy is the large working capital balances the firm holds.
The strategy’s downside is the high inventory-carrying cost associated with owning a high level of
inventory and providing liberal credit terms for its customers.
The higher carrying costs result for two reasons
The investment in the low return current assets deprives the higher returns that management
could earn on longer term assets like plant and equipment.
Higher amounts of inventory results in higher warehousing and storage costs.
B. Restrictive Current Asset Investment Strategy
Current assets are kept to a minimum in the restrictive strategy.
The firm barely invests in cash and inventory, and has tight terms of sale intended to curb credit sales
and accounts receivable.
The restrictive strategy is a high-risk, high-return alternative to the flexible strategy.
The high risk comes in the form of shortage costs that can be either financial or operating.
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Financial shortage costs arise mainly from the illiquidity shortage of cash and a lack of
marketable securities to sell for cash.
o If unpaid bills are due, the firm will be forced to use expensive external emergency
borrowing.
o If funding cannot be secured, default occurs on some current liability and the firm runs
the risk of being forced into bankruptcy by creditors.
Operating shortage costs result from lost production and sales.
o If the firm does not hold enough raw materials in inventory, time may be wasted by a
halt in production.
o If the firm runs out of finished goods, sales may also be lost, and customer
dissatisfaction may arise.
o Restrictive sale policies such as allowing no credit sales will also result in lost sales.
o Overall, operating shortage costs can be substantial, especially if the product markets
are competitive.
C. The Working Capital Trade-off
The optimal current asset investment strategy will depend on the relative magnitudes of carrying costs
versus shortage costs. This conflict is often referred to as the working capital trade-off.
Financial managers need to balance shortage costs against carrying costs to find an optimal
strategy.
If carrying costs are larger than shortage costs, then the firm will maximize value by adopting a
more restrictive strategy.
On the other hand, if shortage costs dominate carrying costs, the firm will need to move toward
a more flexible policy.
Overall, management will try to find the level of current assets that minimizes the sum of the
carrying costs and shortage costs. Prepared by Contessa Petrini 10
14.4 Accounts Receivables
A. Terms of Sale
Whenever a firm sells a product, the seller spells out the terms and conditions of the sale in a document
called the terms of sale.
The agreement specifies when the cash payment is due and the amount of any discount if early
payment is made.
Trade credit, which is short-term financing, is typically made with a discount for early payment rather
an explicit interest charge.
An offer of “3/10, net 40” means that the selling firm offers a 3 percent discount if the buyer
pays the full amount of the purchase in cash within 10 days of the invoice date.
o Otherwise, the buyer has 40 days to pay the balance in full from the date of delivery.
To calculate the cost, we need to determine the interest rate the buyer is paying and convert it to an
equivalent annual rate.
The formula for calculating the EAR for a problem like this is shown below, in Equation 14.4,
Note: The above is the calculation of the true cost of not taking a cash discount.
Example: Suppose that a firm sells its products with terms of 3/15, net 60. What is the implicit cost (EAR) if your firm does not take the cash discount offered?
Effective annual rate =(1+ 3100−3 )
365 / (60 - 15)− 1
= (1.030927835) 8.111111111 - 1 = .2803 = 28.03%
Trade credit is a loan from the supplier and it can be a very costly form of credit.
B. Aging Accounts Receivables
A common tool that credit managers use is called an aging schedule.
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The aging schedule shows the breakdown of the firm’s accounts receivable by their date of sale—how
long has the account not been paid in days.
Its purpose is to identify and then track delinquent accounts and to see that they are paid.
Aging schedules are also an important financial tool for analyzing the quality of a company’s
receivables.
The aging schedule reveals patterns of delinquency and shows where collection efforts should
be concentrated.
Exhibit 14.6 shows aging schedules for three different firms.
14.5 Inventory Management
Inventory management is largely a function of operations management, not financial management.
Manufacturing companies generally carry three types of inventory: raw materials, work in process, and
finished goods.
A. Economic Order Quantity
The economic order quantity (EOQ) mathematically determines the minimum total inventory cost,
taking into account reorder costs and inventory-carrying costs.
The optimal order size strikes the balance between these two costs.
Equation 14.5 shows how to calculate EOQ.
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EOQ=√2 x Reorder costs x Sales per periodCarrying costs
Note: The EOQ model makes the following assumptions: (1) that a firm’s sales are made at a constant rate over a period, (2) that the cost of reordering inventory is a fixed cost, regardless of the number of units ordered, and (3) that inventory has carrying costs, which includes items such as the cost of space, taxes, insurance, and losses due to spoilage and theft.
Example: Jackson Electricals is one of the largest dealers of generators in Phoenix and sells about 2,000 of them a
year. The cost of placing an order with their supplier is $750, and the inventory-carrying costs are $170 for each
generator. They like to maintain safety stock of 15 at all times.
a. What is the firm’s EOQ?
EOQ=√2×Reorder costs×Sales per periodCarrying cos ts
=√2×$750×2 , 000$ 170
=132 . 8422
Economic order quantity = 132.8422 = 133 generators
b. How many orders will the firm need to place this year?
Number of orders the firm needs to place = 2,000 / 133 = 15.0376 = 15 orders