Lecture 3

• Working capital: Working capital (abbreviated WC) is a financial metric which

represents operating liquidity available to a business, organization, or other entity,

including governmental entity. Along with fixed assets such as plant and

equipment, working capital is considered a part of operating capital. Net working

capital is calculated as current assets minus current liabilities.

 NWC = CA – CL

• Current assets:

 Cash

 Cash equivalents

 A/R

 Inventory

 Marketable securities

 Prepaid

• Current liabilities:

 A/P

 Notes payable

 Accruals

 Current maturities of long-term debt

• Understanding liquidity:

Hi to Lo in terms of liquidity

 Cash
  Commercial paper

 Short-term bond

 MMI

 Capital market instruments

 Long-term bond

 Debenture

 Customized derivatives

• Working capital math:

1. Current ratio = CA / CL

2. Quick ratio = (CA – Inventories) / CL

3. Inventory turnover ratio = COGS / Average inventory

4. Payable turnover ratio = Purchases / Average payable

5. Days inventory held (DIH) = Inventory / (COGS / 365)

6. Days sales outstanding (DSO) = Receivables / (Sales / 365)

7. Days payable outstanding (DPO) = Payables / (COGS / 365)

• Understanding Accounts Receivable

 A/R usually accounts for the largest share of current assets

 It is considered as one of the highly liquid asset

 A/R is the outstanding balance that a customer owe to the business

 A/R arises from trade credit

Trade Credit vs. Bank Credit

Goods sold under delayed payment terms

Goods in exchange of PTP (Promise to pay)

For goods only

Usually no collateral except sold goods

Interest is built within the price

Short-term maturity

Bank lend money under certain terms

Loan-able fund backed up by collateral or good credit score

Money

Collateral is usually fixed assets of the borrower

Explicit interest policy

Long-term maturity

Trade Credit Dilemma

Necessary to increase sales

Effective to create customer loyalty

Source of customer data

Overinvesting in receivables can be costly

High A/R can create liquidity crisis

High A/R can reduce stockholder equity

Too stringent credit = Lost revenue

Too lax credit = Chance of default/delinquency