Working Capital Managent

Working Capital Terminology

Working Capital Management
The management of short-term assets
(investments) and short-term liabilities
(financing sources)

Working Capital Terminology

Working Capital
A firms investment in ST assets:
Cash
Marketable securities
Inventory
Accounts receivable

Working Capital Terminology

Working capital includes only current

liabilities that are specifically used to
finance current assets
Working capital does not include
current liabilities that may be due in the
current period if they are due from longterm capital decisions, even though
these must be considered when
assessing the firms ability to meet its
current obligations

Working Capital Terminology

Net Working Capital
= Current assets - current liabilities
= amount of current assets financed
by long-term liabilities

NWC is usually growing with the

firm.
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Net Working Capital and Liquidity

Net Working Capital
Current Assets Current Liabilities
Positive when the cash that will be received over the
next 12 months exceeds the cash that will be paid out
Usually positive in a healthy firm

Liquidity
Ability to convert to cash quickly without a significant
loss in value
Liquid firms are less likely to experience financial
distress
But, liquid assets earn a lower return
Trade to find balance between liquid and illiquid
assets

The Relationships of Working

Capital Accounts
A decision affecting one working capital
account (e.g. inventory) will have an impact
on other working capital accounts (e.g.
receivables and payables).
If a firms operations are stable, the balance
in accounts receivable and accounts payable
can be computed using this equation:
Account
=
balance

)(

Amount of
daily activity

Average life of
the account

Examples of impact on working

capital accounts.
Purchase of raw materials determine an increase
of both inventories and accounts payable;
As we transform these raw materials into final
products, the total amount of inventories increase
with the cost of the services used to transform the
raw materials into final products and we have an
increase of accrued expenses;
As we pay our suppliers the accounts payable are
reduced;
As we sell our products (decrease in inventories)
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the accounts receivable increase;

The Cash Conversion Cycle

The length of time from the payment for

purchases of raw materials, to
manufacture a product, until the
collection of accounts receivable
associated with the sale of the product

The Cash Conversion Cycle

The Inventory Period
Length of time required to convert materials into
finished goods and then sell those goods
The amount of time the product remains in
inventory in various stages of completion
Inventory
Inventory
Inventory
=
=
period
Cost of goods Annual cost of goods sold

365

sold per day

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The Cash Conversion Cycle

The Receivables Period
Average length of time required to convert the
firms receivables into cash. Also called days
sales outstanding (DSO)

Receivables
period

Receivables

Average daily credit sales

Receivables

Annual credit sales

365

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The Cash Conversion Cycle

The Payables Period
Average length of time between the
purchase of raw materials and labor and the
payment of cash for them
Payables

Accounts payable

Accounts payable
=
=
Credit purchases per day Cost of goods sold
period

365

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The Cash Conversion Cycle

The Cash Conversion Cycle
Average length of time a dollar is tied up in
current assets
Cash
Inventory
conversion =
period
cycle

Receivables
Payables
_
period
period
+

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The Efficient Management of Cash

The Operating Cycle (OC) is the time between
ordering materials and collecting cash from
receivables.
The Cash Conversion Cycle (CCC) is the time
between when a firm pays its suppliers (payables)
for inventory and collecting cash from the sale of
the finished product.
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The Efficient Management of Cash

Both the OC and CCC may be computed
mathematically as shown below.
Operating Cycle (OC) = Inventory conversion period (ICP) +
Receivable Collection Period (RCP)
Cash Conversion Cycle (CCC) = Operating Cycle (OC) Payable Period (PP)
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The Efficient Management of Cash

MAX Company, a producer of dinnerware, sells all its
merchandise on credit. The credit terms require
customers to pay within 70 days of a sale. On average, it
takes 85 days to manufacture, warehouse, and ultimately
sell a finished good. In other words, the average age of
Inventory (IP) is 85 days. It also takes an average of 70
days to collect on its accounts receivable (RP).
Substituting IP = 85 days and RP = 70 days into the into
the OC equation (OC = ICP + RP), we get OC = 85 + 70 =
155 days.
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The Efficient Management of Cash

Continuing with the example, assume that the credit
terms for MAXs raw material purchases currently
require payment within 40 days and employees are paid
every 15 days. The firms weighted average payment
period (PP) for raw materials and labor is 35 days.
Substituting APP days into the CCC equation (CCC = OC
- PP), we get CCC = 155 - 35 = 120 days.

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The Working Capital Management

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The Working Capital Management

Managing the Cash Conversion Cycle
In this example, MAX (like most companies) has a
positive CCC.

As a result, the company will have to finance this period

using some combination of short-term financing such as
a line of credit or revolving credit agreement.

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Ways of improving CCC

shortening the IP;

shortening the RP;

lengthening the PP;

some combination of the above.

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Ways of short term financing

collect early and pay late

Spontaneous Financing
accounts payable that arise spontaneously
in day-to-day operations (trade credit,
wages payable, accrued interest and
taxes)

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Ways of short term financing

Trade credit (increasing the account payable)

Increase the other accruals;

Factoring (finance 90% of the invoice value);

Credit on commercial papers;

Seasonal working capital loans (inventory loans);
Open credit lines

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Short-Term Financing
- Accrued liabilities Continually recurring short-term liabilities,
such as accrued wages or taxes.
Is there a cost to accrued liabilities?
They are free in the sense that no explicit
interest is charged.
However, firms have little control over the
level of accrued liabilities.
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Short-Term Financing
-Trade credit Trade credit is credit furnished by a firms
suppliers.
Trade credit is often the largest source of
short-term credit, especially for small
firms.

Spontaneous, easy to get, but cost can

be high.

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Short-Term Financing
- Commercial paper (CP) Short-term notes issued by large companies
with a good credit rating.
CP trades in the market at rates just above
T-bill rate (depends on the issuing
companys risk).

CP is bought with surplus cash by banks

and other companies, then held as a
marketable security for liquidity purposes.
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Advantages of
Short-Term Financing
Speed
A short-term loan can be obtained much
faster than long-term credit

Flexibility
For cyclical needs, avoid long-term debt
Cost of issuing long-term debt is higher
Penalties for payoff prior to maturity
Restrictive covenants
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Advantages of
Short-Term Financing
Cost of Long-Term versus
Short-Term Debt
Yield curve is generally upward sloping
Short term interest rates are generally lower
than long-term rates

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Disadvantages of
Short-Term Financing
Risk of Long-Term versus
Short-Term Debt
Short-Term Debt subjects the firm to more
risk than long-term debt
Short-term interest expenses fluctuate
Firm may not be able to repay short-term debt and
be forced into bankruptcy

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The cost of trade credit

- example A firm buys within a financial year raw materials
of $550000 and can get 1% financial discount if
it pays within 10 days.

The firm can forego discounts and pay on Day

40, without penalty.

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The cost of trade credit

- example Firm buys goods worth $550000. Thats the cash
price.
If the firm pays in 10 days it can pay 550000 less
55000 the financial discount it gets, if not the firm will
pay the cash price 550000.
Think of the $55000 extra payed if the payment is
made after 10 days as a financing cost similar to the
interest on a loan.
In order to compare the cost of a bank loan and a
trade credit we should anualize the cost of the trade
credit.
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Nominal trade credit cost formula

Discount % Cash Price

365 days

100
Cash Price - Discount % Cash Price Payment period - Discount period
Discount %
365 days
=

100
1 - Discount % Payment period - Discount period
55000
365
1
365
=

100 =
100 = 12.29%
550000 - 55000 40 - 10
99 40 - 10

k TC =

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The cost of credit on commercial papers

- Example A company has $300000 commercial papers.
The bank it offers a credit for 30 days (including
three banks days) with an annual interest rate of
13,2%.
The interest to be payed for the credit on
commercial paper
Interest =

13,2% 300000 30
= $3254,8
365

The cost of the credit

kCP

3254,8
365
=

100 = 14,83%
300000 - 3254,8 30 - 3

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Quick Quiz (I)

Which is the significance of the length of
operational cycle and cash conversion
cycle?
What means a negative cash conversion
cycle? It is a good situation for the
company?
Which are the factors that determine the
cost of trade credit?
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Quick Quiz (II)

Wich firm is more likely to have a longer
cash conversion cycle: a car
manufacturer, a retailer, a software
company?
Do you think a firm is more likely to
receive a loan to cover its working capital
needs if increases in working capital result
from increases in receivables or increases
in inventories? Explain.
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Quick Quiz (III)

The companys policy was not to take the discount
offered by its suppliers if it pays its invoices in 15 days from
delivery.
The suppliers offer was the following: if Topeka pays
in 15 day from delivery will get 3% discount at its invoices,
otherwise the payment of the whole amount of invoices can
be made in 80 day from delivery.
The companys management made a good decision
by not accepting the discount and paying at term the
companys invoices if the interest rate for a bank loan is
9.5%? Make calculus and justify your answer!

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Quick Quiz (IV)

The firm ABC when got offers from its
supliers to pay its invoices in terms 2/10,
net 30 the firm was always taken the
discount. Does this makes financial sense,
if the interest rate for short term credits is
10%?

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