Lecture

9 & 10

MANAGEMENT OF WORKING CAPITAL

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 Learning Outcomes

At the completion of this session, participants will be able to:

Identify the main elements of working capital.

Discuss the purpose of working capital and the nature of the working capital cycle.

Explain the importance of establishing policies for the control of working capital.

Explain the factors that have to be taken into account when managing each element of the
working capital.
 Management of Working Capital
Financial management is also concerned with the funding and control of Working Capital
How should funds be provided to finance the current assets
Is there an ideal size of investment in working capital? If so, what are the consequences of
having too much or too little working capital
The efficient management of working capital (i.e. cash, debtors, creditors and stocks) is
important from the point of view of both liquidity and profitability.
Poor management of working capital means that funds are unnecessarily tied up in idle assets
hence reducing liquidity and also reducing the ability to invest in productive assets such as plant
and machinery hence affecting profitability.
 Objectives of working capital
The two main objectives of working capital management are to ensure it has:
Sufficient liquid resources to continue in business and
Increase its profitability

Every business needs adequate liquid resources to maintain day-to-day cash flow.
It needs enough to pay wages, salaries and accounts payable if it is to keep its workforce and
ensure its supplies.
Liquidity
Although profitability and the selection of good investments are the keys to the prosperity of a
firm in the long term, it is the liquidity that ensures a firms shortterm survival.
A companys liquidity position is often assessed using financial ratios. Although ratios can be
criticized as being largely arbitrary and therefore of little use, it remains true that banks and
credit agencies use them in assessing a companys financial strength.
Therefore, financial ratios should be of concern to management. The most widely used ratios
are:
Liquidity ratios
Current ratio :
The ideal current ratio is given as 2:1 and anything lower than this amount indicates
poor liquidity.

Quick ratio :
The quick ratio is supposed to give a better indication of liquidity since it excludes stocks
that are not immediately realizable. The ideal ratio is given as 1:1.
Define Working Capital and Net Working Capital

Working Capital
Current Assets Current Liabilities
Cash Accounts Payables
Marketable Securities
Accounts Receivables
Notes Payables
Inventories Accrued Liabilities

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Net Working Capital

NWC CA - CL

Working Capital consists of short-term balance sheet items such as current assets and
liabilities.
Current assets include cash, marketable securities, accounts receivables and inventories.
Current liabilities include accounts payables, notes payables and accrued liabilities.
Net working capital is the difference between current assets and current liabilities.

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Understand the importance of working capital
management

Risk Return
Manage Liquidity Risk Manage Returns
Use CA to pay CL Liquid assets has poor returns
Need to balance risk with
return

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Understand the importance of working capital
management
Firms need to have enough current assets to pay off its current liabilities.
To reduce the liquidity risk, firms would like to have more current assets to cover
the current liabilities.

However, current assets have very low returns.

Firms need to balance the risk return tradeoffs in managing its working capital.

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NWC > 0
When we have more current assets than current liabilities, we have a positive net
working capital.

Hence, we have ample liquidity which will reduce the firms liquidity risk.

However, as current assets generate low returns, this strategy will also result in lower
returns.

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 CA > NWC >
CL 0

Low Low
Risk Return

Current Current Liabilities Low Cost

Low Returns
Assets
LT Debt High Cost

High Fixed
Returns Assets Equity Highest Cost

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NWC < 0
When we have more current liabilities than current assets, we have a negative net working capital.

Hence, we do not have sufficient liquidity.

This will increase the firms liquidity risk.

However, as we are using more current liabilities which cost less, this strategy will also result in
higher returns.

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 CA < NWC
CL < 0

High High
Risk Return

Current
Assets Current Liabilities Low Cost
Low Returns

LT Debt High Cost

Fixed
High Returns Assets
Equity Highest Cost

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Define cash & marketable securities
Cash

Money
Immediate Access
No returns or very low returns

Marketable Securities

Highly liquid securities

Treasury Bills
Certificates of Deposits
Maturity < 1 year
Can be converted to cash easily
Low returns

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Cash and market securities

Cash is money that you can get immediate access to. It could be in physical form, such as bank notes
or coins, or such as the savings deposits that you have in a bank.

If it is in a physical form, it will not generate any returns. Savings deposits have very low returns as it
can be withdrawn anytime. Cash is considered to be the most liquid asset class.

Marketable Securities are highly liquid securities which can be converted to cash easily.

They have better returns than cash. So, there are good reasons to hold cash. However, cash has little
or no returns. Hence, we would only keep enough cash for our requirements.

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Objectives & motives of holding cash & marketable securities

Need for payments

Cash No returns
Aim to reduce to minimum

Marketable More returns than cash

Securities Yet still very liquid

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Marketable Securities
Securities that can be easily converted into cash. Such securities will generally have
highly liquid markets allowing the security to be sold at a reasonable price very quickly.

Examples of marketable securities include Treasury bills and Certificate of Deposits.

Marketable securities are very liquid as they tend to have maturities of less than one
year.

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Motives for holding cash

Transactional Motive
To dispense with cash needs that arise in the ordinary course of
Transactional business. Cash is necessary in order that a company can conduct
its business. It is needed to pay wages, suppliers etc.
Precautionary Motive
Precautionary To meet unexpected fund needs. Cash inflows and outflows
cannot be predicted with certainty and therefore a company will
have to keep a certain amount of cash in reserve in case of
Speculative unanticipated fluctuations.
Speculative Motive
To take advantage of profit-making situations. Cash may also be
held in anticipation of making future investment decisions e.g. in
fixed assets or future takeovers.

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Term finance - long or short term capital?
One of the major problems in managing working capital is the decision whether to finance with
long-term or short-term capital.
The general rule regarding the length of a companys finance is that it should match the maturity
of the investments.
Fixed assets with a long maturity would therefore require long-term finance
Working capital is usually seen as a short-term investment with a maturity of less than 1
year, it would be appropriate solely to use short-term finance.
Although short-term finance is more risky than long-term finance, it is usually cheaper because
there is less commitment on the part of the investor. It is also much more flexible since if less
finance is required it can easily be repaid.
Most firms will finance working capital using a combination of long-term and short-term finance.
 Funding strategies - Conservative Approach &
Aggressive Approach
There are two financing strategies in working capital management:

The first strategy is the Conservative Approach. Here, the firm looks at the maximum funding
requirement on a monthly basis, and then borrows this amount throughout the twelve months of
the year. As the amount borrowed for each month does not change, this is a permanent form of
financing. The firm would have to borrow at the long term rate, which cost more than the short
term rate.

The second strategy is the Aggressive Approach. Here, the firm looks at the minimum funding
requirement on a monthly basis, and then borrows this amount throughout the twelve months of
the year. As the amount borrowed for each month does not changed, this is a permanent form of
financing. The firm would have to borrow this permanent portion at the expensive long term rate.
The balance of the funding requirements that is above the minimum permanent requirements
would be considered as seasonal funding requirements, which will be funded by the cheaper short-
term rate.

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Financing Strategies and its impact on
profitability and risk

Conservative Aggressive
Borrow maximum
Borrow minimum Borrow seasonal
requirements (Permanent
permanent requirements requirements
financing)

LT Expensive rate Expensive LT rate Cheap ST rate

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Financing Strategies and its impact on
profitability and risk

Conservative Aggressive

Return Risk Return Risk

Low Low High High

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Financing Strategies and its impact
on profitability and risk

The Aggressive Approach has a lower cost of financing than the Conservative
Approach.

Hence, this lower cost of financing allows the firm using the Aggressive Approach
to have a higher return.

However, its dependence on cheap short-term funds to finance its seasonal needs
means it runs the risk of not being able to borrow the required amount or at a
favorable rate when the need arises.

If the interest rate rises drastically or if there is a shortage of funds in the market,
the firm will have to pay very high short-term rates.

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Example: Aggressive versus
Conservative Funding Strategies
Total Funds
Requirements
Month
January $2,000,000
February 2,000,000
$16,000,000

$14,000,000 March 2,000,000

$12,000,000 April 4,000,000
$10,000,000
May 6,000,000
$8,000,000

$6,000,000 June 9,000,000

$4,000,000 July 12,000,000
$2,000,000
August 14,000,000
$0

November
May

July
January

March

June

December
September
April
February

August

October September 9,000,000

October 5,000,000
November 4,000,000
December 3,000,000

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Example: Aggressive versus Conservative Funding
Strategies
Under a conservative strategy:
the firm would borrow at the peak need level of $14,000,000 at the long-term rate.

Under an aggressive strategy:

the firm would borrow according to the seasonal requirement schedule shown at the short-
term rate.
The firm would borrow $2,000,000, or the permanent portion of its requirements, at the
long-term rate.

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 CONSERVATIVE STRATEGY

No borrowings to
make up for
Total Funds Maximum Seasonal
Month Requirements Requirements Requirements
January $2,000,000 $14,000,000 $0
February 2,000,000 $14,000,000 $0
March 2,000,000 $14,000,000 $0
April 4,000,000 $14,000,000 $0
May 6,000,000 $14,000,000 $0
June 9,000,000 $14,000,000 $0
July 12,000,000 $14,000,000 $0
August Max 14,000,000 $14,000,000 $0
September 9,000,000 $14,000,000 $0
October 5,000,000 $14,000,000 $0
November 4,000,000 $14,000,000 $0
December 3,000,000 $14,000,000 $0
SUM 72,000,000 168,000,000 0

Borrow at maximum (permanent) $14m for the year 27

 AGGRESSIVE STRATEGY

Min: $2,000,000 (Permanent)

Max: $14,000,000
Total Funds Permanent
Month Requirements Requirements Seasonal Requirements
January $2,000,000
February Min 2,000,000
March 2,000,000
April 4,000,000
May 6,000,000
June 9,000,000
July 12,000,000
August Max 14,000,000
September 9,000,000
October 5,000,000
November 4,000,000
December 3,000,000
SUM 72,000,000
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 AGGRESSIVE STRATEGY

Total Funds Permanent Seasonal

Month Requirements Requirements Requirements
January $2,000,000 $2,000,000 $0
February 2,000,000 2,000,000 0
March 2,000,000 2,000,000 0
April 4,000,000 2,000,000 2,000,000
May 6,000,000 2,000,000 4,000,000
June 9,000,000 2,000,000 7,000,000
July 12,000,000 2,000,000 10,000,000
August 14,000,000 2,000,000 12,000,000
September 9,000,000 2,000,000 7,000,000
October 5,000,000 2,000,000 3,000,000
November 4,000,000 2,000,000 2,000,000
December 3,000,000 2,000,000 1,000,000
SUM 72,000,000 24,000,000 48,000,000

Average minimum (permanent) requirement = $24,000,000 / 12 = $2,000,000 per month

Average seasonal requirement = $48,000,000 / 12 = $4,000,000 per month 29
Example: Aggressive versus Conservative Funding Strategies
Given: Cost of long-term funds at 17%, short-term funds at 12%
Conservative
= ($14,000,000 0.17)
= $2,380,000

Aggressive
= ($2,000,000 0.17) + ($4,000,000 0.12)
Avg. Permanent Avg. Seasonal

= $340,000 + $480,000
= $820,000

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 Aggressive Conservative

Permanent Long-term funds Long-term funds

requirements (expensive) (expensive)

Seasonal Short-term funds Long-term funds

requirements (cheap) (expensive)

Cost of funding Lower cost More costly

Returns
Higher Returns Lower Returns
Risk Higher Risk Lower Risk

May have difficulty obtaining Minimum since all funding

funds during seasonal peaks. requirements have been
Interest Rate rises. borrowed

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Operating Cycle (OC) and Cash Conversion Cycle (CCC)
The Operating Cycle (OC) starts from the time we order the inventory to the time we collect the
accounts receivables from the sale of the finished goods.

The Cash Conversion Cycle (CCC) starts from the time we pay off the accounts payable in cash to the
time we receive cash from our accounts receivables.

A longer cash conversion cycle (CCC) will generally indicate higher financing cost.
Attention should be paid more to the individual components to reduce the length of the cycle.

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Operating Cycle (OC) and Cash Conversion Cycle (CCC)

The Average Age of Inventory (AAI) starts from the time we order the
inventory to the time we sell off the finished goods on credit.

The Average Collection Period (ACP) starts from the time these accounts
receivables were created from the credit sales to the time we collect cash from
these receivables.

The Average Payment Period (APP) starts from the time of the credit purchase
to the time we pay off these accounts.

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Managing the Operating and Cash Conversion Cycles to ensure efficient cash
management and thereby contributing toward maximization of shareholders
wealth

OC

AAI ACP

cash

APP CCC
C
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a
s
h
 1
OC

AAI ACP

Buy Inventory on
Credit = AP
cash

APP CCC
C
a
Account s
Payable h 35
2
OC

AAI ACP

cash

APP CCC
C
a
s
PAY Account Payable
h 36
3
OC

AAI ACP

Sold Inventory on
Credit = cas
AR h

APP CCC
C
a
s
h 37
4
OC

AAI ACP

Collect Cash from

Accounts Receivables
cash

APP CCC
C
a
s
h 38
Operating Cycle (OC) and Cash Conversion Cycle (CCC)
When we purchase inventory, we purchase them on credit, which generates the accounts
payable.

Average Payment Period starts from the time of the credit purchase to the time we pay off
these accounts payable in cash.

The Cash Conversion Cycle starts from the time we pay off the accounts payable in cash to the
time we receive cash from our accounts receivables.

OC = AAI + ACP
CCC = OC - APP
CCC = AAI + ACP - APP

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Reducing CCC

The longer the C. C. C., the longer we have to fund the negative cash flow.

This will result in higher financing costs. Hence, it is in the companys interest to shorten the
Cash Conversion Cycle so as to reduce the financing costs.

We can reduce the Cash Conversion Cycle by either shortening the AAI or ACP or lengthening
APP (or a combination of these).
 Management of debtors Account receivable
management

The importance of accounts receivable investment

Financing of
Sale on Credit Accounts
Receivables

Account
Receivables Incur cost
increased

The longer the ACP, the higher the financing cost

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Management of debtors Account receivable
management

Suppose all the sales to our customers are done with granting the customer credit.
This means that the customer can delay paying us with cash.

In our books, these unpaid accounts are known as Accounts Receivables, which are short term
assets.

As these short term assets have to be financed, we would incur additional financing costs.
The longer it takes for our firm to collect from our customers, the more cost it will incur for us.

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5 Cs in credit selection and Credit policy
Credit
Policy

Character Credit
Relax Tight
Terms
Capacity
Dollar
amount
Capital
Time/
Period
Collateral
Discounts
Conditions
Penalties

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5 Cs in credit selection
When we are considering the credit terms to our customers, we can use the 5 Cs of credit to evaluate the
appropriateness:
If these customers are existing customers, where they have a record with us on their payment patterns, we
can use this record to help us assess their Character.
Next, we wish to see the ability of the customer to pay what it owes. We can use their financial statements
to assess their Capacity to repay the requested credit.
Thirdly, we assess the customers Capital to see the degree of indebtedness it has. The more debt the
customer has, the less likely that the customer can repay the requested credit.
Fourth, we can consider the amount of Collateral that the customer can put up. The higher the collateral
amount, the more credit we can grant.
Lastly, we consider the general business Conditions, where the better the conditions are, the more likely
that the customers can repay. Hence, the more credit we can grant.

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Evaluate the effects of changing the credit/collection policy
RELAX

ACCOUNTS BAD DEBT

SALES GOODS SOLD ON
CREDIT RECEIVABLES EXPENSE

PROFITS PROFITS
PROFITS

CAN SELL MORE TO LOWER A/C RECs are ASSETS (LHS). POORER QUALITY CREDIT
CREDITWORTHY CLIENTS Need to Finance MORE with CUSTOMERS DEFAULT AND
LIABILITIES [COST UP](RHS). DONT PAY
 Credit policy - Relax
As the firm relaxes its credit policy, it gives more credit to those customers with poorer
credit scores.
As a result, sales would go up, resulting in an increase in profits.
However, the increase in sales also means that the accompanying accounts receivables
would also increase.
This will result in higher funding costs, and reduces profits.
Lastly, the firm would also incur a higher bad debt expense, due to more defaults from poor
credit scoring customers.
This will reduce its profits

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Evaluate the effects of changing the credit/collection policy
TIGHTEN
GOODS SOLD ON
CREDIT
ACCOUNTS BAD DEBT
SALES
RECEIVABLES EXPENSE

PROFITS
PROFITS PROFITS

CANNOT SELL TO LOWER A/C RECs are ASSETS (LHS). BETTER QUALITY CREDIT
CREDITWORTHY CLIENTS Need to Finance LESS with CUSTOMERS WILL PAY ON
LIABILITIES [COST TIME
DOWN](RHS).
Credit policy - Tighten
As the firm tightens its credit policy, it gives less credit to those customers with poorer credit
scores.
As a result, sales would go down, resulting in a decrease in profits.

However, the decrease in sales also means that the accompanying accounts receivables
would also decrease.
This will result in lower funding costs, and increases profits.

Lastly, the firm would also incur a lower bad debt expense, due to less defaults from poor
credit scoring customers.
This will increase its profits.

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 Account receivable management
Manage accounts receivables through collection efforts and aging of receivables

Credit Monitoring

ACP Aging of AR
Time taken to Shorten ACP to Monitor those
Collection Reminders to
collect AR when keep in line with overdue Penalties
agency customers
they are due credit terms accounts

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Average Collection Period
After we have given our customers credit for the sale of our goods, we must monitor our collection
efforts.

A good collection policy would reduce the amount of uncollected accounts.

First, we check on the length of time taken for the customers to pay. The longer it takes, the longer
will be the Average Collection Period.

We have to compare this with the credit period that we have given to our customers.

If we are unable to effectively collect these accounts receivables, we may have to pay a collection
agency to help us in collecting the cash due to us.

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Aging Schedule

Next, we can use the aging schedule to help us check on those overdue accounts which are
not paid within the credit period.

We can send reminders to these customers.

In more extreme cases, we may have to impose penalties to discourage future late payments.

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Aging Schedule of Accounts Receivables
AGE BALANCE OUTSTANDING PERCENTAGE

LESS THAN 30 DAYS $ 50,000 50%

(CURRENT)
31 TO 60 $ 15,000 15

61 TO 90 $ 20,000 20

91 TO 120 $ 10,000 10

OVER 120 DAYS $ 5,000 5

TOTAL $ 100,000 100%

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Collection of debts
Having decided upon granting credit and what the terms are to be, a company will then need
to ensure that the cash is received as quickly as possible after the credit period has elapsed.
Chasing bad debts can be expensive, particularly where small amounts are involved;
the benefits of obtaining more prompt payment should be weighed up against the costs
incurred.
Chasing debtors will, as a rule, initially involve sending statements and reminders
followed by telephone calls and possibly personal visits. Ultimately legal action can be
used, although the costs can be high.
The steps that are taken to recover overdue debts should be applied promptly.
Some Collection Techniques (for Accounts Receivables)

Letter Polite Reminder

Ask immediate payment

Telephone Call Any reasonable excuse?

Visit Personal visit

Professional debt collectors

Collection Agencies High Fees

Legal Action Law Suit

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Small claims tribunal and the legal
proceeding on debt recovery

As consumers typically buys on credit, there may be instances

Consumers where the consumers would not pay the suppliers, even after
the credit period. As such, suppliers usually have to sue the
consumers for the debt.

This can be a very expensive legal affair, involving lawyers and

court time. For claims that are below ten thousand dollars, the
Forum supplier can use the Small Claims Tribunal forum to resolve
the issue.

Mediator Suppliers This is a quick and inexpensive way where a mediator can
assist the consumer and supplier to come to an acceptable
solution.

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Accounts payable management
Many firms offer a cash discount to customers if payment for goods is made within a few days,
usually 7 days instead of the normal 30 days.
A company may, offer a discount of 2% for payment within 10 days while granting a normal
credit period of 40 days. This is sometimes written as 2/10 net 40.
One of the problems of obtaining finance using discounts is that the purchaser must find the
discount attractive enough to think that early payment is justified.
Accounts Payable Management
Buy Goods on Credit
Pay AP
AP

Credit Period

Stretch

When we buy goods, our supplier would usually give us some time before we need to pay for the goods.
The time delay for us to repay the accounts payable is known as the credit period.
As payers, we would like to delay, or stretch the payment period, for as long as possible, without hurting
our credit ratings.

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Accounts Payable Management

Terms offered by suppliers

Credit Terms Allow buyers to delay payment

Encourage buyers to pay earlier

Cash Discount Can be annualised for comparison

Take discount and pay earlier

Buyers Strategy Give up discount and pay on due date

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 Credit Terms

2 / 10 net 30
Discount Discount Credit
percentage period period

2% 10 days 30 days

2% discount from original invoice amount if payment made within 10 days,

Otherwise, pay the full amount within 30 days

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Example: Firm makes $100 Purchase: Credit term 2/10 net 30
Cash Discount Period Ends; Credit Period Ends;
Pay $98 Pay $100

Credit Period Begins

Mar 1st Mar 10th Mar 30th

Cost of Additional 20 Days = $100 - $ 98 = $2

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What is the cost of the discount?

Cost of discount = Discount/(100 Discount) X 365/(Credit Period Discount Period)

= 2/(100-2) X 365/(30-10)
= 37.24 %

We should always take up the discount if we can borrow at a lower rate (e.g. 10%) from the
bank.
We can borrow at a lower rate to take advantage of the cash discount.

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Analyzing credit terms - Should take up cash discount?

Decision:
v If cash discount > bank rate : TAKE DISCOUNT
Borrow from bank at lower rate, pay early to enjoy the discount
Pay $98 on the 10th day (last day of discount period)

v If cash discount < bank rate : GIVE UP DISCOUNT

Pay $100 on the 30th day (last day of credit period)

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Factoring

Factoring involves raising funds on the security of a firms debts.

Factoring companies are financial institutions often linked with banks.

If finance is also being provided by the factor, up to about 80 per cent of the value of
sales will be immediately paid over to the company
Advantages of factoring

It is an alternative source of finance that is particularly useful as a method of improving the

liquidity of companies that have large levels of debtors.

Useful for high-growth companies where the level of working capital increases at a much
faster rate than cash can be generated internally

The factor may well be able to manage a companys sales ledger more efficiently than the
company itself could. A factor will employ specialist staff to assess credit risk and to collect
overdue accounts, whereas small companies in particular would not be able to do this.
 Disadvantages of factoring

The finance raised may well be more expensive than other comparable sources such as a
bank overdraft.

The factor may be rather pushing when collecting outstanding debts and a company
might feel this could lose customers.

Factoring has in the past achieved a bad name since it was thought a company using a
factor must have liquidity problems and therefore be unstable but this is not so today since
all companies appreciate the problems of financing.
Managing inventories Economic order quantity (EOQ)

An economic order quantity (EOQ) can be calculated as a guide to minimising costs in

managing inventory levels.

Businesses could control inventories on a scientific basis by balancing the costs of

inventory shortages against those of inventory holding.

The economic order quantity (EOQ) model can be used to decide the optimum order size
for inventories which will minimise the costs of ordering inventories plus inventory holding
costs.
Managing inventories Economic order quantity (EOQ)
 Just-in-time (JIT) Procurement
Some manufacturing companies have sought to reduce their inventories of raw materials and
components to as low a level as possible.
Just-in-time procurement is a term which describes a policy of obtaining goods from suppliers at the
latest possible time (i.e. when they are needed) and so avoiding the need to carry any materials or
components inventory
Introducing JIT might bring the potential benefits of reduction in inventory holding costs
Reduced inventory levels mean that a lower level of investment in working capital will be required.