CFA Level I Corporate Finance

Working Capital Management

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 Contents
1. Introduction
2. Managing and Measuring Liquidity
3. Managing the Cash Position
4. Investing Short-Term Funds
5. Managing Accounts Receivable
6. Managing Inventory
7. Managing Accounts Payable
8. Managing Short-Term Financing

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 1. Introduction

Working capital management involves managing the relationship between a firm's

short term assets and its short term liabilities

The goal of effective working capital management is to ensure that a company has
adequate ready access to the funds necessary for day to day operating expenses

Several factors impact working capital needs

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Internal and External Factors That Affect Working Capital Needs

Internal Factors External Factors

Company size and growth rates Banking services

Organizational structure Interest rates

Sophistication of working capital New technologies and new products

management

Borrowing and investing positions, The economy

activities and capacities

Competitors

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 2. Managing and Measuring Liquidity
Liquidity is the extent to which a company is able to meet its short term obligations
using assets that can be readily transformed into cash. Liquidity management refers
to the ability of an organization to generate cash when and where needed

Primary Sources of Liquidity Secondary Sources of Liquidity

Cash balance Negotiating debt contracts

Trade credit Liquidating assets

Short term investment portfolio Filing for bankruptcy protection

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 Drags and Pulls on Liquidity
Cash receipts and disbursements effect a companys liquidity position

Pull on liquidity: disbursements

Drag on liquidity: receipts lag are paid too quickly or trade
credit is limited
Uncollected receivables
Payments made early
Obsolete inventory
Reduced credit limits

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 Measuring Liquidity
Liquidity contributes to a companys creditworthiness; creditworthiness is the
perceived ability of the borrower to pay what is owed in a timely manner

High creditworthiness allows a company to

obtain lower borrowing costs
obtain better terms for trade credit
have greater flexibility
exploit profitable opportunities

Liquidity ratios measure a companys ability to meet short-term obligations

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 Liquidity Ratios: Current, Quick and RTO
Ratio Numerator Denominator

Current ratio Current assets Current liabilities

Cash + short term

Quick ratio marketable securities + Current liabilities
receivables
Receivable
Credit sales Average receivables
turnover

Number of days of
365 Receivable turnover
receivables

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 Liquidity Ratios: ITO and PTO
Ratio Numerator Denominator

Inventory turnover Cost of goods sold Average inventory

Number of days of
365 Inventory turnover
inventory

Payables turnover ratio Purchases Average trade payables

Number of days of
365 Payables turnover ratio
payables

Example 1: Liquidity improving but still below industry average

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 (Net) Operating Cycle
Operating cycle = days of inventory + days of receivables

Cash conversion cycle = Net operating cycle =

average days of receivables + average days of inventor - average days of payables

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 3. Managing The Cash Position
Purpose of managing a firms daily cash position is to make sure there is sufficient
cash(target balance)
Do not want low or negative balances because it is expensive to borrow cash on short notice
Do not want unnecessarily high case balances either

Companies should recognized the major sources of cash inflows and outflows in
order to forecast and manage cash position

Outflows:
Inflows:
Payments to employees
Receipts from operations
Payments to suppliers
Fund transfers from subsidiaries
Other expenses
Maturing investments
Investments
Other income
Debt payments
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 4. Investing Short-Term Funds
A temporary store of funds that are not necessarily needed in a companys daily
transactions

Short term working capital portfolios consist of securities that are highly liquid, less
risky and shorter in maturity than other types of investment portfolios

Generally working capital portfolios consist of short term government securities,

and short term bank and corporate obligations

Exhibit 7 Examples of Short Term Investment Instruments

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 Yield on Short-Term Investment
A 90-day $100,000 U.S. T-bill was purchased at a discount rate of 4%. Calculate the
money market yield and bond equivalent yield.

Yield Formula

Discount basis yield (F P) / F x (360/T)

Money market yield (F P) / P x (360/T)

Bond equivalent yield (*) (F P) / P x (365/T)

(*) In Quant we studied that BEY = 2 x semi-annual yield

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 Strategies and Evaluation
Objective: Earn reasonable return while taking on limited credit and liquidity risk

Create investment policy statement. This should identify the purpose, authorities,
limitations and/or restrictions, etc.
Exhibit 9 and Example 3

Short-term strategies can be passive or active

Passive strategies focus on rules; safety and liquidity are prioritized
Active strategies are more aggressive and require constant monitoring; types of active strategies
include matching, mismatching and laddering

Evaluate short-term funds management

Compute weighted average of bond equivalent yields of all investments and compare with
short-term benchmark rate (Exhibit 10)
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 5. Managing Accounts Receivables
Three primary activities in accounts receivable management
Establishing credit terms; granting credit and processing transactions
Monitoring credit balances
Measuring performance

Trade off between stricter credit terms and the ability to make sales

Managing customers receipts

Electronic funds transfer
Lockbox: Customer payments mailed to post office box and bank collects
Float factor is good measure for check deposits; float factor = Avg. daily float / Avg. daily deposit

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 Evaluating Receivables Management
Many ways of measuring accounts receivable performance; most deal with how effectively outstanding
receivables can be converted into cash. A simple measure is number of days of receivables but this
does not consider the age distribution within the outstanding balance

Days outstanding Jan Feb Mar Days outstanding Jan Feb Mar
< 31 days 2000 2120 1950 < 31 days 40% 39% 40%
31 60 days 1500 1650 1400 31 60 days 30% 31% 28%
61 90 days 1000 900 920 61 90 days 20% 17% 19%
> 90 days 500 700 660 > 90 days 10% 13% 13%

Days outstanding Avg. collection days % weight Days x weight

< 31 days 15 40% 6.0 Weighted average collection
31 60 days 45 30% 13.5 period for Jan: 46.5
61 90 days 75 20% 15.0
> 90 days 120 10% 12.0

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 6. Inventory Management
Inventory represents a significant cost for many companies and needs to be
managed

Inventory levels that are too low will result in loss of sales due to stock-outs; high
inventory levels means excess capital is tied up in inventory.

Two broad approaches to managing inventory:

Economic order quantity reorder point
Just in time inventory

Evaluating inventory management

Inventory turnover and days of inventory Example 5
Consider changes over time and relative to industry

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 7. Managing Accounts Payables
A/P represents an important source of funds and should be managed well
Paying too early is costly unless the company can take advantage of discounts
Late payment impact a companys perceived credit-worthiness
Evaluate A/P management using PTO and number of days of payables

Example: Assume a firm purchases on credit and the terms are 2/10, Net 30. What is
the cost of not taking the discount if the payment is made on the 30th day.

Example 6
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 8. Managing Short-term financing
Short-term financing strategy should focus on ensuring that a company maintains a
sound liquidity position
Ensure sufficient capacity to handle peak cash needs
Maintain sufficient sources of credit (alternate sources)
Ensure rates are cost effective

Short-term borrowing could be from banks or from non-bank sources

Bank sources include uncommitted lines of credit, committed lines of credit,
revolving credit arrangements
Companies that do not have sufficient credit quality could borrow from other
financial institutions using asset-based loans
Commercial paper and bankers acceptance can also be used for short-term financing

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 Computing Cost of Borrowing
You need to borrow $1 million for one month and have the three options shown
below. Which one represents the lowest cost?
1. Drawing down on a line of credit at 5.5% with a 0.5% commitment fee on the full
amount. Note: 1/12 of the commitment fee is allocated to the first month
2. A bankers acceptance at 5.75%, an all inclusive rate
3. Commercial paper at 5.15% with a dealers commission of 0.125% and a backup
line cost of 0.25%, both of which would be assessed on the $1 million commercial
paper issued.

Example 7
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 Summary
Managing and Measuring Liquidity

Managing the Cash Position

Investing Short-Term Funds

Managing Accounts Receivable

Managing Inventory

Managing Accounts Payable

Managing Short-Term Financing

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 Conclusion
Read summary

Review learning objectives

Examples are good

Practice problems: good but not enough

Practice questions from other sources

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