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Working Capital Management

Controlling cash, inventories, and receivables, plus short-term liability

Consists of (1) Managing Current Assets, and (2) Financing Current Assets
Gross Working Capital or Working Capital
Current Assets used in operations
These are the assets that turn over, where they are used and then replaced
all during the year.
Includes short-term assets: cash, cash equivalents, accounts receivables, and
Net Working Capital
Current assets Current liabilities
Current assets (Payables + Accruals)
Net Operating Working Capital
Operating current assets operating current liabilities.
Operating current assets are current assets used in operations (cash
A/R and inventory) and do not include short-term investments like
marketable securities.
Operating current liabilities

Working Capital Policy

A policy which decides the level of each type of current asset to hold,
and how to finance current assets.
1.Relaxed (Liberal) Current Asset Investment
A policy in which relatively large amounts of cash, marketable securities, and
inventories are carried and sales are stimulated by the use of a credit policy that
provides liberal financing to customers, resulting to a corresponding high level of
Appropriate if it leads to greater profitability
The firm will have ready current assets in case of contingencies and will have ready current assets to
use when good investment opportunities come their way.
Eliminates the firms exposure to fluctuating loan rates and potential unavailability of short-term
Less risk of stock-outs.
Low liquidity risk.
Less profitable because of higher fluctuating costs. Excessive working capital may lead to idle current
assets. There may be an opportunity cost involved because, had the company invested the current
assets which actually turned out to be idle, the firm could have been earning higher returns. (Risk
Return Trade-off: High risk = high return; Low risk = low return)
2.Restricted Current Asset Investment Policy
A policy in which holdings of cash, securities, inventories, and receivables are
Current assets are turned over more frequently, so each peso of current assets
is forced to work harder.
The company may be able to put its current assets to better use, earning higher returns
for the company.
Increases profitability by taking advantage of the cost differential between long-term and
short-term debt.
If forecasted financial statements are understated and the company adopts a highly
restricted policy, the company would have a hard time continuing its operations smoothly
and may not have the ability to meet short term obligations.
There is a risk of stock-out which leads to lost sales an opportunity cost.
When contingencies occur, the company will have difficulty overcoming such unexpected
The company may not be able to take advantage of good investment opportunities if it
doesnt have ample current assets to use invest in such projects.
High liquidity risk.
3.Moderate (Balanced) Current Asset
Investment Policy
A policy that is in between relaxed and restricted
It balances the trade-off between risk and profitability in
a manner consistent with its attitude toward bearing
1.Moderate Maturity matching or Self-
Liquidating Approach
A policy that matches the maturity of a financing
source with specific financing needs. It matches the
maturities of assets and liabilities.
Short-term temporary assets are financed with short-
term liabilities.
Short-term permanent assets and long-term assets
are funded by long-term financing sources.
2. Aggressive Approach
Finances temporary, permanent, and long-term assets from short-term debt/equity
Uses short-term financing to finance both short-term and long-term assets.
Greatest use of short-term debt.
Advantageous during periods of falling interest rates.
Cost of LT debt vs ST debt
As YC is normally upward sloping, ST interest rates are generally lower for ST debt.
Speed short term loan can be obtained much faster than long-term loan.
Flexibility for seasonal/cyclical needs, a firm doesnt want to commit to long-term debt due
Flotation costs per transaction are higher for long term debt
Long-term loan agreements always contain provisions or covenants that constrain the firms future
More illiquid than firms that adopt a conservative policy.
Disadvantageous during periods of rising interest rates leads to bankruptcy if firm cant meet
rising interest costs.
Default risk
Temporary recessions may render firms inability to repay short-term debt.
Lenders wont lend to companies whose financial position is weak.
3. Conservative Approach
Uses permanent capital for both permanent assets and temporary assets.
Uses long-term financing to finance both short-term and long-term assets.
Least use of short term debt.
More liquid than firms that adopt an aggressive policy.
Advantageous during periods of rising interest rates.
When financing short-term assets with long-term debt, company pays interest
for a long period and only benefits for a short period.
Disadvantageous during periods of falling interest rates.

Most firms tend to finance ST assets from ST

sources and LT assets from LT sources.
Rentz Corporation is investigating the optimal level of current assets for the
coming year. Management expects sales to increase to approximately $2 million
as a result of an asset expansion presently being undertaken. Fixed assets total $1
million, and the firm plans to maintain a 60% debt ratio. Rentzs interest rate is
currently 8% on both short-term and longer term debt (which the firm uses in its
permanent structure). Three alternatives regarding the projected current assets
level are under consideration: (1) a tight policy where current assets would be only
45% of projected sales, (2) a moderate policy where current assets would be 50%
of sales, and (3) a relaxed policy where current assets would be 60% of sales.
Earnings before interest and taxes should be 12% of total sales, and the federal-
plus-state tax rate is 40%.

Requirement 1: What is the expected return on equity under each current asset
Requirement 2: In this problem, we assume that expected sales are independent
of the current asset policy. Is this a valid assumption? Why or why not?
Requirement 3: How would the firms risk be affected by the different policies?
Management of Current Assets

Financing Current Assets

Marketable Securities
Accounts Receivable
Not as important as before due to credit cards, debit cards, and other
payment mechanisms.
Demand Deposits
An account from which deposited funds can be withdrawn at any time
without any notice to the depository institution. (Excludes term deposits)
More important than currency for most businesses. They are used for
business transactions.
Typically earn no interest so holdings in demand deposits are minimized by
Marketable Securities
Very liquid securities that can be converted into cash quickly at a
reasonable price.
Typically they are low risk and yield low returns, but some marketable
securities have high risk and yield high returns.
Transaction balances
They are held to provide the cash needed to conduct normal
business operations.
Precautionary balances
They are held in reserve for random, unforeseen fluctuations in
cash inflows and outflows. The less predictable the firms cash
flows, the larger such balances should be.
Speculative balances
They are held to take advantage of investment opportunities.
Compensating balances
They are often required by banks for providing loans and
The cash conversion cycle is the length of time where
funds are tied up in working capital or the length of
time between paying for working capital and
collecting cash from the sale of the working capital.
Inventory Inventory Payables
CCC = conversion + collection deferral
period period period
Inventory Inventory
OC = conversion + collection
period period
Inventory Conversion Period
The average time required to convert raw materials into
finished goods and then to sell them.
Inventory Collection Period (Receivables Collection
Period, Average Collection Period, Days Sales
The average length of time required to convert the firms
receivables into cash, that is, to collect cash following a sale.
Payables Deferral Period
The average length of time between the purchase of
materials and labor and the payment of cash for them.
Inventory Inventory Payables
CCC = conversion + collection deferral
period Period (DSO) period

CCC = Inventory + Receivables Payables

CGS (or credit sales or Credit sales (or Purchases (or CGS or
total sales)/365 total sales)/365 total sales)/365
2,000,000 657,534 657,534
CCC = 10m / 365 + 10m / 365 8m / 365
CCC = 73 + 24 30
CCC = 67 days.
Primrose Corp has $15 million of sales, $2 million of
inventories, $3 million of receivables, and $1 million of
payables. Its cost of goods sold is 80% of sales, and it
finances working capital with bank loans at an 8% rate.
What is Primroses CCC? If Primrose could lower its
inventories and receivables by 10% each and increase its
payables by 10%, all without affecting sales or cost of
goods sold, what would be the new CCC, how much cash
would be freed up, and how would that affect pretax
Zocco Corporation has an inventory conversion period of
75 days, an average collection period of 38 days, and a
payables deferral period of 30 days.

Requirement 1: What is the length of the CCC?

Requirement 2: If Zoccos annual sales are $3,421,875 and
all sales are on credit, what is the investment in accounts
Requirement 3: How many times per year does Zocco turn
over its inventory?
Jordan Air Inc. has average inventory of $1,000,000. Its
estimated annual sales are $10 million and the firm
estimates its receivables collection period to be twice as
long as its inventory conversion period. The firm pays its
trade credit on time; its terms are net 30 days. The firm
wants to decrease its CCC by 10 days. It believes that it
can reduce its average inventory to $863,000. Assume a
365-day year and that sales will not change. By how much
must the firm also reduce its accounts receivable to meet
its goal of a 10-day reduction in its CCC?
The time that elapses from mailing, processing,
and clearing checks. In general, it is the difference
between the banks balance for firms account and
the balance that the firm shows on its own books.
Two aspects of float:
The time it takes a company to process its checks
The time consumed in clearing the check through the
banking system.
Disbursement Float
Refers to the value of the checks that have been written by a firm but
still being processed and therefore has not yet been deducted from its
account balance by the bank. The goal is to maximize disbursement
float (slow down payments), and this can be done through the use of
a remote disbursement account.
Collections Float
Refers to the amount of checks that the firm has received but not yet
credited to its account. The goal is to minimize collections float
(speed up collections).
Net float
Net float is the difference between the balance shown in a firms
checkbook and the balance on the banks record. (Disbursement Float
Collections Float). The goal is to maximize net float, which can lead to
the increase in cash balance.
Each business day, on average, a company writes
checks totalling $43,000 to pay its suppliers. The
usual clearing time for the checks is five days.
Meanwhile, the company is receiving payments from
its customers each day, in the form of checks,
totalling $57,000. The cash from the payments is
available to the firm after 2 days. Calculate the
companys disbursement float, collection float, and
net float
A table that shows cash receipts,
disbursements, and balances over some
Target cash balance = the desired cash
balance that a firm plans to maintain in order
to conduct business
Chadmark Corporations budgeted monthly sales are
$3,000. Forty percent of its customers pay in the first
month and take the 2 percent discount. The remaining 60
percent pay in the month following the sale and dont
receive a discount. Chadmarks bad debts are very small
and are excluded from this analysis. Purchases for next
months sales are constant each month at $1,500. Other
payments for wages, rent, and taxes are constant at $700
per month. Construct a single months cash budget with
the information given. What is the average cash gain or
(loss) during a typical month for Chadmark Corporation?
Hold marketable securities rather than
demand deposits to provide liquidity.
Borrow on short notice
Forecast payments and receipts better
Speed up payments (lockbox)
Use credit cards, debit cards, wire transfers,
and direct deposits.
Synchronize cash flows
HGC began operations 5 years ago as a small firm serving customers in the Detroit
area. However, its reputation and market area grew quickly. Today, HGC has
customers all over the US. Despite its broad customer base, HGC has maintained
its headquarters in Detroit; and it keeps its central billing system there. On
average, it takes 5 days from the time customers mail in payments until HGc can
receive, process, and deposit them. HGC would like to set up a lockbox collection
system, which it estimates would reduce the time lag from customer mailing to
deposit by 3 days bringing it down to 2 days. HGC receives an average of $1.4
million in payments per day.

Requirement 1: How much free cash would HGC generate if it implemented the
lockbox system? Would this be a one-time cash flow or a recurring one, assuming
the company ceases to grow? How would growth affect your answer?
Requirement 2: If HGC has an opportunity cost of 10%, how much is the lockbox
system worth on an annual basis?
Requirement 3: What is the maximum monthly charge HGC should pay for the
lockbox system?
Short term liquid securities that bought and sold.
Offer investors short term yields, liquidity and
safety of principal
Can be readily converted to cash with little risk of
Safe heaven for funds that would otherwise sit idle.
A 6-month treasury bill is purchased with par
value of P10,000 is purchased for P9,791.
Compute for:
Discount yield = [(Par value Price) / Par value] x
(360 / # of days to maturity)
Simple yield = (Interest earned / Amount invested)
x (365 / # of days to maturity)
Compound annualized yield = Price * (1+i) ^ (#
days to maturity / 365)
Kinds of Inventories:
Raw Material Inventory
Work-in-process Inventory
Finished goods Inventory
Task of Inventory Management:
Ensure that inventories needed to sustain operations are
Weaknesses of the inventory system towards the firms financial
performance (profitability) must be identified and rectified.
Hold costs of holding and ordering inventories to the lowest
possible level.
The optimal size of an order of inventory which
minimizes the sum of the ordering and carrying
Ordering costs:
Shipping, brokerage, and processing.
They decline (lower per unit) as inventory increases.
Carrying costs:
Insurance, storage, and cost of financing inventory.
Increase as the size of the inventory increases and offset
the lower per unit costs of larger orders.
Assumptions of the EOQ Model:
Demand occurs at a constant rate throughout the year.
Lead time on the receipt of the orders is constant.
The entire quantity ordered is received at one time.
The unit costs of the items ordered are constant; thus, there
can be no quantity discounts.
There are no limitations on the size of the inventory.
Stockout costs:
Costs when inventory is not enough to satisfy demand.
Reorder point:
Point when inventory should be ordered to avoid stockouts.
Should not be too early, nor should it be too late.
Assume that Fashion Clothiers Inc. uses 1,440,000 yards of material each year.
Further, assume that Fashion can order the material at a cost of P2 per yard,
plus fixed ordering costs of P100 per order. The firms carrying cost is 20
percent of the inventory value, at cost. What is the EOQ? What is the firms
minimum cost of ordering and holding inventory?
Other formulas:
Average inventory = EOQ/2
Purchase cost = Purchase cost per unit x annual demand quantity of the
Ordering cost = Fixed cost per order x Demand/order quantity
Holding/Carrying cost = Annual holding cost per unit x Average inventory
Average usage = Annual usage / working days in a year
Normal time usage = Normal lead time x Average usage
Safety stock = (Maximum lead time Normal lead time) x Average usage
ROP if safety stock is not required: ROP = Normal lead time usage
ROP if safety stock is required:
ROP = safety stock + normal lead time usage or ROP = maximum lead time x
average usage
Duration of EOQ = EOQ / Daily sales
Assuming that occasionally, the company experiences
delays in the delivery of Material Y, such that the lead
time reaches a maximum of 30 days, how many units of
safety stock should the company maintain and what is
the reorder point?
Funds due from customers.
Credit policy a set of rules governing the firms credit
terms: credit period, discounts, credit standards, and
collection procedures offered.
Credit score a numerical score from 0 to 10 that indicates
the likelihood that a person or business will pay on time.
Four variables of credit policy:
Credit period the length of time customers have to pay for purchases.
Discount price reductions given for early payment.
Credit standards the financial strength customers must exhibit to
qualify for credit.
Collection policy the degree of toughness in enforcing the credit
Importance of credit policy:
It has a major effect on sales
It influences the amount of funds tied up in receivables
It affects allowance for doubtful accounts
Information in detailed credit reports:
Summary balance sheet and income statement
Number of key ratios with trend information
Data obtained from the firms suppliers telling whether it pays promptly or
slowly and whether it has recently failed to make any payments.
Verbal description of the physical condition of the firms operations
Verbal description of the backgrounds of the firms owners, including any
previous bankruptcies, lawsuits, or divorce settlement problems.
Summary rating ranging from A for the best credit risks down to F for those
firms that are deemed likely to default.
McDowell Industries sells on terms 3/10, net 30. Total sales for the
year are $912,500; 40% of the customers pay on the 10th day and
take discounts, while the other 60% pay, on average, 40 days after
their purchases.

What is the days sales outstanding

What is the average amount of receivables?
What is the percentage cost of trade credit to customers who take
the discount?
What is the percentage cost of trade credit to customers who do not
take the discount and pay in 40 days?
What would happen to McDowells accounts receivable if it
toughened up on its collection policy with the result that all non-
discount customers paid on the 30th day?
Short Construction offers its customers credit terms of 2/10, net 30 days, while
Fryman Construction offers its customers credit terms of 2/10, net 45 days. The
aging schedules for each of the two companies accounts receivable are reported

Short Construction Fryman Construction

Age of Value of Percentage of Value of Percentage of
Account (Days) Account Total Value Account Total Value
0-10 $58,800 60% $ 73,500 50%
11-30 19,600 20 29,400 20
31-45 14,700 15 29,400 20
46-60 2,940 3 10,290 7
Over 60 1,960 2 4,410 3
Total Receivables $98,000 $147,000

Which company has the greatest percentage of overdue accounts and what is
their percentage of overdue accounts?
Any debt scheduled for repayment within one year.
Major sources of short-term credit
Bank Loans
Commercial Loans
From the borrowing firms perspective, ST credit is more risky
than LT credit
Always have a required payment around the corner.
May have trouble rolling over loans
Accrued liabilities
Continually recurring short-term liabilities, especially accrued wages and taxes.
Accounts payable (trade credit)
Debt arising from credit sales and recorded as A/R by the seller and as an A/P
by the buyer
Bank loans
ST bank loans are non-spontaneous funds provided by the bank and are 2nd in
importance to trade credit as a source of ST financing for non-financial
Commercial paper
Unsecured short term promissory notes of large firms, usually issued in
denominations of USD100,000 or more and having an interest rate somewhat
below the prime rate
Continually recurring ST liabilities such as
accrued wages and taxes
Increase automatically or spontaneously as a
firms operations expand.
Is there a cost to Accrued Liabilities?
No. They are free in the sense that no explicit interest
is paid on funds raised through accrued liabilities.
Firms can use all the accrued liabilities they can
However, firms have little control over the levels of
these accounts
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.
Stretching A/P the practice of deliberately paying late
Free Trade Credit credit received during the discount period
Costly Trade Credit credit taken in excess of free trade
credit. Its cost = discount lost.
Microchip Inc. sells chips per day for $100 on terms 2/10, net 30. PCC buys
an average of $11,923,333 worth of chips per year at net price. If PCC
wants an additional 20 days of credit beyond the 10 day discount period, it
must incur $1.50 per chip.
What is the gross price per chip? P100
What is the net or true price per chip? P98
What is the list price per chip? P99.50
What is the net daily purchase? 11,923,333/365 = 32,666.67
What is the free trade credit in dollars? 326,667
What is the costly trade credit in dollars? 653,333
What is the total trade credit in dollars? 980,000
What is the total annual chip purchases if it takes the discount? 11,923,333
What is the total annual chip purchases if it doesnt take the discount? 12,166,667

In finance, we must always use the NET or TRUE price rather than the GROSS price.
Benny Construction buys on terms of 2/15, net
60 days. It does not take discounts, and it
typically pays on time, 60 days after the invoice
date. Gross purchases amount to $450,000 per
year. On average, how much free trade credit
does the firm receive during the year? What is
the costly trade credit? What is the total trade
With terms 2/10, n/30, find the nominal rate:
With terms 2/10, n/30, find the effective rate:
Discount % 365 days
1 - Discount % Days taken - Disc. period
2 365

98 30 - 10
Angie Inc.'s business is booming, and it needs to
raise more capital. The company purchases
supplies on terms of 1/10 net 20, and it currently
takes the discount. One way of getting the
needed funds would be to forgo the discount, and
the firm's owner believes she could delay
payment to 40 days without adverse effects.
What would be the effective annual percentage
cost of funds raised by this action?
Lamar Lumber buys $8 million of materials (net of
discounts) on terms 3/5, net 60; and it currently pays after
5 days and takes discounts. Lamar plans to expand, which
will require additional financing. If Lamar decides to
forego discounts, how much additional credit could it get
and what would be the nominal and effective cost of that
credit? If the company could get the funds from a bank at
a rate of 10%, interest paid monthly, based on a 365-day
year, what would be the effective cost of the bank loan?
Should Lamar use bank debt or additional trade credit?
Aegis Inc. buys on terms of 2/10 net 30, and it always pays
on the 30th day. The CFO calculates that the average
amount of costly trade credit carried is $375,000. What is
the firm's average accounts payable balance? Assume a
365-day year.
Promissory Note a document specifying the terms and conditions of a loan,
including the amount owed, interest rate, maturity date, and repayment
Compensating Balance a minimum checking account balance that a firm must
maintain with a commercial bank, generally equal to 10 to 20 percent of the
amount of loans outstanding.
Line of Credit an informal arrangement in which a bank agrees to lend up to a
specified maximum amount of funds during a designated period.
Revolving Credit Agreement a formal committed line of credit extended by a
bank or other lending institution. It is a formal agreement in which the bank
extends the right to borrow up to a specified amount within a specified time
Prime Rate a published interest rate charged by commercial banks to large,
strong borrowers.
Annual Percentage Rate (APR) a rate reported by banks and other lenders on
loans when the effective rate exceeds the nominal rate of interest.
Weiss Inc. arranged a $9,000,000 revolving credit
agreement with a group of banks. The firm paid an
annual commitment fee of 0.5% of the unused
balance of the loan commitment. On the used portion
of the revolver, it paid 1.5% above prime for the funds
actually borrowed on a simple interest basis. The
prime rate was 3.25% during the year. If the firm
borrowed $6,000,000 immediately after the
agreement was signed and repaid the loan at the end
of one year, what was the total dollar annual cost of
the revolver?
Interest may be set under one of the following scenarios:
Regular or simple interest
The situation when interest is not compounded, that is, interest is not earned
on interest.
Discount interest
Interest that is calculated on the face amount of a loan but is paid in advance.
Its effect is to raise the effective rate on the loan
Discount interest with compensating balance
Interest is paid in advance, and there is a certain percentage (e.g. 10% or 20%)
that the borrower must leave with the bank at the beginning of the loan
period, in which he can redeem at the end of the loan period.
Its effect is to raise the effective rate on the loan
Installment loan, add-on interest
Interest that is calculated and added to funds received to determine the face
amount of an installment loan.
Effective interest rate = (Interest paid /
Principal available) x (# of days in a year /
# of days the funds are borrowed)
A firm buys goods for $100,000 on credit, with terms 2/10, n/60. It is
contemplating on whether to forego the discount and/or to borrow (loan)
$100,000 from the bank and use the proceeds to pay within the discount
period and take the discount. The loan is to be paid in 1 year at an 8%
nominal rate. If the firm chooses to take the loan, the following loan
terms are available:

a. Simple annual interest

b. Discount interest
c. Discount interest with 10% compensating balance
d. Installment loan, add-on, 12 months.

Should the firm pay forego the discount or should it take the loan to avail
of the discount? If the firm loans, which of the following loan terms
should he choose?
Nominal or quoted rate in all cases is 8%.
We want to compare loan cost rates and
choose the LOWEST COST LOAN.
We must make comparison of the EAR or
effective or equivalent annual rate.
Simple annual interest 8%
Discount interest 8.6957%
Discount interest with 10% CB 9.7561%
Installment loan, add-on, 12 months. 15.45%
Credit Terms (2/10, n/60) additional =) 15.891%
How will we choose which one to take?
We should choose the SIMPLE ANNUAL INTEREST as it has the least cost.
A type of unsecured promissory note issued by large, strong firms and sold
primarily to other business firms, to insurance companies, to pension
funds, to money market mutual funds, and to banks.
Vary from one day to 9 months, average of 5 months.
Fluctuates with supply and demand conditions, around 1.5% to 3% below the stated
prime rate, and 1/8 to of 1% above the treasury bill rate.
Use of Commercial Paper
Restricted to a comparatively small number of very large companies that have
exceptionally good credit risks.
A firm that is in temporary financial difficulty may not be able to sell its commercial
Using a commercial paper permits a corporation to tap a wide range of credit sources
including financial institutions outside its own area and industrial corporations across
the country, and this can reduce interest costs.
Effective Annual Interest Rate = (Interest cost per period + Issue
cost)/Usable loan amount) x (# of days in a year / # of days funds
are borrowed)

GG Corporation plans to issue P500 million in commercial

paper for 180 days at a stated, discounted interest rate of
10%. Dealers of the commercial paper charge P50,000 in
placement fees and flotation costs. What is the effective
annual interest rate? (Assume 360 days in a year)
Secured Loan a loan backed by collateral,
often inventories or receivables.
In a secured loan, the borrower pledges
assets as collateral for the loan.
For short-term loans, the most commonly
pledged assets are receivables and
Securities are great collateral, but generally
not available.
Willingness to assume risk (lending)
Advice and counsel
Loyalty to Customers
Maximum Loan Size
Merchant Banking
Other Services