Working Capital

Chapte
Slides Developed by:
Terry Fegarty
Seneca College
The Management of
Working Capital
Chapter 4 Outline (1)

Working Capital Basics
Working Capital and the Current Accounts

Working Capital and Funding Requirements
Objective of Working Capital Management
Working Capital Trade-offs
OperationsThe Cash Conversion Cycle
The Operating Cycle and the Cash Conversion Cycle
2006 by Nelson, a division of Thomson Canada Limited
Permanent and Temporary Working Capital

Maturity Matching Principle
Financing Net working Capital
Short-Term vs. Long-Term Financing
Working Capital Policy

Cash Management
Objectives of Cash Management

Marketable Securities
Yield on a Discounted Money Market Security
Components of Float
Cheque Disbursement and the Cheque Clearing
process
Accelerating Cash Receipts
Electronic Funds Transfer
Managing Cash Outflow
Evaluating Cash Management Services

Managing Accounts Receivable
Tradeoffs in Managing Accounts Receivable

Credit Policy
Terms of Sale
Collections policy

Inventory Management
Benefits and Costs of Carrying Adequate Inventory

Inventory Ordering Costs
Inventory Control and Management
Economic Order Quantity Model
Safety Stocks, Reorder Points and Lead Times
Inventory on Hand Including Safety Stock
Tracking InventoriesThe ABC System
Just In Time (JIT) Inventory System
Working Capital Basics

Working Capital
Assets/liabilities required to operate
business on day-to-day basis
Cash
Accounts Receivable
Inventory
Accounts Payable
Accruals
Short-term in natureturn over regularly
Working Capital and the Current

Accounts
Gross working capital = Current assets
Gross Working Capital (GWC) represents
investment in current assets
(Net) working capital =

Current assets Current liabilities
Working Capital and Funding

Requirements
Working Capital Requires Funds
Maintaining working capital balance requires
permanent commitment of funds
Example: Firm will always have minimum level of
Inventory, Accounts Receivable, and Cashthis
requires funding

Requirements
Spontaneous Financing
Firm will also always have minimum level of
Accounts Payablein effect, money you have
borrowed
Accounts Payable (and Accruals) are generated
spontaneously
Arise automatically with inventory and expenses
Offset the funding required to support current assets
10

Requirements
Net working capital is Gross Working
Capital Current Liabilities (including
spontaneous financing)
Reflects net amount of funds needed to
support routine operations
11
Objective of Working Capital

Management
To run firm efficiently with as little money
as possible tied up in Working Capital
Involves trade-offs between easier operation
and cost of carrying short-term assets
Benefit of low working capital
Money otherwise tied up in current assets can be
invested in activities that generate higher payoff
Reduces need for costly financing
Cost of low working capital

Risk of shortages in cash, inventory
12

Inventory
High Levels
Benefit:
Happy customers
Few production delays (always have needed
parts on hand)
Cost:
Expensive
High storage costs
Risk of obsolescence
Low Levels
Cost:
Shortages
Dissatisfied customers
Benefit:
Low storage costs
Less risk of obsolescence
Cash
High Levels
Benefit:
Reduces risk
Cost:
Increases financing costs
Low Levels
Benefit:
Reduces financing costs
Cost:
Increases risk
13

Accounts Receivable
High Levels (favourable credit terms)
Benefit:
Happy customers
High sales
Cost:
Expensive
High collection costs
Increases financing costs
Low Levels (unfavourable

terms)
Cost:
Dissatisfied customers
Lower Sales
Benefit:
Less expensive
Accounts Payable and Accruals

High Levels
Low Levels
Benefit:
Reduces need for external finance--using a
spontaneous financing source
Cost:
Unhappy suppliers
Benefit:
Happy suppliers/employees
Cost:
Not using a spontaneous
financing source
14
Current Assets
Profitability
Risk
High Level
Lower
Lower
Low Level
Higher
Higher
15
OperationsThe Cash Conversion

Cycle
Firm begins with cash which then
becomes inventory and labour
Which then becomes product for sale
Eventually this will turn into cash again
Firms operating cycle is time from

acquisition of inventory until cash is
collected from product sales
16
Figure 4.1:
The Cash Conversion

Cycle
Product is
converted into
cash, which is
transformed into
more product,
creating the cash
conversion cycle.
17
Figure 4.2:
Cycle
Time Line Representation

of the Cash Conversion
18
The Operating Cycle and the Cash

Conversion Cycle
plus:
equals:
minus:
equals:
Inventory conversion period

Receivable collection period
Operating cycle
Payables deferral period
Cash conversion cycle
Shortening cash conversion cycle frees up cash

to reinvest in business or to reduce debt and
interest
19
Cash Conversion Cycle Analysis

Inventory
Conversion
Period
Receivables
Collection
Period
Payables
Deferral
Period
365
Inventory Turnover
Accounts Receivable 365
Annual Credit Sales
Accounts Payable 365
Cost of Goods Sold
20
Cash Conversion Cycle

Purchase
Inventory
Sell Inventory
on Credit
Pay for
Inventory
Collect
Receivables
Operating Cycle
Inventory Conversion Period
Receivables Collection Period
Payables Deferral Period
Cash Conversion Cycle
21
Working Capital
Needs of Different Firms
Figure 4.3:
22
Permanent and Temporary

Working Capital
Working capital is permanent to the
extent that it supports constant or
minimum level of sales
Temporary working capital supports
seasonal peaks in business
23
Maturity Matching Principle

Maturity (due date) of financing should
roughly match duration (life) of asset
being financed
Then financing /asset combination becomes
self-liquidating
Cash inflows from asset can be used to pay off
loan
24
Financing Net Working Capital

According to maturity matching principle
Temporary (seasonal) should be financed
with short-term borrowing
Permanent working capital should be
financed with long-term sources, such as
long-term debt and/or equity
In practice, firms may use more or less

short-term funds to finance working
capital
25
Figure 4.4(a):
Working Capital
Financing Policies
26
Figure 4.4(b): Working
Capital
Financing Policies
27
Short-Term vs. Long-Term

Financing
The mix of short- or long-term working
capital financing is a matter of policy
Use of long-term funds is a conservative
policy
Use of short-term funds is an aggressive
policy
28

Financing
Short-term financing
Cheap but risky
Cheapshort-term rates generally lower than
long-term rates
Riskybecause you are continually entering
marketplace to borrow
Borrower will face changing conditions (ex; higher
interest rates and tight money)
29

Financing
Long-term financing
Safe but expensive
Safeyou can secure the required capital
Expensivelong-term rates generally higher
than short-term rates
30
Working Capital Policy

Firm must set policy on following issues:
How much working capital is used
Extent to which working capital is supported
by short- vs. long-term financing
How each component of working capital is
managed
The nature/source of any short-term
financing used
31
Cash Management
Cash managementdetermining:
Optimal size of firms liquid asset balance
Appropriate types and amounts of
short-term investments
Most efficient methods of controlling
collection and disbursement of cash
32
Cash Management
Why have cash on hand?
Transactions demand: need money to pay bills
(employees, suppliers, utility/phone, etc.)
Precautionary demand: to handle emergencies
(unforeseen expenses)
Speculative demand: to take advantage of

unexpected opportunities (purchase of raw materials
that are on sale)
33
Objectives of Cash Management

Cash doesnt earn a return
Want to maintain liquidity
Take cash discounts

Maintain firms credit rating
Minimize interest costs
Avoid insolvency
Good cash management implies maintaining

adequate liquidity with minimum cash in bank
Can place portion of cash balance into marketable
securities (AKA: near cash or cash equivalents)
34
Marketable Securities
Liquid investments that can be held
instead of cash and earn a modest return
Examples include Treasury bills,
commercial paper, bankers acceptances
Many are bought and sold at a discount in
money market
35
Examples of Marketable Securities

Treasury Bills
Short-term government notes issued at a
discount with principal repaid at maturity
Commercial Paper
Short-term unsecured promissory notes
issued by corporations with good credit
Bankers Acceptances
Short-term promissory notes issued by a firm
and accepted (or guaranteed) by a bank
36
Yield on a Discounted Money Market

Security
Annualized yield
r
= 100 P
P
365
d
where P = Discounted price as a

percentage of maturity value
d = Number of days to maturity
r = Annualized yield
37
Components of Float
Mail Float
delay between when cheque is sent to a payee and
is received by payee
Processing Float
time between receipt of payment by a payee and the
deposit of the payment in the payees account
Clearing Float
time between depositing a cheque and having
available spendable funds
38
Cheque Disbursement and the

Cheque Clearing Process
When you pay a bill,
You write cheque and mail to payee (2-3
days of mail float)
Payee receives cheque and performs internal
processing (1 day of processing float)
Payee deposits cheque in its own bank (1 day
of processing float)
Payees bank sends cheque into interbank
clearing system which processes cheque (2
days of clearing float)
39
Figure 4.5:
The Cheque-Clearing
Process
40

Lock-box systems
Post office box(es) located near customers in
order to shorten mail and processing float
Local bank empties the box, deposits payments
into firms account, and reports payments to firm
May involve significant fees
More cost-effective if small number of larger

deposits
41
A Lock Box System in

the Cheque-Clearing Process
Figure 4.6:
42

Concentration Banking
Customers send cheques sent to firms local
collection centres, where they are deposited
Local deposits are transferred electronically
into one central concentration account
Reduces mail float
Funds available for paying loans or investing
in marketable securities
43

Electronic funds transfer mechanisms
are reducing the importance of float
management techniques for many
companies
44

Wire Transfers
Transferring money electronically
Preauthorized Cheques
Customer gives payee signed cheque-like
documents in advance
When payee ships product, it deposits
preauthorized cheque in its bank account
Eliminates mail float
Payee must trust payer
45
Managing Cash Outflow

Zero balance accounts (ZBAs)
Decentralization of cash payments can lead to large

number of cash balances around the country
Divisions write cheques on ZBAsfunded from
central account only when cheques are cleared
Solves problem of idle cash in decentralized bank
accounts
Remote disbursing
Using bank in remote location for disbursement

chequing account
Increases mail float
46
Evaluating Cash Management

Services
Evaluation involves comparison of costs
versus benefits of faster collection
47
Evaluating Cash
Management Services
Example
Example 4.1:
Q: Kelso Systems Inc. has customers in British Columbia that remit

about 500 cheques a year. The average cheque is for $10,000.
West coast cheques currently take an average of eight days
from the time they are mailed to clear into Kelsos east coast
account.
A British Columbia bank has offered Kelso a lock box system for
$1,000 a year plus $0.20 per cheque. The system can be
expected to reduce the clearing time to six days.
Is the banks proposal a good deal for Kelso if it borrows at 8%?
48
Evaluating Cash
Management Services
Example
Example 4.1:
A: The cheques represent revenue of: 500 $10,000 =

$5,000,000 per year.
The average amount tied up in the cheque clearing process is:
8/365 x $5,000,000 = $109,589.
The proposed lockbox system will reduce this to: 6/365 x
$5,000,000 = $82,192, thus freeing up $27,397 of cash.
Kelso will be able to borrow $27,397 less, thus saving: $27,397
x 0.08 = $2,192 in interest
The system is expected to cost: $1,000 + ($0.20 x 500) =
$1,100.
The net saving is: $2,192 - $1,100 = $1,092
The banks proposal should be accepted
49

Generally firms like as little money as possible
tied up in receivables
Reduces costs (firm has to borrow to support the
receivable level)
Minimizes bad debt exposure
But, having good relationships with customers

is important
Increases sales
Firm needs to strike a balance on these issues

50
Trade-offs in Managing
Trade-offs
ReceivableAccounts
Receivable
Management
Strict Management
Less sales and gross
More sales and gross
margin, but
margin, but
Less bad debts
More bad debts
Lower collection costs
Higher collection costs
Less discount
More discount
expenses
expenses
Lower receivables
Higher receivables
Shorter collections
Longer collections
Less interest expense
More interest expense
Liberal Management
51

Policy Decisions Influencing Accounts
Receivable
Credit Policy
Criteria used to screen credit applications
Controls quality of accounts to which credit is extended
Terms of Sale
Terms and conditions under which credit extended must be
repaid
Collections Policy
Methods employed to collect payment on past due accounts
52
Credit Policy
Must examine creditworthiness of potential
credit customers
Credit report
Customers financial statements
Bank references
Customers reputation among other vendors
Conflicts often arise between sales and credit

departments
Sales departments job to generate sales
Credit department may refuse credit to high risk
accounts
53
Terms of Sale
Credit sales are made according to
specified terms of sale
Example: 2/10, net 30 means customer
receives 2% discount if payment is made
within 10 days, otherwise entire amount is
due by 30 days
Customers pay quickly to save money
Firms terms of sale generally follow
industry practice
54
Collections Policy
Firms collection policymanner and aggressiveness
with which firm pursues payment from delinquent
customers
Being overly aggressive can damage customer relations
Function of collections department to follow up on

overdue receivables (called dunning)
Mail polite letter

Follow up with additional dunning letters
Phone calls
Collection agency
Lawsuit
55
Inventory Management
Inventory management establishes a balance
between carrying enough inventory to meet
sales or production requirements while
minimizing inventory costs
Inventory usually managed by manufacturing
or operations
However, finance department has an oversight
responsibility
Monitor level of lost or obsolete inventory
Supervise periodic physical inventories
56
Benefits and Costs of Carrying

Adequate Inventory
Benefits
Reduces stockouts and backorders
Makes operations run more smoothly, improves customer
relations and increases sales
Carrying Costs
Interest on funds used to acquire inventory

Storage and security
Insurance
Taxes
Shrinkage
Spoilage
Breakage
Obsolescence
57
Inventory Ordering Costs

Inventory ordering costs
Expenses of placing orders with suppliers,
receiving shipments, and processing
materials into inventory
Excludes vendor charges
Relate to the number of orders placed

rather than to the amount of inventory held
Tend to vary inversely with carrying costs
58
Economic Order Quantity (EOQ)

Model
EOQ model recognizes trade-offs between
carrying costs and ordering costs
Carrying costs increase with amount of inventory
held ( from larger orders)
Ordering costs increase with the number of orders
placed (from more orders)
EOQ minimizes total of sum of ordering and

carrying costs
59
Inventory Costs and the EOQ

Cost
($)
Total
Cost
Carrying
Cost
Ordering
Cost
EOQ
Q (Order Size)
60

Model
EOQ model is:
2FD
Q
c
where
Q= order size in units
D= annual quantity used in units
F= cost of placing one order
C= annual cost of carrying one unit in stock
denotes square root
61
Figure 4.7:
Inventory on Hand for a

Steadily Used Item
62

Model
Other Inventory Formulas
Q
Average Inventory =
2
Total Carrying Cost: =
Q
c
2
Number of Orders = N = D
Q
D
Total Ordering Cost = FN = F
Q
Q
D
Total Ordering and Carrying Cost = TC = c +F
2
Q
63
Example
Example 4.3:
Economic Order
Quantity
Q: The Galbraith Corp. buys a part that costs $5. The carrying
cost of inventory is approximately 20% of the parts dollar value
per year. It costs $50 to place, process and receive an order.
The firm uses 900 of the $5 parts per year.
What ordering quantity minimizes inventory costs?

How many orders will be placed each year if that order quantity
is used?
What inventory costs are incurred for the part with this ordering
quantity?
64
Example 4.3:
Economic Order
Quantity
A: Annual carrying cost per unit is 20% x $5 = $1
Example
2 50 900
1
EOQ = 300 units

The annual number of reorders is 900 300 = 3
Ordering costs are $50 x 3 = $150 per year
Average inventory is 300 2 = 150 units
Carrying costs are 150 x $1 = $150 a year
Total inventory cost of the part is $300
65
Safety Stocks, Reorder Points and

Lead Times
Safety stock provides insurance against
unexpectedly rapid use or delayed
delivery
Additional supply of inventory that is carried
at all times to be used when normal working
stocks run out
Rarely advisable to carry so much safety
stock that stockouts never happen
Carrying costs would be excessive
66
Safety Stocks, Reorder Points and

Lead Times
Ordering lead timeadvance notice
needed so that an order placed will arrive
when required
Usually estimated by items supplier
Reorder pointlevel of inventory at

which order is placed
67
Inventory on Hand
Including Safety Stock
Figure 4.9:
68

Model
Other Inventory Formulas (with Safety
Stock)
Average Inventory =
Q
Safety Stock
2
Total Carrying Cost: = c Safety Stock

2
Total Ordering and Carrying Cost =

Q
D
TC = c SafetyStock +F
2
Q
69
Tracking InventoriesThe ABC

System
Some inventory items (A items) require great

deal of attention
Very expensive
Critical to firms processes or to those of customers
Some inventory items do not require great deal

of attention (C items)
Commonplace, easy to obtain
B items fall between items A & C

ABC system segregates items by value and
places tighter control on higher cost (value)
pieces
70
Just In Time (JIT) Inventory

System
Inventory supplied
At exactly the right time
In exactly the right quantities
Theoretically eliminates the need for factory inventory
Shortens operating cycle

Reduces costs
Eliminate wasteful procedures
But: late delivery can stop factorys entire production line
Works best with large manufacturers who are powerful

with respect to supplier
Supplier is willing to do almost anything to keep the
manufacturers business
71

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Chapte

Slides Developed by:

Chapter 4 Outline (1)

Working Capital and the Current Accounts

2006 by Nelson, a division of Thomson Canada Limited

Chapter 4 Outline (2)

Permanent and Temporary Working Capital

2006 by Nelson, a division of Thomson Canada Limited

Chapter 4 Outline (3)

Objectives of Cash Management

Chapter 4 Outline (4)

Tradeoffs in Managing Accounts Receivable

2006 by Nelson, a division of Thomson Canada Limited

Chapter 4 Outline (5)

Benefits and Costs of Carrying Adequate Inventory

2006 by Nelson, a division of Thomson Canada Limited

Working Capital Basics

Short-term in natureturn over regularly

2006 by Nelson, a division of Thomson Canada Limited

Working Capital and the Current

(Net) working capital =

2006 by Nelson, a division of Thomson Canada Limited

Working Capital and Funding

2006 by Nelson, a division of Thomson Canada Limited

Working Capital and Funding

2006 by Nelson, a division of Thomson Canada Limited

Working Capital and Funding

2006 by Nelson, a division of Thomson Canada Limited

Objective of Working Capital

Cost of low working capital

Working Capital Trade-offs

2006 by Nelson, a division of Thomson Canada Limited

Working Capital Trade-offs

Low Levels (unfavourable

Accounts Payable and Accruals

2006 by Nelson, a division of Thomson Canada Limited

Working Capital Trade-offs

2006 by Nelson, a division of Thomson Canada Limited

OperationsThe Cash Conversion

Firms operating cycle is time from

The Cash Conversion

2006 by Nelson, a division of Thomson Canada Limited

Time Line Representation

2006 by Nelson, a division of Thomson Canada Limited

The Operating Cycle and the Cash

Inventory conversion period

Shortening cash conversion cycle frees up cash

Cash Conversion Cycle Analysis

2006 by Nelson, a division of Thomson Canada Limited

Cash Conversion Cycle

2006 by Nelson, a division of Thomson Canada Limited

Permanent and Temporary

2006 by Nelson, a division of Thomson Canada Limited

Maturity Matching Principle

2006 by Nelson, a division of Thomson Canada Limited

Financing Net Working Capital

In practice, firms may use more or less

2006 by Nelson, a division of Thomson Canada Limited

Figure 4.4(b): Working

2006 by Nelson, a division of Thomson Canada Limited

Short-Term vs. Long-Term

2006 by Nelson, a division of Thomson Canada Limited

Short-Term vs. Long-Term

2006 by Nelson, a division of Thomson Canada Limited