- Working Capital Management -

Click here for title

Its impact on company’s Cash Flows
27-2
The Balance-Sheet Model of the Firm

The Capital Budgeting Decision

Current
Working Liabilities
Current capital
Assets management
Long-Term
Debt
Fixed Assets Financing
1 Tangible decision
Investment Shareholders’
2 Intangible decision Equity

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27-3

Balance Sheet Structure

Current
Liabilities
Current
Net
Assets Working
Capital Long-Term
Debt

Fixed Assets There is a

financial
1 Tangible equilibrium
Shareholders’
between
2 Intangible Equity
resources and
their uses?
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27-4
Tracing Cash and Net Working Capital

• Current Assets are cash and other assets that are

expected to be converted to cash with the year.
– Cash
– Marketable securities
– Accounts receivable
– Inventory
• Current Liabilities are obligations that are expected
to require cash payment within the year.
– Accounts payable
– Accrued wages
– Taxes
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27-5
Defining Cash in Terms of Other Elements

Long-
Net Working Fixed
+ = Term + Equity
Capital Assets
Debt

Long- Net Working

Fixed
Cash = Term + Equity – Capital –
Assets
Debt (excluding cash)

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27-6
Defining Cash in Terms of Other Elements

Long- Net Working

Fixed
Cash = Term + Equity – Capital –
Assets
Debt (excluding cash)
• An increase in long-term debt and or equity leads
to an increase in cash—as does a decrease in fixed
assets or a decrease in the non-cash components
of net working capital.
• The Sources and Uses of Cash Statement follows
from this reasoning.

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27-7
The Operating Cycle and the Cash Cycle

Raw material
Cash
purchased Finished goods sold
received
Order Stock
Placed Arrives

Inventory period Accounts receivable period

Time
Accounts payable period

Firm receives invoice Cash paid for materials

Operating cycle

Cash cycle
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27-8

The Operating Cycle and the Cash Cycle

Accounts
Cash cycle = Operating cycle – payable
period

• In practice, the inventory period, the accounts

receivable period, and the accounts payable period
are measured by days in inventory, days in
receivables and days in payables.

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27-9

The Cash Conversion Cycle

The Inventory Conversion Period (Days in

inventory)
–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

conversion= =
 Cost of goods Annual cost of goods sold 
period    
 sold per day   365 
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27-10

The Cash Conversion Cycle

The Receivables Collection Period (Days in

receivables)
–Average length of time required to convert the firm’s
receivables into cash. Also called days sales outstanding
(DSO)

Receivables Receivables Receivables

collection period= Average daily credit sales
=
 Annual credit sales

 365 

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27-11

The Cash Conversion Cycle

The Payables Period (Days in payables)

–Average length of time between the purchase of raw
materials and labor and the payment of cash for them

Payables
Accounts payable Accounts
= = payable
period Credit purchases per  Cost of goods sold 
day  
 365 
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27-12
Some Aspects
of Short-Term Financial Policy
• There are two elements of the policy that a firm
adopts for short-term finance.
– The Size of the Firm’s Investment in Current Assets
– Usually measured relative to the firm’s level of total
operating revenues.
• Flexible
• Restrictive
– Alternative Financing Policies for Current Assets
– Usually measured as the proportion of short-term debt to
long-term debt.
• Flexible
• Restrictive

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27-13
The Size of the Investment in Current Assets

• A flexible (conservative) policy short-term finance policy

would maintain a high ratio of current assets to sales.
– Keeping large cash balances and investments in marketable
securities.
– Large investments in inventory.
– Liberal credit terms.
• A restrictive (aggressive) short-term finance policy would
maintain a low ratio of current assets to sales.
– Keeping low cash balances, no investment in marketable securities.
– Making small investments in inventory.
– Allowing no credit sales (thus no accounts receivable).

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27-14
Alternative Financing Policies for Current
Assets
• A flexible (conservative) short-term finance policy
means low proportion of short-term debt relative to
long-term financing.
• A restrictive (aggressive) short-term finance policy
means high proportion of short-term debt relative to
long-term financing.

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27-15
Alternative Financing Policies for Current
Assets
• In an ideal world, short-term assets are always
financed with short-term debt and long-term assets
are always financed with long-term debt.
• In this world, net working capital is always zero.

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27-16

Financing Policy for an Idealized Economy

Current assets =
$
Short-term debt

Long-term
debt plus
common
Fixed assets: stock
a growing firm

0 1 2 3 4 5 Time

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27-17
Hedging (or Maturity Matching)
Approach
A method of financing where each asset would be offset with a financing
instrument of the same approximate maturity.

Short-term financing**
DOLLAR AMOUNT

Current assets*

Long-term financing
Fixed assets

TIME
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27-18
Risks vs. Costs Trade-Off
(Conservative Approach)
Firm can reduce risks associated with short-term borrowing by using a larger
proportion of long-term financing.

Short-term financing
DOLLAR AMOUNT

Current assets

Long-term financing
Fixed assets

TIME
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27-19
Risks vs. Costs Trade-Off
(Aggressive Approach)
Firm increases risks associated with short-term borrowing by using a larger proportion of
short-term financing.

Short-term financing
DOLLAR AMOUNT

Current assets

Long-term financing
Fixed assets

TIME
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27-20
Short- vs. Long-Term Financing

Financing
Maturity
SHORT-TERM LONG-TERM
Asset
Maturity

SHORT-TERM Moderate Low

(Temporary)
Temporary Risk-Profitability Risk-Profitability

LONG-TERM High Moderate

(Permanent) Risk-Profitability Risk-Profitability
Permanent

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27-21

Ways of short term financing

• Trade credit (increasing the account payable)

• Increase the other accruals;

• Factoring (finance ≅ 97% of the invoice value);

• Credit on commercial papers;

• Seasonal working capital loans (inventory loans);

• Open credit lines

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27-22
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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27-23
Short-Term Financing
-Trade credit -

• Trade credit is credit furnished by a firm’s 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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27-24
The cost of trade credit
- example-

• A firm buys within a financial year raw materials of

$551150 and can get 5567 commerce discount if it pays
within 10 days.

• The firm can forego discounts and pay on Day 40, without
penalty.

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27-25

Nominal trade credit cost formula

Discount% 365days
k TC = ×
1 - D iscount% D aystaken- D isc.period
1 365
= ×
99 40 - 10
= 0.1229
= 12.29%

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27-26
The cost of trade credit
- example-

• Firm buys goods worth $551150. That’s the cash price.

• They must pay $5567 more if they don’t take discounts.

• Think of the extra $5567 as a financing cost similar to

the interest on a loan.

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27-27 Nominal trade credit cost formula
- another way to estimate it -

5567 365days
k TC = ×
551150 D aystaken- Disc.period
5567 365
= ×
551150 40 - 10
= 0.1229
= 12.29%

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27-28
Short-Term Financing
- Commercial paper (CP) -

• Short-term notes issued by large, strong companies

• CP trades in the market at rates just above T-bill rate
(depends on the issuing company’s 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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27-29
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 bank’s days) with an
annual interest rate of 13,2%.
 The cost of credit =
13,2%× 300000× 30
 Annual percentage rate of the credit 365
= $3254,8
=

3254,8 365
× × 100 = 14,83%
300000- 3254,8 30 - 3
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27-30

Quick Quiz
 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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