Ch. 15 Working Capital Management
Topics
Alternative working capital policies
Cash management
Inventory and A/R management
Trade credit
Bank loans
Working capital terminology
Net working capital:
capital: Current assets minus current
liabilities. Often called working capital.
Net operating working capital: Current assets minus nonnoninterest bearing current liabilities.
Working capital policy:
policy: Deciding the level of each type of
current asset to hold, and how to finance current assets.
Working capital management: Controlling cash,
inventories, and A/R, plus shortshort-term liability management.
Working capital – Operating cycle
Inventory –
Raw Materials
Inventory –
Finished Goods
Cash
Account
Receivables
Selected ratios for Bulldog Inc.
Bulldog
Industry
Avg
Current ratio
1.75x
2.25x
Debt/Assets
58.76%
50.00%
Turnover of cash & securities
16.67x
22.22x
Days sales outstanding
45.63
32.00
Inventory turnover
4.82x
7.00x
Fixed assets turnover
11.35x
12.00x
Total assets turnover
2.08x
3.00x
Profit margin
2.07%
3.50%
Return on equity
10.45%
21.00%
How does Bulldog’s working capital policy
compare with its industry?
Working capital policy is reflected in the current ratio,
turnover of cash and securities, inventory turnover, and
days sales outstanding.
These ratios indicate Bulldog has large amounts of working
capital relative to its level of sales.
Bulldog is either very conservative or inefficient.
Working capital financing policies
Aggressive:
Aggressive: Use shortshort-term financing to finance permanent
assets.
Moderate
Moderate:: Match the maturity of the assets with the
maturity of the financing.
Conservative
Conservative:: Use permanent capital for permanent assets
and temporary assets.
Why hold cash?
1. Transactions: Must have some cash to operate.
2. Precaution: “Safety stock”. Reduced by line of credit and
marketable securities.
3. Compensating balances for loans and/or services
provided.
4. Speculation: To take advantage of bargains and to take
discounts. Reduced by credit lines and marketable
securities.
Cash Management Goals:
To meet the above objectives, especially to have cash for
transactions, yet not have any excess cash.
To minimize transactions balances in particular, and also
needs for cash to meet other objectives.
objectives.
Cash budget
Forecasts cash inflows, outflows, and ending cash
balances.
Used to plan loans needed or funds available to invest.
Can be daily, weekly, or monthly, forecasts.
Monthly for annual planning and daily for actual cash
management.
Steps to preparing a cash budget
Step 1 - Forecast the sources of cash.
Step 2 - Forecast uses of cash.
Step 3 - Calculate whether the firm is facing a cash shortage
or surplus.
Elements of credit policy
Credit Period:
Period: How long to pay? Shorter period reduces
average collection period (ACP, a.k.a. DSO) and average
A/R, but it may discourage sales.
Cash Discounts:
Discounts: Lowers price. Attracts new customers
and reduces ACP.
Credit Standards:
Standards: Tighter standards tend to reduce sales,
but reduce bad debt expense. Fewer bad debts reduce
ACP.
Collection Policy:
Policy: How tough? Tougher policy will reduce
ACP but may damage customer relationships.
How could bad debts be worked into the
cash budget?
Collections would be reduced by the amount of the bad
debt losses.
For example, if the firm had 3% bad debt losses,
collections would total only 97% of sales.
Lower collections would lead to higher borrowing
requirements.
Cash conversion cycle
The cash conversion cycle focuses on the length of time
between when a company makes payments to its creditors
and when a company receives payments from its
customers.
Cash conversion cycle
The cash conversion cycle (CCC) formula:
Inventory
Average Payables
CCC = conversion + collection − deferral
period
CCC =
period
period
Inventory
Receivables
Payables
+
−
(COGS/365) (Sales/365)
(COGS/365)
Minimizing cash holdings
Use a lockbox
Insist on wire transfers from customers
Synchronize inflows and outflows
Use a remote disbursement account
Reduce need for “safety stock” of cash
Increase forecast accuracy
Hold marketable securities
Negotiate a line of credit
Inventory Management
Components of Inventory
Raw materials
Work in process
Finished goods
Goal = Minimize amount of cash tied up in inventory
Inventory costs
Types of inventory costs
Carrying costs – storage and handling costs, insurance,
property taxes, depreciation, and obsolescence.
Ordering costs – cost of placing orders, shipping, and
handling costs.
Costs of running short – loss of sales or customer goodwill,
and the disruption of production schedules.
Reducing inventory levels generally reduces carrying costs,
increases ordering costs, and may increase the costs of
running short.
Tools used to minimize inventory
Just-in
Justin--time
Lean manufacturing
Short--term financing
Short
Debt scheduled for repayment within 1 year.
Major sources of shortshort-term financing
Accounts payable (trade credit)
Bank loans
Commercial paper
Secured loans
From the firm’s perspective, SS-T financing is riskier than L
L-T debt.
Always a required payment around the corner.
Fluctuating interest expense.
May have trouble rolling over loans.
Firm may be at risk of default as a result of temporary
economic conditions.
What is trade credit?
Terms of Sale:
Sale: Credit, discount, and payment terms
offered on a sale.
Trade credit:
credit: Debt arising from credit sales and recorded
as an account receivable by the seller and as an account
payable by the buyer.
Trade credit is often the largest source of shortshort-term credit,
especially for small firms. Easy to get, but cost can be high.
A firm that buys on credit is in effect borrowing from its
supplier. It saves cash today but will have to pay later. This,
of course, is an implicit loan from the supplier.
Trade credit
Example
5/10 net 60
5 - percent discount for early payment
10 - number of days that the discount is available
net 60 - number of days before payment is due
Implied interest rate on trade credit
Nominal annual cost of trade credit formula
rnominal =
Discount
365 days
×
100 - Discount Days outstandin g - Disc. period
Effective annual cost of trade credit formula
reffective = 1 + Discount 
100 - Discount 

365/extra days credit
-1
Nominal vs. effective cost of trade credit
Example
On a $100 sale, with terms 5/10 net 60, what is the implied
interest rate on the credit given?