NET WORKING CAPITAL AND CASH CORVERSION CYCLE

BASIC CONCEPTS:

 Working Capital – sometimes referred to as gross working capital simply refers to

current assets

 Net Working Capital – the excess of current assets over the current liabilities

 Working Capital Management – administration and control of current assets and

current liabilities to ensure that they are adequate and used effectively for business

purposes

SIGNIFICANCE OF WORKING CAPITAL MANAGEMENT

 Working Capital represents a margin of safety for short-term creditors - Short-term

creditors look to the current assets as a source of repayment of their claims. The working

capital also indicates the amount by which the value of current assets could drop from

their book values and still cover the claims of short-term creditors without loss.

 The amount of working capital represents the extent to which current assets are

financed from long-term sources – Although current assets are turned over within

relatively short periods, they always represent some percentage of sales. In this sense, a

portion of current assets must be owned by the firm permanently. Consequently, it is

appropriate that a portion of current assets be financed from permanent sources

FACTORS AFFECTING THE LEVEL OF CURRENT ASSETS

 General nature of the business and product – Trading and manufacturing companies

usually require higher proportions of current assets than service and utility companies do.
  Effect of sales pattern - The working capital needs will be affected by the nature of the

change in sales or business activity. If the change in sales is brought about by cyclical or

seasonal changes, the periodic build-up of receivables and inventory is temporary and

financing need is considered short-term. This is so because the conversion of these

investments into cash will come in the normal course of operation. If the change in sales

is due to secular or permanent changes, the incremental working capital required is

permanent and will require long-term financing.

 Length of manufacturing process – the longer the period of time required to

manufacture the products of the company, the higher the level of working capital

requirement is.

 Industry practices – the industry or line of business with greater proportion of assets

readily convertible to cash can afford to have lower working capital investment and a

higher level of current liabilities.

 Terms of purchase and sales – the longer the credit period granted by suppliers of

merchandise is, the lower the requirement for permanent working capital is. Meanwhile,

the longer the credit period given to customer of the firm is, the higher the requirement

for working capital is.

ADVANTAGES OF ADEQUATE WORKING CAPITAL

 The company can settle its debts promptly thereby enabling it to maintain its good credit

standing

 Credit may be extended to customers thereby increasing the sales volume of the firm

 Inventories can be readily replenished

  Current operating expenses are paid promptly

 Management and employee morale is enhanced

 Profitable opportunities can be taken advantage of

DISADVANTAGES OF INADEQUATE WORKING CAPITAL

 The risk of business failure is increased

 The company may not be able to pursue its objectives because of lack of funds

DISADVANTAGE OF EXCESSIVE WORKING CAPITAL

 The management may become inefficient and complacent

 Management may be tempted to speculate

 Unnecessary expenses and extravagance may result

 Resources are not optimally employed

PERMANENT CURRENT ASSETS

The current assets a firm needs in order to continue operations. Examples include inventory

and perhaps rapidly depreciating assets such as computers. These assets are current because

they do not remain assets for longer than a year, but they are permanent because they must be

replaced with similar assets. Despite the seeming contradiction in the name, they are called

permanent current assets because every company must permanently maintain a certain

amount in current assets in order to exist.

TEMPORARY ASSETS
 A subset of a company’s current assets that changes according to seasonal fluctuations. For

example, a retail store’s current inventory may include holiday decorations around

Christmas. These decorations would be temporary assets with respect to the remainder of the

store’s inventory.

ALTERNATIVE CURRENT ASSET INVESTMENT POLICIES

 Conservative or Relaxed current asset investment policy – This is a policy under

which relatively large amount of cash, marketable securities and inventories are carried and

under which sales are stimulated by liberal credit policy, resulting in a high level of

receivables. This policy generally provides the lowest expected return on investment because

capital tied up in current assets either does not earn any substantial income at all or a minimal

income if any, but it entails the lowest risk.

 Under relaxed policy, the company maintains current assets up to the level of ‘C2’ for the

same level of sales (S) as in restricted policy. It allows the company to have sufficient

cushion for uncertainties, contingencies, seasonal fluctuations, changes in activity levels,

changes in sales etc. The level of investment in current assets is high, which results in lesser

return, but the risk level is also reduced.

 Aggressive or Restricted current asset investment policy – In this policy, the firm has

fewer liquid assets with which to prevent a possible financial failure. Holdings in cash,

securities, investors, and receivables are minimized. While risk of financial failure is high

because of the small amount of total capital commitment, the profitability rate measured by

the rate of return as total assets however is high.

When the company adopts ‘restricted policy’, for a sales level of ‘S’ it maintains the current

assets level of ‘C’. Under this policy the company maintains lower investments in current

assets represent aggressive approach; intend to yield high return and accepting higher risk.

The management is ready to counter any financial difficulties arising out of restricted policy.

The level of investment in current assets is lesser and high risk is perceived for increase of

marginal return on investment. The determination of level of investment in currents is

dependent on risk-return perception of the management.

 Moderate current assets investment policy – This is a policy that is between the

relaxed and restricted policies.

In moderate policy, the investment in currents lies in between ‘C’ and ‘C2‘. With this policy,

the expected profitability and risk levels fall between relaxed policy and restricted policy.

The higher the level of investment in current assets represents the liberal working capital

policy, in which the risk level is less and also the marginal return is also lesser.
Illustration:

The financing pattern, current ratio, profitability net working capital position is explained

under conservative, moderate and aggressive working capital policies are explained by way

of hypothetical figures as follows:

Analysis:

We can observe from the above analysis that current ratio is 4 times if conservative policy is

followed; it has dropped to 1.5 in management of working capital under aggressive policy.

However, the return on investment has increased from 16.95% to 19.71%, if aggressive approach

is adopted. Higher risk is attached with the higher return, under aggressive policy.
In conservative approach majority of current assets are financed from long-term sources of

finance. When it comes to financing current assets under aggressive approach, majority of

current assets are financed from short-term sources.

The moderate policy stands in between two extremes of conservative and aggressive financing

approaches. Majority of the corporate follow the moderate policy of working capital financing,

which enables to avoid higher risk and to earn moderate profit margin on additional investments

in current assets.

ALTERNATIVE CURRENT ASSET FINANCING POLICIES

 Moderate (Maturity Matching or Self-Liquidating) Approach - the maturity of the

firm's assets is matched with the maturity of the firm's liabilities. This means that all long-

term assets including the permanent level of current assets are financed with long-term

sources of financing. Temporary current assets are financed with short-term debt.

 Aggressive Approach - the firm uses some short-term debt to finance some of its

permanent level of current assets, which means the firm must raise even more short-term

debt during seasonal fluctuations. The firm is "rolling over" short-term and using it more as

a permanent source of financing. This is considered a risky approach with high potential for

return.

 Conservative Approach - the firm uses long-term financing for all of its long-term

assets, permanent current assets, and even some of it temporary current assets. The firm has
 periods of excess liquidity (cash) where the firm invests in marketable securities but relies

less on short-term debt during seasonal fluctuations. This is considered a low risk approach

with low return potential.

These lines indicate the extent of utilization of long-term sources. Higher the line, bigger is

the investment through the long-term source of finance.

RISK-RETURN TRADEOFF

The risk-return tradeoff states that the potential return rises with an increase in risk. Using this

principle, individuals associate low levels of uncertainty with low potential returns, and high

levels of uncertainty or risk with high potential returns. According to the risk-return tradeoff,

invested money can render higher profits only if the investor will accept a higher possibility of

losses.
CASH CONVERSION CYCLE

Cash Conversion Cycle (CCC) also known as net trade cycle, measures how fast a company

can convert cash on hand into inventory and accounts payable, through sales and accounts

receivable, and then back into cash.

Cash Conversion Cycle

=Average collection period + Average age of inventory - Average age of payables; OR

= Operating cycle – Average age of Payables

Reported by:

CATHERINE H. CAPIAN