TASMANIAN SCHOOL OF

BUSINESS AND ECONOMICS

Topic 12
Working capital
management

Based on slides prepared By

Alex Proimos, John Wiley & Son

Learning objectives
After studying this presentation, you should be
able to:
12.1 define and calculate net working capital and
discuss the importance of working capital
management
12.2 define the operating and cash conversion
cycles, explain their use, and calculate their
values
12.3 discuss the relative advantages and (2)
restrictive current asset management
strategies

Learning objectives
12.4 explain how accounts receivable are created
and managed, and calculate the cost of
trade credit
12.5 explain the trade-off between carrying costs
and reorder costs, and calculate the
economic order quantity for inventory
12.6 define cash collection time and discuss how
a company can minimise this time
12.7 identify three current asset financing
strategies and discuss the main sources of
short-term financing.

1
 Working capital basics
What is working capital management?
➢ Working capital management involves two key
issues.

1. What is the appropriate amount and mix of

current assets for the company to hold?
2. How should these current assets be financed?

Working capital basics

Working capital terms and concepts
➢ Current assets are cash and other assets that the
company expects to convert into cash in a year or less.

➢ Current liabilities (or short-term liabilities) are

obligations that the company expects to pay off in a
year or less.

➢ Working capital is the funds invested in a company’s

cash account, account receivables, inventory, and other
current assets.

Working capital basics

6 2/09/2020

2
 Working capital basics
Working capital terms and concepts
➢ Net working capital (NWC) refers to the difference
between current assets and current liabilities.

➢ NWC is important because it is a measure of

liquidity and represents the net short-term
investment the company keeps in the business.

➢ Working capital management involves making

decisions regarding the use and sources of current
assets

Working capital basics

Working capital terms and concepts
➢ Working capital efficiency refers to the length of
time between when a working capital asset is
acquired and when it is converted into cash.

➢ Liquidity is the ability of a company to convert

assets—real or financial—into cash quickly without
suffering a financial loss.

Working capital basics

9 2/09/2020

3
 Working capital basics
Working capital accounts and trade-offs
➢ Cash: This account includes cash and
marketable securities like treasury securities.
The higher the cash balance the better the ability
of the company to meet its short-term financial
obligations.
➢ Receivables: These represent the amount owed by
customers who have taken advantage of the
company’s trade credit policy.

Working capital basics

Working capital accounts and trade-offs
➢ Inventory: Companies maintain inventory of raw
materials, work in process and finished goods.

➢ Payables and accruals: The payables balance

represents the amount owed to the company’s
vendors and suppliers on materials purchased on
credit. The accrual accounts are liabilities incurred but
not yet paid. Examples include accrued wages or tax.

12 2/09/2020

4
 Time Line for Operating and Cash
Conversion Cycles

The operating and cash conversion

cycles
Cash conversion cycle
➢ Begins when the company invests cash to purchase
the raw materials that would be used to produce the
goods that the company manufactures.

➢ Ends not with the finished goods being sold to

customers and the cash collected on the sales; but
when you take into account the time taken by the company
to pay for its purchases.

The operating and cash conversion

cycles

➢ When managing working capital accounts,

financial managers want to do the following:
➢ Delay paying accounts payable as long as
possible without suffering any penalties.
➢ Maintain minimal raw material inventories
without causing manufacturing delays.
➢ Use as little labour as possible to manufacture the
product while producing a quality product.

5
 The operating and cash conversion
cycles

➢ When managing working capital accounts,

financial managers want to do the following:
➢ Maintain minimal finished goods inventories
without losing sales.
➢ Offer customers the most attractive credit terms
possible on trade credit to maximise sales while
minimising the risk of non-payment.
➢ Collect cash payments on accounts receivable as
fast as possible to close the loop.

The operating and cash conversion

cycles

➢ With the financial manager’s goal being to maximise

the value of the company, each of the decisions
above is intended to shorten the cash conversion
cycle and improve the company’s liquidity.

The operating and cash conversion

cycles
Cash conversion timelines
➢ Two tools to measure the working capital
management efficiency are the operating cycle and
the cash conversion cycle.

6
 The operating and cash conversion
cycles
Cash conversion timelines

➢ The operating cycle begins when the company uses its

cash to purchase raw materials and ends when the
company collects cash payments on its credit sales.
➢ Two measures – Days sales outstanding and Days
Sales in Inventory – help determine the operating
cycle.

The operating and cash conversion

cycles
Cash conversion timelines
➢ Days sales outstanding (DSO) estimates how long it
takes on average for the company to collect its
outstanding accounts receivable balance.
➢ This ratio also called the Average Collection
Period (ACP).
➢ An efficient company with good working capital
management should have a low average collection
period compared to its industry.

The operating and cash conversion

cycles
Cash conversion timelines

➢ Days of Sales in Inventory (DSI) shows how long the

company keeps its inventory before selling it. It is the
ratio of the inventory balance to the daily cost of
sales.
➢ The quicker a company can move out its raw
materials as finished goods, the shorter the
duration when the company holds its inventory, and
the more efficient it is in managing its inventory.

7
 The operating and cash conversion
cycles

Cash conversion timelines

➢ The operating cycle is calculated by summing the

Days of Sales Outstanding and the Days of Sales in
Inventory.
OperatingCycle=DSO+DSI

The operating and cash conversion

cycles

Cash conversion timelines

➢ The cash conversion cycle is related to the operating
cycle, but it does not start until the company
actually pays for its inventory.
➢ The cash conversion cycle is the length of time
between the cash outflow for materials and the
cash inflow from sales.
➢ To measure the cash conversion cycle we need
another measure called the days payables
outstanding.

The operating and cash conversion

cycles
Cash conversion timelines
➢ Days of Payables Outstanding (DPO) tells how long a
company takes to pay off its suppliers for the cost of
inventory.
➢ The cash conversion cycle is then calculated by
summing the Days of Sales Outstanding and the
Days of Sales in Inventory and subtracting the Days
of Payables Outstanding.

CashConversionCycle=DSO+DSI- DPO

8
 The Cash Conversion Cycle

Time Line for Operating and Cash

Conversion Cycles

Tutorial week 9 topic 12 part 1

Critical Thinking Questions: 12.5,
Questions and problems: 12.24,
(demonstrate calculations on
whiteboard)12.28,

9
 Part 2

28 2/09/2020

Working capital investment strategies

Flexible current asset investment strategy
➢ Financial managers use two types of strategies for
current assets investments: flexible and restrictive.

➢ The flexible strategy has a high percent of current

assets to sales, whereas a restrictive policy has a
low percent of current assets to sales.

Working capital investment strategies

Working capital trade-off
➢ The flexible strategy calls for management to invest
large amounts in cash, marketable securities, and
inventory.
➢ The strategy also promotes a liberal trade credit
policy for customers, which results in high levels of
accounts receivable.
➢ The flexible strategy is perceived to be a low risk and
low return course of action for management to
follow.

10
 Working capital investment strategies
Working capital trade-off
➢ The advantage of this policy is the large working
capital balances the company holds.
➢ The strategy’s downside is the high carrying cost
associated with owning a high level of inventory and
providing liberal credit terms for its customers.

Working capital investment strategies

Working capital trade-off
➢ The higher carrying costs result for two reasons

➢ The investment in the low return current assets

deprives the higher returns that management
could earn on longer term assets like property,
plant and equipment.
➢ Higher amounts of inventory results in higher
warehousing and storage costs.

Working capital investment strategies

Restrictive current asset investment strategy
➢ Current assets are kept to a minimum in the
restrictive strategy.
➢ The company barely invests in cash and inventory,
and has tight terms of sale intended to curb credit
sales and accounts receivable.
➢ The restrictive strategy is a high-risk high-return
alternative to the flexible strategy.

11
Working capital investment strategies
Restrictive current asset investment strategy
➢ The high risk comes in the form of shortage costs
which can be either financial or operating.
➢ Financial shortage costs arise mainly from illiquidity
shortage of cash a lack of marketable securities to
sell for cash.
➢ If there are unpaid bills that are due, the company
will be forced to use expensive external emergency
borrowing.

Working capital investment strategies

The working capital trade-off
➢ If funding cannot be secured, default occurs on some
current liability and the company runs the risk of
being forced into insolvency by creditors.
➢ Operating shortage costs result from lost production
and sales.
➢ If the company does not hold enough raw materials
in inventory, time may be wasted by a halt in
production.

Working capital investment strategies

The working capital trade-off

➢ If the company runs out of finished goods, sales may

also be lost, and customer dissatisfaction may arise.

➢ Restrictive sale policies such as allowing no credit

sales will also result in lost sales.

➢ Overall, operating shortage costs can be substantial,

especially if the product markets are competitive.

12
 Working capital trade-off
The working capital trade-off
➢ The optimal current asset investment strategy will
depend on the relative magnitudes of carrying costs
versus shortage costs. This conflict is often referred
to as the working capital trade-off.
➢ Financial managers need to balance shortage costs
against carrying costs to find an optimal strategy.
➢ If carrying costs are larger than shortage costs, then
the company will maximise value by adopting a
more restrictive strategy.

Working capital trade-off

The working capital trade-off
➢ On the other hand, if shortage costs dominate
carrying costs, the company will need to move
towards a more flexible policy.
➢ Overall, management will try to find the level of
current assets that minimises the sum of the carrying
costs and shortage costs.

39 2/09/2020

13