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PK14 Notes
PK14 Notes
Learning Objectives
1. Define net working capital, discuss the importance of working capital management, and be able to
2. Define the operating and cash cycles, explain how they are used, and be able to compute their values for
a firm.
3. Discuss the relative advantages and disadvantages of pursuing (1) flexible and (2) restrictive current
4. Explain how accounts receivable are created and managed, and be able to compute the cost of trade
credit.
5. Explain the trade-off between carrying costs and reorder costs, and be able to compute the economic
6. Define cash collection time, discuss how a firm can minimize this time, and be able to compute the cash
7. Identify three current asset financing strategies and discuss the main sources of short-term financing.
I. Chapter Outline
What is the appropriate amount and mix of current assets for the firm to hold?
Discussions with CFOs quickly lead to the conclusion that, as important as capital budgeting and
capital structure decisions are, they are made less frequently, while the day-to-day complexities
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involving the management of net working capital (especially cash and inventory) consume
tremendous amounts of management time. Also, it is clear that while poor long-term investment
and financing decisions will adversely impact firm value, poor short-term financial decisions will
impair the firm’s ability to remain operating. Finally, working capital decisions can also have a
major impact on firm value.
Current assets are cash and other assets that the firm expects to convert into cash in a year or
less.
Current liabilities (or short-term liabilities) are obligations that the firm expects to pay off in a
year or less.
Working capital, also called gross working capital, includes the funds invested in a company’s
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
current assets.
Working capital efficiency refers to the length of time between when a working capital asset
Cash: This account includes cash and marketable securities like Treasury securities.
○ The higher the cash balance, the better the ability of the firm to meet its short-
Receivables: These represent the amount owed by customers who have taken advantage
Inventory: Firms maintain inventory of raw materials and work in process and finished
goods.
Payables: The payables balance represents the amount owed to the firm’s vendors and
○ The accrual accounts are liabilities incurred but not yet paid, such as accrued
wages or taxes.
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• The cash conversion cycle begins when the firm invests cash to purchase the raw materials that would be used
to produce the goods that the firm manufactures and ends with the finished goods being sold to customers and
the cash collected on the sales, also taking into account the time taken by the firm to pay for its purchases.
See Exhibit 14.2 for a graphical representation of the cash conversion cycle.
• When managing working capital accounts, financial managers want to do the following:
Delay paying accounts payable as long as possible without suffering any penalties.
Use as little labor as possible to manufacture the product while producing a quality product.
Offer customers the most attractive credit terms possible on trade credit to maximize sales while
Collect cash payments on accounts receivable as fast as possible to close the loop.
• With the financial manager’s goal being to maximize the value of the firm, each of the decisions above is
intended to shorten the cash conversion cycle and improve the firm’s liquidity.
• Two tools to measure the working capital management efficiency are the operating cycle and the cash
conversion cycle.
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A. Operating Cycle
• The operating cycle begins when the firm receives the raw materials it purchased and ends when the
• Two measures—days’ sales outstanding and days’ sales in inventory—help determine the operating
cycle.
Days’ sales in inventory (DSI) shows how long the firm keeps its inventory before selling it.
○ It is the ratio of the inventory balance to the daily cost of goods sold.
○ The quicker a firm can move out its raw materials as finished goods, the shorter the
duration when the firm holds it inventory, and the more efficient it is in managing its
inventory.
Days’ sales outstanding (DSO) estimates how long it takes on average for the firm to collect
○ An efficient firm with good working capital management should have a low average
• The operating cycle is calculated by summing the days’ sales outstanding and the days’ sales in
inventory.
(14.1)
Operating Cycle = DSO + DSI
The cash conversion cycle is the length of time between the cash outflow for materials and the
• To measure the cash conversion cycle, we need another measure called the day’s payables outstanding.
• Days’ payable outstanding (DPO) shows how long a firm takes to pay off its suppliers for the cost of
inventory.
• The cash conversion cycle is then calculated by summing the days’ sales outstanding and the days’
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Article: Dell Manages Profitability, Not Inventory
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Operating cycle = DSO + DSI = 57.13 + 111.28 = 168.41 days
Cash conversion cycle = DSO + DSI – DPO = 57.13 + 111.28 – 38.95 = 129.46 days
Short-term financial management in a large firm involves coordination between the credit manager, marketing
manager, and controller. Potential for conflict may exist if particular managers concentrate on individual
objectives as opposed to overall firm objectives.
The cash conversion cycle depends on the inventory, receivables, and payables periods. The cash conversion cycle
increases as the inventory and receivables periods get longer. It decreases if the company is able to defer payment of
payables and thereby lengthen the payables period. Most firms have a positive cash conversion cycle, and they thus
require financing for inventories and receivables. The longer the cash conversion cycle, the more financing is
required. Also, changes in the firm's cash conversion cycle are often monitored as an early-warning measure. A
lengthening cycle can indicate that the firm is having trouble moving inventory or collecting on its receivables. Such
problems can be masked, at least partially, by an increased payables cycle, so both should be monitored.
We can easily see the link between the firm's cash conversion cycle and its profitability by recalling that one of the
basic determinants of profitability and growth for a firm is its total asset turnover, which is defined as Sales/Total
assets. The higher this ratio is, the greater are the firm's accounting return on assets, ROA, and return on equity, ROE.
Thus, all other things being the same, the shorter the cash conversion cycle is, the lower is the firm's investment in
inventories and receivables. As a result, the firm's total assets are lower, and total turnover is higher.
14.3 Working Capital Investment Strategies
• Financial managers use two types of strategies for current assets investments: flexible and restrictive.
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A. Flexible Current Asset Investment Strategy
• The flexible strategy has a high percent of current assets to sales, whereas a restrictive policy has a low
• 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 be a low risk and low return course of action for management to
follow.
• The advantage of this policy is the large working capital balances the firm holds.
• The strategy’s downside is the high inventory-carrying cost associated with owning a high level of
The investment in the low return current assets deprives the higher returns that management
• The firm barely invests in cash and inventory, and has tight terms of sale intended to curb credit sales
The high risk comes in the form of shortage costs that can be either financial or operating.
Financial shortage costs arise mainly from the illiquidity shortage of cash and a lack of
○ If unpaid bills are due, the firm will be forced to use expensive external emergency
borrowing.
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○ If funding cannot be secured, default occurs on some current liability and the firm runs
○ If the firm does not hold enough raw materials in inventory, time may be wasted by a
halt in production.
○ If the firm runs out of finished goods, sales may also be lost, and customer
○ 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.
• 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 firm will maximize value by adopting a
On the other hand, if shortage costs dominate carrying costs, the firm will need to move toward
Overall, management will try to find the level of current assets that minimizes the sum of the
A. Terms of Sale
• Whenever a firm sells a product, the seller spells out the terms and conditions of the sale in a document
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• The agreement specifies when the cash payment is due and the amount of any discount if early
payment is made.
• Trade credit, which is short-term financing, is typically made with a discount for early payment rather
An offer of “3/10, net 40” means that the selling firm offers a 3 percent discount if the buyer
pays the full amount of the purchase in cash within 10 days of the invoice date.
○ Otherwise, the buyer has 40 days to pay the balance in full from the date of delivery.
• To calculate the cost, we need to determine the interest rate the buyer is paying and convert it to an
• The formula for calculating the EAR for a problem like this is shown below, in Equation 14.4,
Note: The above is the calculation of the true cost of not taking a cash discount.
Example: Suppose that a firm sells its products with terms of 3/15, net 60. What is the implicit cost (EAR) if your
firm does not take the cash discount offered?
• Trade credit is a loan from the supplier and it can be a very costly form of credit.
• The aging schedule shows the breakdown of the firm’s accounts receivable by their date of sale—how
• Its purpose is to identify and then track delinquent accounts and to see that they are paid.
• Aging schedules are also an important financial tool for analyzing the quality of a company’s
receivables.
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The aging schedule reveals patterns of delinquency and shows where collection efforts should
be concentrated.
• Manufacturing companies generally carry three types of inventory: raw materials, work in process, and
finished goods.
• The economic order quantity (EOQ) mathematically determines the minimum total inventory cost,
• The optimal order size strikes the balance between these two costs.
Note: The EOQ model makes the following assumptions: (1) that a firm’s sales are made at a constant rate
over a period, (2) that the cost of reordering inventory is a fixed cost, regardless of the number of units
ordered, and (3) that inventory has carrying costs, which includes items such as the cost of space, taxes,
insurance, and losses due to spoilage and theft.
Example: Jackson Electricals is one of the largest dealers of generators in Phoenix and sells about 2,000 of them a
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year. The cost of placing an order with their supplier is $750, and the inventory-carrying costs are $170 for each
generator. They like to maintain safety stock of 15 at all times.
b. How many orders will the firm need to place this year?
Number of orders the firm needs to place = 2,000 / 133 = 15.0376 = 15 orders
• In this system the exact day-by-day, or even hour-by-hour, raw material needs are delivered by the
suppliers, who deliver the goods “just in time” for them to be used on the production line.
• A big advantage of this system is that there are essentially no raw inventory costs and no chance of
• On the other hand, if the supplier fails to make the needed deliveries, then production shuts down.
• If the system works for a firm, it cuts down their investment in working capital dramatically.
• Two reasons exist for holding a cash balance. First, it facilitates transactions with suppliers,
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• The second reason is simply that most banks require firms to hold minimum cash balances, or
A. Cash Collection
• Collection time, or float, is the time between when a customer makes a payment and when the cash
○ When a customer mails payment, it may take several days before that payment arrives.
○ Once the payment is received, it must be opened, examined, accounted for, and
Finally, there is a delay between the time of the deposit and the time when the cash is available
Payments in cash at the point of sale reduce the collection time to zero.
○ Payment by check or credit card at the point of sale eliminates the mail time but not the
processing time.
• A lockbox system allows geographically dispersed customers to send their payments to a post office
Lockboxes are special post office boxes that allow banks to process the incoming checks and then
send the information on account payment to the firm; that reduces processing time and often reduces
mail time because several regional lockboxes can be used.
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• With a concentration account, a post office box is replaced by a local branch, which receives the
Cash concentration is the practice of moving cash from multiple banks into the firm’s main accounts.
This is a common practice that is used in conjunction with lockboxes.
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• Either approach will reduce the collection time to an extent, but there is a cost associated with it.
• Another increasingly popular means of reducing cash collection time is through the use of electronic
Finally, electronic funds transfers typically have little or no delay in funds availability.
• Exhibit 14.7 shows the three basic strategies that a firm can follow to finance its working capital and fixed
assets.
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Each of the three panels show: (1) the total long-term financing needed, which consists of long-
term debt and equity, and (2) the seasonal needs for working capital that fluctuates with the level of
sales.
All working capital is funded with short-term borrowing, and, as the level of sales varies
seasonally, short-term borrowing fluctuates between some minimum and maximum level.
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The “matching of maturities” is one of the most basic techniques used by financial managers to
This strategy relies on long-term debt to finance both capital assets and working capital.
This strategy reduces the risk of funding current assets because there is no need to worry about
Figure C in Exhibit 14.7 shows the short-term funding strategy whereby all working capital and a
While this lowers the cost under some interest rate scenarios, it forces the firm to continually
refinance the funding of the long-term assets in a changing interest rate environment.
• Many financial managers try to match the maturities of assets and liabilities when funding the firm.
That is, short-term assets are funded with short-term financing, and long-term assets are funded
• Most financial managers like to fund some of their currents assets with long-term debt as shown in Figure
• In recent years, a number of large, well-known firms of the highest credit standing have been funding
some of their long-term fixed assets with short-term debt sold in the commercial paper market.
• Accounts payable (trade credit), bank loans, and commercial paper are common sources of short-term
financing.
• Between 1990 and 2003, accounts payable constituted 37 percent of total current liabilities for all
The buyer needs to figure out whether it makes financial sense to pay early and take advantage of
the discount or to wait and pay in full when the account is due.
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• Between 1990 and 2003, short-term bank loans accounted for 19 percent of total current liabilities for all
An informal line of credit is a verbal agreement between the firm and the bank, allowing the
In exchange for providing the line of credit, a bank may require that the firm holds a
A formal line of credit is also known as “revolving credit,” whereby the bank has a legal
○ The firm pays a yearly fee, in addition to the interest expense on the amount they borrow.
If the firm backs the loan with an asset, the loan is defined as secured; otherwise, the loan is
unsecured.
Secured loans allow the borrower to borrow at a lower interest rate, all else being equal.
• Commercial paper is a promissory note issued by large financially secure firms, which have high
credit ratings.
Commercial paper is not “secured,” which means that the issuer is not pledging any assets to
However, most commercial paper is backed by a credit line from a commercial bank.
Therefore, the default rate on commercial paper is very low, resulting in an interest rate that is
• For medium-size and small businesses, accounts receivable financing is an important source of funds.
A company can secure a bank loan by pledging the firm’s accounts receivable as security.
A second way for a business to finance itself with accounts receivables is to sell the receivables
to a factor at a discount.
The firm that sold the receivables has no further legal obligation to the factor.
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Chapter 14 – Sample Problems
1. Operating cycle: Trend Foods distributes its products to more than 100 restaurants and delis. The company’s
collection period is 32 days, and it keeps its inventory for 10 days. What is Trend’s operating cycle?
a. 22 days
b. 32 days
c. 42 days
d. None of the above.
2. Operating cycle: Stamp, Inc., has an operating cycle of 81 days and takes 47 days to collect on its receivables.
What is its level of inventory if the firm’s cost of goods sold is $312,455? Round to the nearest dollar.
a. $9,190
b. $14,685
c. $29,105
d. $69,339
3. Cash conversion cycle: Wolfgang Electricals estimates that it takes the company 31 days on average to pay off its
suppliers. It also knows that it has days’ sales in inventory of 54 days and days sales’ outstanding of 34 days. What is
its cash conversion cycle?
a. 119 days
b. 34 days
c. 57 days
d. 46 days
4. Cash conversion cycle: West Handicrafts, Inc., has net sales of $423,000 with 30 percent of it being credit sales.
Its cost of goods sold is $324,000. The firm’s cash conversion cycle is 47.9 days. The firm’s operating cycle is 86.3
days. What is the firm’s accounts payable? Round to the nearest dollar.
a. $34,087
b. $126,900
c. $71,203
d. $56,322
5. Cost of trade credit: Senter Corp. sells its goods with terms of 2/10 EOM, net 30. What is the implicit (effective)
cost of the trade credit?
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a. 18.50%
b. 30.00%
c. 44.59%
d. 21.89%
1. Solution:
DSI = 10 days
DSO = 32 days
Operatingcycle = DSO + DSI
= 32 + 10
= 42 days
2. Solution:
3. Solution:
DPO = 31 days
DSI = 54 days
DSO = 34 days
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4. Solution:
Net sales = $423,000
Credit sales = (0.3 x $423,000) = $126,900
Cash conversion cycle = 47.9 days
Operating cycle = 86.3 days
Cost of goods sold = $324,000
Accountspayables Accountspayables
DPO = = = 38.4 days
COGS 365 $324,000 365
= [(1 + 2/98)^(365/20)] – 1
= [(1.0204)^18.2500] – 1
= 1.4459 – 1
= 0.4459, or 44.59%
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