Working Capital

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Is working capital management value-enhancing?

• Existence of an optimal level of working capital policy

• Convergence to optimal working capital improve firm value

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Working Capital
• Why working capital is important for business
• Working capital Concept
• Short-term liquidity ratios
• Working Capital and Project Cash Flow
Working capital Concept
• Gross working capital
• The firm’s investment in current assets
• Net working capital
• Current Assets-Current Liabilities

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 Short-term liquidity ratios
Current Assets
Current ratio =
Liquidity Current Liabilities
ratios Cash + Marketable Securities + Receivables
Quick ratio =
Current Liabilities
Short-term
liquidity Net credit sales
Accounts receivable turnover =
Average accounts receivable

Activity Cost of Goods Sold

Inventory turnover =
ratios Average inventory

Inventory purchases
Accounts payable turnover =
Average accounts payable

Days Receivable, Days Inventory, and Days Payable are calculated

by dividing 365 by respective turnover ratios

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➢ Working capital (Current Ratio>1:1) is good or bad
– Traditional View
• Lender
– Modern View
• Current Assets that do not contribute to ROE hinder the
performance of the company
• The concept of working capital as a hindrance to financial
performance is a complete change in attitude from earlier
conventional wisdom

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 𝐹𝐶𝐹𝐸
= 𝑁𝐼 + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 – 𝐹𝐶 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 – 𝑊𝐶 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
+ 𝑁𝑒𝑡 𝑏𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔

WC Investment: the investment in net working capital is equal

to the change in working capital excluding cash, cash
equivalents, note payables, and the current portion of long-
term debt
𝑊𝐶 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 = 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦𝑡 + 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠𝑡 − 𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑡 - 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦𝑡−1 + 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠𝑡−1 − 𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑡−1
 𝐹𝐶𝐹𝐹 = [𝐸𝐵𝐼𝑇 × (1 − 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒)] + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 – 𝐹𝐶 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 – 𝑊𝐶 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

WC Investment: the investment in net working capital is equal to

the change in working capital excluding cash, cash equivalents,
note payables, and the current portion of long-term debt

𝑊𝐶 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 = 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦𝑡 + 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠𝑡 − 𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑡 - 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦𝑡−1 + 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠𝑡−1 − 𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑡−1

 Liquidity Analysis:
Short-term liquidity ratios
Current Assets
Current ratio =
Liquidity Current Liabilities
ratios Cash + Marketable Securities + Receivables
Quick ratio =
Current Liabilities
Short-term
liquidity Average accounts receivable
Days Sales Outstanding = × 365
Net credit sales
Average inventory
Activity Days Inventory Outstanding = × 365
ratios Cost of Goods Sold

Average accounts payable

Days Payable Outstanding = × 365
Inventory purchases

Cost of Goods Sold = Beginning Inventory + Inventory Purchase – Ending Inventory

 Days Inventory Outstanding Days Sales Outstanding

Days Payable
Outstanding

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Working Capital and the Cash Conversion Cycle

• Cash Conversion Cycle

= operating cycle – accounts payable period
= (inventory period + receivables period) – accounts payable period

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Trade Credit

• Terms of Sale
• Credit, discount, and payment terms offered on sale

• Example: 5/10 net 30

• 5: Percent discount for early payment
• 10: Number of days discount is available
• Net 30: Number of days before payment due

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Trade Credit

• Terms of Sale
• Firm that buys on credit borrows from supplier
• Save cash today, pay later (implicit loan)
• Cost of implicit loan:

Effective annual rate

(
= 1+ discount
discounted price
)365/extra days credit
−1

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Trade Credit

• Example
• Calculate implied interest rate on 100 sale with terms 5/10 net 60

Effective annual rate

(
= 1+ discount
discounted price
)365/extra days credit
−1
= (1 + )
5 365/50
95 − 1 = .454, or 45.4%

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Rec/TA Payable/TA
Source: Sinha & Damle, 2021

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Source: Damle & Sinha, 2021

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Source: Damle & Sinha, 2021

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Source: Damle & Sinha, 2021

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Source: Damle & Sinha, 2021

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Theories
• Financing advantage theory
• Price discrimination theory
• Transaction cost theory
• Liquidity theory
• Financial Distress theory
• Quality guarantee theory
• Product differentiation theory
• Market power theory

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