Teresa del Campo Rodríguez

CORPORATE FINANCIAL MANAGEMENT 2

WEEK 11: WORKING CAPITAL MANAGEMENT

1. What is a firm’s net working capital?
In financial statements we defined it as the difference between current assets and current
liabilities, but we have to be more precise. Net working capital is the capital required in the short
term to run the business.
It involves short-term asset accounts such as cash, inventory, and accounts receivable, as well
as short-term liability accounts such as accounts payable.

2. What indirect cost are in the activity of investing in inventories?

There are opportunity costs associated with investing in inventories and accounts receivable,
and from holding cash. Excess funds invested in these accounts could instead be used to pay
down debt or returned to shareholders in the form of a dividend or share repurchase. There are
tools so he company can minimize these opportunity costs.
3. What are the main components of the net working capital?
Working capital includes:
- The Cash Cycle: Working capital only includes the cash needed to run the firm on a day-
to-day basis, no the excess cash. A firm’s cash cycle is the length of time between when
the firm pays cash to purchase its initial inventory and when it receives cash from the
sale of the output produced from that inventory. It can be measured through the cash
conversion cycle (CCC):

- Inventory: the things purchased by the firm that act as an input in order to produce the
output.
- Receivables and payables

4. What is the difference between the cash cycle and the operating cycle?
- cash cycle is the length of time between when the firm pays cash to purchase its initial
inventory and when it receives cash from the sale of the output produced from that
inventory.
- operating cycle is the average length of time between when a firm originally
- purchases its inventory and when it receives the cash back from selling its product.
If the firm pays cash for its inventory, this period is identical to the firm’s cash cycle. However,
most firms buy their inventory on credit, which reduces the amount of time between the cash
investment and the receipt of cash from that investment.
5. What is the relationship between the cash cycle and the working net capital?
The longer a firm’s cash cycle, the more working capital it has, and the more cash it needs to
carry to conduct its daily operations.
Any reduction in working capital requirements generates a positive free cash flow that the
firm can distribute immediately to shareholders.
 Teresa del Campo Rodríguez
CORPORATE FINANCIAL MANAGEMENT 2

6. What is the trade credit and when does a firm has to deal with it?
It is the amounts of money a firm is extending to its customer. This term appears when the firm
allows the customer to pay for goods at some date later that the date of purchase creating the
“account receivable”. Trade credit is, in essence, a loan from the selling firm to its customer. The
price discount represents an interest rate. Often, firms offer favorable interest rates on trade
credit as a price discount to their customers.

7. Why it is profitable for companies to provide trade credits?

Customers take trade credits instead of loans because it is simple and convenient to use (no
paperwork and lower transaction cost) and also it is also a more flexible source of funds.
Companies will be willing to provide this kind of “loans” because providing financing at below-
market rates is an indirect way to lower prices for only certain customers, also because the
supplier may have an ongoing business relationship with its customer,
it may have more information about the credit quality of the customer than a traditional
outside lender such as a bank. Finally, if the buyer defaults, the supplier may be able to seize the
inventory as collateral.

8. How a firm adopts a policy for offering credit to its customers and how it monitors its
accounts receivable on an ongoing basis?
Establishing a credit policy involves three steps that we will discuss in turn:
1. Establishing credit standards: The company has to establish a formal policy on whom
are going to be able to access to this credit, be selective about which customers will be
able to take benefit from this. The decision of how much credit risk to assume plays a
large role in determining how much money a firm ties up in its receivables.
2. Establishing credit terms: decides on the length of the period before payment
must be made (the “net” period) and chooses whether to offer a discount to encourage
early payments.
3.Establishing a collection policy: The content of this policy can range from doing nothing
if a customer is paying late (generally not a good choice), to sending a polite letter of
inquiry, to charging interest on payments extending beyond a specified period, to
threatening legal action at the first late payment.
After establishing a credit policy, a firm must monitor its accounts receivable to analyse whether
its credit policy is working effectively.

9. Which tools do the firms use in order to monitor the accounts receivable?
Analyse whether the credit policy is working effectively is as important as the first three steps
we have to follow, and the tools used for that purpose: the account receivable days and the
aging schedule.
- The accounts receivable days is the average number of days that it takes a firm to collect
on its sales. A firm can compare this number to the payment policy specified in its credit
terms to judge the effectiveness of its credit policy.
Because accounts receivable days can be calculated from the firm’s financial
statements, <outside investors commonly use this measure to evaluate a firm’s credit
management policy.
- An aging schedule categorizes accounts by the number of days they have been on the
firm’s books. If the aging schedule gets “bottom-heavy”—that is, if the percentages in
the lower half of the schedule begin to increase—the firm will likely need to revisit its
credit policy.
The aging schedule is also sometimes augmented by analysis of the payments pattern,
which provides information on the percentage of monthly sales that the firm collects in
each month after the sale.
 Teresa del Campo Rodríguez
CORPORATE FINANCIAL MANAGEMENT 2

10. What are the costs of stretching accounts payable?

This situation comes out when firms ignore the payment due period and pay later, by doing so
the firm reduces the direct cost of trade
credit because it lengthens the time that a firm has use of the funds. these actions will reduce
the effective annual rate associated with the trade credit,
the firm may incur costs as a result of these actions:
- It constitutes unethical business behaviour in most people’s minds
- Suppliers might impose terms of cash delivery (COD) or cash before delivery. This leads
to additional cost which will make the firm negotiate a bank loan to pay.
- Suppliers might also discontinue business with the firm that always pays late (need to
find another source)
- Finally, a poor credit rating might also result in making difficult for the firm to obtain
good terms with another supplier

11. What is accounts payable days outstanding?

The accounts payable days outstanding is the accounts payable balance expressed in terms of
the number of days of cost of goods sold. It is calculated by firms to be able to ensure that it is
making its payments at an optimal time.

12. What is inventory management and why is it so important? Who is really in charge of
the inventory policy?
Inventory is one of the required factors of production, the firm need it and there is no option B,
that is why its management receives an extensive coverage in courses on operations
management. the role of the inventory manager is to balance the costs and benefits associated
with inventory. Because excessive inventory uses cash, efficient management of inventory
increases firm value. it is the firm’s financial manager who must arrange for the financing
necessary to support the firm’s inventory policy and who is responsible for ensuring the firm’s
overall profitability.

13. What are the benefits and cost of holding inventory?

Firms needs its inventory to operate for several reasons:
- Helps minimize the risk that the firm will not be able to obtain an input it needs for
production. (if the firm has stock-outs it can run out of goods)
- It is more efficient for firms to produce at relatively constant levels in order to be able
to face seasonality. A company should evaluate whether for them is more effective to
produce at a constant rate or use seasonal manufacturing as a strategy and produce at
the level of efficient production.
Tying up capital in inventory is costly for a firm. Here we can distinguish 3 categories of costs:
- Acquisition costs: costs of the inventory itself
- Order costs: total cost of placing an order
- Carrying costs: storage costs, insurance, taxes, spoilage, obsolescence and the
opportunity costs of having funds in the inventory.

14. What is the “just in time” inventory management?

It is a strategy some firms use in order to reduce their carrying costs as much as possible. The
JIT inventory management is when a firm acquires inventory precisely when needed so that its
inventory balance is always zero, or very close to it. This technique requires exceptional
coordination with suppliers as well as a predictable demand for the firm’s products. In addition,
there may be a trickle-down effect when one firm in an industry adopts JIT.
 Teresa del Campo Rodríguez
CORPORATE FINANCIAL MANAGEMENT 2

15. Why does a firm hold cash?

Liquidity has a cost because in real markets the companies can’t instantly raise money at a fair
rate and also holding excess cash has a cost, because you have to pay the double taxation of
corporate interest income. In these cases, the optimal strategy for a firm is to hold cash in
anticipation of seasonality in its operating or investment cash flows, as well as to buffer random
shocks that affect the business. Risky firms and firms with high-growth opportunities tend to
hold a relatively high percentage of assets as cash. Firms with easy access to capital markets (for
which the transaction costs of raising cash are lower) tend to hold less cash. Some motives for
holding cash are:
- To meet its day-to-day needs: firm must hold enough cash to pay its bills. The amount
of cash a firm needs to be able to pay its bills is sometimes referred to as a transactions
balance.
- To compensate for the uncertainty associated with its cash flows: The amount of cash a
firm holds to counter the uncertainty surrounding its future cash needs is known as a
precautionary balance. The size of this balance depends on the degree of uncertainty
surrounding a firm’s cash flows. To measure the uncertainty, we focus on volatility.
- To satisfy bank requirements: A firm’s bank may require it to hold a compensating
balance in an account at the bank as compensation for services that the bank performs.
Compensating balances are typically deposited in accounts that either earn no interest
or pay a very low interest rate.

16. What trade-off does a firm face when choosing how to invest its cash?
Investing in cash short-term securities is not the only alternative a firm has when deciding what
to do with their excess cash flows. In fact, the firm may choose from a variety of short-term
securities that differ somewhat with regard to their default risk and liquidity risk.
Thus, a financial manager who wants to invest the firm’s funds in the least risky security will
choose to invest in Treasury bills. However, if the financial manager wishes to earn a higher
return on the firm’s short-term investments, she may opt to invest some or all of the firm’s
excess cash in a riskier alternative, such as commercial paper.