WORKING CAPITAL

WORKING CAPITAL MANAGEMENT

MANAGEMENT
 Alternative working capital policies
DR. M. SADIQUL ISLAM  Cash management

Professor  Inventory management

Department of Finance  Accounts receivable management

University of Dhaka  Working capital financing policies

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Basic Definitions
 Working Capital Management:
Includes both establishing working capital
 Gross working capital:
policy and then the day-to-day control of:
Total current assets. – Cash
 Net working capital: – Inventories
Current assets - Current liabilities. – Receivables
– Short-term liabilities
 Working capital policy:
– The level of each current asset.
– How current assets are financed.
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Current Assets & Current Liabilities

Current Assets Current Liabilities
Selected Ratios for Rabbi Ltd.
Cash (in hand & at bank) Accounts Payable (Creditors)
Inventories Notes Payables Rabbi Industry
Raw Materials Short-term Loans / Overdraft Current 1.75x 2.25x
Quick 0.83x 1.20x
Work-in-progress Dividend Payable Debt/Assets 58.76% 50.00%
Finished Goods Tax Payable Turnover of cash
Supplies (stores/spares) Accrued Expenses & securities 16.67x 22.22x
DSO (days) 45.00 32.00
Accounts Receivables (Debtors) Unearned Income Inv. turnover 4.82x 7.00x
Notes Receivable(Bills Receivables) F.A. turnover 11.35x 12.00x
T.A. turnover 2.08x 3.00x
Short term Investments Profit margin 2.07% 3.50%
Prepaid Expenses ROE 10.45% 21.00%
Accrued Income Pay. deferral period 30.00 33.00
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 How does Rabbi’s working capital policy Alternative Current Asset
compare with the industry? Investment Policies

 Working capital policy is reflected in a firm’s Current Assets (Taka) Relaxed

current ratio, quick ratio, turnover of cash and
securities, inventory turnover, and DSO.
Moderate
 These ratios indicate Rabbi has large amounts of
working capital relative to its level of sales. Thus, Restricted
Rabbi is following a relaxed (fat cat) policy.

Sales (Taka)
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Is Rabbi inefficient or just conservative?

Cash Conversion Cycle
The cash conversion cycle focuses on the time
between payments made for materials and labor
 A relaxed policy may be appropriate if it
reduces risk more than profitability.
and payments received from sales:
 However, Rabbi is much less profitable than
Cash Inventory Receivables Payables
the average firm in the industry. This suggests
conversion = conversion + collection - deferral .
that the company probably has excessive
cycle period period period
working capital.

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Receivables Collection Period

Inventory Conversion Period

It measures how long does it take to convert raw

It measures how long does it take to collect
materials into finished goods. from the customers or debtors.

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 Cash Conversion Cycle (Cont.)
Payables Deferral Period
Payables
CCC = Days per year + Days sales – deferral
Inv. turnover outstanding
It is the average time between purchase period
of materials and labor and payment of CCC = 360 + 45 – 30
cash. 4.82
CCC = 75 + 45 – 30
Payables
Accounts payable Accounts payable CCC = 90 days.
deferral = =
period Credit purchases per day  Cost of goods sold

 360 
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Cash Management: What’s the goal of cash management?

Cash doesn’t earn interest,
so why hold it?
 Transactions: Must have some cash to pay  To have sufficient cash on hand to meet the
current bills.
needs listed on the previous slide.
 Precaution: “Safety stock.” But lessened by
credit line and marketable securities.  However, since cash is a non-earning asset,

 Compensating balances: For loans and/or to have not one dollar more.
services provided.
 Speculation: To take advantage of bargains, to
take discounts, and so on. Reduced by credit line,
marketable securities.
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MANAGEMENT OF Criteria for Selecting

MARKETABLE SECURITIES Marketable Securities
Marketable securities are the securities that (a) Return
can be converted into cash in short time at (b) Risk
little or no transaction cost. i. Default risk
Two basic reasons for holding marketable ii. Event risk – e.g., happening of LBO
securities: iii. Interest rate risk
(a) serves as a substitute of cash balances iv. Purchasing power risk
(b) used as a temporary investment. v. Liquidity or marketability risk

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 Economic Order Quantity
Inventory Management:
Categories of Inventory Costs (EOQ)
 It is order quantity that minimizes
 Carrying Costs: Storage and handling costs, insurance,
property taxes, depreciation, and obsolescence. order costs and carrying costs of
 Ordering Costs: Cost of placing orders, shipping, and inventories.
handling costs.
 Costs of Running Short: Loss of sales, loss of
customer goodwill, and the disruption of production
schedules.

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EOQ EOQ
Cost of ordering and carrying inventories

Total Inventory Costs

EOQ = The Economic Order Quantity
Total Carrying Costs F = Fixed cost of placing and receiving an order;
T = Annual Sales in Units.
C = Annual carrying costs (percentage of inventory value)
P = purchase price per unit of inventory
Total Ordering costs

EOQ Order Size (Units)

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RECEIVABLE MANAGEMENT Monitoring of Receivables

Receivables tie up funds and essentially (a) Monitoring DSO

increases financial expenses. But it also (b) Aging Schedule
increases sales of the firm. Two major (c) Payment Pattern Approach
issues of receivables management are:
(a) How to monitor receivables?
(b) How to determine optimal credit
policy?

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 Monitoring of Receivables Aging Schedule
Aging schedule breaks down a firm’s
Days’ Sales Outstanding: receivables by the age of accounts.
Days’ sales outstanding (DSO) is the Age of Accounts Value of Accounts Percentage of Total
average time in which money is collected (Days) Volume

from receivables. It is estimated as: 0 – 10 110,000 55%

11 – 20 42,000 21%
21 – 30 26,000 13%
31 – 40 12,000 6%
41 – 50 10,000 5%
51 – 60 - -
61 & above - -
Total 200,000 100%

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Payment Pattern Approach Month Cred Receiv Based on Based on year-to-

it ables quarterly data date data
Sales ADS DSO ADS DSO

Jan 120 118

Feb 120 180
It is a monitoring mechanism whether Mar 120 204 4.00 51 4.00 51
Apr 120 204
customers are slowing down their May 180 258
payments. June
July
240
240
348
396
6.00 58 5.00 70

Aug 180 354

Sept 120 264 6.00 44 5.33 49
Oct 120 216
Nov 120 204
Dec 120 204 4.00 51 5.00 41
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Elements of Credit Policy

 Cash Discounts: Lowers price.
Attracts new customers and reduces
DSO.
 Credit Period: How long to pay?
Shorter period reduces DSO and
average A/R, but it may discourage
sales.
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 Credit Standards: Tighter standards
reduce bad debt losses, but may reduce
sales. Fewer bad debts reduces DSO.
 Collection Policy: Tougher policy will
reduce DSO, but may damage customer
relationships.
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Working Capital Financing Maturity Matching Financing Policy
Policies
 Maturity Matching: Matches the Temp. C.A.
maturity of the assets with the maturity of S-T
Loans
the financing.
 Aggressive: Uses short-term (temporary) Perm C.A. L-T Fin:
capital to finance some permanent assets. Stock,
Bonds,
 Conservative: Uses long-term
Spon. C.L.
(permanent) capital to finance some Fixed Assets
temporary assets.
Years
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Aggressive Financing Policy Conservative Financing Policy

Taka Marketable Securities
Temp. C.A.
Zero S-T
S-T
debt
Loans

L-T Fin: L-T Fin:

Perm C.A.
Stock, Perm C.A. Stock,
Bonds, Bonds,
Spon. C.L. Spon. C.L.
Fixed Assets Fixed Assets

Years Years
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