Working capital (Lecture 11)

Intro
• Firms need money to pay for their day to day activities, such as wages, raw materials, bills etc. The
money bailable to them is working capital
• A company is short of liquidity when its assets cannot be quickly converted to cash
• Positive working capital is required to ensure that the rm is able to continue with its operations and
that it has su cient funds to satisfy maturing short term debts and up-coming operational expenses
• Working capital management refers to choosing and controlling the levels and mix of cash,
marketable securities, receivables and inventories.

Terminology
• Gross working capital : total current assets
• Net working capital : current assets - current liabilities
• NOWC : current assets - non interest bearing liabilities
◦(cash + inv + A/R ) - (Accruals + A/P )
• Working capital policy : deciding the level of each type of current asset to hold and how to nance
current assets

Operating cycle and cash conversion cycle Time

between theinventory
purchasing andcollecting
cash
fromsellingthemventory
Operatingcycle period
inventory 1AccountsReceivableperiod
or
avg.mx Time topurchase
required Are
Receivables a
inventory
purchasedwas as andselltheinventory inventory credit
salesias timetocollectonoreditsales
a sold 365
period AccountsReceivablePeriod
inutturnoverinventory turnover
receivables
so
i s a
n s time
Accounts v cashcycle
as payableperiod
cash 10
paid craescheived

payabies inventory
period Accounts
period AccountsReceivable Period
turnover inventory 1 Payable
• Accounts payable period
◦payables deferral period : time between the purchase of inventory and payment for inventory
• Payables turnover
◦total purchase from suppliers \ average payable
◦(Cost of goods sold + end inventory - Beg inventory ) \ Average payable
• Accounts payable period
◦365\ payables turnover
• Cash conversion cycle ( operating cycle - accounts payable period )
◦time period for which we need to nance the inventory.
◦Minimising it minimise the amt of external nancing the rm has to raise to fund operations
• Working capital policy re ected in
◦Current ratio
◦Turnover of cash and securities
◦Inventory turnover
◦Accounts receivable turnover
• Carrying and shortage costs
◦there is a trade-o between carrying and shortage costs
‣ Carrying costs : increase with the increased levels of currents assets, the costs to store and
nance the assets
‣ Shortage costs : decrease with the increased levels of currents assets, the costs to
replenish assets
• trading or order costs
• Costs related to safety reserve , lost sales and customers and production shortages
Cash management
• Why hold cash
◦ Transactions
◦Precaution
◦Compensating balance : for loans and services provided
◦Speculation : to take advantage of bargains and discounts
• Goal of management
◦To have enough cash but not excess. Minimise the cash required
• Ways to manage
◦lockbox
‣ banks speed up the process of collecting, processing and making accessible customer’s
payments
‣ Reduce mailing time and processing delay
‣ Helps to turn accounts receivables as quickly as possible
‣ Shorten cash cycle
‣ When calculating up front bank setup fee, the PV of the costs shall be calculated as a
perpetuity
◦Insist on wire transfers / digital payments from customers
◦Use a remote disbursement account
◦Reduce need for safety stock of cash
‣ increase forecast accuracy
‣ Hold marketable securities
‣ Negotiate a line of credit
• Float : di erence between cash in the bank account and cash recorded in one’s own accounting
books.
◦available bank balance - book balance
◦Disbursement oat
‣ when a rm writes checks
‣ Available balance in bank - book balance > 0
◦Collection oat
‣ checks received increase book balance before the bank credits the account
‣ Available balance - book balance < 0
◦Net oat = disbursement oat (+ve )+ collection oat (-ve)
◦Cost of oat : opportunity cost of the money
• Cash disbursement
◦slowing down payments can increase disbursement oat , but it may not be optimal to ethical to
do this.
◦Control disbursement
‣ zero- balance account reduce
‣ Controlled disbursement account tytocollectiondelay
a
• Cash collection Payment Payment
received cashavailable
◦Paymentmailed peposited
mailingtime delay
Processing availability
delay

L collection
delay

• Cash budget - primary cash management tool.

◦purpose : forecast cash in ow, out ow and ending cash balances. Used to plan loans needed or
funds available to invest
◦Timing: daily, weekly or monthly, depending on the burpees of the forecast. Monthly for annual
planning, daily for actual cash management
Receivable management
creditsale checkmailed Check
d eposited cashavailable

casncoueceim

AccountsReceivable

• Credit management

◦Bene ts of credit 3115net40

‣ increase sales a
◦Costs of credit payfullamtin4odays
solodiscountifpaid
‣ chance that customers won’t pay resulting in bad debts withinb days
‣ Financing receivables
◦Examines the trade o between increased sales and costs of granting credit
• Accumulation of receivables
◦determined by
‣ volume of credit sales
‣ Average length of time between sales and collections
◦Accounts receivables = credit sales per day x length of collection period
◦Day Sales Outstanding (DSO) = receivables/ credit sales per day
‣ credit sales per day = annual credit sales / 365
‣ The higher the number is , the less promptly the customers are paying
• credit policy
◦credit period
‣ shorter period reduce DSO and average A/R but may discourage sales
◦Cash discount
‣ lowers price
‣ Attracts new customers and reduce DSO
◦Credit standards
‣ Tighter standards tend to reduce sales but also reduce bad debt expense
‣ Fewer bad debt expense reduce DSO
◦Collection policy
‣ tougher policy will reduce DSO but may damage customer relationships
◦E ects
‣ revenue
• delay in receiving cash from sales
• May be blue to increase sales and price
‣ Cost
• cost of sales is incurred although cash from sales has not been received
• Cost of debt - rm must nance receivables
• Probability of nonpayment
• Cash discount - some customers may pay early and pay less than the full price