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W.C.M (C 1) (Arafat)
W.C.M (C 1) (Arafat)
(1) What is the appropriate amount of working capital, both in total and for each specific
account? (2) How should working capital be financed?
Sound working capital management involves more than just finance. It requires collaboration
between various departments within a company. Professionals from logistics, operations
management, information technology, and production work together to streamline processes,
reduce inventory, and improve manufacturing efficiency. Marketing managers and logistics
experts also join forces to enhance product delivery to customers. Finance plays a role in
comparing the company's performance with industry standards and evaluating the profitability
of different strategies for working capital management. Financial managers determine the
optimal cash reserves and short-term financing needed to support working capital.
1. Working capital, sometimes called gross working capital, simply refers to current assets used
in operations.
2. Net working capital is defined as current assets minus all current liabilities.
We can use the Du Pont equation to demonstrate how working capital management affects the
return on equity:
A relaxed policy means the company holds a lot of assets, resulting in a low total assets
turnover ratio and a low return on equity (ROE). On the other hand, a restricted policy means
the company holds fewer assets, leading to a high turnover ratio and a relatively high ROE.
However, the restricted policy carries the risk of shortages, work stoppages, and dissatisfied
customers. The moderate policy aims to strike a balance between the two extremes. The
optimal strategy is the one that management believes will maximize the company's long-term
earnings and the intrinsic value of its stock.
Changing technologies can impact the optimal policy for managing current assets. For instance,
if a new technology enables faster production, work-in-progress inventories can be reduced.
Retailers like Wal-Mart and Home Depot use barcode-based inventory management systems,
which track merchandise sales and automatically reorder items when stock levels are low.
These systems minimize the need for excess inventory and improve profitability. Overall,
technology advancements have significantly decreased inventories and increased profits.
Even though maturity matching can be a reasonable approach, it can still carry risks. Many firms
discovered this during the financial crisis in 2009. For instance, if a company borrowed a 30-day
bank loan to finance inventories expecting to sell them within that time frame, but then
experienced a drop in sales, they might not have the funds to repay the loan. If the bank
doesn't extend the loan, the company could face bankruptcy. This situation was worsened by
the banks' own problems during that time, as they had suffered significant losses and restricted
credit to conserve their own cash.
Panel b of Figure 2 illustrates the situation for a more aggressive firm that finances some of its
permanent assets with short-term debt. Note that we used the term "relatively" in the title for
Panel b because there can be different degrees of aggressiveness.
For example, the dashed line in Panel b could have been drawn below the line designating fixed
assets, indicating that all of the current assets-both permanent and temporary-and part of the
fixed assets were financed with short-term credit. This policy would be a highly aggressive,
extremely risky position, and the firm would be subject to dangers from loan renewal as well as
rising interest rate problems. However, short-term interest rates are generally lower than long-
term rates, and some firms are willing to gamble by using a large amount of low-cost, short-
term debt in hopes of earning higher profits.
Scenario: Let's say a company borrowed $1 million for one year to purchase machinery that
would save them $200,000 annually for 10 years. However, the cash flows generated by the
machinery wouldn't be enough to repay the loan within one year. If the lender refuses to renew
the loan, especially during an economic downturn like the one in 2009, it could lead to
bankruptcy for the company. If the company had matched the loan's maturity with the
equipment's lifespan (10 years), the annual loan payments would have been lower and better
aligned with the cash flows, avoiding the loan renewal problem.
i. Purchasing raw materials and supplies on credit, thereby creating accounts payable.
Such purchases have no Immediate cash flow effect because payment is not made at
the time of purchases.
ii. Labor and other factory expenses are used to convert the materials into the finished
products.
iii. The finished products are sold on credit, thereby creating accounts receivables. Such
sales have no immediate cash inflows to the business.
iv. Later on, the question of paying off accounts payable and other accrued operating costs
like wages and factory overheads arises which involves cash outflows.
v. The last process arises when the question of collection from accounts receivables arises.
This leads to cash inflows in the business.
There are three important stages of a cash conversion cycle namely, the inventory conversion
period, receivables collection period and the payables deferral period. The following
paragraphs deals with the following stages:
(i) The Inventory Conversion Period: The inventory conversion period is the average length of
time required to convert materials into finished goods and then to sell those goods. It is the
amount of time the product remains in inventory in various stages of completion. The inventory
conversion period is calculated by dividing inventory by the cost of goods sold per day.
(ii) The Receivables Collection period/Average Collection Period: The average collection period
is the average time it takes for a company to convert its receivables into cash, or in simpler
terms, the time it takes for customers to pay for goods after a sale. The receivables collection
period also is called the day's sales outstanding (DSO), and it is calculated by dividing accounts
receivable by the average credit sales per day.
(iii) The Payable Deferred Period: It is the average length of time between the purchase of raw
materials and labor and the payment of cash for them. It is computed by dividing accounts
payable by the daily credit purchases.
The cash conversion cycle computation nets out the three periods just defined, The cash
conversion cycle is the period between a company's cash expenditure for productive resources
(like materials and labor) and the cash receipts from selling products. It represents the average
time that money is tied up in current assets. Therefore, the formula for finding out the cash
conversion cycle goes as follows:
Inventories 140.0
Thus, its net operating working capital due to inventory, receivables, and payables is $140 +
$445 - $115 = $470 million, and that amount must be financed-in GBM's case, through bank
loans at a 10% interest rate. Therefore, its interest expense is $47 million per year.
Thus, it takes GBM an average of 50.4 days to sell its merchandise. Note also that inventory is
carried explains why the denominator here is the cost of goods sold per day, not at cost, which
daily sales. The average collection period (or days sales outstanding) is calculated next:
Thus, it takes GBM 133.5 days after a sale to receive cash. Because receivables are recorded at
the sales price, we use daily sales (rather than the cost of goods sold per day) in the
denominator for the ACP.
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