Chapter 16

Working Capital
Management

Alternative Working Capital

Policies
Cash Management
Inventory and A/R Management
Trade Credit
Bank Loans

16-1

Working Capital Terminology

Working Capital = Current Asset

Net Working capital = current assets- Current
Liability.
Net operating working capital=current assets(Current Liability Notes payable).
Working capital policy deciding the level of
each type of current asset to hold, and how to
finance current assets.
Working capital management controlling
cash, inventories, and A/R, plus short-term
liability management.
16-2

Selected Ratios for SKI Inc.

SKI
Ind Avg
Current ratio
1.75x
2.25x
Debt/Assets
58.76% 50.00%
Turnover of cash & securities 16.67x 22.22x
Days sales outstanding
45.63
32.00
Inventory turnover
4.82x
7.00x
Fixed assets turnover
11.35x 12.00x
Total assets turnover
2.08x
3.00x
Profit margin
2.07%
3.50%
Return on equity
10.45% 21.00%
16-3

How does SKIs working capital policy

compare with its industry?

Working capital policy is reflected in

the current ratio, turnover of cash and
securities, inventory turnover, and
days sales outstanding.
Some ratios indicate SKI has large
amounts of working capital relative to
its level of sales.

16-4

What is the investment policy for

SKI?

Relaxed Investment Policy: Relatively large

amounts of cash, marketable securities,
and inventories are carried, and liberal
credit policy results in a high level of
receivables.
Restricted investment Policy: Holdings of
cash, marketable securities, inventories,
and receivable are constrained.
Moderate investment Policy: An investment
policy that is between the relaxed and
restricted policy.
16-5

Working Capital Financing

Policies

Moderate Match the maturity of the

assets with the maturity of the
financing.
Aggressive Use short-term financing to
finance permanent assets.
Conservative Use permanent capital
for permanent assets and temporary
assets.

16-6

Moderate Financing Policy

$

Temp. C.A.
S-T
Loans
Perm C.A.

Fixed Assets

L-T Fin:
Stock,
Bonds,
Spon. C.L.
Years

Lower dashed line would be more

aggressive.

16-7

Conservative Financing Policy

$

Marketable
securities

Perm C.A.

Zero S-T
Debt
L-T Fin:
Stock,
Bonds,
Spon. C.L.

Fixed Assets
Years
16-8

Cash Conversion Cycle

The cash conversion cycle focuses on

the length of time between when a
company makes payments to its
creditors and when a company
receives payments from its customers.
Inventory Receivable
s Payables
CCC conversion collection deferral
period
period
period

16-9

Cash Conversion Cycle

Inventory Conversion Periods: the average

time required to convert raw materials into
goods and then to sell them.
Average collection periods: the average
length of time required to convert the firms
receivables into cash, that is, to collect cash
following a sale.
Payables Deferral Periods: the average
length of time between the purchase of
materials and labor and the payment of
cash for them.
14-10

11

Calculate CCC from financial

statement

Inventory collection periods=

inventory /COGS per day.
Average Collection Periods= receivable /
(sales/365).
Payable Deferral Periods= payable /
COGS per day.

14-12

Cash Conversion Cycle

Inventory Receivables Payables

CCC conversion collection deferral
period
period
period
Payables
Days sales
Days per year
CCC

deferral
Inventory turnover outstanding
period

16-13

Cash Budget

Target Cash budget is the desire cash

balance that a firm plans to maintain in
order to conduct business.
Forecasts cash inflows, outflows, and ending
cash balances.
Used to plan loans needed or funds
available to invest.
Can be daily, weekly, or monthly, forecasts.

Monthly for annual planning and daily for

actual cash management.

16-14

How could bad debts be worked

into the cash budget?

Collections would be reduced by the

amount of the bad debt losses.
For example, if the firm had 3% bad
debt losses, collections would total
only 97% of sales.
Lower collections would lead to higher
borrowing requirements.

16-15

Cash and Marketable securities

Cash = Currency + Demand deposit +

Marketable securities
Marketable securities= very safe, highly
liquid than can be sold quickly at
predictable price, and thus be
converted to bank deposits.
Those securities will eventually be
liquidated; and the cash will be used for
such things as paying short-term debt.
14-16

Currency

The importance of currency has

decreased over time due to the rise of
credit cards, debit cards, and other
payment mechanism.
Holding too much will raise capital cost
and tempt robbers.

14-17

Demand deposit

Used for paying labor and raw

materials, purchasing fixed assets,
paying taxes, servicing debt and paying
dividends.

14-18

Minimizing& speeding up receipt

of cash

Use a lockbox
Insist on wire transfers and
debit/credit cards from customers
Synchronize inflows and outflows
Reduce need for safety stock of
cash

Increase forecast accuracy

Hold marketable securities
Negotiate a line of credit
16-19

Inventory Management
Read page 552

SKIs inventory turnover (4.82x) is

considerably lower than the industry

average (7.00x).
By holding excessive inventory, the firm
is increasing its costs, which reduces its
ROE.
16-20

Credit Policy and Account Receivable

Do SKIs customers pay more or less
promptly than those of its competitors?

SKIs DSO (45.6 days) is well above the

industry average (32 days).

SKI should consider tightening its credit
policy in order to reduce its DSO.

16-21

Elements of Credit Policy

1. Credit Period How long to pay? Shorter
period reduces DSO and average A/R, but
it may discourage sales.
2. Cash Discounts Lowers price. Attracts
new customers and reduces DSO.
3. Credit Standards Tighter standards tend
to reduce sales, but reduce bad debt
expense. Fewer bad debts reduce DSO.
4. Collection Policy How tough? Tougher
policy will reduce DSO but may damage
customer relationships.
16-22

Does SKI face any risk if it

tightens its credit policy?

Yes, a tighter credit policy may

discourage sales.

Some customers may choose to go

elsewhere if they are pressured to pay

their bills sooner.

SKI must balance the benefits of fewer bad

debts with the cost of possible lost sales.

16-23

What is trade credit(Accounts

Payable)?

Trade credit is credit furnished by a firms

suppliers.

Trade credit is often the largest source of

short-term credit, especially for small
firms.

Spontaneous, easy to get, but cost can

be high.

16-24

Accounts Payable

Dians Design just recently opened as

upscale dress shop in northeast Florida.
The owner is trying to decide whether
to take the discount offered from her
suppliers, or whether to pay at the end
of month. Dianas suppliers are offering
her a 3% discount if she pays within 15
days; otherwise, the balance is due 30
days after purchase. What are Dianas
Nominal costs of credit?
14-25

Nominal Cost of trade credit

Nominal annual cost credit= (Discount/

(100-Discount%)) * 365/ (Days credit
outstanding Discount periods)
= (3/97)* ( 365/ 30-15)= 3.093%X
24.33 = 75.26%
Effective annual cost of trade credit =
(1+(Dis%/(100-dis%))^ (365/(days-Dis
period)= (1.03093)^24.333= 109.84%

14-26

Bank Loan

Promissory Note: A document specifying the terms and conditions

of a loan, including the amount, interest rate, and payment
schedule.
Line of Credit: An arrangement in which a bank agree to lend up to a
specified maximum amount of funds during a designated periods
Secured Loan: A loan backed by collateral, often inventories or
account receivable.

16-27

Accruals (Accrued Liabilities)

Continuing recurring short-term liabilities, especially
accrued wages and accrued taxes.

They are spontaneous funds that are generated

spontaneously as the firm expands.

For example: if sales grow by 50% accrued wages and

taxes should also grow by about 50%. Accruals are
free in the sense that no interest is paid on them.

16-28

Review

Working capital
Cash
Account payable
Account receivable
Inventory

14-29