WORKING CAPITAL MANAGEMENT &

CASH MANAGEMENT

Presented by: Ricky A. Cera

 1. INTRODUCTION
• Working capital management is the management of the short-term investment
and financing of a company.
• Goals:
- Adequate cash flow for operations
- Most productive use of resources

Internal and External Factors that Affect Working Capital Needs

Internal Factors External Factors
• Company size and growth rates • Banking services
• Organizational structure • Interest rates
• Sophistication of working capital • New technologies and new products
management • The economy
• Borrowing and investing • Competitors
positions/activities/capacities

Bottom line: There are many influences on a company’s need for working capital.

Copyright © 2013 CFA Institute 2

TYPES OF WORKING CAPITAL

WORKING CAPITAL

BASIS OF BASIS OF
CONCEPT TIME

Gross Net Permanent Temporary

Working Working / Fixed / Variable
Capital Capital WC WC

Seasonal Special
WC WC
Regular Reserve
WC WC
THREE ALTERNATIVE WORKING CAPITAL
INVESTMENT POLICIES

Policy C

Policy B
Current Assets ($)

Policy A

Sales ($)
WORKING CAPITAL MANAGEMENT &
CASH MANAGEMENT

Presented by: Ricky A. Cera

 1. INTRODUCTION
• Working capital management is the management of the short-term investment
and financing of a company.
• Goals:
- Adequate cash flow for operations
- Most productive use of resources

Internal and External Factors that Affect Working Capital Needs

Internal Factors External Factors
• Company size and growth rates • Banking services
• Organizational structure • Interest rates
• Sophistication of working capital • New technologies and new products
management • The economy
• Borrowing and investing • Competitors
positions/activities/capacities

Bottom line: There are many influences on a company’s need for working capital.

Copyright © 2013 CFA Institute 6

TYPES OF WORKING CAPITAL

WORKING CAPITAL

BASIS OF BASIS OF
CONCEPT TIME

Gross Net Permanent Temporary

Working Working / Fixed / Variable
Capital Capital WC WC

Seasonal Special
WC WC
Regular Reserve
WC WC
THREE ALTERNATIVE WORKING CAPITAL
INVESTMENT POLICIES

Policy C

Policy B
Current Assets ($)

Policy A

Sales ($)
WORKING CAPITAL MANAGEMENT &
CASH MANAGEMENT

Presented by: Ricky A. Cera

 1. INTRODUCTION
• Working capital management is the management of the short-term investment
and financing of a company.
• Goals:
- Adequate cash flow for operations
- Most productive use of resources

Internal and External Factors that Affect Working Capital Needs

Internal Factors External Factors
• Company size and growth rates • Banking services
• Organizational structure • Interest rates
• Sophistication of working capital • New technologies and new products
management • The economy
• Borrowing and investing • Competitors
positions/activities/capacities

Bottom line: There are many influences on a company’s need for working capital.

Copyright © 2013 CFA Institute 10

TYPES OF WORKING CAPITAL

WORKING CAPITAL

BASIS OF BASIS OF
CONCEPT TIME

Gross Net Permanent Temporary

Working Working / Fixed / Variable
Capital Capital WC WC

Seasonal Special
WC WC
Regular Reserve
WC WC
THREE ALTERNATIVE WORKING CAPITAL
INVESTMENT POLICIES

Policy C

Policy B
Current Assets ($)

Policy A

Sales ($)
WORKING CAPITAL MANAGEMENT &
CASH MANAGEMENT

Presented by: Ricky A. Cera

 1. INTRODUCTION
• Working capital management is the management of the short-term investment
and financing of a company.
• Goals:
- Adequate cash flow for operations
- Most productive use of resources

Internal and External Factors that Affect Working Capital Needs

Internal Factors External Factors
• Company size and growth rates • Banking services
• Organizational structure • Interest rates
• Sophistication of working capital • New technologies and new products
management • The economy
• Borrowing and investing • Competitors
positions/activities/capacities

Bottom line: There are many influences on a company’s need for working capital.

Copyright © 2013 CFA Institute 14

TYPES OF WORKING CAPITAL

WORKING CAPITAL

BASIS OF BASIS OF
CONCEPT TIME

Gross Net Permanent Temporary

Working Working / Fixed / Variable
Capital Capital WC WC

Seasonal Special
WC WC
Regular Reserve
WC WC
THREE ALTERNATIVE WORKING CAPITAL
INVESTMENT POLICIES

Policy C

Policy B
Current Assets ($)

Policy A

Sales ($)
• Policy C represents conservative approach
• Policy A represents aggressive approach
• Policy B represents a moderate approach

• Optimal level of working capital investment

• Risk of long-term versus short-term debt

 DIFFERENCE BETWEEN PERMANENT &
TEMPORARY WORKING CAPITAL

Amount Variable Working Capital

of
Working
Capital

Permanent Working Capital

Time
 Variable Working Capital
Amount
of
Working
Capital
Permanent Working Capital

Time
FINANCING NEEDS OVER TIME
Total Assets

$
Fluctuating Current Assets

Permanent Current Assets

Fixed Assets

Time
MATCHING APPROACH TO ASSET
FINANCING
Total Assets
Short-term
Debt
$
Fluctuating Current Assets

Long-term
Permanent Current Assets Debt +
Equity
Capital

Fixed Assets

Time
CONSERVATIVE APPROACH TO ASSET
FINANCING

Total Assets
Short-term
Debt
$
Fluctuating Current Assets

Long-term
Permanent Current Assets Debt +
Equity
capital

Fixed Assets

Time
AGGRESSIVE APPROACH TO ASSET
FINANCING

Total Assets
Short-term
Debt
$
Fluctuating Current Assets

Long-term
Permanent Current Assets Debt +
Equity
capital

Fixed Assets

Time
EXCESS OR INADEQUATE WORKING CAPITAL

EVERY BUSINESS CONCERN SHOULD HAVE

ADEQUATE WORKING CAPITAL TO RUN ITS
BUSINESS OPERATIONS. IT SHOULD HAVE NEITHER
REDUNDANT OR EXCESS WORKING CAPITAL NOR
INADEQUATE OR SHORTAGE OF WORKING CAPITAL.

BOTH EXCESS AS WELL AS SHORTAGE OF

WORKING CAPITAL SITUATIONS ARE BAD FOR ANY
BUSINESS. HOWEVER, OUT OF THE TWO,
INADEQUACY OR SHORTAGE OF WORKING CAPITAL
IS MORE DANGEROUS FROM THE POINT OF VIEW OF
THE FIRM.
DISADVANTAGES OF REDUNDANT OR EXCESS
WORKING CAPITAL

 IDLE FUNDS, NON-PROFITABLE FOR

BUSINESS, POOR ROI
 UNNECESSARY PURCHASING &
ACCUMULATION OF INVENTORIES OVER
REQUIRED LEVEL
 EXCESSIVE DEBTORS AND DEFECTIVE
CREDIT POLICY, HIGHER INCIDENCE OF B/D.
OVERALL INEFFICIENCY IN THE
ORGANIZATION.
WHEN THERE IS EXCESSIVE WORKING
CAPITAL, CREDIT WORTHINESS SUFFERS
 DUE TO LOW RATE OF RETURN ON
INVESTMENTS, THE MARKET VALUE OF SHARES
MAY FALL
DISADVANTAGES OR DANGERS OF
INADEQUATE OR SHORT WORKING CAPITAL

 CAN’T PAY OFF ITS SHORT-TERM LIABILITIES

IN TIME.
 ECONOMIES OF SCALE ARE NOT POSSIBLE.
 DIFFICULT FOR THE FIRM TO EXPLOIT
FAVOURABLE MARKET SITUATIONS
 DAY-TO-DAY LIQUIDITY WORSENS
 IMPROPER UTILIZATION THE FIXED ASSETS
AND ROA/ROI FALLS SHARPLY
 2. MANAGING AND MEASURING LIQUIDITY
• Liquidity is the ability of the company to satisfy its short-term obligations using
assets that are readily converted into cash.
• Liquidity management is the ability of the company to generate cash when
and where needed.
• Liquidity management requires addressing drags and pulls on liquidity.
- Drags on liquidity are forces that delay the collection of cash, such as slow
payments by customers and obsolete inventory.
- Pulls on liquidity are decisions that result in paying cash too soon, such as
paying trade credit early or a bank reducing a line of credit.

Copyright © 2013 CFA Institute 27

 SOURCES OF LIQUIDITY
• Primary sources of liquidity
- Ready cash balances (cash and cash equivalents)
- Short-term funds (short-term financing, such as trade credit and bank loans)
- Cash flow management (for example, getting customers’ payments
deposited quickly)
• Secondary sources of liquidity
- Renegotiating debt contracts
- Selling assets
- Filing for bankruptcy protection and reorganizing.

Copyright © 2013 CFA Institute 28

 MEASURE OF LIQUIDITY

LIQUIDITY RATIOS
Current assets Ability to satisfy current
Current ratio =
Current liabilities liabilities using current assets

Short−term Ability to satisfy current

Cash + + Receivables
Quick ratio = investments liabilities using the most liquid
Current liabilities of current assets

RATIOS INDICATING MANAGEMENT OF CURRENT ASSETS

Total revenue How many times accounts

Receivables turnover =
Average receivables receivable are created and
collected during the period

Cost of goods sold How many times inventory is

Inventory turnover =
Average inventory created and sold during the
period

Copyright © 2013 CFA Institute 29

 OPERATING AND CASH CONVERSION CYCLES
• The operating cycle is the length of time it takes a company’s investment in
inventory to be collected in cash from customers.
• The net operating cycle (or the cash conversion cycle) is the length of time
it takes for a company’s investment in inventory to generate cash, considering
that some or all of the inventory is purchased using credit.
• The length of the company’s operating and cash conversion cycles is a factor
that determines how much liquidity a company needs.
- The longer the cycle, the greater the company’s need for liquidity.

Copyright © 2013 CFA Institute 30

 OPERATING AND CASH CONVERSION CYCLES

Collect on Acquire Acquire

Pay
Accounts Inventory Inventory
Suppliers
Receivable for Cash for Credit

Collect on Sell
Accounts Inventory
Sell Inventory for Receivable for Credit
Credit

Operating Cycle Cash Conversion Cycle

Copyright © 2013 CFA Institute 31

OPERATING AND CASH CONVERSION CYCLES:
FORMULAS
Inventory 365 Average time it
Number of days of inventory = =
Average day′s Inventory turnover takes to create
cost of goods sold
and sell
inventory
Receivables 365 Average time it
Number of days of receivables = =
Average day′s Receivables turnover takes to collect
revenues on accounts
receivable
Accounts payable 365 Average time it
Number of days of payables = =
Average day′s Accounts payables turnover takes to pay its
purchases suppliers
Number of days Number of days
Operating cycle = +
of inventory of receivables

Net operating cycle Number of days Number of days Number of days

or = + −
Cash conversion cycle of inventory of receivables of payables

32
EXAMPLE: LIQUIDITY AND OPERATING CYCLES
Compare the liquidity and liquidity needs for
Company A and Company B for FY2:

Company A Company B
FY2 FY1 FY2 FY1
Cash and cash equivalents €200 €110 €200 €300
Inventory €500 €450 €900 €900
Receivables €600 €625 €1,000 €1,100
Accounts payable €400 €350 €600 €825

Revenues €3,000 €950 €6,000 €6,000

Cost of goods sold €2,500 €750 €5,200 €5,050

Copyright © 2013 CFA Institute 33

EXAMPLE: LIQUIDITY AND OPERATING CYCLES
Company A Company B
FY2 FY2
Current ratio 3.3 times 3.5 times
Quick ratio 2.0 times 2.0 times

Number of days of inventory 73.0 days 63.2 days

Number of days of receivables 73.0 days 60.8 days
Number of days of payables 57.3 days 42.1 days

Operating cycle 146.0 days 124.0 days

Cash conversion cycle 88.7 days 81.9 days

1. How do these companies compare in terms of liquidity?

2. How do these companies compare in terms of their need for
liquidity, based on their operating cycles?

Copyright © 2013 CFA Institute 34

 3. MANAGING THE CASH POSITION
• Management of the cash position of a company has a goal of maintaining
positive cash balances throughout the day.
• Forecasting short-term cash flows is difficult because of outside, unpredictable
influences (e.g., the general economy).
• Companies tend to maintain a minimum balance of cash (a target cash
balance) to protect against a negative cash balance.

Examples of Cash Inflows and Outflows

Inflows Outflows
 Receipts from operations, broken down by  Payables and payroll disbursements, broken
operating unit, departments, etc. down by operating unit, departments, etc.
 Fund transfers from subsidiaries, joint ventures,  Fund transfers to subsidiaries
third parties  Investments made
 Maturing investments  Debt repayments
 Debt proceeds (short and long term)  Interest and dividend payments
 Other income items (interest, etc.)  Tax payments
 Tax refunds

Copyright © 2013 CFA Institute 35

MANAGEMENT OF CASH

1. Importance of Cash
When planning the short or long-term funding requirements of a business, it
is more important to forecast the likely cash requirements than to project
profitability etc.

Bear in mind that more businesses fail for lack of cash than for want of
profit.
2. CASH VS PROFIT

Sales and costs and, therefore, profits do not

necessarily coincide with their associated cash
inflows and outflows.

The net result is that cash receipts often lag cash

payments and, whilst profits may be reported, the
business may experience a short-term cash shortfall.

 For this reason it is essential to forecast cash

flows as well as project likely profits.
 Income Statement: Month 1

Sales ($000) 75

Costs ($000) 65

Profit ($000) 10

CFs relating to Month 1: Month 1 Month 2 Month 3 Total

Amount in ($000)

Receipts from sales 20 35 20 75

Payments to suppliers etc. 40 20 5 65

Net cash flow (20) 15 15 10

(20) (5) 10 10
Cumulative net cash flow
 MANAGING CASH
• Managers use cash forecasting systems to estimate the flow (amount and
timing) of receipts and disbursements.
• Managers monitor cash uses and levels.
- They keep track of cash balances and flows at different locations.
Cash Management will be successful only if cash collections are accelerated
and cash payments (disbursements), as far as possible, are delayed.
• A company’s cash management policies include
- Investment of cash in excess of day-to-day needs and
- Short-term sources of borrowing.
• Other influences on cash flows:
- Capital expenditures
- Mergers and acquisitions
- Disposition of assets

Copyright © 2013 CFA Institute 39

Methods of ACCELERATING CASH INFLOWS
Prompt payment from customers (Debtors)
Quick conversion of payment into cash
Decentralized collections
Lock Box System (collecting centers at different locations)

Methods of DECELERATING CASH OUTFLOWS

Paying on the last date
Payment through Cheques and Drafts
Adjusting Payroll Funds (Reducing frequency of payments)
Centralization of Payments
Inter-bank transfers
Making use of Float (Difference between balance in Bank Pass
Book and Bank Column of Cash Book)
 9. SUMMARY
Major points covered:
• Understanding how to evaluate a company’s liquidity position.
• Calculating and interpreting operating and cash conversion cycles.
• Evaluating overall working capital effectiveness of a company and comparing it
with that of other peer companies.
• Identifying the components of a cash forecast to be able to prepare a short-
term (i.e., up to one year) cash forecast.

Copyright © 2013 CFA Institute 41