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Lecture7 WorkingCapitalManagement
Lecture7 WorkingCapitalManagement
Introduction
The concept of working capital management
originated with the old Yankee peddler, who
would borrow to buy inventory, sell the
inventory to pay off the bank loan, and then
repeat the cycle
Working Capital
A firm’s investment in short-term assets (cash,
marketable securities, inventory, and accounts
receivable)
Turnover (Tshs)
May 27, 2020 Lecture7_Working Capital Management 11
Working Capital Policies:
Example
Sikujua Ltd (SKL)
SKL Ind. Avg.
Current ratio 1.75x 2.25x
Debt/Assets 58.76% 50.00%
Turnover of cash & securities 16.67x 22.22x
DSO (days) 45.63 32.00
Inv. turnover 4.82x 7.00x
F. A. turnover 11.35x 12.00x
T. A. turnover 2.08x 3.00x
Profit margin 2.07% 3.50%
ROE 10.45% 21.00%
Years
Note: Lower dashed line would be more aggressive.
May 27, 2020 Lecture7_Working Capital Management 19
Financing Working Capital
Conservative Funding Policy
Uses long-term funds to finance not only
fixed assets and permanent current assets,
but some fluctuating current assets as well.
As there is less reliance on short-term funding,
the risk of such a policy is lower.
The higher cost of long-term finance means that
profitability is reduced as well.
May 27, 2020 Lecture7_Working Capital Management 20
Financing Working Capital:
Conservative
Tshs Marketable (Long-term finance reinvested short-term)
securities
Zero S-T
Debt
FCA
L-T Fin:
Perm C.A. Stock,
Bonds,
Spon. C.L.
Fixed Assets
Years
May 27, 2020 Lecture7_Working Capital Management 21
Financing Working Capital
Aggressive Funding Policy
Uses short term funds to finance not only
fluctuating current assets, but some
permanent current assets as well.
Carries the greatest risk to solvency, but also
offers the highest profitability.
FCA S-T
Loans
Perm C.A.
L-T Fin:
Stock,
Fixed Assets Bonds,
Spon.
C.L.
Years
Note: Lower dashed line would be more aggressive.
May 27, 2020 Lecture7_Working Capital Management 24
Working Capital and the Cash
Conversion Cycle (CCC)
The general concept of liquidity requirements (cf the
peddler effect) has been applied to more complex
businesses, and it is useful when analysing the
effectiveness of a firm’s working management process
This gives rise to the concept of the cash conversion
cycle (CCC) - the length of time from the payment for
the purchase of the raw materials to the collection of
accounts receivable generally by the sale of the final
product
PDP
Time
0 t1 t2 t3 t3
May 27, 2020 Lecture7_Working Capital Management 34
The Cash Conversion Cycle
Goods ordered at time 0
Goods received at time t1
Length between 0 and t1 depends on lead time
Production starts sometime after t1 and ends sometime before
t3
Payment for purchases made at time t2
Length between t1 and t2 depends on credit terms received from suppliers and their
collection efficiency
Goods sold at time t3
Money for goods sold received at time t4
Length between t3 and t4 depends on credit terms given to customers and efficiency
of collection
ICP RCP
(72 days) (24 days)
PDP
(30 days) CCC
(72 + 24 – 30 = 66 days)
R/M Received Cash paid for R/M purchased on credit A/R Collected
Days
Ordering cost
Order Quantity
0 Q*
Using float
Float is the term used to the amount of
money tied up in the period between the
initiation of payment and the point at which
money appears in the company’s bank
account.
It is the difference between the balance
shown in a firm’s (or individual’s) checkbook
and the balance on the bank’s records
C/2
Time
Z Return point
Time
May 27, 2020 t1 t
Lecture7_Working Capital2Management 69
Miller - Orr Model (Cont..)
The model specifies two control limits
h - an upper bound and zero - a lower bound
Note: The minimum bound can be set at some amount
higher than zero and h and Z would move up in the figure
When the cash balance touches the upper bound h -
z of marketable securities are bought and the new
balance becomes z
When the cash balance touches zero, z marketable
securities are sold and the new balance becomes z