Working Capital Management

IQRA University Gulshan Campus.

Raheel Bhagar
raheel.bhagar@iuk.edu.pk

4/6/22 Finance For Managers - 0387 1

 Working Capital Management
• Working capital
= current assets – current liabilities

• Working capital management refers to

choosing the levels and mix of:
– cash, marketable securities, receivables and
inventories.
– different types of short-term financing.
 Considerations in Working Capital Management

• Sales impact
• Liquidity
• Relations with stakeholders
– suppliers
– customers
• Short-term financing mix
– profitability
– risk considerations
 Working Capital Management
• Maturity matching approach
• Conservative approach
• Aggressive approach
 Maturity Matching Approach
• Hedge risk by matching the maturities of
assets and liabilities.
• Permanent current assets are financed with
long-term financing, while temporary current
assets are financed with short-term financing.
• There are no excess funds.
 Maturity Matching Approach

Temporary Current Assets

$ Short Term
Financing

e nt A ssets
e nt Curr
Perman
Long Term
Financing
Fixed Assets

Time
 Conservative Approach
• Long-term funds are used to finance both
permanent as well as some temporary short-
term assets.
• When there are excess funds, they are
invested in marketable securities.
 Conservative Approach

Temporary Current Assets Short Term

$
Financing

nt A s sets
ne nt Curre
a
Permsecurities
Marketable
Long Term
Financing

Fixed Assets

Time
 Aggressive Approach
• Use less long-term and more short-term
financing than the conservative approach.
 Aggressive Approach

Temporary Current Assets

$ Short Term
Financing

re nt Assets
ne nt Cur
Perma

Long Term
Fixed Assets Financing

Time
 Cost and Risk Considerations
• Yield curve is usually upward sloping.
• Short-term rates are more volatile than long-
term rates.
• Firm's ability to obtain needed short-term
financing.
 Cash Conversion Cycle

The cash conversion cycle is the length of time

between payment of accounts payable and the
receipt of cash from accounts receivable.
 Cash Conversion Cycle

Purchase Sale on Collect Acct.

Inventory Credit Receivable

Inventory Conversion Period Receivables Collection

Period

Time
Payables Cash Conversion Cycle
Deferral Period

Payment of
Accts. Payable
 Cash Conversion Cycle

Cash Inventory Receivable s Payables

conversion  conversion  collection  deferral
cycle period period period
 Inventory Conversion Period
• The inventory conversion period is the length of
time from the purchase of inventory to the time
the sales are made on credit.
Inventory
Inventory 365
conversion  
Cost of Sales/365 Inventory turnover
period
 Receivables Collection Period
• The receivables collection period is the
average number of days it takes to collect on
accounts receivable.
– Equal to days sales outstanding (DSO)

Receivable s
Receivable s 365
collection  
Sales/365 Receivable s turnover
period
 Payables Deferral Period
• The payables deferral period is the average length
of time between the purchase of materials and
labor and the payment of cash for the same.

𝐴𝑐𝑐𝑜𝑢𝑛𝑡 𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠
𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠 𝐷𝑒𝑓𝑒𝑟𝑟𝑎𝑙 𝑃𝑒𝑟𝑖𝑜𝑑=
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑 𝑆𝑜𝑙𝑑/365
 Cash Conversion Cycle
Given the following information about Vision Opticals,
compute the firm’s cash conversion cycle.
Inventory $19,000
Accounts Receivable $21,000
Accounts Payable $5,600
Wages, Benefits, Payroll Taxes $9,000
Sales $227,000
Cost of Sales $93,000
Selling & Other Expenses $22,000
 Inventory Conversion Period
Inventory
Inventory 365
conversion  
Cost of Sales/365 Inventory turnover
period
Inventory
$19,000
conversion   74.57 days
$93,000/365
period
 Receivables Collection Period
Receivable s
Receivable s 365
collection  
Sales/365 Receivable s turnover
period

Receivable s
$21,000
collection   33.77 days
$227,000/3 65
period
 Payables Deferral Period
Payables
deferral 
period
Accounts payable  Wages, benefits, payroll taxes payable
(Cost of sales  Selling, general and administrative expenses)/365

$5,600  $9,000
  46.34 days
($93,000  $22,000) / 365
 Cash Conversion Cycle

Cash Inventory Receivable s Payables

conversion  conversion  collection  deferral
cycle period period period

Cash
conversion  74.57 days  33.77 days  46.34 days
cycle
 62 days
 Another illustration
• We can illustrate the process with data from Real Time Computer Corporation (RTC), which
in early 2001 introduced a new minicomputer that can perform one billion instructions per
second and that will sell for $250,000. RTC expects to sell 40 computers in its first year of
production. The effects of this new production RTC’s working capital position were
analyzed in terms of the following
• five steps:
1. RTC will order and then receive the materials it needs to produce the 40 computers it expects to sell.
Because RTC and most other firms purchase materials on credit, this transaction will create an
account payable. However, the purchase will have no immediate cash flow effect.
2. Labor will be used to convert the materials into finished computers. However, wages will not be fully
paid at the time the work is done, so, like accounts payable, accrued wages will also build up.
3. The finished computers will be sold, but on credit. Therefore, sales will create receivables, not
immediate cash inflows.
4. At some point before cash comes in, RTC must pay off its accounts payable and accrued wages. This
outflow must be financed.
5. The cycle will be completed when RTC’s receivables have been collected. At that time, the company
can pay off the credit that was used to finance production, and it can then repeat the cycle.
 CCC Example - RTC
1. Selling price 250,000
2. Cost = 197,250
3. Annual Sales = $ 10 million
4. Average inventory $ 2 million
5. Receivables = $ 657,534
6. 1 month credit from suppliers
7. 1 month to pay labor
8. CGS = $ 8 million
9. Payables = $ 657,534
10.Calculate CCC
 Inventory conversion period
• Inventory conversion period, which is the average time required to
convert materials into finished goods and then to sell those goods. Note
that the inventory conversion period is calculated by dividing inventory by
sales per day. For example, if average inventories are $2 million and sales
are $10 million, then the inventory conversion period is 73 days

Inventory turnover = cost of goods sold

Inventory
Days of Inventory on hand = 365
Inventory turnover
Thus, it takes an average of 73 days to convert materials into finished goods
and then to sell those goods
 Receivables collection period
• Receivables collection period, which is the average length of time
required to convert the firm’s receivables into cash, that is, to collect cash
following a sale. The receivables collection period is also called the days
sales outstanding (DSO), and it is calculated by dividing accounts
receivable by the average credit sales per day. If receivables are $657,534
and sales are $10 million, the receivables collection period is

Thus, it takes 24 days after a sale to convert the receivables into cash.
 Payables deferral period
• Payables deferral period, which is the average length of time between the
purchase of materials and labor and the payment of cash for them. For
example, if the firm on average has 30 days to pay for labor and materials,
if its cost of goods sold are $8 million per year, and if its accounts payable
average $657,534, then its payables deferral period can be calculated as
follows:

• The calculated figure is consistent with the stated 30-day payment period.
 Cash conversion cycle
• Cash conversion cycle, which nets out the three periods, therefore equals the
length of time between the firm’s actual cash expenditures to pay for productive
resources (materials and labor) and its own cash receipts from the sale of
products (that is, the length of time between paying for labor and materials and
collecting on receivables). The cash conversion cycle thus equals the average
length of time a dollar is tied up in current assets.

• Days in Cash Conversion Cycle = 73 days + 24 days - 30 days = 67 days.

• To look at it another way
• Cash inflow delay - Payment delay = Net delay
• (73 days + 24 days) - 30 days = 67 days.
 SHORTENING THE CASH CONVERSION CYCLE

• Given these data, RTC knows when it starts producing a computer that it will have
to finance the manufacturing costs for a 67-day period. The firm’s goal should be
to shorten its cash conversion cycle as much as possible without hurting
operations. This would improve profits, because the longer the cash conversion
cycle, the greater the need for external financing, and that financing has a cost.

• The cash conversion cycle can be shortened

1. by reducing the inventory conversion period by processing and selling goods
more quickly
2. by reducing the receivables collection period by speeding up collections,
3. By lengthening the payables deferral period by slowing down the firm’s own
payments.
• To the extent that these actions can be taken without increasing costs or
depressing sales, they should be carried out.
 Goal: Shortening the CCC
• Process & sell more quickly
• Shorten the receivables period, improve
collections
• Slow down payables, delay payments

Desirable if:
1. Don’t increase cost
2. Doesn’t decrease sales
 BENEFITS
• The benefits of shortening the cash conversion cycle by looking again at
Real Time Computer Corporation.
• Suppose RTC must spend approximately $197,250 on materials and labor to
produce one computer, and it takes about nine (9) days to produce a
computer.
• It must invest $197,250/9 = $21,917 for each day’s production.
• This investment must be financed for 67 days—the length of the cash
conversion cycle—so the company’s working capital financing needs will be
67 * $21,917 = $1,468,439
• If RTC could reduce the cash conversion cycle to 57 days, say, by deferring
payment of its accounts payable an additional 10 days, or by speeding up
either the production process or the collection of its receivables, it could
reduce its working capital financing requirements by $219,170.