CHAPTER 4

WORKING CAPITAL MANAGEMENT

The Faculty of Finance

University of Economics, The University of Danang

1
 Reading
• Chapter 18,19 & 20, Fundamentals of Corporate
Finance; Stephen A. Ross, Randolph W.
Westerfield, Bradford D. Jordan; McGraw-Hill
(2010).

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 Chapter Outline
• Working Capital Management Overview
• Cash Management
• Account Receivables Management
• Inventory Management

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 Key Concepts and Skills

•The basic concepts and the role of the working

capital management.
•The different types of working capital policies.
•How firms manage their cash and some of the
collection, concentration, and disbursement
techniques used.
•The basic components of a firm’s credit policies.
•The types of inventory and inventory management
systems used by firms.

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 Did you know?

Working Capital ?
Keywords should be prioritized.

5
 Did you know?

Net Working Capital ?

Keywords should be prioritized.

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Could you explain…?
 Did you know?

Short-term financial policy?

Keywords should be prioritized.

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Flexible vs. Restrictive ?
 Did you know?

Reasons for Holding Cash ?

Keywords should be prioritized.

10
 Did you know?

Cash manager ?
Keywords should be prioritized.

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Collect cash from customers?
 Did you know?

Credit Policy ?
Keywords should be prioritized.

13
 Working Capital
Management Overview

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 Definition of working capital
• There are two major concepts of working capital – net
working capital and gross working capital (called
working capital)
• From the financial analyst view, working capital is
involved in current assets
• when accountants use the term working capital, they are
generally referring to net working capital, which is the
dollar difference between current assets and current
liabilities.

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 Short-term operating
liabilities
Payables
Current assets
Working Accrual: Wages, Tax
Cash
capital Inventory
receivables
Short-term debt

Net Working
capital

Long-term capital
Non- current assets

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 Net working capital (NWC)
NWC = Current Asset – Current Liabilities
= Total Assets – Fixed assets – (Total
Liabilities & Equity – Long-term capital)

 Net working capital = Long-term Capital –

Fixed assets

Net working capital is the amount of long –term

capital that is devoted to financing the current asset
of the firm.
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 Net working capital (NWC)
A Company has the following financial information:
* Current Assets:
• Cash: $20,000
• Accounts Receivable: $30,000
• Inventory: $40,000
* Current Liabilities:
• Accounts Payable: $25,000
• Short-term Debt: $15,000
Calculate the Net Working Capital (NWC) for the Company.

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 Net working capital (NWC)
Solution:
• Net Working Capital (NWC) is calculated by
subtracting current liabilities from current
assets.
• NWC = (Cash + Accounts Receivable + Inventory)
- (Accounts Payable + Short-term Debt)

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 The operating and cash cycles

Figure 4.1 Cash-flow time line and the short-term operating activities of typical manufacturing firm
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 The operating cycle
• The time it takes to receive inventory, sell
it and collect on the receivables generated
from the sale
• Operating cycle = inventory period +
accounts receivable period
– Inventory period = the time inventory sits on
the shelf
– Accounts receivable period = the time it takes
to collect on receivables

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 The cash cycle
• The time between payment for inventory and
receipt from the sale of inventory
• Cash cycle = Operating cycle – Accounts
payable period
– Accounts payable period = time between
receipt of inventory and payment for it
• The cash cycle measures how long we need to
finance inventory and receivables

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 Example
Corporation A operates in the manufacturing industry. The
company has the following financial information for the past
year:
• Average Accounts Receivable: $50,000
• Average Inventory: $70,000
• Average Accounts Payable: $30,000
• Cost of Goods Sold (COGS): $300,000
• Sales Revenue: $500,000
• Operating Expenses (excluding depreciation): $100,000

Calculate the operating cycle and cash cycle for this Corporation.

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 Example
• Operating Cycle: Operating Cycle = Days Inventory
Outstanding (DIO) + Days Sales Outstanding (DSO)
• Days Inventory Outstanding (DIO) = (Average
Inventory / COGS) * 365 DIO = ($70,000 /
$300,000) * 365 DIO ≈ 85.83 days
• Days Sales Outstanding (DSO) = (Average Accounts
Receivable / Sales Revenue) * 365 DSO = ($50,000 /
$500,000) * 365 DSO = 36.5 days
• Operating Cycle = DIO + DSO Operating Cycle =
85.83 days + 36.5 days Operating Cycle ≈ 122.33
days

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 Example
• Cash Cycle: Cash Cycle = Operating Cycle - Days
Payables Outstanding (DPO)
• Days Payables Outstanding (DPO) = (Average
Accounts Payable / Operating Expenses) * 365
DPO = ($30,000 / $100,000) * 365 DPO = 109.5
days
• Cash Cycle = Operating Cycle - DPO Cash Cycle =
122.33 days - 109.5 days Cash Cycle ≈ 12.83
days

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 Managers who deal with
short-term financial problems

Table 5.1 Managers who deal with short-term financial problems 26

 Short-term financial policy
Flexible (conservative) Restrictive (aggressive)
policy policy
• Large amounts of cash • Low cash and marketable
and marketable securities security balances
• Large amounts of • Low inventory levels
inventory • Little or no credit sales
• Liberal credit policies (low accounts receivable)
(large accounts • Relatively high levels of
receivable) short-term liabilities
• Relatively low levels of Low liquidity
short-term liabilities
High liquidity

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 Flexible Financial Policy
Advantages Disadvantages

• No difficulty • Liquid securities

meeting short- = lower return
term obligations • Financing short-
• Cash available term assets with
for emergencies long-term debt
• Lower storage risky
costs

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 Example
Corporation A is considering implementing a conservative short-term
financial policy. Currently, the company has the following financial
information:
• Current Assets: $200,000
• Current Liabilities: $100,000
• Sales Revenue: $500,000
• Cost of Goods Sold (COGS): $300,000
• Accounts Receivable Turnover: 6 times per year
• Inventory Turnover: 8 times per year

If ABC Corporation decides to adopt a conservative short-term financial

policy by increasing its current ratio to 2:1, calculate the maximum
allowable increase in current liabilities under this policy.

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 Example
• Calculate the desired level of current assets:
Current Ratio = Current Assets / Current Liabilities
2 = Current Assets / Current Liabilities
Current Assets = 2 * Current Liabilities
Desired Current Assets = 2 * $100,000 = $200,000
• Calculate the increase in current assets required:
Increase in Current Assets = Desired Current Assets - Current Assets
= $200,000 - $200,000
Increase in Current Assets = $0
• Since the increase in current assets is $0, the increase in current
liabilities should cover any change in the current ratio:
• Increase in Current Liabilities = Increase in Current Assets Increase in
Current Liabilities = $0

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 Restrictive Financial Policy

Advantages Disadvantages

• Higher returns on • Less liquidity for

long-term assets emergencies
• Lower carrying costs • Higher storage costs
• Short-term liabilities
can be decreased
more easily in event
of economic
downturn

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 Carrying vs Shortage Costs
• Carrying costs
– Storage costs, insurance, obsolescence,
depreciation, opportunity cost of capital tied up in
inventory, and costs related to managing and
handling inventory
• Shortage costs
– Order costs—the cost of ordering additional
inventory or transferring cash
– Stock-out costs—the cost of lost sales owing to
lack of inventory, including lost customers
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 Temporary vs Permanent
Assets
• Are current assets temporary or
permanent?
– Both!
• Permanent current assets refer to the level
of current assets that the company retains
regardless of any seasonality in sales
• Temporary current assets refer to the
additional current assets that are added
when sales are expected to increase on a
seasonal basis

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Alternative asset financing
policies

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 Choosing the best policy
• Best policy will be a combination of
flexible and restrictive policies
• Things to consider:
– Cash reserves
– Maturity hedging
– Relative interest rates
• Compromise policy—borrow short-term
to meet peak needs; maintain a cash
reserve for emergencies

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A compromise financing policy

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Cash Management

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 Reasons For Holding Cash
• Speculative Motive is the need to hold
cash in order to be able to take advantage
of, for example, bargain purchases that
might arise, attractive interest rates.
• Precautionary Motive is the need for a
safety supply to act as a financial reserve.
Once again, there probably is a
precautionary motive for maintaining
liquidity.

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 Reasons For Holding Cash
• Transaction Motive: the need to have cash
on hand to pay bills. Transaction-related
needs come from the normal
disbursement and collection activities of
the firm.
• Compensating balances: cash balances
are kept at commercial banks to
compensate for banking services the firm
receives.

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 No More Cash Than Necessary
• When a firm holds cash in excess of
some necessary minimum, it incurs an
opportunity cost.
• If the firm maintains too small a cash
balance, it may run out of cash.

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 Cash Management
• Collection of Cash:
– speed up collections and reduce the lag
between the time customers pay their bills
and the time the cash becomes available.
• Disbursement of Cash:
– control payments and minimize the firm’s
costs associated with making payments.

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 Cash Management
Corporation A is analyzing its cash management practices.
Currently, the company has the following information for the
month of January:
• Beginning Cash Balance: $50,000
• Cash Inflows:
– Sales Revenue: $200,000
– Loan Proceeds: $30,000
• Cash Outflows:
– Operating Expenses: $120,000
– Purchase of Equipment: $40,000
– Repayment of Short-term Debt: $10,000
Calculate the ending cash balance for the Corporation at the
end of January.
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 Cash Management
• Calculate Total Cash Inflows:
Total Cash Inflows = Sales Revenue + Loan Proceeds =
$200,000 + $30,000 = $230,000
• Calculate Total Cash Outflows:
Total Cash Outflows = Operating Expenses + Purchase of
Equipment + Repayment of Short-term Debt
= $120,000 + $40,000 + $10,000 = $170,000
• Calculate Net Cash Flow: Net Cash Flow = Total Cash Inflows
- Total Cash Outflows = $230,000 - $170,000 Net Cash Flow
= $60,000
• Calculate Ending Cash Balance: Ending Cash Balance =
Beginning Cash Balance + Net Cash Flow = $50,000 +
$60,000 = $110,000
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 Cash Management
• Corporation A is a manufacturing company that operates on a monthly basis. The
company forecasts its cash flows for the next three months as follows:
• Month 1:
– Cash receipts from sales: $800,000
– Cash payments for raw materials: $300,000
– Cash payments for operating expenses: $150,000
– Loan repayment: $50,000
• Month 2:
– Cash receipts from sales: $900,000
– Cash payments for raw materials: $350,000
– Cash payments for operating expenses: $160,000
– Loan repayment: $60,000
• Month 3:
– Cash receipts from sales: $1,000,000
– Cash payments for raw materials: $400,000
– Cash payments for operating expenses: $170,000
– Loan repayment: $70,000
• A’s beginning cash balance for Month 1 is $200,000. Assume that any surplus cash
is invested in short-term investments with an annual interest rate of 4%,
compounded monthly. Calculate the ending cash balance for each of the next
three months.
 Cash Management
Month 1:
• Beginning Cash Balance: $200,000
• Cash Receipts: $800,000
• Cash Payments (Raw materials + Operating
expenses + Loan repayment): $300,000 +
$150,000 + $50,000 = $500,000
• Net Cash Flow: $800,000 - $500,000 =
$300,000
• Ending Cash Balance: $200,000 + $300,000 =
$500,000
 Cash Management
Month 2:
• Beginning Cash Balance (from previous month):
$500,000
• Cash Receipts: $900,000 Cash Payments (Raw
materials + Operating expenses + Loan
repayment): $350,000 + $160,000 + $60,000 =
$570,000
• Net Cash Flow: $900,000 - $570,000 = $330,000
• Ending Cash Balance: $500,000 + $330,000 =
$830,000
 Cash Management
Month 3:
• Beginning Cash Balance (from previous month):
$830,000
• Cash Receipts: $1,000,000 Cash Payments (Raw
materials + Operating expenses + Loan
repayment): $400,000 + $170,000 + $70,000 =
$640,000
• Net Cash Flow: $1,000,000 - $640,000 = $360,000
• Ending Cash Balance: $830,000 + $360,000 =
$1,190,000
Receivables Management

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 Components of credit policy
• Terms of sale: The conditions under which
a firm sells its goods and services for cash
or credit.
• Credit analysis: The process of
determining the probability that customers
will not pay.
• Collection policy: The procedures
followed by a firm in collecting accounts
receivable.

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 Terms of the Sale
• The credit period
• The cash discount and the discount
period.
• The type of credit instrument

What is the “2/10, net 60”?

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 Credit Period
• Credit period is the basic length of time for
which credit is granted.
• The invoice date is the beginning of the
credit period - the shipping date or the
billing date.

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 Credit Period
Several factors influence the length of
the credit period:
•Perishability and collateral value
•Consumer demand
•Cost, profitability, and standardization
•Credit risk
•Size of the account
•Competition
•Customer type
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 Cash Discounts
• Cash discount is the percentage amount
that can be subtract from the invoice if the
customer pays within the discount period.
• Cash discount may vary according to the
buyer’s creditworthiness and payment
history, order size and season

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 Terms of the Sale
• “2/10, net 60” means that customers have 60
days from the invoice date to pay the full
amount; however, if payment is made within 10
days, a 2 percent cash discount can be taken.
• For example: an order for $1,000, with the
terms of the sale are 2/10, net 60.
Op1: paying $1,000x(1- 0.02) = $980 in 10
days
Op2: paying the full $1,000 in 60 days.

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 Analyzing Credit Policy
In evaluating credit policy, there are five
basic factors to consider:
•Revenue effects
•Cost effects
•The cost of debt
•The probability of nonpayment
•The cash discount

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 Analyzing Credit Policy
• Locust Software is one of several successful
firms that develop computer programs. Currently,
Locust sells for cash only.
• Locust is evaluating a request from some major
customers to change its current policy to net one
month (30 days). To analyze this proposal, we
define the following:
– P = Price per unit
– v = Variable cost per unit
– Q = Current quantity sold per month
– Q’ = Quantity sold under new policy
– R = Monthly required return

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 Analyzing Credit Policy
• Using PV of Switching Policies
• Suppose we have the following for Locust:
– P = $49
– v = $20
– Q = 100
– Q’ = 110
– R = 2% per month
Should Locust make the switch?

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 Analyzing Credit Policy
• Cash flow with old policy
= (P - v)Q
= ($49 - $20)x100
= $2,900
• Cash flow with new policy
=(P - v)Q’
=($49 - $20)x110
= $3,190

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 Analyzing Credit Policy
• Incremental cash inflow
=(P - v)(Q’ - Q)
= ($49 - $20)x(110 100)
= $290
• The present value of the future incremental
cash flows is:
PV = [(P - v)(Q’ - Q)]/R
= ($29 x $10)/0.02
= $14,500

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 Analyzing Credit Policy
• Now that we know the benefit of switching,
what’s the cost?
• Cost of switching
= PQ + v(Q’ - Q)
= $4,900 + $200
= $5,100

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 Analyzing Credit Policy
• Putting it all together, we see that the NPV
of the switch is:
• NPV of switching
= -[PQ+v(Q’-Q)]+[(P-v)(Q’ - Q)]/R
= -$5,100 + 290/0.02
= -$5,100 + $14,500
= $9,400
Therefore, the switch is very profitable.

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 Analyzing Credit Policy
• A Break-Even Application:
We can calculate the break-even point explicitly
by setting the NPV equal to zero and solving for
(Q’ – Q)
• NPV = 0
 -[PQ+v(Q’-Q)]+[(P-v)(Q’ - Q)]/R = 0
 Q’ - Q = PQ/[(P - v)/R - v]

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 Analyzing Credit Policy
• For Locust, the break-even sales increase
is thus:
• Q’ - Q
= $4,900/($ 29/0.02 - $20)
= 3.43 units
This means that the switch is a good idea
as long as Locust is confident that it can
sell at least 3.43 more units per month.

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 Collection Policy
• Monitoring Receivables
– keep track of its average collection period (ACP)
through time
– The aging schedule

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 Collection Policy
• Collection Effort:
1. Send out a delinquency letter informing the
customer of the past-due status of the
account.
2. Make a telephone call to the customer.
3. Employ a collection agency.
4. Take legal action against the customer.

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 Example
• Company A sells products to its customers on credit
terms. The company's credit policy allows
customers to pay their invoices within 30 days.
The Company's sales for the month of January total
$200,000.
• Historically, 20% of customers typically pay within
the discount period (10 days), receiving a 2%
discount off their invoice.
• The remaining customers pay within the credit
period (30 days).
The amount of cash collected from customers who
take the discount?
 Example
• Sales subject to discount = 20% of total sales
= 20% * $200,000 = $40,000
• Discount rate = 2% of the sales subject to
discount
= 2% * $40,000 = $800
• Cash collected from customers who take the
discount = Sales subject to discount - Discount
amount = $40,000 - $800 = $39,200
 Example
• Company A sells products to its customers on credit
terms. The company's credit policy allows
customers to pay their invoices within 30 days.
The Company's sales for the month of January total
$200,000.
• Historically, 20% of customers typically pay within
the discount period (10 days), receiving a 2%
discount off their invoice.
• The remaining customers pay within the credit
period (30 days).
Amount of Cash Collected from Customers who
Pay within the Credit Period?
 Example
• Sales subject to credit period = Total sales -
Sales subject to discount
= $200,000 - $40,000 = $160,000
• Cash collected from customers who pay
within the credit period = Sales subject to
credit period = $160,000
 Example
• Company A sells products to its customers on credit
terms. The company's credit policy allows
customers to pay their invoices within 30 days.
The Company's sales for the month of January total
$200,000.
• Historically, 20% of customers typically pay within
the discount period (10 days), receiving a 2%
discount off their invoice.
• The remaining customers pay within the credit
period (30 days).
Total Cash Collected from Sales for the Month of
January?
 Example
• Total cash collected from sales = Cash
collected from customers who take the
discount + Cash collected from customers
who pay within the credit period
• = $39,200 + $160,000 = $199,200
 Inventory Management

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 Inventory types
• Raw material inventory: represents the
initial input into the production process.
• Work-in process inventory: represents
items that are beyond the raw materials
stage but not yet at the completed product
stage.
• Finished goods inventory: includes
completed products.

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 Inventory costs
• Storage and tracking costs.
• Insurance and taxes.
• Losses due to obsolescence,
deterioration, or theft.
• The opportunity cost of capital on the
invested amount.
• Other types of cost: restocking costs and
costs related to safety reserves, carrying
costs.
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 Inventory Management
Techniques

• The ABC Approach

• The Economic Order Quantity Model

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 The ABC Approach
• The basic idea is to divide inventory into
three (or more) groups.
• A small portion of inventory in terms of
quantity might represent a large portion in
terms of inventory value.

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 The ABC Approach
• A Group items are monitored closely, and inventory
levels are kept relatively low.
• C Group items: large quantities are ordered and
kept on hand.
• B Group is made up of in-between items.

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 The economic order quantity
model
Assumptions:
• This model requires a near perfect forecast of
inventory unit demanded, T and a constant rate of
inventory usage.
• Constant or fixed order cost, F, and a constant cost
of holding each item of inventory, CC.
• The corporation received its ordered inventory
when the inventory is exhausted
• The ordered inventory are used up a constant rate.

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79
 The EOQ Model
• Total cost = Order Cost + Holding Cost
= F x (T/Q) + CC x (Q/2)
In which:
T = Total inventory unit demanded
Q = Order quantity
F = Fixed order cost per order
CC = Holding cost per inventory unit

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The EOQ Model

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 The EOQ Model
• For Example:
– The total number of pairs of boots ordered for
the year ( T ) is 600.
– The restocking cost ( F ) is $20 per order,
– The carrying cost (CC) is $3.
– What is the EOQ and Total Cost for this
situation?

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The EOQ Model

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 Extensions to the EOQ
model
• Two extensions:
– Safety stocks: the minimum level of inventory
that a firm keeps on hand. Inventories are
reordered whenever the level of inventory falls
to the safety stock level.

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 Extensions to the EOQ model
– Reordering points: the times at which the firm will
actually place its inventory orders

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 Extensions to the EOQ model
• Combine reorder point and safety stock to
generalize EOQ model in which the firm orders in
advance of anticipated needs and also keeps a
safety stock of inventory.

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Summary

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Summary

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Summary

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Summary

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Summary

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Summary

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