Working

Capital
Management
DR. MARIA CECILIA P. L AGARAS, CPA
Review Questions
15–1 Why is working capital management one of the most important and time-
consuming activities of the financial manager? What is net working capital?

15–2 What is the relationship between the predictability of a firm’s cash inflows and
its required level of net working capital? How are net working capital, liquidity, and
risk of insolvency related?

15–3 Why does an increase in the ratio of current assets to total assets decrease both
profits and risk as measured by net working capital? How do changes in the ratio of
current liabilities to total assets affect profitability and risk?
Working Capital Management
The goal of working capital (or short-term
financial) management is to manage each of the
firm’s current assets (inventory, accounts receivable,
marketable securities, and cash) and current liabilities
(notes payable, accruals, and accounts payable) to
achieve a balance between profitability and risk that
contributes positively to the firm’s value.
 Working Capital

Current assets, commonly called working capital, represent the

portion of investment that circulates from one form to another in
the ordinary conduct of business.
Current liabilities represent the firm’s short-term financing, because
they include all debts of the firm that come due (must be paid) in 1
year or less.
These debts usually include amounts owed to suppliers (accounts
payable), employees and governments (accruals), and banks (notes
payable), among others.
Net Working Capital
net working capital is defined as the difference between the firm’s current
assets and its current liabilities.

When current assets exceed current liabilities, the firm has positive net
working capital.

When current assets are less than current liabilities, the firm has negative net
working capital.
 TRADE-OFF BETWEEN PROFITABILITY AND RISK

Profitability is the relationship between revenues and costs generated y using

the firm’s assets—both current and fixed—in productive activities.

risk (of insolvency) - The probability that a firm will be unable to pay its bills as
they come due.

Insolvent - Describes a firm that is unable to pay its bills as they come due.
Changes in Current Assets

*Assume: total assets is constant

Cash Conversion Cycle
International Business Machines Corp. (IBM) had annual revenues of P98,786 million,
cost of revenue of P57,057 million, and accounts payable of P8,054 million. IBM had
an average age of inventory (AAI) of 17.5 days, an average collection period (ACP) of
44.8 days, and an average payment period (APP) of 51.2 days (IBM’s purchases were
P57,416 million). Thus the cash conversion cycle for IBM was 11.1 days . The
resources IBM had invested in this cash conversion cycle (assuming a 365-day year)

1. What is the CCC?

2. What is the amount committed to working capital? How much is amount invested to
resources?
Solution
 Cash Conversion Cycle

The cash conversion cycle (CCC) measures the length of time

required for a company to convert cash invested in its operations to
cash received as a result of its operations. CCC = AAI + ACP - APP
operating cycle (OC)
The time from the beginning of the production process to collection of
cash from the sale of the finished product.
OC = average age of inventory (AAI) + the average collection
period (ACP)
Accounts payable reduce the number of days a firm’s
resources are tied up in the operating cycle. The time it takes
to pay the accounts payable, measured in days, is the
average payment
The operating cycleperiod
less the(APP).
average payment period yields
the cash conversion cycle. CCC = OC - APP
Negative Cash flow

a. Assuming the average collection

period is reduced To 30 days? What
will be the CCC?
FUNDING REQUIREMENTS OF THE CASH CONVERSION CYCLE

Permanent versus Seasonal Funding Needs

If the firm’s sales are constant, then its investment in operating

assets should also be constant, and the firm will have only a
permanent funding requirement. If the firm’s sales are
cyclic, then its investment in operating assets will vary over
time with its sales cycles, and the firm will have seasonal
funding requirements in addition to the permanent funding
required for its minimum investment in operating assets.
Example: Permanent funding
Needs
Seasonal Funding Needs
Aggressive versus Conservative Seasonal Funding Strategies

Short-term funds are typically less expensive than long-term funds. (The yield
curve is typically upward sloping.) However, long-term funds allow the firm to
lock in its cost of funds over a period of time and thus avoid the risk of
increases in short-term interest rates.
Also, long-term funding ensures that the required funds are available to the
firm when needed. Short-term funding exposes the firm to the risk that it may
not be able to obtain the funds needed to cover its seasonal peaks.
Under an aggressive funding strategy, the firm funds its seasonal
requirements with short-term debt and its permanent requirements with long-
term debt.
Under a conservative funding strategy, the firm funds both its seasonal and
its permanent requirements with long-term debt.
Cost of Aggressive Strategy
conservative funding strategy
STRATEGIES FOR MANAGING THE CASH CONVERSION
CYCLE

1. Turn over inventory as quickly as possible without stockouts

that result in lost sales.
2. Collect accounts receivable as quickly as possible without
losing sales from high-pressure collection techniques.
3. Manage mail, processing, and clearing time to reduce them
when collecting from customers and to increase them when
paying suppliers.
4. Pay accounts payable as slowly as possible without damaging
the firm’s credit rating.
Inventory Management

The objective for managing inventory, as noted

earlier, is to turn over inventory as quickly as
possible without losing sales from stockouts.
The financial manager tends to act as an
advisor or “watchdog” in matters concerning
inventory
COMMON TECHNIQUES FOR MANAGING
INVENTORY
ABC inventory system - Inventory management technique that divides
inventory into three groups— A, B, and C, in descending order of importance
and level of monitoring, on the basis of the dollar investment in each.

two-bin method - Unsophisticated inventory monitoring technique that is

typically applied to C group items and involves reordering inventory when
one of two bins is empty.

economic order quantity (EOQ) model Inventory management technique

for determining an item’s optimal order size, which is the size that minimizes
the total of its order costs and carrying costs.
 Economic Order Quantity (EOQ) Model
order costs - the fixed clerical costs of placing and receiving an inventory order.

carrying costs - The variable costs per unit of holding an item in inventory for a
specific period of time

total cost of inventory - The sum of order costs and carrying costs of inventory.
Inventory Management
reorder point . The point at which to reorder inventory,
expressed as days of lead time * daily usage.

safety stock - Extra inventory that is held to prevent

stockouts of important items
Illustration
MAX Company, a producer of dinnerware, has an A group inventory item that
is vital to the production process. This item costs $1,500, and MAX uses
1,100 units of the item per year. MAX wants to determine its optimal order
strategy for the item. Order cost per order = $150; Carrying cost per unit per
year = $200.

MAX operates 250 days per year and uses 1,100 units of this item, If its lead
time is 2 days and MAX wants to maintain a safety stock of 4 units,

Determine the EOQ and re-order point

daily usage: 1,100-250 = 4.4
units
Re-order point: (4.4 x 2) + 4 =
13 units
ACCOUNTS RECEIVABLE
MANAGEMENT
The objective for managing accounts receivable is to collect accounts
receivable as quickly as possible without losing sales from high-pressure
collection techniques. Accomplishing this goal encompasses three topics: (1)
credit selection and standards, (2) credit terms, and (3) credit monitoring.

Credit selection involves application of techniques for determining which

customers should receive credit. This process involves evaluating the
customer’s creditworthiness and comparing it to the firm’s credit standards,
its minimum requirements for extending credit to a customer.

credit monitoring - the ongoing review of a firm’s accounts receivable to

determine whether customers are paying according to the stated credit terms.
Five C’s of Credit

1. Character: The applicant’s record of meeting past obligations.

2. Capacity: The applicant’s ability to repay the requested credit, as judged in terms
of financial statement analysis focused on cash flows available to repay debt
obligations.

3. Capital: The applicant’s debt relative to equity.

4. Collateral: The amount of assets the applicant has available for use in securing
the credit. The larger the amount of available assets, the greater the chance that a
firm will recover funds if the applicant defaults.

5. Conditions: Current general and industry-specific economic conditions, and any

unique conditions surrounding a specific transaction.
Credit Scoring
Credit scoring is a method of credit selection that firms commonly use with
high volume/ small-dollar credit requests.

Credit scoring applies statistically derived weights to a credit applicant’s

scores on key financial and credit characteristics to predict whether he or she
will pay the requested credit in a timely fashion.

The purpose of credit scoring is to make a relatively informed credit decision

quickly and inexpensively, recognizing that the cost of a single bad scoring
decision is small.
Changing Credit Standards
The firm sometimes will contemplate changing its credit standards in an effort to
improve its returns and create greater value for its owners. To demonstrate, consider
the following changes and effects on profits expected to result from the relaxation of
credit standards.
Illustration
Dodd Tool, a manufacturer of lathe tools, is currently selling a product for $10 per unit.
Sales (all on credit) for last year were 60,000 units. The variable cost per unit is $6.
The firm’s total fixed costs are $120,000.

The firm is currently contemplating a relaxation of credit standards that is expected to

result in the following: a 5% increase in unit sales to 63,000 units; an increase in the
average collection period from 30 days (the current level) to 45 days; an increase in
bad-debt expenses from 1% of sales (the current level) to 2%. The firm determines
that its cost of tying up funds in receivables is 15% before taxes.
Determine whether to relax its credit standards, (a) calculate its effect on the firm’s
additional profit contribution from sales, (b) the cost of the marginal investment in accounts
receivable, and (c) the cost of marginal bad debts.
Additional Profit Contribution from Sales

Because fixed costs are “sunk” and therefore are unaffected by a

change in the sales level, the only cost relevant to a change in
sales is variable costs. Sales are expected to increase by 5%, or
3,000 units. The profit contribution per unit will equal the
difference between the sale price per unit ($10) and the variable
cost per unit ($6). The profit contribution per unit therefore will be
$4.
Total additional profit contribution from sales: 3,000 x $4 per unit
= $12,000
Cost of the Marginal Investment in
Accounts Receivable
Cost of Marginal Bad Debts
Cash discounts
Including a cash discount in the credit terms is a popular way to speed up
collections without putting pressure on customers. The cash discount provides
an incentive for customers to pay sooner.

By speeding collections, the discount decreases the firm’s investment in

accounts receivable, but it also decreases the per-unit profit.

Additionally, initiating a cash discount should reduce bad debts because

customers will pay sooner, and it should increase sales volume because
customers who take the discount pay a lower price for the product. Accordingly,
firms that consider offering a cash discount must perform a benefit–cost
analysis to determine whether extending a cash discount is profitable.
Illustration
MAX Company has annual sales of $10 million and an average collection period of 40 days
(turnover ). In accordance with the firm’s credit terms of net 30, this period is divided into 32
days until the customers place their payments in the mail (not everyone pays within 30 days) and
8 days to receive, process, and collect payments once they are mailed. MAX is considering
initiating a cash discount by changing its credit terms from net 30 to 2/10 net 30. The firm
expects this change to reduce the amount of time until the payments are placed in the mail,
resulting in an average collection period of 25 days

MAX has a raw material with current annual usage of 1,100 units. Each finished product produced
requires one unit of this raw material at a variable cost of $1,500 per unit, incurs another $800 of
variable cost in the production process, and sells for $3,000 on terms of net 30. Variable costs
therefore total $2,300 ($1,500 $800). MAX estimates that 80% of its customers will take the 2%
discount and that offering the discount will increase sales of the finished product by 50 units
(from 1,100 to 1,150 units) per year but will not alter its bad debt percentage. MAX’s opportunity
cost of funds invested in accounts receivable is 14%. Should MAX offer the proposed cash
discount?
CREDIT MONITORING
The average collection period is the second component of the cash conversion cycle.
The average collection period has two components: (1) the time from sale until the
customer places the payment in the mail and (2) the time to receive, process, and
collect the payment once it has been mailed by the customer.

aging schedule
A credit-monitoring technique that breaks down accounts receivable into groups on the
basis of their time of origin; it indicates the percentages of the total accounts
receivable balance that have been outstanding for specified periods of time.
Aging of Accounts Receivable
The accounts receivable balance on the books of Dodd Tool on December 31, 2012,
was $200,000. The firm extends net 30-day credit terms to its customers. To gain
insight into the firm’s relatively lengthy—51.3-day—average collection period, Dodd
prepared the following aging schedule.