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Chapter 19
Working
Capital
Management
Chapter 19 Outline
19.1 Analyzing
Working Capital
•What Constitutes
Good Working
Capital
Management?
•Cash Flow
Analysis
•The Cash Budget
•Working Capital
Ratios
•Operating and
Cash Conversion
Cycles
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19.2 Managing
Cash and Cash
Equivalents
•Company
Motives for
Holding Cash
•Determining the
Optimal Cash
Balance
•Cash
Management
Techniques
19.3 Managing
Accounts
Receivable
•The Credit
Decision
•Credit Policies
•The Collection
Process
19.4 Managing
Inventory
•Inventory
Management
Approaches
19.5 Short-Term
Financing
Considerations
•Bank Loans
•Factor
Arrangements:
Example
•Money Market
Instruments
•Securitizations
19.1 Analyzing Working
Capital
 Working capital is the sum of the company’s
current assets, whereas net working capital
(NWC) is the difference between a company’s
current assets and its current liabilities.
 Working capital management refers to the way in
which a company manages both its current assets
(i.e., cash and marketable securities, accounts
receivable, and inventories) and its current
liabilities (i.e., accounts payable, notes payables,
and short-term borrowing arrangements).
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What Constitutes Good Working
Capital Management?
1.
2.
3.
4.
5.
4
The maintenance of optimal cash balances.
The investment of any excess liquid funds in
marketable securities that provide the best return
possible, considering any liquidity or default-risk
constraints.
The proper management of accounts receivables.
The development and maintenance of an efficient
inventory management system.
The selection of the appropriate level of short-term
financing in the least expensive and most flexible
manner possible.
Cash Flow Analysis
Companies produce four statements:
1. the income statement,
2. the balance sheet,
3. the cash flow statement, and
4. the statement of owners’ equity.
Of the three, financial analysts tend to focus on the
cash flow statement because the other statements
frequently have accounting adjustments that make it
difficult to find the company’s problems.
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The Cash Budget
 Companies create a cash budget,
which is
essentially a cash flow statement projected for
each month.
 The key components of a cash budget are
sales forecasts, estimated production
schedules, and estimates of the size and
timing of any other major inflows (e.g., from
the sale of an asset) or outflows (e.g., capital
expenditures, dividend payments) that the
company expects.
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The Cash Budget (continued)


The cash budget is the basic tool for forecasting the cash
inflows and outflows through a company. Although it helps
financial managers identify key items, unfortunately, it does not
explain the cause of the problem. Instead, we can look at the
drivers of cash flow.
These drivers include the company’s:



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credit policy, which is the terms under which the company grants credit
to its customers;
payment policy, which is how quickly the company pays off the credit it
receives from other companies; and
inventory policy, which is determining how much and of what type of
inventory to have on hand.
Working Capital Ratios


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Two common measures of company liquidity are the
current ratio and the quick (or acid test) ratio.
The current ratio measures a company’s ability to
repay current obligations from current assets, whereas
the quick ratio is a more conservative estimate of
liquidity that reflects the fact that inventory is
generally not as liquid as other current assets and that
prepaid expenses are virtually worthless in the event
of company liquidation.
Working Capital Ratios:
Accounts Receivable
 To gain better insight into a company’s strengths
and weaknesses, we need to look at how it arrived
at these levels of current assets and current
liabilities. Several efficiency ratios are specifically
related to working capital items. We begin by
looking at two ratios related to accounts
receivables, assuming that all sales are on credit:
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Working Capital Ratios:
Accounts Receivable


The receivables turnover ratio is a measure of the sales
generated for each dollar in receivables, whereas the
days sales outstanding (DSO) is a measure of how long
it takes the average customer to pay his or her
account.
Similar to our derivation of the DSO, we can divide 365
days by the inventory turnover ratio to find the days
sales in inventory (DSI):
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Working Capital Ratios:
Accounts Payable

The following two ratios pertain to a company’s management of
its accounts payable, the accounts payable turnover and the days
payables outstanding. The accounts payable turnover is the
number of times in a year, on average, the company has a
complete cycle of generating payable accounts and paying on
these accounts:
The days payables outstanding (DPO) is the length of time, in days,
it takes for the company to pay its suppliers.
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
Operating and Cash
Conversion Cycles


12
The operating cycle, also known as the days working
capital, DWC, is the average time it takes the company to
acquire inventory, sell it, and collect the sale proceeds. As
such, we estimate the operating cycle as the sum of the
average days of sales in inventory (DSI) and the average
collection period (DSO):
Operating cycle = DSI + DSO
The cash conversion cycle (CCC) is a measure of the average
time between when a company pays cash for its inventory
purchases and when it receives cash for its sales.
CCC = DSI + DSO - DPO
19.2 Managing Cash and
Cash Equivalents
Transactions
motive
Precautionary
motive
•Holding cash to pay for normal operations, such as
bills
•Holding cash to take care of unanticipated
required outlays of cash, such as unexpected
repairs on equipment
Finance
motive
•Holding cash in anticipation of major outlays, such
as lump-sum loan repayments and dividend
payments
Speculative
motive
•Holding cash to take advantage of “bargains,”
such as the opportunity to purchase raw materials
very cheaply
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Determining the Optimal Cash
Balance
 The optimal
cash balance is the one that
balances the risks of illiquidity against the
sacrifice in expected return that is
associated with maintaining cash.
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Cash Management
Techniques
 The
general approach to good cash management
is to speed up inflows as much as possible and
delay outflows as much as possible.
 Float: the funds that are due the company yet not
received
 Float time: the time that elapses between the
time the paying company initiates payment, for
example, mails the check, and when the funds are
available for use by the receiving company
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Cash Management
Techniques (continued)
Ways to eliminate or reduce float:




Debit cards
Preauthorized payments
Electronic collection systems like EFT and EDI
Arrangements with banks
 Lock-box system: arrangement of local post office
boxes for customers to mail their payments to and
authorizing the local bank to empty these boxes and
deposit the checks into the company’s account
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19.3 Managing Accounts
Receivable
Credit analysis: process designed
to assess the risk of nonpayment
by potential customers
 Four Cs of credit:




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Capacity: customer’s ability to pay
Character: how willing the
company is to pay and how reliable
and trustworthy the company is
Collateral: real estate, investments,
and other property of the borrower
Conditions: state of the economy
Credit Policies
 Once a company has decided to grant credit, it
then chooses the terms of credit to offer its
customers, such as the due date, and the discount
date and discount amount, where applicable.
 Effective annual cost of trade credit:
365/n
d
i= 1+
c
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d is the discount, as a percentage of the sales price
c is the cash price, as a percentage of the sales price
n is the number of days payment is made beyond the
discount period
Example
Suppose a company that currently does not grant credit is
considering adopting a credit policy that permits its customers to
pay the full price for purchases (with no penalties) within 40 days of
the purchase (i.e., the credit terms are net 40).
The company estimates that it can increase the price of the product
by $1 per unit with the new policy, which results in a new price per
unit of $111. The company expects that unit sales will increase by
1,000 units per year (to 11,000 units) and that variable costs will
remain at $99 per unit. It also estimates that bad debt losses will
amount to $6,000 per year.
The company will finance the additional investment in receivables
by using its line of credit, which charges 6 percent interest. The
company’s tax rate is 40 percent. Should the company begin
extending credit under the terms described?
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Profit per unit = $111-99 = $12
Example
Because the company did not previously have any
receivables, the initial investment is the amount of
additional funds tied up in receivables, which equals the
number of days that the company finances sales,
multiplied by the estimated sales per day:
Additional investment = 40 days × Sales per day
$111×11,000
Sales per day=
=$3,345.21
365
Additional investment=40 days ×$3,345.21=$133,408
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Example
Now, we need to estimate the present value of
future cash flows, which equals the present value of
the incremental after-tax cash flows generated by
extending credit.
Item
Calculation
Cash Flow
Profit per unit sold, current
price
1,000 extra units sold ×
$12
$12,000
Profit from price increase
10,000 units × $1
Bad debt expense
Incremental before tax annual
cash flow
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10,000
-6,000
$16,000
Example
We can estimate the change in the value of the company by
capitalizing the additional cash flows (after-tax cash flows).
Capitalizing means to determine the value today. If we assume
that these cash flows are received each year, then we divide the
after-tax cash flows by the after-tax cost of funds.
The appropriate after-tax discount rate = 6% x (1 – 0.40) = 3.6%.
If we assume the company reaps the benefits of this change in
policy indefinitely, we can find the present value of the future
benefits by viewing the incremental after-tax annual cash flows as a
perpetuity:
After−tax incremental
$16,000×(1−0.40)
Present value
cash
flows
=
=
=$266.667
of future cash flow
Discount rate
0.036
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Decision: Cost v. benefit
Cost of funds
(borrowing)
$133,808
Increase in
value from
increase in
cash flow
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$266,667
Factoring
Sometimes a company avoids the collection
process by entering into a factoring arrangement:
 Factoring arrangement: sale of a company’s
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receivables, at a discount, to a financial company
specializing in collections; outsourcing of the
collections to a factor
 a.k.a. AR finance
 Factor: financial company that buys receivables and
collects on these accounts
 Example of a factor: GE Capital
The factoring process
Business sells creditworthy receivables to
factor at a discount
•Business receives cash
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Factor collects on the
accounts
•Customers know accounts are
factored.
Invoice discounting
 Invoice discounting is a loan that uses
the
receivables accounts as collateral.
 The business that created the receivable collects
on the receivables
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Financial institution lends
money to the business
Business collects on the
accounts
•Business receives cash
•Receivables are collateral
•Funds deposited in trust for lender
•Customers do not know accounts
are factored.
19.4 Managing Inventory
Inventory Management Approaches
 ABC approach: division of inventory into several
categories based on the value of the inventory
items, their overall level of importance to the
company’s operations, and their profitability, to
determine the time and effort devoted to their
management
 Economic Order Quantity (EOQ) Model:
determines the optimal inventory level as the
level that minimizes the total of shortage costs
and carrying costs
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Inventory Management
Approaches (continued)
 Materials
Requirement Planning (MRP): detailed
computerized system that orders inventory in
conjunction with production schedules to
determine the level of raw materials and work-inprocess that must be on hand to meet finished
goods demand
 Just-in-time (JIT) inventory system: inventory
management approach that fine-tunes the
receipt of raw materials so that they arrive
exactly when they are required in the production
process and thereby reduce inventory to its
lowest possible level
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EOQ
Cost of carrying
inventory
(e.g., storage,
taxes, opportunity
cost, financing)
Cost of ordering
(e.g., cost of
placing order,
inspecting items,
documentation)
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Summary
30
Cost of
carry
Cost of
ordering
Smaller,
more
frequent
orders
Low
High
Larger, less
frequent
orders
High
Low
How Inventory Models Work:
Example
Assume, for simplicity, that the company has one type of
inventory, which we will refer to as screens. Suppose
that the company uses 1 million screens during a fiscal
year.
Every time the company orders screens from its supplier,
the supplier charges $10,000 in shipping and handling.
The cost of keeping screens on hand, in terms of storage
and maintenance costs, is $0.50 per screen.
The question then arises: When the company orders
screens, what quantity should they order?
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How Inventory Models Work:
Example (continued)
 The
EOQ model specifies that the optimal order
quantity is:
2 × Annual usage, in units ×order cost
EOQ=
Annual carrying cost per unit
 In our example,
2 × 1,000,000 × $10,000
EOQ=
=200,000
$0.50
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19.5 Short-Term Financing
Considerations
 Trade
credit: financing provided to
customers for the purchase of a product or
service
 Trade credit provides companies with
many advantages: It is generally readily
available, convenient, and flexible, and it
usually does not entail any restrictive
covenants or pledges of security. In
addition, it is usually inexpensive.
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Cost of trade credit
Extending credit to customers may enhance
sales, but increases a company’s costs:
 Collection
 Bad debts (write-offs as not collectible)
 Cost of funds
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Bank Loans
 The
most common arrangement for businesses is to
establish operating loans (or lines of credit).
 The cost of the short-term bank loan, without any
additional fees is:
n
Rate=
35
1+
Quoted annual rate
No. of loan periods in year
−1
Cost of bank loan
Suppose a bank offers a company a 1-year variable rate
loan at a rate of prime plus 1 percent at a time when the
bank’s prime lending rate is 5.25 percent. The company
must repay the loan in monthly installments. Assuming
there are no other fees associated with this loan, what is
the effective annual cost of this loan?
The annual quoted rate = 5.25% + 1% = 6.25%.
The effective annual rate associated with this
arrangement:
Rate=
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0.0625
1+
12
12
−1 = 6.432%
Factor Arrangements:
Example
Suppose a company has daily credit sales of $40,000 and an
average collection period of 45 days. A factor offers a 45-day
accounts receivable loan equal to 75 percent of accounts
receivable. The quoted interest rate is 10 percent, and there
is a commission fee of 1 percent of accounts receivable.
The company estimates that it will save $2,000 in collection
costs and will experience a 0.5 percent reduction in bad debt
losses (as a percentage of sales) as a result of the factoring
arrangement. What is the effective annual cost of the
arrangement?
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Factor Arrangements:
Example (continued)
First, estimate the accounts receivable that the company can
factor:
Daily credit
Accounts receivabke=DSP×
=45×$40,000=$1,800,000
sales
 Second, calculate the amount of the loan (which is 75 percent of
the accounts receivable):
Accounts
Loan amount=0.75 ×
=0.75 ×$1,800,000=$1,350,000
receivable
 Third, calculate the commission and interest on this arrangement:
Accounts
Commission=0.01 ×
=0.01 ×$1,800,000=$18,000
receivable
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Interest=0.01 ×
×$1,350,000
365

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Factor Arrangements:
Example (continued)
Fourth, calculate the savings on the arrangement:
$40,000
Savings=$2,000+ 0.005×45 days×
=$11,000
day
 Assemble the pieces, minus the cost and savings, and get,
on net, cost of $23,644:
Net cost = $18,000 + 16,644 – 11,000 = $23,644
 Translate this into an effective cost and find that the cost
is 15.12% per year:
365
$23,644 45
i= 1+
−1=15.12%
$1,350,000

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Money Market Instruments

Money market instrument: security with less than one
year in maturity that trades in markets or can be
privately placed

Commercial paper (CP): A short-term promissory note issued
by companies, which is rated by external debt agencies in a
similar fashion as bonds.
Bankers’ acceptance (BA): Differs from commercial paper
because it is “stamped” by a bank as accepted in return for a
fee



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The fee is usually 0.25 percent to 1 percent of the face value of the
bankers’ acceptances.
In return for the fee, the bank guarantees the payments associated
with these instruments.
Yields on CP and BA
The yield on commercial paper and bankers’
acceptances is most often based on the bond equivalent
yield, ibey, which is the annualized rate per period:
𝒊𝒃𝒆𝒚
FV−PV 365
=
×
PV
m
FV = amount paid at end of loan
PV = amount borrowed
m = loan term, in days
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Securitizations
 Special purpose
vehicle (SPV) or special purpose
entity (SPE): Conduits, usually formed as limited
partnerships or limited companies, for packaging
portfolios of receivables and selling them to
investors in the money market. In this way, the
purchaser relies on the credit of the SPV.
 Securitization: Process in which companies sell
the loans directly to the capital market through an
SPV so that neither the loans nor the financing
appear on its balance sheet.
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Securitizations (continued)
 The
essence of securitization is that the credit risk
of the seller of the receivables or loans is not
directly involved.
 If a portfolio of receivables or loans is simply sold
to investors, in all likelihood the credit quality
would not be high enough to get an investmentgrade rating. As a result, investors demand a
credit enhancement, such as requiring collateral,
insurance, or other agreements, to reduce credit
risk.
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Securitizations (continued)



44
Credit rating services consider history of default rates on
loans and of prepayment: payment of a debt before its
due date.
They also perform stress tests: “what-if” examinations of
the value of an asset under challenging conditions, such
as an increase in interest rates or declining economic
conditions.
The most important aspects of the SPV are usually the
credit enhancements because the SPV may need to
enhance the credit quality of the underlying asset’s need
to get an AAA credit rating.
Summary



Cash budgets are useful in working capital
management because these budgets are a means for
companies to forecast their cash requirements.
We can use some common ratios to assess a
company’s overall approach to working capital
management.
The optimal level of investment in cash, receivables,
and inventory occurs when the benefits balance the
costs. In the case of cash, the benefit is the reduced
risk of insolvency, whereas the cost is the opportunity
costs of having funds tied up in assets that provide a
relatively low return.
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Summary (continued)



Managing receivables requires considering the benefits of
extending credit (increased sales), whereas the costs include the
financing costs and the increased risk of nonpayment by
customers.
When managing inventory, the benefits may be improved
production processes or reduced risk of stock-outs, which result in
forgone revenue and can also damage customer goodwill. The
costs include financing, storage, spoilage, obsolescence, and
insurance.
Common short-term financing options available to companies
include trade credit, bank loans, factoring arrangements, and
money market instruments. Each method has advantages and
disadvantages. Key to managing short-term financing is to
estimate the effective annual cost of each alternative.
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