Background on Working Capital

The term working capital originated with the old Yankee peddler who would load up his wagon and go
off to peddle his wares. The merchandise was called "working capital" because it was what he actually
sold, or "turned over," to produce his profits. The wagon and horse were his fixed assets. He generally
owned the horse and wagon (so they were financed with "equity" capital), but he bought his
merchandise on credit (that is, by borrowing from his supplier) or with money borrowed from a bank.
Those loans were called working capital loans, and they had to be repaid after each trip to demonstrate
that the peddler was solvent and worthy of a new loan. Banks that followed this procedure were said to
be employing "sound banking practices." The more trips the peddler took per year, the faster his
working capital turned over and the greater his profits.

Current Assets Investment Policies

In this section, we discuss how the amount of current assets held affects profitability. To begin, Figure
17.1 shows three alternative policies regarding the size of current asset holdings.

 Relaxed Investment Policy

o Relatively large amounts of cash, marketable securities, and inventories are carried, and
a liberal credit policy results in a high level of receivables.
 Restricted Investment Policy
o Holdings of cash, marketable securities, inventories, and receivables are constrained.
 Moderate Investment Policy
o An investment policy that is between the relaxed and restricted policies.

A restricted (lean-and-mean) policy indicates a low level of assets (hence, a high total asset turnover
ratio), which results in a high ROE, other things held constant. However, this policy also exposes the firm
to risks because shortages can lead to work stoppages, unhappy customers, and serious long-run
problems.

The relaxed policy minimizes such operating problems, but it results in a low turnover, which in tum
lowers ROE.

The moderate policy falls between the two extremes. The optimal strategy is the one that maximizes the
firm's long-run earnings and the stock's intrinsic value.

Note that changing technologies can lead to changes in the optimal policy. For example, when a new
technology makes it possible for a manufacturer to produce a given product in 5 rather than 10 days,
work-in-progress inventories can be cut in half. Similarly, retailers typically have inventory management
systems in which bar codes on all merchandise are read at the cash register. This information is
transmitted electronically to a computer that records the remaining stock of each item, and the
computer automatically places an order with the supplier 's computer when the stock falls to a specified
level. This process lowers the "safety stocks" that would otherwise be necessary to avoid running out of
stock, which lowers inventories to profit- maximizing levels.

Current Assets Financing Policies

 Permanent Current Assets

 o Current assets that a firm must carry even at the trough of its cycles.
 Temporary Current Assets
o Current assets that fluctuate with seasonal or cyclical variations in sales.
 Current Assets Financing Policy
o The manner in which current assets are financed.

Investments in current assets must be financed; and the primary sources of funds include bank loans,
credit from suppliers (accounts payable), accrued liabilities, long- term debt, and common equity. Each
source has advantages and disadvantages, so each firm must decide which sources are best for its
situation.

To begin, note that most businesses experience seasonal and/or cyclical fluctuations. For example,
construction firms tend to peak in the summer, retailers peak around Christmas, and the manufacturers
who supply construction companies and retailers follow related patterns. Similarly, the sales of virtually
all businesses increase when the economy is strong; hence, they build up current assets at those times
but let inventories and receivables fall when the economy weakens.

Note, though, that current assets rarely drop to zero-- companies maintain some permanent current
assets, which are the current assets needed at the low point of the business cycle. Then as sales increase
during an upswing, current assets are increased, and these extra current assets are defined as
temporary current assets as opposed to permanent current assets. The manner in which these two
types of current assets are financed is called the firm's current assets financing policy.

The Cash Conversion Cycle

All firms follow a "working capital cycle" in which they purchase or produce inventory, hold it for a lime,
and then sell it and receive cash. This process is similar to the Yankee peddler's trips, and it is known as
the cash conversion cycle (CCC).

Calculating the Targeted CCC

Assume that Great Fashions Inc. (GFI) is a start-up business that buys ladies' golf outfits from a
manufacturer in China and sells them through pro shops at high-end golf clubs in the United States,
Canada, and Mexico. The company's business plan calls for it to purchase S100,000 of merchandise at
the start of each month and have the merchandise sold within 60 days. The company will have 40 days
to pay its suppliers, and it will give its customers 60 days to pay for their purchases. GFI expects to just
break even during its first few years, so its monthly sales will be $100,000, the same as its purchases.
Any funds required to support operations will be obtained from the bank, and those loans must be
repaid as soon as cash is available.

 Inventory conversion period. For GFI, this is the 60 days it takes to sell the merchandise.
 Average collection period {ACPJ. This is the length of time customers are given to pay for goods
following a sale. The ACP is also called the days sales outstanding CDSO). GFl's business plan
calls for an ACP of 60 days, which is consistent with its 60-day credit terms.
 Payables deferral period. This is the length of time GFI's suppliers give GFI to pay for its
purchases (40 days in our example).
On Day 1, GFI buys merchandise and expects to sell the goods and thus convert them to accounts
receivable in 60 days. It should take another 60 days to collect the receivables, making a total of 120
days between receiving merchandise and collecting cash. However, GFI is able to defer its own
payments for only 40 days.

Although GFI must pay $100,000 to its suppliers after 40 days, it will not receive any cash until 60 + 60 =
120 days into the cycle. Therefore, it will have to borrow the $100,000 cost of the merchandise from its
bank on Day 40, and it will not be able to repay the loan until it collects from customers on Day 120.
Thus, for 120 - 40 = 80 days-which is the cash conversion cycle (CCC}-it will owe the bank $100,000 and
will pay interest on this debt. The shorter the cash conversion cycle, the better because that will lower
interest charges. Note that if GFI could sell goods faster, collect receivables faster, or defer its payables
longer without hurting sales or increasing operating costs, its CCC would decline, its interest expense
would be reduced, and its profits and stock price would be improved.

Calculating the CCC from Financial Statements

The preceding section illustrates the CCC in theory, but in practice we would calculate the CCC based on
the firm's financial statements. Moreover, the actual CCC would almost certainly differ from the
theoretically forecasted value because of real-world complexities such as shipping delays, sales
slowdowns, and customer delays in making payments. Moreover, a firm such as GFI would start a new
cycle before the earlier one ended, and this too would muddy the waters.

We begin with the inventory conversion period:

Thus, it takes GFI an average of 90 days to sell its merchandise, not the 60 days called for in its business
plan. Note also that inventory is carried at cost, so the denominator of the equation is the cost of goods
sold, not sales.

The average collection period (or days sales outstanding) is calculated next:

Note that it takes GFI 90 days after a sale to receive cash, not the 60 days called for in its business plan.
Because receivables are recorded at the sales price, we use sales rather than cost of goods sold in the
denominator.

The payables deferral period is found as follows, again using cost of goods sold in the denominator
because payables are recorded at cost:

GFI is supposed to pay its suppliers after 40 days, but it is a slow payer, delaying payment on average
until Day 54.

We can combine the three periods to calculate GFl's actual cash conversion cycle:

GFI's actual 126-day CCC is quite different from the planned 80 days. It takes longer than planned to sell
merchandise, customers don't pay as quickly as they should, and GFI pays its suppliers slower than it
should. The end result is a CCC of 126 days versus the planned 80 days. Although the planned 80-day
CCC is "reasonable," the actual 126 days is too high. The CFO should push salespeople to speed up sales
and the credit manager to accelerate collections. Also, the purchasing department should try to get
longer payment terms. U GFI could take those steps without hurting its sales and operating costs, the
firm would improve its profits and stock price.
The Cash Budget

Cash and Marketable Securities

When most people use the term cash, they mean currency (paper money and coins) in addition to bank
demand deposits. However, when corporate treasurers use the term, they often mean currency and
demand deposits in addition to very safe, highly liquid, marketable securities that can be sold quickly at
a predictable price, and thus be converted to bank deposits. Therefore, "cash" as reported on balance
sheets generally includes short-term securities, which are also called "cash equivalents."

Note that a firm's marketable security holdings can be divided into two categories: (1) Operating short-
term securities, which are held primarily to provide liquidity and are bought and sold as needed to
provide funds for operations, and (2) other short-term securities, which are holdings in excess of the
amount needed to support normal operations. Highly profitable firms such as Microsoft often hold far
more securities than are needed for liquidity purposes. Those securities will eventually be liquidated,
and the cash will be used for such things as paying a large one-ti.me dividend, repurchasing stock,
retiring debt, acquiring other firms, or financing major expansions. This breakdown is not reported on
the balance sheet, but financial managers know how much of their securities will be needed for
operating versus other purposes. In our discussion of net working capital, the focus is on securities held
to provide operating liquidity.

 Currency
o Businesses hold substantial amounts of currency, but the importance of currency has
decreased over time due to the rise of credit cards, debit cards, and other payment
mechanisms.
 Demand Deposits
o Demand (or checking) deposits are far more important than currency for most
businesses. These deposits are used for tra11sactio11s-paying for labor and raw
materials, purchasing fixed assets, paying taxes, servicing debt, paying dividends, and so
forth. However, commercial demand deposits typically earn no interest, so firms try to
minimize their holdings while still ensuring that they are able to pay suppliers promptly,
take trade discounts, and take advantage of bargain purchases.
 Marketable Securities
o Marketable securities held for operations are managed in conjunction with demand
deposits-the management of one requires coordination with the other. Firms also
purchase marketable securities as cash builds up from operations and then sell those
securities when they need cash. Recently, to maintain flexibility and/ or to have funds
available to withstand a future economic decline, many companies have continued to
hold large amounts of cash and marketable securities.

Inventories

Inventories, which can include (1) supplies, (2) raw materials, (3) work i11 process, and (4) finished
goods are an essential part of virtually all business operations. Optimal inventory levels depend on sales,
so sales must be forecasted before target inventories can be established. Moreover, because errors in
setting inventory levels lead to lost sales or excessive carrying costs, inventory management is quite
important. Therefore, firms use sophisticated computer systems to monitor their inventory holdings.
Retailers typically use computers to keep track of each inventory item by size, shape, and color; and bar
code information collected at checkout updates inventory records. When inventories shown in the
computer decline to a set level, the computer sends an order to the supplier's computer, specifying
exactly what is needed. The computer also reports how fast items are moving. If an item is moving too
slowly, the computer will suggest a price cut to lower the inventory stock before the item becomes
obsolete. Manufacturers use similar systems to keep track of items and to place orders as they are
needed.

Although inventory management is important, it is under the operational control of production

managers and marketing people rather than financial managers. Still, financial managers are involved in
several ways. First, it is expensive to install and maintain the computer systems used to track
inventories, and the capital budgeting analysis discussed earlier in the text must be used to determine
which system is best. Second, if the firm decides to increase its inventory holdings, the financial manager
must raise the capital needed to acquire the additional inventory. And third, the financial manager is
responsible for identifying any area of weakness that affects the firm's overall profitability, using ratios
and other procedures for comparing the firm to its benchmark companies. Therefore, the CFO will
compare the firm's inventory-to-sales ratio with those of its benchmarks to see if things look
"reasonable."

Accounts Receivable

Although some sales are made for cash, today the vast majority of sales are on credit. Thus, in the
typical situation, goods are shipped, inventories are reduced, and an account receivable is created."
Eventually, the customer pays, the firm receives cash, and its receivables decline. The firm's credit policy
is the primary determinant of accounts receivable, and it is under the administrative control of the CFO.
Moreover, credit policy is a key determinant of sales, so sales and marketing executives are concerned
with this policy. Therefore, we begin our discussion of accounts receivable by discussing credit policy.

Credit policy consists of these four variables:

 Credit period is the length of time buyers are given to pay for their purchases. For example, the
credit period might be 30 days. Customers prefer longer credit periods, so lengthening the
period will stimulate sales. However, a longer credit period lengthens the cash con version cycle;
hence, it ties up more capital in receivables, which is costly. Also, the longer a receivable is
outstanding, the higher the probability that the customer will default and that the account will
end up as a bad debt.
 Discounts are price reductions given for early payment. The discount specifies what the
percentage reduction is and how rapidly payment must be made to be eligible for the discount.
For example, a 2% discount is often given if the customer pays within 10 days. Offering discounts
has two benefits. First, the discount amounts to a price reduction, which stimulates sales.
Second, discounts encourage customers to pay earlier than they otherwise would, which
shortens the cash conversion cycle. However, discounts also mean lower prices-and lower
revenues unless the quantity sold increases by enough to offset the price reduction. The
benefits and costs of discounts must be balanced when credit policy is being established.
 Credit standards, which refer to the required financial strength of acceptable credit customers.
With regard to credit standards, factors considered for business customers include ratios such as
 the customer's debt and interest coverage ratios, the customer's credit history (whether the
customer has paid on time in the past or tended to be delinquent), and the like. For individual
customers, their credit score as developed by credit rating agencies is the key item. In both
cases, the key question is this: Is the customer likely to be willing and able to make the required
payment on schedule? Note that when standards are set too low, bad debt losses will be too
high; on the other hand, when standards are set too high, the firm loses sales and thus profits.
So, a balance must be struck between the costs and benefits of tighter credit standards.
 Collection policy refers to the procedures used to collect past due accounts, including the
toughness or laxity used in the process. At one extreme, the firm might write a series of polite
letters after a fairly long delay; at the other extreme, delinquent accounts may be turned over to
a collection agency relatively quickly. Companies should be somewhat firm, but excessive
pressure can lead customers whose business is profitable to take their business elsewhere.
Again, a balance must be struck between the costs and benefits of different collection policies.

Monitoring Accounts Receivable

The total amount of accounts receivable outstanding at any given time is determined by the volume of
credit sales and the average length of time between sales and collections. For example, suppose Boston
Lumber Company (BLC), a wholesale distributor of lumber products, has sales of $1,000 per day (all on
credit) and it requires payment after 10 days. BLC has no bad debts or slow-paying customers. Under
those conditions, it must have the capital to carry $10,000 of receivables:

If either sales or the collection period changes, so will accounts receivable. For example, if sales doubled
to $2,000/ day, receivables would also double; and the firm would need an additional $10,000 to finance
this increase. Similarly, if the collection period lengthened to 20 days, this too would double the
receivables and require additional capital.

Accounts Payable (Trade Credit)

Firms generally make purchases from other firms on credit and record the debt as an account payable.
Accounts payable, or trade credit, is the largest single category of short-term debt, representing about
40% of the average corporation's current liabilities. This credit is a spontaneous source of financing in
the sense that it arises spontaneously from ordinary business transactions. For example, if a firm makes
a purchase of $1,000 on terms of net 30, it must pay for goods 30 days after the invoice date. This
instantly and spontaneously provides S1,000 of credit for 30 days. If the firm purchases $1,000 of goods
each day, on average, it will be receiving 30 times $1,000, or $30,000, of credit from its suppliers. If
sales, and consequently purchases, double, its accounts payable also will double, to $60,000. So simply
by growing, the firm spontaneously generates another $30,000 of financing. Similarly, if the terms under
which it buys are extended from 30 to 40 days, its accounts payable will expand from $30,000 to
$40,000. Thus, expanding sales and lengthening the credit period generate additional financing.

Trade credit may be free, or it may be costly. If the seller does not offer discounts, the credit is free in
the sense that there is no cost for using it. However, if discounts are available, a complication arises.

To illustrate, suppose PCC Inc. buys 20 microchips each day, with a list price of 100 per chip on terms of
2/ 10, net 30. Under those terms, the "true" price of the chips is 0.98($100) = $98 because the chips can
be purchased for only $98 by paying within 10 days. Thus, the $100 list price has two components:
If PCC decides to take the discount, it will pay at the end of Day 10 and show $19,600 of accounts
payable:

If it decides to delay payment until the 30th day, its trade credit will be $58,800:

By not taking discounts, PCC can obtain an additional $39,200 of trade credit, but this $39,200 is costly
credit because the firm must forgo the discounts to receive it. Therefore, PCC must answer this
question: Could we obtain the additional $39,200 at a lower cost from some other source (e.g., a bank)?

To illustrate the situation, assume that PCC operates 365 days per year and buys 20 chips per day at a
"true" price of $98 per chip. Therefore, its total chip purchases are 20($98)(365) = $715,400 per year. If
it does not take discounts, its chips will cost 20($100)(365) = $730,000, or an additional $14,600. This
$14,600 is the annual cost of the $39,200 of extra credit. Dividing the $14,600 cost by the $39,200
additional credit yields the nominal annual cost of the additional trade credit, 37.24%:

If PCC can borrow from its bank or some other source for less than 37 24%, it should take the discount
and use only $19,600 of trade credit.

With this background, we can define two types of trade credit: free and costly:

 Free trade credit is the trade credit that is obtained without a cost, and it consists of all trade
credit that is available without forgoing discounts. In PCC's case, when it buys on terms of 2/ 10,
net 30, the first 10 days of purchases, or S19,600, are free.
 Costly trade credit is any trade credit over and above the free trade cred it. For PCC, the
additional 20 days, or $39,200, are not free because receiving the additional credit means
forfeiting the discount.

Firms should always use the free component, but they should use tire costly component only if they
cannot obtain funds at a lower cost from another source.

Bank Loans

The key features of bank loans, another important source of short-term financing for businesses and
individuals, are discussed in this section.

 Promissory Note
o Amount. The amount borrowed is indicated.
o Maturity. Although banks do make longer-term loans, the bulk of their lending is on a
short-term basis-about two-thirds of all bank loans mature in a year or less. Long-term
loans always have a specific maturity date, while a short-term loan may or may not have
a specified maturity. For example, a loan may mature in 30 days, 90 days, 6 months, or 1
year; or it may call for payment "on demand," in which case the loan can remain
outstanding as long as the borrower wants to continue using the funds and the bank
agrees. Bank loans to businesses are frequently written as 90-day notes, so the loan
must be repaid or renewed at the end of 90 days. It is often expected that the loan will
 be renewed; but if the borrower's financial position deteriorates, the bank can refuse to
renew it. This can lead to bankruptcy. Because banks usually don't demand payment
unless the borrower's creditworthiness has deteriorated, some "short-term loans"
remain outstanding for years, with the interest rate floating with rates in the economy.
o Interest rate. The interest rate can be fixed or floating. For larger loans, it is typically
indexed to the bank's prime rate, to the T-bill rate, or to the London Interbank Offer
Rate (LIBOR). The note will also indicate whether the bank uses a 360- or 365-day year
for purposes of calculating interest. The indicated rate is a nominal rate, and the
effective annual rate is generally higher.
o Interest only versus amortized. Loans are either interest only, meaning that only interest
is paid during the life of the loan, with all principal repaid when the loan matures, or
amortized, meaning that some of the principal is repaid on each payment date.
Amortized loans are also called i11stallment loans.
o Frequency of interest payments. If the note is on an interest-only basis, it will indicate
how frequently interest must be paid. Interest is typically calculated daily but paid
monthly.
o Discount interest. Most loans call for interest to be paid only after it has been earned;
but banks also lend on a discount basis, where interest is paid in advance. On a discount
loan, the borrower actually receives less than the face amount of the loan; and this
increases its effective cost.
o Add-on loans. Auto loans and other consumer installment loans are generally set up on
an "add-on basis," which means that interest charges over the life of the loan are
calculated and then added to the face amount of the loan. Thus, the borrower signs a
promissory note calling for payment of the funds received plus all interest that must be
paid over the life of the loan. The add-on feature raises the effective cost of a loan.
o Collateral. If a loan is secured by equipment, buildings, accounts receivable, or
inventories, this fact is indicated in the note.
o Restrictive covenants. The note may also specify that the borrower must maintain
certain ratios at or better than specified levels, and it spells out what happens if the
borrower defaults on those covenants. Default provisions often allow the lender to
demand immediate payment of the entire loan balance. Also, the interest rate on the
loan might be increased.
o Loan guarantees. If the borrower is a small corporation, the bank will probably insist
that its larger stockholders personally guarantee the loan. Troubled companies' owners
have been known to divert assets from the company to relatives or other entities they
own, so banks protect themselves by obtaining personal guarantees.

Commercial Paper

Commercial Paper - Unsecured, short-term promissory notes of large firms, usually issued in
denominations of $100,000 or more with an interest rate somewhat below the prime rate.

It is generally unsecured, but "asset-backed paper" secured by credit card debt and other small, short-
term loans has also been issued.

Accruals (Accrued Liabilities)

firms generally pay employees on a weekly, biweekly, or monthly basis, so the balance sheet typically
shows some accrued wages.

Similarly, the firm's own estimated income taxes, Social Security and income taxes withheld from
employee payrolls, and sales taxes collected are generally paid on a weekly, monthly, or quarterly basis.
Therefore, the balance sheet typically shows some accrued wages and taxes, which we refer to as
accruals.

Accruals arise automatically from a firm's operations; hence, they are spontaneous funds. For example,
if sales grow by 50%, accrued wages and taxes should also grow by about 50%. Accruals are "free" in the
sense that no interest is paid on them. However, firms cannot control their accruals because the timing
of wage payments is set by contract or industry custom and tax payments are set by law. Thus, firms use
all the accruals they can, but they have little control over their levels.

Use of Security in Short-Term Financing

Other things held constant, borrowers prefer to use unsecured short-term debt because the
bookkeeping costs associated with secured loans are high. However, firms may find that they can
borrow only if they put up collateral to protect the lender or that securing the loan enables them to
borrow at a lower rate.

Stocks and bonds, equipment, inventory, accounts receivable, land, and buildings can be used as
collateral. However, few firms that need loans hold portfolios of stocks and bonds. Land, buildings, and
equipment are good forms of collateral; but they are generally used to secure long-term loans rather
than short-term working capital loans. Therefore, most secured short-term business loans use accounts
receivable and inventories as collateral.

Summary

This chapter discussed the management of current assets, including cash, marketable securities,
inventory, and receivables. Current assets are essential, but there are costs associated with holding
them. So, if a company can reduce its current assets without hurting sales, this will increase its
profitability. The investment in current assets must be financed; and this financing can be in the form of
long-term debt, common equity, and / or short-term credit

Firms typically use trade credit and accruals; they also may use bank debt or commercial paper.
Although current assets and procedures for financing them can be analyzed as we did in this chapter,
decisions are normally made within the context of the firm's overall financial plan. We take up financial
planning in the next chapter; hence, we continue our discussion of working capital there.