WORKING CAPITAL

MANAGEMENT
 Learning Objectives

1. Model the cash conversion cycle and explain its

components.
2. Understand why the timing of accounts receivable is
important and explain the components of credit policy.
3. Understand the concept of float and its effect on cash
flow and explain how to speed up receivables and slow
down disbursements.
4. Explain inventory management techniques and
calculate the economic order quantity (EOQ).
5. Account for working capital changes in capital
budgeting decisions.
 The Cash Conversion Cycle
In order to manage working capital efficiently, a firm has to be aware
of how long it takes them, on average, to convert their goods and
services into cash. This length of time is formally known as the cash
conversion cycle.

The cash conversion cycle is made up of 3 separate cycles:

1. The production cycle: i.e. the time it takes to build and sell the
product
2. The collection cycle: i.e. the time it takes to collect from customers
(i.e. collecting accounts receivable) and
3. The payment cycle: i.e. the time it takes to pay for supplies and
labor, i.e. paying accounts payable).
The Cash Conversion Cycle (continued)

The production cycle and the collection cycle together make up the
operating cycle, so the cash conversion cycle can also be calculated as
follows:
Cash conversion cycle = Operating cycle – Payment cycle.

Figure 13.1 The cash

conversion cycle.
The Cash Conversion Cycle (continued)
– The production cycle begins when a customer places an order and
ends when the product is shipped out.
– The collection cycle begins when the order is filled and ends when
payment is received.
– The payment cycle begins when labor is hired or raw materials are
received to start production and ends when the firm pays for
purchases, raw materials and other production costs.

• Firms typically have to pay for production costs before they receive
payment from their customers, a longer cash conversion cycle
would tie up their finances and vice-versa.

• Must keep track of these various cycles and try to shorten the cash
conversion cycle so as to free up much needed funds.
 Average production cycle
Calculated in 3 steps.
First calculate average inventory as shown in Equation 13.2

Next, calculate the inventory turnover rate as follows:

Lastly, calculate the average production cycle as follows:

 Average collection cycle
Makes up the other leg of the operations cycle. It measures the number
of days taken by a firm, on average, to collect its accounts receivables.

To measure it we first calculate the average accounts receivable, i.e.

Then we measure the accounts receivable turnover rate as follows:

Finally, we calculate the average collection cycle, i.e.

Average collection cycle = 365/A/R turnover rate.

 Average payment cycle
• Also calculated with the same three steps
• Except that we use the average accounts
payable and accounts payable turnover to do
it.
 Putting It All together: The Cash
Conversion Cycle
• Production cycle + Accounts receivable cycle – Payment cycle =
Cash conversion cycle i.e. the number of days between when a firm
incurs an outflow to start production until it receives payment on a
credit sale.

• So if a firm can shorten its production cycle or its collection cycle, or

both, while keeping its payment cycle constant or lengthened, it can
shorten the number of days that it would typically have to finance
its operations for, thereby reducing its financing costs and
increasing its profits.

• Thus, shortening the cash conversion cycle essentially requires the

efficient management of receivables (credit policy), inventory, and
payables.
 Putting It All together: The Cash
Conversion Cycle (continued)
Example 1: Measuring Cash Conversion Cycle.
Mark is has just been appointed as the chief financial officer of a mid-sized
manufacturing company and is keen to measure the firm’s cash conversion cycle,
operating cycle, production cycle, collection cycle, and payment cycle, so as to see
if any changes are warranted. He collects the necessary information for the most
recent fiscal year, and puts together the table below:
Cash sales $200,000
Credit sales $600,000
Total sales $800,000
Cost of goods sold $640,000
Ending Balance Beginning Balance
Accounts receivable $40,000 $36,000
Inventory $10,000 $6,000
Accounts payable $ 9,000 $ 5,000
 13.1 (D) Putting It All together: The
Cash Conversion Cycle (continued)
Example 1 Answer
First, we calculate the average values of the 3 accounts:
Average A/R  ($36,000 + $40,000)/2 = $38,000
Average inventory  $(10000+6000)/2 = $8,000
Average A/P ($9 000 + $5,000)/2 = $7,000
Next, we calculate the turnover rates of each:

A/R Turnover = Credit Sales/Avg. A/R $600,000/$38,000 15.7895

Inventory Turnover = Cost of Goods Sold/Avg. Inv $640,000/$8,000
= 80
A/P Turnover = Cost of Goods Sold/Avg. A/P = $640,000/$7,000
= 91.43

Finally we calculate the collections cycle, the production cycle, and the payment cycle
by dividing each of the turnover rates into 365 days, respectively.
 13.1 (D) Putting It All together: The
Cash Conversion Cycle (continued)
Example 1 Answer (continued)

Collection cycle= 365/A/R Turnover365/15.7895 23.12 days

Production cycle = 365/Inv. Turnover365/80 4.56 days
Payment cycle = 365/A/P Turnover365/91.43 3.99 days

So the firm’s operation cycle = Collection cycle + Production cycle

= 23.12+4.56 = 27.68 days
Cash conversion cycle = Operating cycle – Payment cycle
= 27.68-3.99 23.69 days.
So on average, the firm has to finance its credit sales for about 24 days.
 Managing Accounts Receivable and
Setting Credit Policy
• The efficient management of accounts receivable
 critical step in shortening the cash conversion
cycle.

• Lax credit policy  defaults

Strict credit policy Lost sales

• Firms have to establish well-balanced credit and

collection policies to efficiently manage working
capital.
 Collecting Accounts Receivable
• The timing of collecting payments from
customers is hardly uniform.
• A certain percentage of customers always pay
on time, while a small percentage is always
late.
• Firms have to analyze their historical
collection patterns and accordingly plan for
the future.
 Credit : A Two-Sided Coin
• One firm’s accounts receivable is another firm’s accounts
payable.

• The cash conversion cycle decreases with a shortening of

the collection cycle but increases with a lengthening of the
payment cycle,

• If a firms shortens it collection cycle by tightening its credit

policy, its suppliers could do the same, which would negate
the effectiveness of the strategy.

• Firms must establish good credit policies regarding

screening, payment terms, and collecting of over-due bills.
 Qualifying for credit
• Often depends on the customer’s background,
business potential, and competitive pressures.

• There is usually a trade-off between paying the

high screening costs and the lost cash flow due
to defaults resulting from poor screening.
Qualifying for Credit (continued)
Example 2: Evaluating credit screening cost. Go-Green Golf Carts
Inc. has developed an environmentally friendly golf cart, which
costs $2500 to produce and will sell for $4,000.
Market analysis shows that the firm will be able to sell 2000 carts
per year, if it allows credit sales. However, there is a chance that 1%
of the customers may default.
If the firm does not offer credit terms, 40% of the sales will be lost.
It has also been determined that if the firm offers credit only to
credit-worthy customers by screening the buyers, the default rate
will be zero, i.e. the 20 potential defaulters will be screened in
advance.
Should the firm proceed with credit sales and if so, should it screen
the clients and at what cost?
 Qualifying for Credit (continued)
Example 2 Answer

Profit earned on all-cash sales= .6*2000*($1500)

$1,800,000
Profit earned on credit sales (no screen)
= ( .99*2000*1500) - (20*2500)$2,920,000

i.e 99% of 2000 customers will pay and provide a $1500 profit,
while 1% of 2000 or 20 customers will default causing a loss of
$2500 each

Additional profit generated by granting no-screen credit

2,920,000-$1,800,000= $1,120,000
Qualifying for Credit (continued)
Example 2 Answer (continued)

Benefits of screening = 20 *$2500 = $50,000

Maximum cost per customer for screen = $50,000/2000 = $25

Let’s say the firm proceeds with the credit terms and successfully screens
out the 20 bad credit clients at a cost of $25 per screen

Profit = (1980*$1500) - $25*2000=$2,920,000the amount it would earn

if all 2000 sales were on credit and 20 customers defaulted.

If the credit screen costs more than $25 it would be better for them to
merely grant credit and hope that the default rate is not >1%!!
 Setting Payment Policy
• An important part of credit policy is to
determine how many days of free credit to
grant customers and whether or not to offer
discounts for paying early, and if so, how
much of a discount?
• Discounts, if high enough, tend to be mutually
beneficial, since the seller frees up cash and
the buyer pays less.
Setting Payment Policy (continued)
Example 3: Cost of foregoing cash discounts.

Let’s say that a firm grants it customers credit on terms of 1/10,

net 45. You are one of the customers who have an invoice due of
$10,000. You have a line of credit with your bank that is at the
rate of 9% per year on outstanding balances. Should you avail of
the discount and pay on day 11 or wait until the 45th day and
make the full $10,000 payment?
Setting Payment Policy (continued)
Example 3 Answer

If you pay by Day 11, you will owe $10,000*(.99)= $9900

If you pay by Day 45, you will owe $10,000
You benefit by $100 for a 35 day period.
If you could invest $9900 over a 35 day period and end up with more than $10,000,
you would be better off holding off the payment and investing the money rather than
taking the discount.
The holding period return = $100/$9900 = 1.01% over a 35 day period
The APR = HPR * 365/35= 1.01*10.428% 10.53%
The EAR = (1+HPR)365/n -1 = (1.0101)365/35-1 =11.05%
Since you can borrow at 9% per year, it would be better to borrow the money, pay on
Day 10, and take advantage of the discount.
Setting Payment Policy (continued)
Example 3 Answer (continued)

Alternate method:
Calculate the APR and EAR implied by the discount being offered using Equations
13.12 and 13.13 as follows:

APR = (1%/(1-1%)) * (365/days between payment days)

= (.01/.99)* (365/(45-10) .0101*10.428
.1053 or 10.53%

EAR = (1+ (.01/.99)365/35 -1 = (1.0101)10.428 – 1 = 11.05%

 Collecting Overdue Debt
• A firm’s collection policy, involves sending collection
notices, taking court action, and eventually writing off
bad debts.
• The cost to the firm escalates at each step
 Firms should carefully establish and monitor their
credit policy involving:
– screening,
– payment terms, and
– collection procedures
• so as to maximize benefits while minimizing costs.
 The Float
• “Float,” the time it takes for a check to
clear, is of two types:
– Disbursement float is the time lag between when
a buyer writes a check to when the money leaves
his or her account.
– Collection float is the time lag between when a
seller deposits the check to when the funds are
received in the account.
Note: The collection float is part of the disbursement float, so if the seller or his bank can
speed up collection it will automatically shorten the disbursement float.
 The Float (continued)
Figure 13.5 Disbursement and collection float.
 Speeding Up the Collection
(Shortening the Lag Time)
• Firms attempt to speed up collections in a
variety of ways including:

– Lock boxes, which are post office boxes set up at

convenient locations to allow for quick pick up and
deposit of checks by the firm’s bank.

– Electronic fund transfers (EFT) which occur

directly from the buyer’s account. For example by
accepting debit cards.
 Slowing Down Payment (Lengthening
the Lag Time)
• Getting more difficult with the advent of
Check 21 (electronic clearing of checks
between banks) and acceptance of debit
cards.
• One method that continues to be popular,
though, is the wide-spread use of credit cards
which allows for a month long float.
 Inventory Management: Carrying
Costs and Ordering Costs
• Managing inventory essentially involves the balancing of carrying costs (i.e.
storage costs, handling costs, financing costs and costs due to spoilage and
obsolescence) against ordering costs (i.e. delivery charges), which tend to
offset each other.
• To keep carrying costs down requires more frequent orders of smaller sizes,
but could result in lost sales due to stock-outs.
• Fewer, larger orders, lowers ordering costs, but requires carrying larger
amounts of inventory.
• There are 4 cost-minimizing methods that firms can use to manage inventories
efficiently:
– The ABC inventory management model;
– Stocking redundant inventory;
– the Economic Order Quantity method; and
– the Just in Time approach.
 ABC Inventory Management
Involves categorizing inventory into 3 types:
– Large dollar or critical items (A-type);
– Moderate dollar or essential items (B-type),
– Small-dollar or non-essential items (C-type).
Each type is monitored differently with respect to the frequency of taking
stock and re-ordering.

Table 13.1 Inventory Categories for Corporate Seasonings

 Redundant Inventory Items
• Involves maintaining back-up inventory of
items that are currently not needed
frequently, but could be used in emergencies.
• Avoid higher costs due to stoppages.
 Economic Order Quantity
• Method to determine the optimal size of each order by balancing ordering
costs with carrying costs so as to minimize the total cost of inventory.
• The Trade-off between Ordering Costs and Carrying Costs: occurs because
with larger order sizes, fewer orders are needed, reducing delivery
costs, and the costs resulting
from lost sales due to shortages.
However, higher levels of Figure 13.7 Inventory costs.
inventory are held, thereby
increasing costs associated
with storage, handling,
spoilage and obsolescence.
 Measuring Ordering Costs
• Involves multiplying the number of orders
placed per period by the cost of each order
and delivery, i.e.

Where OC = cost per order; S=annual sales; and

Q = order size.
 13.4 (C-2) Measuring Ordering Costs
(continued)
Example 4: Measuring ordering cost.
Nigel Enterprises sells 1,000,000 copies per year. Each order it
places costs $40 for shipping and handling. How will the total
annual ordering cost change if the order size changes from 1000
copies per order to 10000 copies per order.

Answer
At 1000 copies per order:
Total annual ordering cost = $40 X 1,000,000/1000 $40,000

At 10,000 copies per order:

Total annual ordering cost = $40 X 1,000,000/10,000 $4000
As order size increases, ordering costs decline due to fewer orders
 13.4 (C-3) Measuring Carrying Costs
• Involves multiplying the carrying cost by the half the order
quantity, i.e.

• The model assumes that inventory is used up at a constant

rate each period so when it is at its half way point a new order
is received, meaning that on average we are holding about
half the inventory each period.
 Measuring Carrying Costs (continued)
Example 5: Measuring carrying cost.
Nigel Enterprises has determined that it costs them $0.10 to hold
one copy in inventory each period. How much will the total carrying
cost amount to with 1000 copies versus 10,000 copies being held in
inventory.

Answer
With 1000 copies in inventory
Total annual carrying cost = $0.10* 1000/2 = $50
With 10,000 copies in inventory
Total annual carrying cost = $0.10*10,000/2 = $500
As order size increases carrying costs go up proportionately.
Measuring Carrying Costs (continued)
To arrive at the optimal order quantity, we can use Equation
13.17
 Measuring Carrying Costs (continued)
Example 6: Calculating EOQ.
With annual sales of 1,000,000 copies, carrying costs amounting
to $0.10 per copy held and order costs amounting to $40 per
order. What is Nigel Enterprises’ optimal order size? Please verify
that your answer is correct.

Answer
S = 1,000,000; OC = $40; CC = $0.10
EOQ = [(2*1000000*$40)/0.1]1/2= 28, 285
(rounded to nearest whole number)
With order size = 28,285,
Total order cost = (1,000,000/28285)*$40 = $1,414.2
Total carrying cost = 28,285/2*0.1= $1414.2
Total inventory cost = $2,828.4
 Measuring Carrying Costs (continued)
Example 6 Answer (continued)

Verification:
With Q = 28,000 OC = (1,000,000/28,000)*$40
$1428.6
CC28000/2*.11400
Total cost 2828.6>$2828.4
With Q = 29,000 OC= 1,000,000/29,000)*40
1379.31
CC1450
Total cost = $2,829.31>$2,828.4
 Reorder Point and Safety Stock
Inventory gets used up every day lead time necessary for
additional supplies  firms must determine a reorder point  to
avoid a stock-out.
The reorder point = daily usage * days of lead time
Once the inventory hits the re-order point, the next order is placed
so that by time it is delivered, the firm would be just about out of
inventory.

An additional protection measure is to build in some safety stock or

buffer so as to be covered in case of delivery delays as follows:

Average inventory = EOQ/2 + safety stock

Reorder Point and Safety Stock
(continued)
Figure 13.6 Inventory flow.
 Reorder Point and Safety Stock
(continued)
Example 7: Measuring re-order point and safety stock.
Calculate Nigel Enterprises’ re-order point and safety stock assuming that deliveries take 4
days on average with a possibility of 2 day delays sometimes.

Answer
EOQ = 28,285; daily usage rate = 1,000,000/3652740

Reorder point = 4*2740 = 10,960 (without safety stock)

With safety stock built in we calculate average inventory as

Average inventory = EOQ/2 + safety stock

Safety stock = 2 days usage = 2*2740 = 5480

So Nigel Enterprises should reorder when the inventory drops to
10,960 + 5480 16,440 copies.
 Just in Time
• An inventory management system which tries
to keep inventory at a minimum by following
lean manufacturing practices, i.e. producing
only what is required, when it is required and
keeping finished goods in storage for as little
time as possible.
• JIT inventory management, if practiced
successfully would eliminate waste and
improve productivity significantly
 The Effect of Working Capital on
Capital Budgeting
• Inventories and Daily Operations: For capital
budgeting the initial investment required
for working capital i.e. inventory and accounts
receivable, as part of cash outflow at time 0.
• Also, need to account for:
– Periodic fluctuations in working capital, and
– Cash inflow from recovery of working capital at
the end of a project’s useful life i.e. drawing down
on the inventory and collecting the receivables
 Additional Problems with Answers
Problem 1
Measuring Cash Conversion Cycle.
John Gray is really concerned that his company’s working capital is not being managed efficiently.
He decides to take a look at the firm’s operating and cash conversion cycles to see what’s going on.
Using the data provided below, help John measure his firm’s collection, production, payment,
operating, and cash conversion cycles respectively.

Cash sales $350,000

Credit sales $600,000
Total sales $950,000
Cost of goods sold $600,000
Ending Balance Beginning Balance
Accounts receivable $45,000 $32,000
Inventory $22,000 $9,000
Accounts payable $6,000 $5,000
 Additional Problems with Answers
Problem 1 (Answer)
First, we calculate the average values of the 3 accounts:
Average A/R ($45,000 + $32,000)/2 = $38,500
Average inventory$(22,000+9000)/2 = $15,500
Average A/P ($6,000 + $5,000)/2 = $5,500
Next, we calculate the turnover rates of each
A/R Turnover = Credit Sales/Avg. A/R $600,000/$38,500 15.58
Inventory Turnover = Cost of Goods Sold/Avg. Inv  $600,000/$15,500
= 38.71
A/P Turnover = Cost of Goods Sold/Avg. A/P = $600,000/$5,500 = 109.09
Finally we calculate the collections cycle, the production cycle, and the payment cycle by
dividing each of the turnover rates into 365 days, respectively.
 Additional Problems with Answers
Problem 1 (Answer) (continued)
• Collection cycle = 365/A/R Turnover 365/15.58
23.43 days
• Production cycle = 365/Inv. Turnover365/38.71
9.43 days
• Payment cycle = 365/A/PTurnover365 /
``````````````````````````109.093.35 days
• So the firm’s operation cycle = Collection cycle + Production cycle
=23.43+9.43 = 32.86 days

• Cash conversion cycle = Operating cycle – payment cycle = 32.86-3.35

29.51 days. So on average, the firm has to finance its credit sales for
about 30 days.
 Additional Problems with Answers
Problem 2
Credit screening cost-benefit analysis:
Mid-West Marine Products currently sells its light-weight boat
lifts for $3,500 each. The unit cost of each lift is $2,600.
On average, the firm sells 2000 lifts a year on a cash basis.
Consumer Credit Check is offering Mid-West a credit screening
system at the rate of $25 per screen, and assures them that
the system will be at least 99% accurate. Mid-West’s research
indicates that if they offer credit terms, it will boost their sales
by 40% per year. They have also learned that the typical
default rate in their industry is around 3%.
a) Should Mid-West start offering credit terms?
b) If they do offer credit, should they do so with or without
CCC’s credit screening services? Please explain.
 Additional Problems with Answers
Problem 2 (Answer)
Current profit (all-cash sales) = 2,000*($3,500-$2,600) = $1,800,000
With credit terms…Unit sales = 2,000*(1.4) = 2800 lifts
Profit (with credit and no screening)
= $900*2,800*.95 - .03 * 2,800* ($2,600)
$2,394,000-218,400=$2,175,600
Profit (with credit screening) = ($900*2,800*.99)-(.01*2800*($2,600))
=$2,494,800-$72,800$2,422,000
Increase in profit from screen = $2,422,000 - $2,175,600 = $246,400
Maximum cost of screening per customer = $246,600/$2,800 = $88
At $35 per screen, it is definitely worthwhile to offer credit terms with screening service
provided by Consumer Credit Check.
 Additional Problems with Answers
Problem 3
• Cost of foregoing cash discounts: Your raw
material supplier has been accepting payments
on 30 day terms with no interest penalty.
• Recently, you received an invoice which stated
that the supplier would offer terms of 1/10, net
30.
• You have a line of credit with your bank at an EAR
of 14.5% per year on outstanding loans.
• Should you accept the discount offer? Please
explain why or why not.
 Additional Problems with Answers
Problem 3 (Answer)
At terms of 1/10, net 30 you will get 1% off and
be allowed to pay in 10 days, otherwise the full
amount is due in 30 days
HPR = .01/.99 = 1.0101%
EAR = (1+HPR)365/20 – 1
= (1.0101)18.25 -1
= 20.129%
Since you are able to borrow at 14.5%, you are
better off taking the cash discount and
effectively earning an EAR of 20.129%
 Additional Problems with Answers
Problem 4
Economic order quantity (EOQ). The Always-
Stocked Party Store wants to stay true to its name,
especially since the “Out-to-Get-You” Party store is
opening up very close by. One of their main sellers,
the Mega-Keg, costs $2 to stock and accounts for
sales of 3600 kegs per year.
Each order for kegs cost roughly $200 and takes on
average 5 days to be delivered, with the possibility
of 2 day delays.
a) What is the optimal order size for Mega-Kegs?
b) At what point should the kegs be re-ordered to
assure that the store never runs out?
 Additional Problems with Answers
Problem 4 (Answer)
EOQ = [2 x 3600 x $200 / $2]1/2 = 849
EOQ = 849; daily usage rate = 3600/36510

Reorder point = 5*10 = 50 (without safety stock)

Safety stock = 2 days usage = 2*10 = 20

So the store should reorder when the inventory drops to 50+20 70 kegs.
FIGURE 13.4 Invoice payment options, amounts, and dates
for Peak Construction’s bill from Space Lumber Company