UNIT VI

WORKING CAPITAL MANAGEMENT

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.
 This concept can be applied to modern businesses:

The three basic concept

1. Working Capital. Current assets are often called
working capital because this assets “turn
over”(are used and then replaced during the
year).
2. Net working Capital is defined as current asset
minus current liabilities
3. Net operating Working Capital (NOWC)
represents the working capital that is used for
operating purposes.
What is Working Capital?
 Working capital indicates the liquidity levels of
businesses for managing day-to-day expenses and
covers inventory, cash, accounts payable, accounts
receivable, and short-term debt. It is an indicator
of the short-term financial position of an
organization and is also a measure of its overall
efficiency.
 Workingcapital is the net of current assets
and current liabilities.
The cash conversion cycle
 All firms follow a “working capital cycle” in which they
purchase or produce inventory, hold it for a time, and
then sell it and receive cash. This process is known as the
Cash Conversion Cycle (CCC).

 The cash conversion cycle (CCC) – also known as the cash

cycle – is a metric expressing how many days it takes a
company to convert the cash it spends on inventory back
into cash by selling its product. The shorter a company's
CCC, the less time it has money tied up in accounts
receivable and inventory.
 Inventory Conversion Period refers to the time it takes for a
company to convert its inventory into sales. It estimates the
duration from obtaining materials for product, manufacturing it to
selling it. This period represents the time during which a company
invest cash while converting materials into sales
Inventory conversion period (days) =() 365
 Average Collection Period is a financial metric that measures the
average number of days it takes for a company to collect payment
from its customers or clients after making credit sale. It represents
the time it takes for accounts receivable to converted into cash.
Average collection period = (
 Payables deferral period refers to the average amount of time it
takes for a company to pay its trade creditors or supplier for the
materials or good purchased on credit. It is a measure of how long a
company takes to settle its account payable.
Payables deferral period= () 365
 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
$100,000 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. This
information can be used to calculate GFI’s cash conversion cycle, which nets out the three time
periods described below:
•Inventory conversion period. For GFI, this is the 60 days it takes to sell the merchandise.
•Average collection period (ACP). 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 (DSO). GFI’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. We combine these three periods to find the planned cash
conversion cycle, shown here as an equation:
 Although GFI must pay $100,000 to its suppliers after 40 days, it will
not receive any cash until 60 1 60 5 120 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 2 40 5 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.
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 used 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 thus be converted to bank
deposits.
Therefore cash as reported on balance sheets generally
includes short-term securities, which are also called “cash
equivalents”.
 2 categories of firm’s marketable security holdings
 Operating short term securities which are held primarily to
provide liquidity and are bought and sold as needed to provide
funds for operations
 Other short terms 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-time 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.
Demand Deposits
 Demand (or checking) deposits are far more important than currency for most businesses.
These deposits are used for transactions- 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.
The following techniques are used to optimize demand deposit holdings:
1. Holding marketable securities rather than demand deposits to provide liquidity
2. Borrow on short notice.
3. Forecast payments and receipt better.
4. Speed up payments.
5. Use credit cards, debit cards, wire transfers, and direct deposits.
6. Synchronize cash flows.
Banks have experts who help firms optimize their cash management procedures.
The bank charge a fee for this service, but the benefits of a good cash management system
are well worth the cost.
Inventories

 Inventories, which are include(1) supplies (2) raw materials, (3) work in
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, errors in setting inventory levels lead to lost sales or excessive
carrying costs, inventory management is quite important. Therefore, firms
used 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
suppliers 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.
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
 Credit policy consists of these four variables:

1. 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 stimulates sales. However, a longer credit
period lengthens the cash conversion 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.
2. 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.
3. Credit standards refers to 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 the 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 is 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
stuck between the costs and benefits of tighter credit standards.
4. 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 stuck between the cost and the benefits of
different collection policies.
Firms generally publish their credit terms, defined as a statement of their credit period
and discount policy. Thus, Allied Food might have stated credit terms of 2/10, net 30, which
means that it allows a 20% discount if payment is received within 10 days of the purchase; if
the discount is not taken then, the full amount is due in 30 days. Credit standards and
colection policies are relatively subjective, so they are not generally discussed in the
published credit terms.
Setting and Implementing the Credit Policy

Credit policy is important for three reasons:

1. It is a major effect on sales
2. It influences the amount of funds tied up in receivables
3. It affects bad debt losses
Because of the important of the policy, the firm’s executive committee
(which normally consists of the president in addition to the vice presidents of finance and
marketing) has the final say on setting the credit policy. Once the policy has been established,
the credit manager, who typically works under the CFO, must implement it and monitor its
effects. Managing a credit department requires fast, accurate, and up-to-date information.
Several organizations use computer-based networks to collect, store, and distribute credit
information. For businesses, Dun and Bradstreet provides detailed credit reports over the
Internet for a fee. The reports include the following types of information:
4. A summary balance sheet and income statement
2. A number of key ratios with trend information
3. Data obtained from the firm’s suppliers telling whether it pays
promptly or slowly and whether it has recently failed to make any
payments.
4. A verbal description of the physical condition of the firm’s condition
5. A verbal description of the backgrounds of the firm’s owners,
including any previous bankruptcies, lawsuits, or divorce settlement
problems
6. A summary rating ranging from A for the best credit risks down to F
for those firms that are deemed likely to default
Credit scores are numerical scores that are based on a statistical
analysis and provide a summary assessment of the likelihood that a potential
customer will default on a required payment. Computerized analytical
systems assist in making better credit decisions, but in the final analysis,
most credit decisions are exercises in informed judgement.
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 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.

With this background, we can define two types of trade credit: free and costly.
1. 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
2. .Costly trade credit is any trade credit over and above the free trade credit.
Promissory Note
The
terms of a bank loan are spelled out in a promissory note. Here are some key features of
most promissory notes:

1. Amount. The amount borrowed is indicated.

2. 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.
3. Interest rate. The interest rate can be fixed or floating.
4. 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
installment loans.
5. 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.
6. 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.
7.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.
8.Collateral. If a loan is secured by equipment, buildings, accounts receivable, or inventories,
this fact is indicated in the note.
9.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.

10.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.
Line of Credit
A line of credit is an agreement between a bank and a borrower
indicating the maximum amount of credit the bank will extend to the
borrower. For example, in December, a bank loan officer might indicate to a
financial manager that the bank regards the firm as being “good for” up to
P80,000 during the coming year, provided the borrower’s financial condition
does not deteriorate. If on January 10 the financial manager signs a
promissory note for P15,000 for 90 days, this would be called “taking down”
P15,000 of the credit line. The P15,000 would be credited to the firm’s
checking account, and before it was repaid, the firm could borrow an
additional P65,000 for a total of P80,000.
Commercial paper

Commercial paper is a promissory note issued by a large, strong firm—

most often a financial institution—that wants to borrow on a short-term basis.
Commercial paper is sold primarily to other business firms, insurance companies,
pension funds, money market mutual funds, and banks, in denominations of at
least P100,000. It is generally unsecured, but “asset- backed paper” secured by
credit card debt and other small, short-term loans has also been issued.
A large majority of the commercial paper outstanding has been issued by
financial institutions. Non-financial companies also issue a great deal of paper, but
they generally rely more heavily on bank loans for short-term funding.
Use of Security in Short Term Financing
Other things held a 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.

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.
Thank You And
God Bless
Everyone!