Working Capital Management

By: GMAF, CPA

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Topics in Chapter

•Alternative current operating assets investment and financing policies

•Cash, inventory, and A/R management•Accounts payable management•Short-term financing•Bank loans, their costs, and commercial

paper

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Basic Definitions

•Working capital: Total current assets used in

operations.•Net working capital:

Current assets – Current liabilities.•Net operating working capital (NOWC):

Operating CA – Operating CL =(Cash + Inv. + A/R) – (Accruals +

A/P)

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Definitions (Continued)

•Working capital management: Includes both establishing working capital policy and then the day-to-day control of cash, inventories, receivables, accruals, and accounts payable.

•Working capital policy:▫The level of each current asset.▫How current assets are financed.

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Cash Conversion Cycle

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The cash conversion cycle focuses on the time between payments made for materials and labor and payments received from sales: Cash Conversion = Cycle

InventoryConversion + Period

Average Collection − Period

Payables Deferral Period

Cash Conversion Cycle (Cont.)

•Data:▫Annual sales = $660,000▫COGS/Sales = 90%▫Inventory turnover = Sales/Inventory = 6.

•Inventory = $660,000/6 = $110,000.•COGS = (0.9)($660,000) = $594,000.•Inv. Conv. = $110,000/($594,000/365)• = 67.6 days.

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Cash Conversion Cycle (Cont.)

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CCC = + –

CCC = 67.6 + 45.6 – 30

CCC = 83.2 days.

Inventory conversion

period

Payables deferral period

Days salesoutstanding

Cash Management: Cash doesn’t earn interest, so why hold it?•Transactions (Routine): Must have some

cash to pay current bills.•Transactions (Precaution): “Safety stock.”

But lessened by credit line and marketable securities.

•Compensating balances: For loans and/or services provided.

•Essential that the firm have sufficient cash to take trade discounts.

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What’s the goal of cash management?Minimize the cash amount the firm must

hold for conducting its normal business activities, yet, at the same time, have a sufficient cash reserve to:•take trade discounts.•pay promptly and maintain its credit rating.•meet any unexpected cash needs.

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Ways to Minimize Cash Holdings•Use lockboxes.•Insist on wire transfers or automatic debit

from customers.•Synchronize inflows and outflows.•Use float.

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Minimizing Cash (Continued)

•Increase forecast accuracy to reduce the need for a cash “safety stock.”

•Hold marketable securities instead of a cash “safety stock.”

•Negotiate a line of credit (also reduces need for a “safety stock”).

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Cash Budget: The Primary Cash Management Tool•Purpose: Uses forecasts of cash inflows,

outflows, and ending cash balances to predict loan needs and funds available for temporary investment.

•Timing: Daily, weekly, or monthly, depending upon budget’s purpose. Monthly for annual planning, daily for actual cash management.

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Data Required for Cash Budget•Sales forecast.•Information on collections delay.•Forecast of purchases and payment

terms.•Forecast of cash expenses: wages, taxes,

utilities, and so on.•Initial cash on hand.•Target cash balance.

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Should depreciation be explicitly included in the cash budget?•No. Depreciation is a noncash charge.

Only cash payments and receipts appear on cash budget.

•However, depreciation does affect taxes, which do appear in the cash budget.

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What are some other potential cash inflows besides collections?•Proceeds from fixed asset sales.•Proceeds from stock and bond sales.•Interest earned.•Court settlements.

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