Chapter 14

Working Capital Management

The goal is to manage current assets and current liabilities to achieve a balance between
profitability and risk that contributes to the firm’s value.

A. Basics
a. Short-term financial management
: management of current assets and current liabilities
 Too large an investment in current assets can reduce profitability, whereas too little
increases liquidity risk.
 Too little an investment in current liabilities can reduce profitability, whereas too
large increases liquidity risk.

b. Working capital
 Current assets, which represent the portion of investment that circulates from one
form to another in the ordinary conduct of business
 cash, inventory, accounts receivable, marketable securities, and others

 Current liabilities: the firm’s S-T financing (come due in 1 year or less)
accounts payable, notes payable, tax accruals, employee accruals, S-T (bank,
shareholder, or paper) loans, and others

c. Net working capital

= current assets – current liabilities

 Positive net working capital is desirable.

d. Technically insolvent
: a firm that is unable to pay its bills as they come due

B. Cash conversion cycle (CCC)

a. Operating cycle (OC), or production cycle
: the time from the beginning of the production process to the collection of cash from
the sale of the finished produce
 encompasses two major S-T asset categories: inventory and accounts receivable
 OC consists of that period of time measured by the average age of inventory (AAI)
and the average collection period (ACP) of accounts receivable.

OC = average age of inventory (AAI) + average collection period (ACP)

CCC = operating cycle - average payment period = OC - APP

= average age of inventory + average collection period - average payment period
= AAI + ACP - APP

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 CCC represents the time period during which the firm needs investment in
operating assets.
 Operating assets
: the difference between the four principal current assets (cash, marketable
securities, accounts receivable, and inventory) and accounts payable

Ex: p.779: A paper producer has annual credit sales of $10m, a COGS of 75% of sales,
and purchases that are 65% of COGS. AAI, ACP, and APP are as shown
above. What is the firm’s net fund invested in the CCC (inventory and
receivables)?
For 1 operating cycle:
value of inventory = {($10m x 0.75) / 365} x 60 = $1,232,877
+ value of account receivable = ($10m / 365) x 40 = $1,095,890
- value of accounts payable = -{[($10m x 0.75 x 0.65) / 365] x 35} = -$467,466
= $1,861,301

b. Permanent vs. seasonal funding needs

 Permanent funding requirements
: a constant investment in operating assets resulting from constant sales over time
 Seasonal funding requirements
: an investment in operating assets that varies over time as a result of cyclical sales

c. Aggressive vs. conservative strategies

 Aggressive funding strategy
: fund seasonal requirements with S-T debt and its permanent requirements with
L-T debt
 heavily rely on S-T funding and are subject to interest rate swings

Conservative funding strategy

: fund both seasonal and permanent requirements with L-T debt

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  L-T financing and lock-in interest rate; but more costly due to over-funding

d. Strategies for managing CCC

• Turn over inventory as quickly as possible (minimizing AAI).
• Collect accounts receivable as quickly as possible (minimizing ACP).
• Pay accounts payable as slowly as possible (maximizing APP).
• Manage the float, the time of processing all of the above.

C. Inventory management
 The goal is to turn over inventory as quickly as possible without losing sales from
stockouts.
a. Different viewpoints about inventory level
1. financial manager  wants to keep them low to avoid over-investment
2. marketing manager  wants to keep them high to fill orders quickly
3. manufacturing manager  finished goods: desirable level with quality
 raw materials: high inventory
4. purchasing manager  desired quantities at a favorable price
An uncoordinated inventory system can allow these competing views to create
conflicts and inefficiencies in the firm.

b. Techniques for managing inventory

1. Two-bin method
 The items are stored in two bins. As an item is needed, inventory is removed from
the 1st bin. When that bin is empty, an order is place to refill the 1st bin while
inventory is drawn from the 2nd bin.

2. ABC system
: divides inventory into 3 groups – A, B, and C – in descending order of importance
and level of monitoring, on the basis of the dollar investment in each
based on 20/80 concept, that 20% of inventory accounts for 80% of sales

 A items (the 20%): valuable and managed actively; largest investment

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 B items: second largest investment
C items: a large number of items that require relatively small investment

3. Economic order quantity (EOQ)

 total inventory cost = order costs + carrying costs
 order costs: costs of placing and receiving orders, writing a purchase order,
paperwork, and checking inventory
 carrying costs: costs of storage, insurance, deterioration and obsolescence,
financing and opportunity

 EOQ will minimize the total inventory cost:

order cost = O × S / Q carrying cost = C × Q / 2

total cost = O × S / Q + C ×Q / 2

2 ×S × O
EOQ =
C

where S = usage in units per period (normally year)

O = order cost per order
C = carrying cost per unit per period
Q = order quantity in units

 days of lead time: the number of days to place and receive an order
 Most companies also hold safety stock (extra inventory) to prevent stockouts of
important items, causing a higher reorder point.

reorder point = days of lead time × daily usage + safety stock

Ex: A special item costs $1,500 per unit and the firm uses 1,100 units per year. If the
order cost per order is $150, carrying cost per unit per year is $200, what is the
EOQ?
2 ×1100 ×150
EOQ = ≅ 41 units
200
Assuming the firm operates 250 days per year and uses 1,100 units of this item and
the lead time is 2 days and the safety stock is 4 units, what is the reorder point?
reorder point = 2 × (1100 / 250) + 4 = 12.8 ~ 13 units.

 assumptions of EOQ model: constant usage and average inventory

4. Just-in-time system (JIT)

: materials should arrive at exactly the time when thy are needed for production
 minimize inventory investment
 basically no safety stock
 Failure of materials to arrive on time results in a shutdown of the production line.
 Would your suppliers carry the inventory burden for you?

5. Materials requirement planning system (MRP)

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 EOQ + computer to simulate each product’s bill of materials, inventory status, and
manufacturing process to determine what to order and when to order

D. Accounts receivable (A/R) management

The objective for managing accounts receivable is to collect accounts receivable
quickly without losing sales.
 Three elements to accomplish this goal:
– credit selection and standards,
– credit terms, and
– credit monitoring

a. Credit selection and standards

 Credit selection involves application of techniques for determining which
customers should receive credit.
 Credit standards are the firm’s minimum requirements for extending credit to a
customer.

1. Four C’s of credit analysis

 Four key dimensions – character, capacity, capital, and conditions – used by credit
analysis to provide a framework for in-depth credit analysis
a) Character: applicant’s record of meeting past obligations
b) Capacity: ability to repay the requested credit (CFs available to repay debt)
c) Capital: total assets and net worth
d) Conditions: current general and industry-specific economic conditions

2. Evaluating credit applicants

 based on the 4 Cs framework
 request financial and credit information and references
 calculate key ratios of liquidity and activity
 verify and obtain credit information by using external source such as D&B

3. Credit scoring
 applies statistically derived weights for key financial and credit characteristics to
predict whether a credit applicant will pay obligation in a timely fashion

4. Changing credit standards

 create impacts on profit and risk
 Relax credit standards  sales ↗, investment in receivables ↗, bad debt ↗
Tighten credit standards  sales↘, investment in receivables ↘, bad debt ↘

Ex: Changing credit standards, p.797:

A firm is selling a product for $10 per unit and sales are about 60,000 units (all on
credit). The variable cost is $6 per unit and total fixed costs are $120,000. The
credit standard change will result in the following:
Present New (proposed)
Sales: 60,000 63,000
ACP 30 days 45 days (average collection period)
Bad debt 1% 2%
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 The firm’s capital opportunity cost is 15%. Should the firm relax its credit
standards?
 Credit relaxation:
sales ↗  profit ↗; receivables ↗ funding cost ↗; bad debt ↗ loss ↗
rationale: if profit ↗ > (funding cost ↗ + loss ↗)  should relax credit standards
Solution:
Fixed costs are unaffected by the change in the sales level. Only variable costs are
relevant to a change in sales.
1. Profit increase = (10-6) × 3,000 = $12,000

2. Average investment in accounts receivable

= (total annual credit sales / 365) × ACP

Total annual credit sales:

under present plan: $10 × 60,000 = 600,000
under new plan: $10 × 63,000 = 630,000

Average investment in accounts receivable:

under present plan: (600,000 / 365) × 30 = 49,315
under new plan: (630,000 / 365) × 45 = 77,671
new additional investment in accounts receivable = 77,671 – 48,315 = 28,356
additional funding cost per year = 15% × 28,356 = $4,253

3. Cost of marginal bad debt:

under present plan: (1% × 10 × 60,000) = 6,000
under new plan: (2% × 10 × 63,000) = 12,600
the increase of bad debt loss = 12,600 – 6,000 = $6,600

4. Net result = 12,000 – 4,253 – 6,600 = $1,147 > 0

 Should adopt the new standards

b. Credit terms
: the terms of sales for customers who have been extended credit by the firm

 Cash discount: a percentage deduction from the purchase price if the customer
pays its account within a specified time, called the cash discount period

1. “net 30”: has 30 days from the beginning of the credit period to pay the full invoice
amount
2. “2/10, net 30”: take a 2% cash discount from the invoice amount if the payment is
made within 10 days of the beginning credit period (invoice date) or
can pay the full amount within 30 days

Ex: Change credit terms

A firm is adopting a “net 30” credit policy now and has an ACP of 40 days (32
days + 8 days of processing). The proposed credit term is “2/10, net 30”, which will
result in an ACP of 22 days. Other information include: annual raw material
usage 1,100 units, material variable cost per unit $524, production variable cost
$1,381 per unit, finished product price $3,000 per unit, 80% customers will take
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 cash discount, annual ales will increase 50 units to 1,150 units, and cost of capital
14%. The bad debt will remain at 2.6% of sales. Should the firm offer the cash
discount?
Solution:
1. Additional profit from sales: 50 unit × (3,000 – 524 – 1,381) = $54,750
2. Average investment in A/R (present terms)
= [(3,000 x 1,100) / 365] × 40 = $361,644
average investment in A/R (proposed terms)
= [(3,000 x 1,150) / 365] × 22 = $207,945
reduction in A/R investment = 361,644 – 207,945 = $153,699
cost saving in A/R investment = 153,699 × 14% = $21,518
3. Cost of cash discount = -2% × 80% × (1,150 × 3,000) = -$55,200
4. Reduction in bad debt:
current bad debt = $(1,100 × 3,000 × 2.6%) = $85,800
new bad debt = $(1,150 × 3,000 × 20% × 2.6%) = $17,940
reduction = $85,800 - $17,940 = $67,860

5. Net cost from initiation of cash discount = $54,750 + 21,580 + 67,860 – 55,200
= $88,990
 Should initiate the cash discount

c. Credit monitoring
 Ongoing review of a firm’s accounts receivable to determine whether customers are
paying according to stated credit terms

1. Techniques for credit monitoring

a) Average collection period = accounts receivable / average credit sales per day

b) Aging of A/R
: uses a schedule that indicates the percentages of the total A/R balance that have
been outstanding for specified periods of time
Ex: p.704:
Days A/R ($) % of total
Current $60,000 30
0-30 $40,000 20
31-60 $66,000 33 Overdue accounts
61-90 $26,000 13 required attention
Over 90 $8,000 4
Total $2,000000 100%

2. Collection techniques (Table 14.5, p.803)

a) letters b) telephone calls c) personal visits
d) collection agencies e) legal action

E. Managing receipts and disbursements

 Goals: a) speed up collections; b) slow down payments; and c) maximize the return
of S-T investments
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a. Float
: funds that have been sent by the payer but are not yet usable funds to the payee
1. mail float: the time delay between when payment is placed in the mail and
when it is received
2. processing float: the time between receipt of the payment and its deposit into
the firm’s account
3. clearing float: the time between deposit of the payment and when spendable
funds become available to the firm
 The goal is to minimize the float time.

b. Speeding up collections
 reduces customer collection float time and thus reduces the firm’s average
collection period, which reduces the investment the firm must make in its CCC

1. Lock-box system
: A collection procedure in which customers mail payments to a post office box in a
major city that is emptied regularly by the firm’s bank, which processes the
payments and deposits them in the firm’s account.
 speed up collection time by reducing process time as well as mail and clearing time

2. Electronic fund transfer

 Payments are made electronically and funds are transferred directly from payers’
bank accounts to the recipient’s account. Funds are available immediately.
Ex: debit (ATM) card

3. Preauthorized checks
 For repetitive payments, firms authorize their creditors to draw checks on their
accounts. This may also be done electronically.

4. Cash concentration
 Central accounts can be more closely and efficiently managed.

5. On-line payments
 the payments are made or transferred electronically

c. Slowing down payments

 slow down payments by using payment float
1. Managed balance account
 a special checking account that has a zero balance
 As checks are presents to this account, a negative balance is created. Funds are
then transferred automatically from a master account to bring the account back to
zero or another predetermined balance.
 In this way, all funds are centralized and no idle balances remain in the disbursing
account.

2. Controlled disbursement system

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 : maximizes the time it takes for checks to clear a firm’s account by making
payments through geographically remote banks, the clearing time is increased

d. Investing in marketable securities

 goals: to maximize the fund available to invest, reduce the need to raise additional
capital, and maximize the return from investment.

Idle cash is unproductive.

 Good managers maximize the return on these fund balances by investing them in
the money market or by using a line of credit to cover a temporary imbalance.
 money market instruments: T-bills, commercial paper, term deposits, bankers’
acceptances, & repos (repurchase agreements)