MR C NKOMO

Office SD 46
Contact +263 77 959 6495
clifford.nkomo@nust.ac.zw
Depart of Finance
 WORKING CAPITAL MANAGEMENT
Working capital, sometimes called gross working capital,
simply refers to current assets used in operations.
Net working capital is defined as current assets minus
current liabilities.
Net operating working capital (NOWC) is defined as
operating current assets minus operating current liabilities.
Generally, NOWC is equal to cash, accounts receivable,
and inventories, less accounts payable and accruals.
 THE CASH CONVERSION CYCLE
Firms typically follow a cycle in which they purchase
inventory, sell goods on credit, and then collect accounts
receivable. This cycle is referred to as the cash conversion
cycle.
The cash conversion cycle model, which focuses on the
length of time between when the company makes payments
and when it receives cash inflows.
• Inventory conversion period, which is the average
time required to convert materials into finished goods
and then to sell those goods. Note that the inventory
conversion period is calculated by dividing inventory by
sales per day. For example, if average inventories are
$2 million and sales are $10 million, then the inventory
conversion period is 73 days:
Inventory conversion period =
2. Receivables collection period, which is the average
length of time required to convert the firm’s receivables
into cash, that is, to collect cash following a sale. The
receivables collection period is also called the days sales
outstanding (DSO), and it is calculated by dividing
accounts receivable by the average credit sales per day.
If receivables are $657,534 and sales are $10 million, the
receivables collection period is:
Receivables collection period = DSO =
3. Payables deferral period, which is the average length
of time between the purchase of materials and labour
and the payment of cash for them. For example, if the
firm on average has 30 days to pay for labour and
materials, if its cost of goods sold is $8 million per year,
and if its accounts payable average $657,534, then its
payables deferral period can be calculated as follows:
Payables deferral period =
=
4. Cash conversion cycle, which nets out the three
periods just defined and therefore equals the length of
time between the firm’s actual cash expenditures to pay
for productive resources (materials and labour) and its
own cash receipts from the sale of products (that is, the
length of time between paying for labour and materials
and collecting on receivables). The cash conversion
cycle thus equals the average length of time a dollar is
tied up in current assets.
 (1) + (2) - (3) = (4)

Inventory + Receivables - Payables = Cash conversion

• Conversion collection deferral cycle
period period period

Days in cash conversion cycle 73 days + 24 days - 30 days

= 67 days
SHORTENING THE CASH CONVERSION
CYCLE
The firm’s goal should be to shorten its cash conversion
cycle as much as possible without hurting operations. This
would increase the value, because the shorter the cash
conversion cycle, the lower the required net operating
working capital, and the higher the resulting free cash flow.
The cash conversion cycle can be shortened (1) by
reducing the inventory conversion period by processing
and selling goods more quickly, (2) by reducing the
receivables collection period by speeding up collections,
or (3) by lengthening the payables deferral period by
slowing down the firm’s own payments. To the extent that
these actions can be taken without increasing costs or
depressing sales, they should be carried out.
 ALTERNATIVE NET OPERATING
WORKING CAPITAL POLICIES
A relaxed working capital policy is one in which relatively
large amounts of cash and inventories are carried, where
sales are stimulated by the use of a credit policy that
provides liberal financing to customers and a corresponding
high level of receivables, and where a company doesn’t
take advantage of credit provided by accruals and accounts
payable.
 Conversely, with a restricted working capital policy,
the holdings of cash, inventories, and receivables are
minimized, and accruals and payables are maximized.

 Under the restricted policy, NOWC is turned over more

frequently, so each dollar of NOWC is forced to “work
harder.” A moderate working capital policy is
between the two extremes.
 Under conditions of certainty—when sales, costs, lead
times, payment periods, and so on, are known for sure
—all firms would hold only minimal levels of working
capital.

 Any larger amounts would increase the need for

external funding without a corresponding increase in
profits, while any smaller holdings would involve late
payments to suppliers along with lost sales due to
inventory shortages and an overly restrictive credit
policy.
 However, the picture changes when uncertainty is
introduced. Here the firm requires some minimum
amount of cash and inventories based on expected
payments, expected sales, expected order lead times,
and so on, plus additional holdings, or safety stocks,
which enable it to deal with departures from the
expected values.

 Similarly, accounts receivable levels are determined by

credit terms, and the tougher the credit terms, the lower
the receivables for any given level of sales.
 With a restricted policy, the firm would hold minimal
safety stocks of cash and inventories, and it would
have a tight credit policy even though this meant
running the risk of losing sales.
 A restricted, lean-and-mean working capital policy
generally provides the highest expected return on this
investment, but it entails the greatest risk, while the
reverse is true under a relaxed policy. The moderate
policy falls in between the two extremes in terms of
expected risk and return.
Firms face a fundamental trade-off: Working capital is
necessary to conduct business, and the greater the
working capital, the smaller the danger of running short,
hence the lower the firm’s operating risk.
However, holding working capital is costly—it reduces a
firm’s return on invested capital (ROIC), free cash flow,
and value.
 CASH MANAGEMENT
Approximately 1.5 percent of the average industrial firm’s
assets are held in the form of cash, which is defined as
demand deposits plus currency. Cash is often called a
“nonearning asset.” It is needed to pay for labour and raw
materials, to buy fixed assets, to pay taxes, to service debt,
to pay dividends, and so on. However, cash itself earns no
interest.
Thus, the goal of the cash manager is to minimize the
amount of cash the firm must hold for use in conducting
its normal business activities, yet, at the same time, to
have sufficient cash (1) to take trade discounts, (2) to
maintain its credit rating, and (3) to meet unexpected
cash needs.
 REASONS FOR HOLDING CASH
Firms hold cash for two primary reasons:
1. Transactions. Cash balances are necessary in business operations.
Payments must be made in cash, and receipts are deposited in the
cash account. Cash balances associated with routine payments and
collections are known as transactions balances. Cash inflows and
outflows are unpredictable, with the degree of predictability varying
among firms and industries. Therefore, firms need to hold some cash in
reserve for random, unforeseen fluctuations in inflows and outflows.
These “safety stocks” are called precautionary balances, and the less
predictable the firm’s cash flows, the larger such balances should be.
2. Compensation to banks for providing loans and
services. A bank makes money by lending out funds that
have been deposited with it, so the larger its deposits,
the better the bank’s profit position. If a bank is providing
services to a customer, it may require the customer to
leave a minimum balance on deposit to help offset the
costs of providing the services. Also, banks may require
borrowers to hold deposits at the bank. Both types of
deposits are called compensating balances.
In addition to holding cash for transactions, precautionary,
and compensating balances, it is essential that the firm
have sufficient cash to take trade discounts. Suppliers
frequently offer customers discounts for early payment of
bills.
 THE CASH BUDGET
The cash budget shows the firm’s projected cash inflows
and outflows over some specified period. Generally, firms
use a monthly cash budget forecasted over the next year,
plus a more detailed daily or weekly cash budget for the
coming month.
The monthly cash budgets are used for planning purposes,
and the daily or weekly budgets for actual cash control.
 CASH MANAGEMENT TECHNIQUES
Most business is conducted by large firms, many of which
operate regionally, nationally, or even globally. They collect
cash from many sources and make payments from a
number of different cities or even countries.
Their collection points follow sales patterns. Some
disbursements are made from local offices, but most are
made in the cities where manufacturing occurs, or else
from the home office.
Thus, a major corporation might have hundreds or even
thousands of bank accounts, and since there is no reason
to think that inflows and outflows will balance in each
account, a system must be in place to transfer funds from
where they come in to where they are needed, to arrange
loans to cover net corporate shortfalls, and to invest net
corporate surpluses without delay.
 SYNCHRONIZING CASH FLOW
• -by improving their forecasts and by timing cash receipts
to coincide with cash requirements, firms can hold their
transactions balances to a minimum. Recognizing this,
utility companies, oil companies, credit card companies,
and so on, arrange to bill customers, and to pay their own
bills, on regular “billing cycles” throughout the month.
This synchronization of cash flows provides cash when it
is needed and thus enables firms to reduce the cash
balances needed to support operations.
SPEEDING UP THE CHEQUE-CLEARING
PROCESS
When a customer writes and mails a cheque, the funds are
not available to the receiving firm until the cheque-clearing
process has been completed. The bank must first make
sure that the deposited cheque is good and the funds are
available before it will give cash to the company.
 USING FLOAT
Float is defined as the difference between the balance
shown in a firm’s (or individual’s) Cheque book and the
balance on the bank’s records. Suppose a firm writes, on
average, cheques in the amount of $5,000 each day, and it
takes six days for these cheques to clear and be deducted
from the firm’s bank account. This will cause the firm’s own
cheque book to show a balance $30,000 smaller than the
balance on the bank’s records; this difference is called
disbursement float.
Now suppose the firm also receives cheques in the
amount of $5,000 daily, but it loses four days while they
are being deposited and cleared. This will result in
$20,000 of collections float. In total, the firm’s net float
—the difference between the $30,000 positive
disbursement float and the $20,000 negative collections
float—will be $10,000.
 SPEEDING UP RECEIPTS
Payment by Wire or Automatic Debit Firms are
increasingly demanding payments of larger bills by wire, or
even by automatic electronic debits. Under an electronic
debit system, funds are automatically deducted from one
account and added to another. This is, of course, the
ultimate in a speeded-up collection process, and computer
technology is making such a process increasingly feasible
and efficient, even for retail transactions.
 INVENTORY
The twin goals of inventory management are (1) to ensure
that the inventories needed to sustain operations are
available, but (2) to hold the costs of ordering and carrying
inventories to the lowest possible level.
 RECEIVABLES MANAGEMENT
Firms would, in general, rather sell for cash than on credit,
but competitive pressures force most firms to offer credit.
Thus, goods are shipped, inventories are reduced, and an
account receivable is created.
Eventually, the customer will pay the account, at which time
(1) the firm will receive cash and (2) its receivables will
decline. Carrying receivables has both direct and indirect
costs, but it also has an important benefit—increased sales.
 CREDIT POLICY
The success or failure of a business depends primarily on the
demand for its products—as a rule, the higher its sales, the larger
its profits and the higher its stock price. Sales, in turn, depend on a
number of factors, some exogenous but others under the firm’s
control. The major controllable determinants of demand are sales
prices, product quality, advertising, and the firm’s credit policy.
Credit policy, in turn, consists of these four variables:
1. Credit period, which is the length of time buyers are given to pay
for their purchases. For example, credit terms of “2/10, net 30”
indicate that buyers may take up to 30 days to pay.
2. Discounts given for early payment, including the discount
percentage and how rapidly payment must be made to qualify for
the discount. The credit terms “2/10, net 30” allow buyers to take
a 2 percent discount if they pay within 10 days. Otherwise, they
must pay the full amount within 30 days.
3. Credit standards, which refer to the required financial strength
of acceptable credit customers. Lower credit standards boost
sales, but also increase bad debts.
4. Collection policy, which is measured by its toughness or laxity
in attempting to collect on slow-paying accounts. A tough policy
may speed up collections, but it might also anger customers,
causing them to take their business elsewhere.
 THE ACCUMULATION OF
RECEIVABLES
The total amount of accounts receivable outstanding at any given
time is determined by two factors: (1) the volume of credit sales
and (2) the average length of time between sales and collections.
• Accounts Credit sales Length of
• Receivable per day collection period
 MONITORING THE RECEIVABLES
POSITION
Investors—both stockholders and bank loan officers—
should pay close attention to accounts receivable
management, one can be misled by reported financial
statements and later suffer serious losses on an
investment.
When a credit sale is made, the following events occur:
(1) Inventories are reduced by the cost of goods sold, (2)
accounts receivable are increased by the sales price,
and (3) the difference is profit, which is added to retained
earnings.
If the sale is for cash, then the cash from the sale has
actually been received by the firm, but if the sale is on
credit, the firm will not receive the cash from the sale
unless and until the account is collected
Firms have been known to encourage “sales” to very
weak customers in order to report high profits. This could
boost the firm’s stock price, at least until credit losses
begin to lower earnings, at which time the stock price will
fall.
Analyses along the lines suggested in the following
sections will detect any such questionable practice, as
well as any unconscious deterioration in the quality of
accounts receivable. Such early detection could help
both investors and bankers avoid losses.
 DAYS SALES OUTSTANDING (DSO)

Suppose Dube Sets Inc., a television manufacturer, sells 200,000

television sets a year at a price of $198 each. Further, assume that all
sales are on credit with the following terms: If payment is made within
10 days, customers will receive a 2 percent discount; otherwise the full
amount is due within 30 days. Finally, assume that 70 percent of the
customers take discounts and pay on Day 10, while the other 30
percent pay on Day 30.
Dube Sets’s days sales outstanding (DSO), sometimes called the
average collection period (ACP), is 16 days:
DSO= ACP= 0.7(10 days)+ 0.3(30 days) = 16 days
 AGING SCHEDULES
An aging schedule breaks down a firm’s receivables by
age of account.
Aging schedules cannot be constructed from the type of
summary data reported in financial statements; they must
be developed from the firm’s accounts receivable ledger
Management should constantly monitor both the DSO
and the aging schedule to detect trends, to see how the
firm’s collection experience compares with its credit
terms, and to see how effectively the credit department is
operating in comparison with other firms in the industry.
If the DSO starts to lengthen, or if the aging schedule
begins to show an increasing percentage of past-due
accounts, then the firm’s credit policy may need to be
tightened.
ACCRUALS AND ACCOUNTS PAYABLE
(TRADE CREDIT)
Accruals
Firms generally pay employees on a weekly, biweekly, or
monthly basis, so the balance sheet will typically show
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;
hence the balance sheet will typically show some accrued
taxesalong with accrued wages.
These accruals increase automatically, or
spontaneously, as a firm’s operations expand. However,
a firm cannot ordinarily control its accruals: The timing of
wage payments is set by economic forces and industry
custom, while tax payment dates are established by law.
Thus, firms use all the accruals they can, but they have
little control over the levels of these accounts.
ACCOUNTS PAYABLE (TRADE CREDIT)
Firms generally make purchases from other firms on credit,
recording the debt as an account payable. Accounts payable,
or trade credit, is the largest single category of operating
current liabilities, representing about 40 percent of the current
liabilities of the average nonfinancial corporation.
The percentage is somewhat larger for smaller firms: Because
small companies often do not qualify for financing from other
sources, they rely especially heavily on trade credit.
Trade credit is a “spontaneous” source of financing in the
sense that it arises from ordinary business transactions.
For example, suppose a firm makes average purchases
of $2,000 a day on terms of net 30, meaning that it must
pay for goods 30 days after the invoice date. On
average, it will owe 30 times $2,000, or $60,000, to its
suppliers.
If its sales, and consequently its purchases, were to
double, then its accounts payable would also double, to
$120,000. So, simply by growing, the firm would
spontaneously generate an additional $60,000 of
financing.
Similarly, if the terms under which it bought were
extended from 30 to 40 days, its accounts payable would
expand from $60,000 to $80,000. Thus, lengthening the
credit period, as well as expanding sales and purchases,
generates additional financing.
Nominal annual cost=*
Thus, the first term, 2.04%, is the cost per period for the
trade credit. The denominator of the second term is the
number of days of extra credit obtained by not taking the
discount, so the entire second term shows how many times
each year the cost is incurred, 18.25 times in this example.
The nominal annual cost formula does not take account of
compounding, and in effective annual interest terms, the
cost of trade credit is even higher. The discount amounts to
interest, and with terms of 2/10, net 30, the firm gains use
of the funds for 30 - 10 = 20 days, so there are 365/20
18.25 “interest periods” per year.
(Discount percent)/(100 -Discount percent) 0.02/0.98=
0.0204, is the periodic interest rate. This rate is paid
18.25 times each year, so the effective annual cost of
trade credit is
Effective annual rate= -1.0 =1.4459 - 1.0= 44.6%
 ALTERNATIVE SHORT-TERM
FINANCING POLICIES
Most businesses experience seasonal and/or cyclical
fluctuations. For example, construction firms have peaks in
the spring and summer, retailers peak around Christmas,
and the manufacturers who supply both construction
companies and retailers follow similar patterns. Similarly,
virtually all businesses must build up net operating working
capital (NOWC) when the economy is strong, but they then
sell off inventories and reduce receivables when the
economy slacks off.
Still, NOWC rarely drops to zero—companies have some
permanent NOWC, which is the NOWC on hand at the
low point of the cycle. Then, as sales increase during the
upswing, NOWC must be increased, and the additional
NOWC is defined as temporary NOWC. The manner in
which the permanent and temporary NOWC are financed
is called the firm’s short-term financing policy.
Maturity Matching, or “Self-Liquidating,”
Approach
The maturity matching, or “self-liquidating,” approach
calls for matching asset and liability maturities. This strategy
minimizes the risk that the firm will be unable to pay off its
maturing obligations.
At the limit, a firm could attempt to match exactly the
maturity structure of its assets and liabilities. Inventory
expected to be sold in 30 days could be financed with a 30-
day bank loan; a machine expected to last for 5 years could
be financed with a 5-year loan; a 20-year building could be
financed with a 20-year mortgage bond; and so forth.
In practice, firms don’t actually finance each specific
asset with a type of capital that has a maturity equal to
the asset’s life. However, academic studies do show that
most firms tend to finance short-term assets from short-
term sources and long-term assets from long-term
sources.
 Aggressive Approach
Is the situation for a relatively aggressive firm that finances
all of its fixed assets with long-term capital and part of its
permanent NOWC with short-term debt.
However, short term debt is often cheaper than long-term
debt, and some firms are willing to sacrifice safety for the
chance of higher profits.
 Conservative Approach
long-term sources are being used to finance all permanent
operating asset requirements and also to meet some of the
seasonal needs. In this situation, the firm uses a small
amount of short-term debt to meet its peak requirements,
but it also meets a part of its seasonal needs by “storing
liquidity” in the form of marketable securities.
 SHORT-TERM INVESTMENTS:
MARKETABLE SECURITIES
Marketable securities typically provide much lower yields
than operating assets.
In many cases, companies hold marketable securities for
the same reasons they hold cash. Although these securities
are not the same as cash, in most cases they can be
converted to cash on very short notice (often just a few
minutes) with a single telephone call. Moreover, while cash
and most commercial accounts yield nothing, marketable
securities provide at least a modest return.
For this reason, many firms hold at least some
marketable securities in lieu of larger cash balances,
liquidating part of the portfolio to increase the cash
account when cash outflows exceed inflows. In such
situations, the marketable securities could be used as a
substitute for transactions balances or for precautionary
balances.
There are both benefits and costs associated with
holding marketable securities.
The benefits are twofold: (1) the firm reduces risk and
transactions costs because it won’t have to issue
securities or borrow as frequently to raise cash; and
(2) it will have ready cash to take advantage of bargain
purchases or growth opportunities. Funds held for the
second reason are called speculative balances. The
primary disadvantage is that the after-tax return on short-
term securities is very low. Thus, firms face a trade-off
between benefits and costs.
 END!!
• NB: Take note of key term definations
• Examples used.

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