INTRODUCTION TO

WORKING CAPITAL
MANAGEMENT

Outline

Working Capital Defined

Goals of working capital management
Cash Conversion Cycle
Working capital policies

WORKING CAPITAL
MANAGEMENT
Net Working Capital = Current Assets - Current
Liabilities

WORKING CAPITAL
MANAGEMENT
Goals of Working Capital Management:
1. Stimulate sales by offering customers credit
(accounts receivable) and ready goods for sale
(inventory) Increase Profits
2. Minimize costs by balancing production and
sales levels through inventory Increase Profits
3. Secure low cost financing Increase Profits
4. Reach above 3 goals but never run out of cash
by having enough cash and marketable
securities on hand and/or by limiting use of
short-term debt

WORKING CAPITAL
MANAGEMENT
Issues to Study:
1. What types and amounts of current assets
should a firm hold?
2. What types and amounts of short-term
financing should a firm employ?
3. How do firms ensure they have enough cash
to meet on-going obligations?
4. How do firms forecast their cash needs?

Cash Conversion Cycle for a

Manufacturing Firm
Purchase of Raw
Sale on
Materials
Credit
Inventory
Conversion Period

Cash Received
From Credit Sale
Average
Collection Period

Operating Cycle
Payable
Deferral Period
Cash Outlay

Cash Conversion Cycle

MANAGEMENT OF CASH
CONVERSION CYCLE
Cash Conversion Cycle = (Operating Cycle) (Accounts Payable Deferral Period)
1. Operating Cycle = The time between ordering or
raw materials and receiving cash from credit sales
2. Inventory conversion period = time required to
order, produce and sell final products on credit
3. Average collection period = time required to collect
cash from credit sales
4. Accounts payable deferral period = time firm is
able to delay payment for raw materials, wages
and other accounts
5. Cash conversion cycle = time between payments
for raw materials and and labour (resources) and
cash collection from sales

OPERATING AND CASH CYCLES FOR XYZ

DISTRIBUTORS INC.
(In this example, we use average balance but could also use year-end
figures for inventory, accounts receivable and accounts payable)

1.

Inventory Conversion Period

- Assume that beginning of year inventory
balance was Rs.30 and cost of goods sold
was Rs.350

AverageInv entory

365
Cost of Goods Sold
( Rs.30 40)
2

365 36.5 days

Rs.350

OPERATING AND CASH CYCLES FOR

XYZ DISTRIBUTORS INC.
2.

Receivables Conversion Period or Average Collection

Period
- Assume 100% of sales are on credit

- Assume that beginning of year accounts

receivable was Rs.20 and sales was Rs.500

Average Re ceivables

365
Credit Sales
( Rs.20 30)
2

365 18.25 days

Rs.500

OPERATING AND CASH CYCLES FOR

XYZ DISTRIBUTORS INC.
3. Payables Deferral Period
- assume beginning of
Year accounts payable was
Rs.20

Average Accounts Payables

365
Cost of Goods Sold
( Rs.20 30)
2

365 26.07 days

Rs.350

4. Operating Cycle
=
Inventory Conversion Period +
Receivables Conversion Period
= 36.50 days + 18.25 days
= 54.25 days
5. Cash Cycle = Operating Cycle - Accounts
Payable Deferral Period
= 54.25 days 26.07 days
= 28.18 days

Working Capital Policies and the Current Ratio

Current Ratio is a measure of the extent to which
current Assets are financed by current liabilities
Current Ratio = Current Assets / Current Liabilities
XYZ Distributors has a current ratio of 70/50 or 1.4
A current ratio of 1.40 means that for every Rs.1.40 of
current assets there is one dollar of current liabilities

Working Capital Policies

(Relative to Industry)
Working
Capital
Policy

Levels of How
Current Current
Assets
Assets are
Financed

Current
Ratio

Operating
and Cash
Cycles

Trade-off
Between
Profitability
and Risk

Conservative High

With Long- Higher

term Debt than
and Equity Industry
Average

Longer
than
Industry
Average

Lower
Profits /
Lower Risk

Aggressive

With
Short-term
Debt

Shorter
than
Industry
Average

Higher
Profits /
Higher Risk

Low

Lower
than
Industry
Average

How a Conservative Working Capital Policy

Lowers Profitability and Risk
(Vice-versa for Aggressive Policy)
Impact

Higher Level
of Cash and
Marketable
Securities

Higher Level Higher

of Accounts Level of
Receivable
Inventory

Less Short-term
Debt /Greater
Long-term
Liabilities and
Equities

Lower
Return

Liquid assets
earn lower
returns than
less liquid
assets

Greater cost
of financing
and possibly
more writeoffs.

Higher
carrying
costs and
higher
obsolescenc
e

With upwardsloping yield curve,

interest costs are
higher. Equity costs
are normally higher

Less
Risk

Less Risk
Because Cash
is Readily
Available

Wont miss a
potentially
profitable
sale.

Fewer
Stock-outs

Less short-term
debt payments to
meet.

Working Capital Policies

Understanding Liquidity
To understand how well a company can meet its
ongoing cash obligations (its liquidity), you need
to understand whether the firm is using or
generating cash flow
To help you understand the nature of cash flows,
you need to know how to develop and interpret a
statement of cash flows
Before developing a statement of cash flows, let us
review how the balance sheet and income
statements are created

Summary
Working Capital = Short-term Assets
Short-term liabilities
Cash Conversion Cycle
Operating cycle
Cash cycle

Policies
Aggressive
Conservative

Cash and Marketable Securities

Management

Liquid Asset Management

CASH- motives for holding cash:
Transactions: to meet cash needs that
arise from doing business.
Precautionary: having cash on hand for
unexpected needs.
Speculative: to take advantage of
potential profit-making situations.

Liquid Asset Management

CASH:

Trade Off: cash decreases risk of

insolvency, but earns no returns!

Cash Management
Managing Cash Inflow

Lockbox System
Instead of mailing checks to the firm,
customers mail checks to a nearby P.O.
Box.
A commercial bank collects and deposits
the checks.

Cash Management
Managing Cash Inflow

Lockbox System
Instead of mailing checks to the firm,
customers mail checks to a nearby P.O.
Box.
A commercial bank collects and deposits
the checks.
This reduces mail float, processing float and
transit float.

Cash Management
Managing Cash Inflow

Preauthorized Checks (PACs)

Arrangement that allows firms to create
checks to collect payments directly from
customer accounts.

Cash Management
Managing Cash Inflow

Preauthorized Checks (PACs)

Arrangement that allows firms to create
checks to collect payments directly from
customer accounts.
This reduces mail float and processing
float.

Cash Management
Managing Cash Inflow

Depository Transfer Checks

(DTCs)
Moves cash from local banks to
concentration bank accounts.
Firms avoid having idle cash in multiple
banks in different regions of the country.

Cash Management
Managing Cash Inflow

Wire Transfers
Moves cash quickly between banks.
Eliminates transit float.

Cash Management
Managing Cash Outflow

Zero Balance Accounts (ZBAs)

Different divisions of a firm may write
checks from their own ZBA.
Division accounts then have negative
balances.
Cash is transferred daily from the firms
master account to restore the zero balance.
Allows more control over cash outflows.

Cash Management
Managing Cash Outflow

Payable-Through Drafts (PTDs)

Allows the firm to examine checks written
by the firms regional units.
Checks are passed on to the firm, which
can stop payment if necessary.

Cash Management
Managing Cash Outflow

Remote Disbursing
Firm writes checks on a bank in a distant
town.
This extends disbursing float.
(Discouraged by the Federal Reserve
System)

Marketable Securities
Considerations
Financial Risk - uncertainty of
expected returns due to changes in
issuers ability to pay.
Interest rate risk - uncertainty of
expected returns due to changes in
interest rates.

Marketable Securities
Considerations
Liquidity - ability to transform
securities into cash.
Taxability - Taxability of interest
income and capital gains.
Yield - Influenced by the previous 4
considerations.

Marketable Securities
Types
Treasury Bills - short term securities
issued by the U.S. government.

Marketable Securities
Types
GOI Agency Securities - Debt issued
by agencies, including:
National Mortgage Association
Central Home Loan Banks (HDFC)
Central Land Banks (NABARD)
Intermediate Credit Banks
Banks for the Cooperatives

Marketable Securities
Types
Bankers Acceptances - short term
securities used in international
trade. Sold on discount basis.
Negotiable CDs - short-term
securities issued by banks, with
typical deposits of $100,000,
$500,000 and $1 million.

Marketable Securities
Types
Commercial Paper - short-term
unsecured IOUs sold by large
reputable firms to raise cash.
Repurchase Agreements - an investor
acquires short-term securities subject
to a commitment from a bank to
repurchase the securities on a specific
date.

Marketable Securities
Types
Money Market Mutual Funds - a
pool of money market securities,
divided into shares, which are sold to
investors.