Introduction to Working Capital Management

Introduction to Working Capital Management

• Working capital management involves managing current assets (cash, accounts receivable, inventory) and current liabilities (accounts payable, short-term debt).
• Students should be able to describe basic working capital management, the determinants of a firm's investment into accounts receivable, and how credit policy changes are determined.
• Students should also understand the reasons for carrying inventory and how inventory management decisions are made.

Topic and Structure of the Lesson

• The lesson covers the key components of working capital management:
  • Cash conversion cycle
  • Cash management
  • Inventory management
  • Receivables management

Key Terms

• Key terms used in working capital management include:
  • Cash conversion cycle
  • Inventory conversion
  • Cash budget
  • Credit policy
  • Days sales outstanding

Introduction to Working Capital Management

• Definition of working capital as current assets minus current liabilities.

Figure 2.1: Working Capital

• Illustrates the concept of working capital as a component of a firm's total assets and the relationship with total liabilities and shareholders' equity.
• Shows the subcategories of fixed and current assets, and the different kinds of liabilities.
• Current assets are categorized as fixed and intangible.
• Liabilities include current and long-term categories.

Short-Term Financing Questions

• Focused on determining appropriate cash levels, short-term borrowing amounts, and appropriate credit extensions to customers.

Figure 30.2: Simple Cycle of Operations

• A diagram showing the sequential flow of goods and cash from raw materials purchase to cash collection on sales,
• This illustration shows how cash is tied up by raw materials, work-in-progress, and finished goods inventory.

Figure 30.3: Cash Conversion Cycle

• Breakdown of how long it takes from purchasing raw materials to converting those materials into cash through sales.
• Components of the cash conversion cycle include; Inventory period, Accounts payable period, and Accounts receivable period.
• Operating cycle is the sum of inventory and receivables period.
• Cash conversion cycle is the operating cycle minus accounts payable period.

Cash Conversion Cycle, US Manufacturing, 2011

• Data is presented to illustrate the relationships between sales, cost of goods sold, inventory, accounts receivable, and accounts payable of USD in billions (2011).

30-1 Working Capital and the Cash Conversion Cycle

• Calculates average inventory period, average receivables period, and average payables period.
• Shows how the different periods are added together to determine the cash conversion cycle
• Uses figures from the previous section to calculate lengths in days

Quick Quiz 1

• Presents a case study to assess students' ability to calculate the operating cycle and cash conversion cycle, given average inventory, average receivables, average payables, net sales, and cost of goods sold.

Quick Quiz 1 Solution

• Provides the calculations to find the inventory turnover, inventory period, receivables turnover, average collection period, payables turnover, payables period, operating cycle, and the cash cycle for the case in the Quick Quiz 1

Alternative Formulae

• Provides the calculations to find the length in days for the inventory period, average collection period, and payables period given average inventory values, cost of goods sold, sales amounts.

Working Capital Terminology

• Definitions of net working capital, working capital policy, and working capital management.

Cash

• Cash Does Not Pay Interest
• Move money from cash accounts into short-term securities
• Concentration banking
• Lock-box system
• Financial managers balance liquidity and opportunity costs.
• Trade-off between cost of keeping an inventory of cash and benefits of potentially saving from transaction costs.

Cash Doesn't Earn a Profit

• Importance of holding cash for transactions, precautionary, compensating balances and speculation.

What is the Goal of Cash Management?

• To meet the short-term cash needs of day-to-day operations.
• To minimize transaction balances
• To meet other needs and objectives.

Ways to Minimize Cash Holdings

• Use a lockbox
• Insist on wire transfers from customers
• Synchronize inflows and outflows
• Increase forecast accuracy
• Hold marketable securities
• Negotiate a line of credit

What is "Float"?

• The difference between the cash shown on a firm's books and the cash balance shown on the bank's records.

Cash Budget: The Primary Cash Management Tool

• Purpose: Forecast cash inflows, outflows, and ending cash balances.
• Used to plan loans needed or funds available to invest daily, weekly or monthly.

SKI's Cash Budget

• Illustrative example of a cash budget with details for January and February, including collections (sales), purchases, wages, rent, and other payments.

###Should Depreciation Be Explicitly Included in the Cash Budget?

• No, Depreciation is a noncash charge, in a cash budget only cash payments and receipts are included.
• Depreciation does impact taxes; taxes which are included in a cash budget.

What are Some Other Potential Cash Inflows Besides Collections?

• Proceeds from sale of fixed assets, Stock and bond sales, Interest earned, and Court settlements.

How Could Bad Debts be Worked Into the Cash Budget?

• Collections would reduced by the amount of the bad debt losses.
• For instance, if the firm had a 3% bad debt loss, total collections would be 97% of sales.
• Lower collections result in higher borrowing needs.

Analyze SKI's Forecasted Cash Budget

• SKI's cash holdings would exceed the target level for each month.
• SKI would improve Economic Value Added (EVA) through investments or returns to shareholders.

Why Might SKI Want to Maintain a Relatively High Amount of Cash?

• To prevent cash shortfall if sales are less than forecasted
• For conservative planning, or if confidence in sales forecast is low.
• To fund future investments.

Inventory Management Components

• Raw materials
• Work-in-process
• Finished goods

Types of Inventory Costs

• Carrying costs: Storage, insurance, property taxes, dep and obsolescence
• Ordering costs: Placing orders, Shipping and handling
• Costs of running short: Lost sales, customer goodwill, disruption to schedules.

Determining Optimal Order Size (EOQ Model)

• Graph illustrating the relationship between order size, carrying costs, order costs and total costs..
• Minimum total costs indicate the economically optimal order quantity.

Inventory Model

• The EOQ (economic order quantity) model determines the ideal order size that minimizes total inventory costs.
• Assumptions for EOQ calculations include perfect sales forecasting, evenly distributed sales throughout the year and no unexpected delays in order receiving.

Inventories (Example)

• Calculation of EOQ given annual sales, ordering cost and carrying cost.

EOQ Example

• Illustrative example of a calculation of the Economic Order Quantity(EOQ) given specified values for annual sales, cost per order, and cost of carrying 1 unit in inventory.

Elements of Credit Policy

• Credit Period, Cash Discounts, Credit standards, and Collection Policies

Does a Firm Face Any Risk if it Tightens its Credit Policy?

• Tightening credit policy may discourage sales, and some customers might choose to do business elsewhere.

If SKI Succeeds in Reducing DSO

• Reduces cash holdings in the short run if customers pay sooner, but over time could be reinvested in more productive assets or distributed as dividends to shareholders.

Reading Assignment

• Ross Chapter 14 and 15