Laurence Booth Sean Cleary. LEARNING OBJECTIVES Working Capital Management: General Issues 2323 23.1...

Laurence Booth

Sean Cleary

LEARNING OBJECTIVES

Working Capital Management: General Issues23

23.1 Explain why the management of net working capital is critical for the survival of a firm.

23.2 Explain how managing receivables, inventory, and payables is related in an integrated approach to net working capital management.

23.3 Explain how the financing and current asset investment decisions interact to determine a company’s overall working capital position.

23.4 List and describe some common ways to analyze a firm’s management of its net working capital.

23.1 THE IMPORTANCE OF WORKING CAPITAL MANAGEMENT

• Working capital management is the way in which a firm manages both its current assets and current liabilities

• Good working capital management is characterized by:1. Maintaining optimal cash balances2. Investing any excess liquid funds in marketable securities

that provide the best possible return, considering any liquidity or default-risk constraints

3. Effectively managing accounts receivable4. Efficiently managing inventory5. Maintaining an appropriate level of short-term financing

in the least expensive and most flexible manner

Booth • Cleary – 3rd Edition 3© John Wiley & Sons Canada, Ltd.

23.2 AN INTEGRATED APPROACH TO NET WORKING CAPITAL MANAGEMENT

• Cash flow management is important because the exhaustion of liquid resources can leave a firm insolvent (i.e., unable to pay its obligations as they come due)

• Firms can deplete liquid financial resources for bad reasons:– Continuing to produce inventory even when sales are

falling– Selling products and services for less than their variable

cost of production


• Firms can also deplete liquid financial resources for seemingly good reasons:– Rapid growth in production and sales can cause a firm to

use up all of its cash pursuing growth, leaving it invested in illiquid assets like inventories, accounts receivable and net fixed assets

– A firm may be highly profitable in an accounting sense, but on the verge of bankruptcy if it cannot collect its receivables to generate the cash necessary to fund sales growth



• The cash flow cycle is a crucial part of understanding how a business functions because it gives managers an awareness of the dynamics of working capital management

• The cash flow cycle can be used to help managers determine the impact of changes in variables on the cash account:

• Examples:– Increasing sales requires additional investment in

inventory– Increasing accounts receivable reduces cash– Delaying the payment of payables preserves cash– Speeding up collections of receivables improves the cash

positionBooth • Cleary – 3rd Edition 6© John Wiley & Sons Canada, Ltd.


• Activities that Increase Cash– Increasing long-term debt– Increasing equity– Increasing current liabilities– Decreasing current assets

other than cash– Decreasing fixed assets


• Activities that Decrease Cash– Decreasing long-term debt– Decreasing equity– Decreasing current

liabilities– Increasing current assets

other than cash– Increasing fixed assets– Paying cash dividends


The Cash Budget• The monthly cash budget is a management tool for

forecasting the timing, magnitude and duration of both cash surpluses and deficits and their cumulative impact over time



• Management can change plans before they are implemented to produce a more favourable cash result

• Management can choose the best investment option for forecast cash surpluses, and arrange financing solutions for forecast cash deficits

• Investing Forecast Surpluses– Small surpluses (i.e., less than $100,000) available for short periods of time

(i.e., 30 to 90 days) can be kept in a current account– Small surpluses available for longer periods of time can be paid out as a cash

dividend or used to retire debt obligations– Large surpluses (i.e., greater than $100,000) available for short periods of

time (i.e., 30 to 90 days) can be invested in marketable securities with minimal risk like Treasury bills

– Large surpluses available for longer periods of time can be used to pay cash dividends, or to invest in longer-maturity, higher-yielding investments



• Financing Forecast Deficits

– Small deficits (i.e., less than $100,000) lasting for short periods of time (i.e., 30 to 90 days) can be resolved by delaying purchases, speeding up collections or trying to better synchronize cash flows; an operating line of credit could also be negotiated with a financial institution.

– Small deficits lasting for longer periods of time must be financed by more permanent solutions to under-funding

– Large deficits (i.e., greater than $100,000) lasting for short periods of time (i.e., 30 to 90 days) can be resolved with operating lines of credit or other longer-term permanent capital solutions, particularly if large cash flow deficits are likely to reoccur

– Large deficits lasting for longer periods of time must be financed with permanent increases in capital in the form of debt and/or equity



23.3 ANALYZING CASH INFLOWS AND OUTFLOWS

• Equation 23-1 analyzes the impact of sales growth on the firm’s cash position:

• where:– g = monthly sales growth– b = the cash production cost and (1 – b) = unit contribution

margin– St – 1 = Sales in the previous time period

• The sensitivity of cash to sales growth is strongly related to the firm’s inventory and accounts receivable policies


)21(11 gbSCash t

• Equation 23-2 shows that the change in cash each month depends on credit, inventory management and payables policies:

• where:α = the proportion of sales collected this month (credit policy)1 – α = the proportion of sales collected next month (only two periods)β = the proportion of this month’s production costs paid this month1 - β = the proportion of production costs paid next monthγ = the proportion of the firm’s monthly sales tied up in inventory


)()1()1( 1111 ttttt SSbSbSbSSCash


• We can simplify Equation 23-2 into Equation 23-3 by including the sales growth rate and removing the different sales levels:

• Equation 23-4 solves Equation 23-3 for the sales growth rate at which the firm can grow without either needing or generating cash:

• A firm can grow faster if:– It has a higher gross margin (1 – b)– It lowers production costs b– It collects receivables more quickly α– It pays its bills more slowly β– It has less inventory γ


g)(b)b1(S

Cash

1t

)(

1

b

bg


• The slope of the line is determined by the firm’s credit, inventory and payables policies

• A shallower slope reduces the sensitivity of cash to changes in sales• A shallower slope can be achieved by: collecting AR more quickly,

delaying AP payments, and increasing inventory turnover.



23.4 WORKING CAPITAL MANAGEMENT• Ratios are commonly used to assess or summarize a firm’s working capital

management, focusing on:

– Liquidity management

– Asset utilization

– Current liability management

• Liquidity Ratios

– The current ratio and the quick ratio assess a firm’s liquidity

– Excessive liquidity reduces ROI and ROE, and can also indicate credit policy is too lenient or excess inventories


)( sliabilitieCurrent

)( assetsCurrent ratioCurrent

CL

CA

)CL(

)AR)MS)C

sliabilitie Current

( Receivable Accounts( s SecuritieMarketable( Cash ratio Quick

Working Capital Ratios: Accounts Receivable – Changes in receivables turnover and average collection

period can indicate deteriorating or improving collection efforts


AR

vRe (RT) Turnover sReceivable

(RT) Turnover sReceivable

(ADR) RevenueDaily Average (ACP) Period Collection Average

365

AR

23.4 WORKING CAPITAL MANAGEMENT

Working Capital Ratios: Inventory– Cost of goods sold is unlikely to be comparable across firms, so

an alternative is to use revenues in the numerator– Higher receivables turnover and higher inventory turnover are

generally indicative of more efficient management of current assets


Inventory

Rev (IT) turnoverInventory

(IT) TurnoverInventory

ADR

Inventory (ADRI)inventory in revenues days Average

365


Inventory

(CGS) soldgoods of Cost (IT) turnoverInventory

Working Capital Ratios: Accounts Payable– Payables turnover shows how many times per year, on average,

a firm pays its suppliers– ADRP shows how long, in days, a firm defers payments to its

suppliers, on average


yableAccountsPa

vRe (PT) turnover Payables

(PT) Turnover Payables

ADR (ADSR) payables in revenues of days Average

365

yableAccountsPa


Operating and Cash Conversion Cycles• The operating cycle (OC) is the time period between the acquisition of

inventory and the collection of cash from receivables, and is defined by Equation 23-14:

• The operating cycle is the sum of average days revenues in inventory (ADRI) and the average collection period (ACP)

• The cash conversion cycle (CCC) is the time between cash disbursement and cash collection, or an estimate of the average time between when a firm pays cash for its inventory purchases and when it receives cash for its sales.

• The cash conversion cycle is the average number of days of revenues that must be financed outside the use of trade credit, and is defined by Equation 23-15:

or


ACPADRIOC

ADRPOCCCC


ADRPACPADRICCC

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Laurence Booth Sean Cleary. LEARNING OBJECTIVES Working Capital Management: General Issues 2323 23.1...

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