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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
Booth • Cleary – 3rd Edition 4© John Wiley & Sons Canada, Ltd.
• 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
Booth • Cleary – 3rd Edition 5© John Wiley & Sons Canada, Ltd.
23.2 AN INTEGRATED APPROACH TO NET WORKING CAPITAL MANAGEMENT
• 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.
23.2 AN INTEGRATED APPROACH TO NET WORKING CAPITAL MANAGEMENT
• Activities that Increase Cash– Increasing long-term debt– Increasing equity– Increasing current liabilities– Decreasing current assets
other than cash– Decreasing fixed assets
Booth • Cleary – 3rd Edition 7© John Wiley & Sons Canada, Ltd.
• 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
23.2 AN INTEGRATED APPROACH TO NET WORKING CAPITAL MANAGEMENT
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
Booth • Cleary – 3rd Edition 8© John Wiley & Sons Canada, Ltd.
23.2 AN INTEGRATED APPROACH TO NET WORKING CAPITAL MANAGEMENT
• 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
Booth • Cleary – 3rd Edition 9© John Wiley & Sons Canada, Ltd.
23.2 AN INTEGRATED APPROACH TO NET WORKING CAPITAL MANAGEMENT
• 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
Booth • Cleary – 3rd Edition 10© John Wiley & Sons Canada, Ltd.
23.2 AN INTEGRATED APPROACH TO NET WORKING CAPITAL MANAGEMENT
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
Booth • Cleary – 3rd Edition 11© John Wiley & Sons Canada, Ltd.
)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
Booth • Cleary – 3rd Edition 12© John Wiley & Sons Canada, Ltd.
)()1()1( 1111 ttttt SSbSbSbSSCash
23.3 ANALYZING CASH INFLOWS AND OUTFLOWS
• 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
Booth • Cleary – 3rd Edition 13© John Wiley & Sons Canada, Ltd.
g)(b)b1(S
Cash
1t
)(
1
b
bg
23.3 ANALYZING CASH INFLOWS AND OUTFLOWS
• 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.
Booth • Cleary – 3rd Edition 14© John Wiley & Sons Canada, Ltd.
23.3 ANALYZING CASH INFLOWS AND OUTFLOWS
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
Booth • Cleary – 3rd Edition 15© John Wiley & Sons Canada, Ltd.
)( 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
Booth • Cleary – 3rd Edition 16© John Wiley & Sons Canada, Ltd.
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
Booth • Cleary – 3rd Edition 17© John Wiley & Sons Canada, Ltd.
Inventory
Rev (IT) turnoverInventory
(IT) TurnoverInventory
ADR
Inventory (ADRI)inventory in revenues days Average
365
23.4 WORKING CAPITAL MANAGEMENT
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
Booth • Cleary – 3rd Edition 18© John Wiley & Sons Canada, Ltd.
yableAccountsPa
vRe (PT) turnover Payables
(PT) Turnover Payables
ADR (ADSR) payables in revenues of days Average
365
yableAccountsPa
23.4 WORKING CAPITAL MANAGEMENT
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
Booth • Cleary – 3rd Edition 19© John Wiley & Sons Canada, Ltd.
ACPADRIOC
ADRPOCCCC
23.4 WORKING CAPITAL MANAGEMENT
ADRPACPADRICCC
WEB LINKS
Wiley Weekly Finance Updates site (weekly news updates): http://wileyfinanceupdates.ca/
Textbook Companion Website (resources for students and instructors): www.wiley.com/go/boothcanada
Booth • Cleary – 3rd Edition © John Wiley & Sons Canada, Ltd. 20
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