Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1 of 20 Chapter 14 Working Capital Policy

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1 of 20

Chapter Chapter 1144

Working Capital Policy


• Financial management decisions are divided into the

management of assets (investments) and management

of liabilities (liabilities).

• The short-term financial management (working capital

management) involves the management of a firm’s

current assets and current liabilities

• The maximization of the firm’s value in the long run

depends on its survival in the short-run, i.e. meeting its

working capital needs.

Working Capital Policy: Overview


• Working capital, sometimes called gross working capital,

generally refers to cur rent as sets, while net working capital is

defined as current assets minus current liabilities—the amount

of current assets financed by long-term liabilities.• The current ratio, calculated as current assets divided by

current liabilities, is intended to measure a firm’s liquidity.– A high current ratio does not insure that a firm will have the cash

required to meet its needs.

• The best and most comprehensive picture of a firm’s liquidity

position is obtained by examining its cash budget, which

forecasts a firm’s cash inflows and outflows. It focuses on what

really counts, the firm’s ability to generate sufficient cash

inflows to meet its required cash outflows.

Working Capital Policy: Definitions


• Distinction should be made between current liabilities, specifically used to finance current assets and current liabilities that represent (a) current maturities of long-term debt; (b) financing associated with a construction program, after its completion will be funded with proceeds of a long-term security issue; or (c) the use of short-term debt to finance fixed assets.– Even though we define long-term debt coming due in the next

accounting period as a current liability, it is not a working capital decision variable in the current period.

– Similarly, when construction is temporarily financed with a short-term loan and later replaced with mortgage bonds, the construction loan would not be considered part of working capital management.

– Although such accounts are not part of the working capital decision process, they cannot be ignored because they are due in the current period, and they must be considered when the cash budget is constructed and the firm’s ability to meet its current obligations is assessed.

Working Capital Policy: Definitions


• At the peak of a business cycle, business carry their maximum amounts of current assets

• Financing needs decline during recessions and increase during booms

Relationship between the current asset Relationship between the current asset levels and financing requirements and levels and financing requirements and

the business cyclethe business cycle


• Once a firm’s operations have stabilized and cash collections from credit sales and cash payments for credit purchases have begun, the balance in accounts receivable and accounts payable can be computed using the following equation:

• A decision affecting one working capital account will have an impact on other working capital accounts.

The firm’s accounts balanceThe firm’s accounts balance


• The cash conversion cycle focuses on the length of time between when the company makes payments, or invests in the manufacture of inventory, and when it receives cash inflows, or realizes a cash return from its investment in production.

The cash conversion cycleThe cash conversion cycle


• Inventory conversion period is the average length of time required to convert materials into finished goods and then to sell these goods;

it is the amount of time the product remains in inventory in various stages of completion.

The cash conversion cycle - DefinitionsThe cash conversion cycle - Definitions


• Inventory conversion period is the average length of time required to convert materials into finished goods and then to sell these goods;

it is the amount of time the product remains in inventory in various stages of completion.

The cash conversion cycle – Inventory The cash conversion cycle – Inventory conversion periodconversion period

.

360

sold goods ofCost

Inventoryperiod conversion

Inventory


• Receivables collection period is the average length of time required to convert the firm’s receivables into cash, that is, to collect cash following a sale. It is also called the days sales outstanding (DSO).

The cash conversion cycle – The cash conversion cycle – Receivables collection periodReceivables collection period

.

360

salesCredit

sReceivableDSOperiod collection

sReceivable


• Payables deferral period is the average length of time between the purchase of raw materials and labor and the payment of cash for them.

The cash conversion cycle – Payables The cash conversion cycle – Payables deferral period deferral period

.

360

sold goods ofCost

payable AccountsDPO

period deferralPayables


• The cash conversion cycle, which nets out the three periods just defined, equals the length of time between the firm’s actual cash expenditures to pay for (invest in) productive resources (materials and labor) and its own cash receipts from the sale of its products. Thus, the cash conversion cycle equals the average length of time a dollar is tied up in current assets.

• Using these definitions, the cash conversion cycle is defined as follows:

Analysis of the cash conversion cycle Analysis of the cash conversion cycle

.period

deferralPayables

periodcollection

sReceivable

periodconversionInventory

cycleconversion

Cash


• If receivables (debtors) are collecred faster, then – cash is released from the cycle

• If receivables (debtors) are collected slower – receivables soak up cash

• If better credit (in terms of duration or amount) from suppliers is obtained – cash resources are increased

• If inventory (stocks) is shifted faster – Cash is freed up

• If inventory (stocks) move slower – more cash is being consumed

Analysis of the cash conversion cycle Analysis of the cash conversion cycle


• Suppose it takes a firm an average of 79.0 days to convert raw materials and labor to widgets and to sell them, and it takes another 43.2 days to collect on receivables, while 8.8 days normally lapse between the receipt of materials (and work done) and payments for materials and labor. In this case, the cash conversion cycle is 79.0 days + 43.2 days – 8.8 days = 113.4 days.

The cash conversion cycle - Example The cash conversion cycle - Example


• The firm’s goal should be to shorten its cash conversion cycle as much as possible without increasing costs or depressing sales. This would maximize profits because the longer the cash conversion cycle, the greater the need for external, or nonspontaneous, financing and such financing has a cost.

• The cash conversion cycle can be shortened – by reducing the inventory conversion period by processing and

selling goods more quickly, – by reducing the receivables collection period by speeding up

collections– by lengthening the payables deferral period by slowing down its

own payments.

The cash conversion cycle and the goal The cash conversion cycle and the goal of the corporation of the corporation


Cash conversion cycle: things to note Cash conversion cycle: things to note • When taking actions to reduce the inventory conversion

period, a firm should be careful to avoid inventory shortages that could cause good customers to buy from competitors.

• When taking actions to speed up the collection of receivables, a firm should be careful to maintain good relations with its good credit customers.

• When taking actions to lengthen the payables deferral period, a firm should be careful not to harm its own credit reputation.

• Actions that affect the inventory conversion period, the receivables collection period, and the payables deferral period all affect the cash conversion cycle; hence, they influence the firm’s need for current assets and current asset financing.


Cash conversion cycle: Example 1Cash conversion cycle: Example 1• A firm purchases raw materials on June 1st. It

converts the raw materials into inventory by the last day of the month, June 30th. However, it pays for the materials on June 20th. On July 10th, it sells the finished goods for inventory. Then the firm collects cash from the sale one month later on August 10th. If this sequence accurately represents the firm’s average working capital cycle, what is the firm’s cash conversion cycle?


Cash conversion cycle: Solution 1 Cash conversion cycle: Solution 1

• Payables deferral period = 20 days (June 1 to June 20).• Inventory conversion period = 40 days (June 1 to July 10).• Receivables collection period = 31 days (July 10 to August

10).• Cash conversion cycle = 40 + 31 – 20 = 51 days.


Cash conversion cycle: Example 2Cash conversion cycle: Example 2• The Cairn Corporation is trying to determine the

effect of its inventory turnover ratio and days sales outstanding (DSO) on its cash flow cycle. Cairn’s sales (which were all on credit) were $750,000, and it earned a net profit margin of 12 percent, or $90,000. It turned over its inventory 9 times during the year, its DSO (receivables collection period) was 45 days, and the firm’s cost of goods sold (COGS) was two-thirds of sales. The firm had fixed assets totaling $60,000. Cairn’s payables deferral period is 30 days. What is Cairn’s cash conversion cycle?


Cash conversion cycle: Solution 2 Cash conversion cycle: Solution 2 • DSO = 45 days; Payables deferral period = 30 days.

Because inventory is turned over 9 times during the year, the inventory conversion period must be 40 days = (360 days)/9.

Alternatively, calculate the average inventory balance:• Cost of goods sold (COGS) = $750,000(2/3) = $500,000.• Inventory = ($500,000)/9 = $55,556. So, the inventory

conversion period is:

days. 40

360

000,500$556,55$

360

COGSInventory

periodconversionInventory

days. 55days 30- days 45days 40

period deferralPayables

period collectionsReceivable

period conversionInventory

cycleconversionCash

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Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1 of 20 Chapter 14 Working Capital Policy