Working capital

Working capital
• Working capital is the difference between the company’s current assets
and its current liabilities.
• Working capital management is a business tool that helps companies
effectively make use of current assets and maintain sufficient cash flow to
meet short-term goals and obligations.
• By effectively managing working capital, companies can free up cash that
would otherwise be trapped on their balance sheets.
• Positive working capital means the company can pay its bills and invest to
spur business growth.
• Working Capital = Current Assets - Current Liabilities

• Current Assets are cash and other assets that are expected to be
converted to cash within the year.
– Cash
– Marketable securities
– Accounts receivable
– Inventory
• Current Liabilities are obligations that are expected to require cash
payment within the year.
– Accounts payable
– Accrued wages
– Taxes
• Working capital is required to…
 operate the business
 serve the customers
 deal with some variation in the timing of cash flows

• Working capital is a basic measure of both a company's efficiency and its

short-term financial health
 Too much: may indicate inefficient use of resources, low return
 Not enough: may indicate potential cash flow problems, high risk
• Working capital analysis considers the…
 Magnitude of each component
 Timing of the cash flows (permanent and temporary)
 The Standard Balance Sheet
LIABILITIES
TOTAL ASSETS AND SHAREHOLDERS’ EQUITY
Cash
Short-term debt
Current assets
Accounts receivable
Current liabilities
plus Inventories plus Accounts payable plus
Prepaid expenses Accrued expenses

Long-term debt
plus
Net fixed assets Shareholders’ equity

• Assets = Liabilities + Shareholders' Equity

• Cash= Long-term debt + Equity + Current liabilities
- Current assets other than cash - Fixed assets
 Issues on working capital
• Let assume that
– Three different policies for current asset levels are possible
– 50,000 maximum units of production
– Continuous production

• Impact on liquidity Policy A

• Greater current asset levels Policy B

ASSET LEVEL ($)

generate more liquidity; all other Policy C
factors held constant.

• Impact on profitability Current Assets

Net Profit
Return on Investment 
Total Assets
Net Profit 0 25,000 50,000
 OUTPUT (units)
Current  Fixed Assets
• Impact on risk
– Decreasing cash reduces the firm’s ability to meet its financial obligations.
More risk!
– Stricter credit policies reduce receivables and possibly lose sales and
customers. More risk!
– Lower inventory levels increase stock-outs (out of inventory) and lost sales.
More risk

• Summary Policy Liquidity Profitability Risk

A High Low Low
B Average Average Average
C Low High High

• Profitability varies inversely with liquidity.

• Profitability moves together with risk.
 Working capital management
• Working capital management is about setting working capital policy and
carrying out that policy in day-to-day operations.
• Assets and liabilities must be matched and coordinated in order to keep
costs to a minimum and to control risks.

• The basic working capital decisions include in day-to-day operations the

following areas:
1. manage collections from customers and disbursement to suppliers,
employees, taxes
2. bank and credit relations
3. liquidity management – determinate expected cash surplus or deficit
4. receivables management – firm´s credit policy, collection procedures
5. inventory management – investments in inventory and financing
• In order to reduce working capital requirements
– Collect payment as quickly as possible
– Keep stock levels as low as possible
– Delay paying suppliers as long as possible

• Firm Value and Working Capital

– Any reduction in working capital requirements generates a positive
free cash flow that the firm can distribute immediately to
shareholders.
• Thus, efficiently managing working capital will maximize firm
value.
 Positive vs. Negative Working Capital
• A company has positive working capital if it has enough cash, accounts
receivable and other liquid assets to cover its short-term obligations, such
as accounts payable and short-term debt.

• In contrast, a company has negative working capital if it doesn’t have

enough current assets to cover its short-term financial obligations.
• A company with negative working capital may have trouble paying
suppliers and creditors and difficulty raising funds to drive business
growth. If the situation continues, it may eventually be forced to shut
down.
 The Cash and Operating
Cycle for a Firm
• Firms hold cash to:
• Meet their unexpected expenses
• Acquire assets on short notice
• Maintain some compensating balances required by banks, etc.
• The aim of working capital management is to minimize the cash
conversion cycle.
 Cash-to-Cash Cycle
• The terms Cash Conversion Cycle and Cash-to-Cash Cycle are used
interchangeably
• Cash conversion cycle= (Inventory days + Account Receivables Days) –
Accounts Payable Days

• Focuses on account receivables, account payables, and inventory

• It is the amount of time (in days) that a company takes to sell inventory,
collect receivables and pay accounts payable
• The combined cycle indicates how much cash is tied up in the company’s
operations (procurement, production, sales, etc.)
 Inventory Days
• Inventory Days = Average Inventory/One day Cost of Goods Sold (COGS)
= Average Inventory/(COGS/365)
– A financial measure indicating how long it takes a company to turn its
inventory (including raw materials, WIP, and finished goods) into sales
– Inventory is recorded at cost, so COGS is used
– It is the inverse of Inventory Turnover (e.g. Inventory Days of 91 days is
the same as Inventory Turnover of 4)
– In general, lower Inventory Days is better, provided the company is not
missing out on sales due to lack of inventory
 Accounts Payable Days
• Accounts Payable Days = Average Accounts Payable/One day Cost of
Goods Sold (COGS) = Average Accounts Payable/(COGS/365)
– A financial measure indicating how long a company is takes to pay its
suppliers
– Accounts Payables are recorded at cost of the materials, so COGS is
used
– In general, higher Accounts Payable Days is better, provided the
company is not damaging supplier relationships or performance by
delaying payment
 Accounts Receivable Days
• Accounts Receivable Days = Average Accounts Receivable/One
Day Sales = Average Accounts Receivable/(Sales/365)
– A financial measure indicating how long a company takes to
collect the cash after making a sale
– Accounts Receivable are credit sales to customers, so Total
(credit) Sales is used
• Note that if the business uses cash, then one should
separate out credit sales because cash sales are not
‘outstanding’
– In general, lower Accounts Receivable Days is better, provided
the company is not missing out on sales due to lack of customer
credit
• Operating Cycle
– The average length of time between when a firm originally purchases
its inventory and when it receives the cash back from selling its
product
– Most firms buy their inventory on credit, which reduces the amount of
time between the cash investment and the receipt of cash from that
investment.
 Working Capital Trade-off
• Working capital trade-off is an art to find the level of current assets that
minimizes the sum of Carrying Costs and Shortage Costs.
• It is the trade off in terms of profitability and risks.
• Carrying Costs:
– Costs of maintaining Current Assets; including opportinity cost of
capital.
– Investment in cash and receıvables may cause an interest loss and
– Investment in ınventory has opportinity cost of capital; storage and
insurance costs
• Carrying Costs encourage firm to hold current assets to a mınımum
• Shortage Costs:
– Costs incurred from shortages in Current Assets
– Shortage in cash may incur unnecassary transaction costs of selling
marketable securities and
– Shortage in receıvables may cause to lose customers because of credit
sales’ restrictions
– Shortage in ınventory may have shut down production and unable to
to fill orders promptly
• Shortage Costs encourage firm to hold current assets to a maximum.
 Sources and uses of cash
• Assets = Liabilities + Shareholders' Equity
• Cash= Long-term debt + Equity + Current liabilities
- Current assets other than cash - Fixed asset

• An increase in long-term debt and or equity leads to an increase in cash—

as does a decrease in fixed assets or a decrease in the non-cash
components of net working capital.
• The sources and uses of cash follow from this reasoning.
– Sources of Cash
• Long term financing
• Share capital
• Preferred share
• Long term bond
• Reserve and surplus
• FDI
– Uses of Cash
• Working Capital
• Fixed Assets
• Fees
 Importance of Working Capital
• The firm´s well-being shows up first in its working capital accounts and the
flow of cash.
• Working capital management must ensure that a firm can meet its short-
term maturity obligations.
• Working capital requirements are an investment
– Firm finances accounts receivables and inventory
• An important job of the financial manager is to strike a balance between
the costs and benefits of current assets.
• Manager has to find the level of current assets investment that minimizes
the sum of carrying costs and shortage costs.
 Working Capital Strategy – in terms
of volume
• A conservative working capital strategy maintains working capital more
than the optimum requirement. This implies higher safety (lower risk) and
lower rate of return for the firm.
• There is a theoretical optimum for working capital (Moderate strategy)
• An aggressive working capital strategy maintains working capital less than
the optimum requirement. This implies lower safety (higher risk) and the
rate of return that depends upon the degree of reduction in sales.
 Working Capital Strategy – in terms
of financing
• A company that is growing over time, its assets can be decomposed
into three categories
– fixed assets
– permanent current assets
– fluctuating current assets
• Matching principle:
 Permanent assets (fixed assets + permanent current assets) financed
with long-term sources of financing.
 Fluctuating assets – short-term sources of financing.
 The idea is to match the cash flow generating characterises with the
maturity of the financing.
• Working capital strategy
 Conservative: Use permanent capital for permanent assets and
temporary assets.
 Moderate: Match the maturity of the assets with the maturity of the
financing.
 Aggressive: Use short-term financing to finance permanent assets.
 Inventory Management
• Inventory management is about the control of investments in inventories.
Because excessive inventory uses cash, efficient management of inventory
increases firm value.
• Common major determinants of inventory level:
– level of sales
– length and technical nature of production process
– durability, perishability
• Examples:
– Large inventories: machinery , precious metals
– Seasonal: agriculture, canning
– Low: oil and gas production, baking
• There are broadly three costs associated with the merchant’s inventory
holding.
1. Holding (or carrying) costs: An increase in order size increases
the carrying cost. They include the costs of maintaining
economic value and opportunity costs.
2. Ordering costs: This cost does not depend on quantity ordered.
E.g., Cost to prepare a purchase requisition, cost to prepare a
purchase order, cost of the labor required to inspect goods
when they are received etc.
3. Shortage costs (stock-out costs): the loss due to losing a specific
sale, customers goodwill, or future business. Shortage costs fall
with increases in order size.
• The role of the inventory manager is to balance the costs and benefits
associated with inventory.
• Effective inventory management requires turning over inventory as quickly
as possible without losing sales from inventory stock-outs (return versus
risk).
• The approaches to inventory management:
– EOQ approach: technique for determining the optimal order size, i.e.
order size that minimizes total order costs and carrying cost
– The ABC system
– Just-in-Time system
– Computerized systems for resource control