Working Capital
Management
Helena Svov
[email protected]
Guest lecture for the Czech University of Agriculture
Course: Corporate Finance
November, 2007
Content of the lecture
Working Capital Terminology
Working Capital Decisions
Cash Conversion Cycle
Importance of Working Capital
Working Capital Strategy
Inventory management
Summary of the lecture
Assignments for the tutorial
2
Working Capital Terminology
Working capital (operating capital), sometimes called
gross working capital, simply refers to the firm's total
current assets.
Short-term financial management includes mgmt of
current assets and current liabilities, including accounts
payable (trade credit), notes payable (bank loans), and
accrued liabilities.
Typical current assets include :cash and cash equivalents,
accounts receivable,inventory.
Net working capital = current assets - current liabilities.
Current assets are closely related to sales. Moreover
influenced by the size of the firm, the nature of the firm,
firms market position etc.
3
Working Capital Decisions
Working capital policy/strategy refers to decisions
Target levels of each category of current assets
How current assets will be financed
Flexible rate financing versus fixed rate financing
Working capital management = setting working capital
policy and carrying out that policy in day-to-day
operations
Working Capital Decisions
The basic working capital decisions include in day-today operations the following areas:
1.
2.
3.
4.
5.
manage collections from customers and disbursement to suppliers,
employees, taxes
bank and credit relations
liquidity management determinate expected cash surplus or deficicit
receivables management firms credit policy, collection procedures
inventory management investments in inventory and financing
Q: Which financial ratios reflect working capital
management?
Cash Conversion Cycle
(Working Capital /Operating Cycle)
Cash Conversion Cycle
Purchase
Sale on credit
Cash received
made
Receivables
Inventory collection period
collection period
Operating cycle
Payable deferral period
(avrg payment period)
Cash conversion cycle
The aim of WCM:
minimize the CCF
Cash outlay
Cash Conversion Cycle
Operating cycle = inventory collection period + avrg receivables
collection period
Cash conversion cycle = operating cycle payable deferral
period
. quick and convenient way to analyse ongoing liquidity
How can we calculate cash conversion cycle?
accounts receivable turnover = net credit sales/avrg accounts receivable
receivable collection period = 365/accounts receivable turnover
inventory turnover = cost of goods sold/ avrg inventory
inventory conversion (collection) period = 365/inventory turnover ratio
payables turnover = (cost of goods sold + general, selling, administrative
expenses)/current liabilities
payable deferral period = 365/payables turnover
8
Importance of Working Capital
Why do firms have working capital?
Under perfect markets a firm would hold exactly enough
current assets and the value of the firm would be
independent of its working capital decisions.
But the world is not perfect
Current assets typically > 40 % of total assets=> large
investment
Working capital accounts are the most manageable
The firms 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
9
Working Capital Strategy in terms
of volume
Working Capital Strategy in terms of volume:
There is a theoretical optimum for working
capital..=> moderate working capital strategy
Working Capital > optimum + higher safety (lower risk)
- lower rate of return
= conservative working capital strategy
Working Capital < optimum - lower safety (higher risk)
? rate of return
rate of return depends upon the degree of reduction in sales
= aggressive working capital strategy
10
Working Capital Strategy
Aggressive strategy
Safety stock
Total
current
assets
Required
minimum of
current
assets
Conservative strategy
Safety stock
Required
minimum of
current
assets
Total
current
assets
11
Working Capital Strategy in terms
of financing
Idealized model for
agriculture
Current
assets
EUR
Fixed assets
Time
Short-term
credit
Long-term
debt plus
equity
Fixed assets growing
steadily
Current assets jump
at season
X
In real world
different patterns
But seasonal
patterns exist and
cause fluctuations
12
Working Capital Strategy
Permanent current assets some (minimum)
level of current assets that is always maintained
Matching principle:
Permanent assets (= fixed assets + permanent
current assets) financed with permanent sources of
financing
Temporary assets temporary financing
The idea is to match the cash flow generating
characterics with the maturity of the financing
13
Working Capital Strategy
Working capital strategy .. in terms of financing
Moderate: Match the maturity of the assets with the
maturity of the financing.
Aggressive: Use short-term financing to finance permanent
assets.
Conservative: Use permanent capital for permanent assets
and temporary assets.
14
Working Capital Strategy Moderate
and Aggressive
$
Fluctuating current assets
}
Permanent current assets
Short-term
(temporary)
financing
Permanent
(L-T financing)
Equity + LT debt
Fixed Assets
Years
Lower dashed line, more aggressive.
15
Working Capital Strategy
Conservative
$
Zero or very low S-T
debt
Permanent current assets
Permanent
(L-T financing)
Equity + LT debt
Fixed Assets
Years
16
Inventory Management
Inventory management control of
investments in inventories
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
17
Inventory Management
Ways of improvement in inventory control?
Effective inventory mgmt = turning over inventory as quickly as
possible without losing sales from inventory stockouts (return
versus risk)
EOQ approach
Costs of storage and carrying rise with larger and less frequent
orders
Costs of placing orders are lower with larger and less frequent
orders
! Find a good classification of costs and determinate the
minimum of costs
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Inventory Management
A. Carrying
costs
B. Ordering costs
C. Costs related to
safety stocks
storage
cost of placing order
or production setup
costs
loss of sales
insurance
shipping and handling
costs
loss of customer
goodwill
cost of tied up
capital
quantity discounts
taken or lost
disruption or
production schedules
depreciation
Prevailing
character:
variable
Prevailing character:
fixed
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Inventory Management
Economic order quantity (EOQ) model
S usage in units per period
Oorder cost per order
C carrying cost per unit per period
Qquantity order
Order cost = O . number of orders = O . S/Q
Carrying cost = C . Q/2
(it is supposed that inventory is depleted at a constant rate)
Total cost = O . S/Q + C . Q/2
We are looking for the quantity Q that minimizes total costs
20
Inventory Management
Q =
2 OS
C
.. basic EOQ model
EOQ model = technique for determining the
optimal order size, i.e. order size that minimizes
total order costs and carrying cost
21
Inventory Management
Other approaches to inventory management:
The ABC system
Size of investment in
the type of inventory
Level and intensity of
monitoring
A high
Perpetual usually daily
B middle
Periodic (weekly,
monthly)
C low
Unsophisticated,
unregular
Just-in-Time system
Computerized systems for resource control
22
Summary
Working capital management involves management of
current assets and current liabilities
Net working capital = current assets current liabilities
Cash conversion cycle is a way to analyse the liquidity
and helps to set the level of net working capital.
Conservative versus aggressive working capital
strategy/policy
Inventory management = control of investments in
inventories
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Assignments for the tutorial
1.
2.
3.
4.
Give your reaction: Merely increasing the level of current
assets does not necessarily reduce the riskiness of the firm,
rather, composition of the currenr assets is important to
consider. (Q 11.1.)
How does seasonal nature of a firms sales influence the level
of current assets and the decision amount of short-term credit?
(Q 11.2.)
What is the advantage of matching the maturities of assets and
liabilities (fixed assets long term financing; current assets
ST financing)? What is the disadvantage? (Q 11.3.)
There have been times when short-term rates were higher than
long-term rates. Does this imply that a firm should use only
long-term debt and no short-term? (Q 11.4.)
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Assignments for the tutorial
5.
Define and explain:
6.
A firms cash conversion cycle is 40 days. The receivables
turnover is 8, payables turnover is 10.
7.
working capital, net working capital
cash conversion cycle
permanent current assets
seasonal, or temporary current assets
matching principle
What is the firms inventory turnover?
What are accounts receivable if credit sales are 920 000 EUR?
What was the net working capital of EZ in 2005 and 2004?
What is the main source of CEZs short-term financing? Can
we recognize whether CEZs working capital strategy is
conservative or aggressive?
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Assignments for the tutorial
8.
a)
b)
c)
The Warner Flooring sales 1.2 mil. USD. Fixed assets total 500
000 USD, it wishes to maintain 60 % debt ratio, interest cost is
10 % on both S-T and L-T debt. Three alternatives regarding
projected current assets: 1) aggressive (current asstes = 45 %
of sales), 2) average (50 % of sales), 3) conservative (60 % of
sales). Expected EBIT is 12 % of sales, tax rate is 40 %.
What is the expected ROE under each strategy?
There is an assumption that earnings rate and level of expected
sales are independent of current asset policy. Is this a valid
assumption?
How would the overall riskiness of the firm vary under each
policy? (P 11.2.)
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Assignments for the tutorial
9.
Inventory management: Describe the basic nature of the fundamental
inventory control model, discussing specifically the nature of increasing
costs, decreasing costs and total costs.
What are the probable effects of the following decisions on invetory
holdings?
10.
11.
Changing the structure of suppliers
Greater use of of intermediate goods for production instead of raw mtl
Substantial increase of the number of styles produced
Starting to manufacture for specific orders
EOQ analysis: Tiger Corp purchases 1 200 000 units per year of one
component. the fixed xcost per order is 25$. The annual carrying cost of
the item is 27 % of its 2 $ cost. a) Determine the EOQ model under: (1)no
changes, (2) order cost of zero, and (3) carrying cost of zero. b) What do
your answers illustrate about the EOQ model. Explain.
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