Working capital management

Dr. Long Phi Tran

1
A bit about me
— Lecturer of School of Banking and
Finance.
— Research areas: Corporate Finance,
Corporate Governance
— Office: Room A1-901
— Email: [email protected]

2
Topics
— Topic 1: Overview of working capital
management
— Topic 2: Cash management
— Topic 3: Managing account receivable
— Topic 4: Managing inventory
— Topic 5: Managing account payable
— Topic 6: Managing the working capital
cycle
— Topic 7: Short-term financial planning

3
Key textbooks
— Sagner, J., 2014. Working capital
management: Applications and case
studies. John Wiley & Son.
— Berk, J. and DeMarzo, P., 2014.
Corporate Finance, Pearson.

4
Overview of working capital
management

Dr. Long Phi Tran

5
Objectives
— Working capital
— Working capital management
— Working capital financing
— Working capital management ratios

6
Definition
— Working capital refers to the cash a
company requires in order to finance
its day-to-day business operations or
in other words,Textworking capital refers
to the amount of capital which is
readily available to an organization.
Working Capital: abilities to pay due debt

7
Definition
— Working capital is one of the most
fundamental measures of a company’s
financial strength. If a company
possesses a significant value of liquid
assets, it can easily fund its day-to-day
business obligations. If, however, a
company is under cash crunch, whether
by way of a lack of cash, trouble in
collecting its account receivable, or a
dearth of inventory, it may face difficulties
keeping up with demand for its products/
services.

8
Definition
— Working capital =Current Asset - Current Liabilities

— The definition leads to the principle that

the entire amount of current assets
should not be financed out of current
liabilities. The other conclusion from this
concept leads to the notion that the
majority part of investment in working
capital assets should be financed with
long-term sources of finance.

9
Definition
— Dangers of too much working capital
- High investment in working capital denotes idling of
funds which earns no returns on its investment.
- High level of inventory and receivable demands more
supervision and good amount of control which has its
cost too.
- Chances of wastages in inventory and bad debt losses
are more when the level of working capital is very high.
- Idling and accumulation of funds may bring
inefficiencies in the system.
- High liquidity in the business results into low profitability
which can shake the confidence of shareholders and
the market price of share may fall.

10
Definition
— Dangers of too little working capital
- Illiquidity is the biggest danger of inadequate
working capital. A firm, which is not able to meet
its short-term obligations, endangers its goodwill
and long-term survival.
- Inadequacy of working capital leads to frequent
and regular stoppages in the production.
- A firm short of liquidity cannot take short-term
environmental opportunities due to lack of funds.
- Advantages of bulk purchases are forgone.
- In case of emergency, the firm has to resort to
external borrowing which has a very high cost.

11
Characteristics of working capital
— Short life span: Current assets like cash,
bank balance, marketable securities,
account receivable and inventories are
short lived.
— Swift transformation: Swift transformation
of current assets into other form of
current assets.
— Short-term focus: The present value of
money is not significant for the purpose
of analysing financial condition.

12
Characteristics of working capital
— Repetitive and frequent: Working capital
management involves repetitive and
frequent activities.
— Liquidity: The essence of working capital
management is in providing liquidity all
the time in business in such a way that
neither the risk is very high nor the return
on the investment should fall.
— Inter-relation among assets: Current
assets cannot be viewed in isolation.

13
Operating cycle

14
Characteristics of working capital
— Operating cycle: The length of time
between when a firm originally
purchases its inventory and when it
receives the cash back from selling its
product.
— Cash cycle: The length of time
between when the firm pays cash to
purchase its initial inventory and when
it receives cash from the sale of the
output produced from that inventory.

15
Characteristics of working capital

Pay in advance <=> Cash cycle > operating cycle

Cash Cycle indicates the time you have to finance your inventory
Ex: 60 days of Cash cycle means you have finance (borrow) your inventory 16
Components of working capital
— Cash: is the most liquid form of current
assets. After this, in order of liquidity, come
cash equivalents.
- Is the cash level adequate to meet current
expenses as they come due?
- What is the time lag between cash inflows
and out flows?
- When is the peak season which requires high
volume of cash?
- What will be the magnitude of bank borrowing
required to meet any cash shortfalls? When
will this borrowing be necessary and when
may repayment be expected?
17
Components of working capital
— Inventory: is kept in many forms - raw
materials, work in progress and finished
goods.
- What is the reasonable level of inventory
in relation to sales? Sale/Inventory (turnover ratio)
- What is the inventory turn over rate?
- Is there any slow moving inventory? Inventory is
slowly sold
- Is the firm losing sales due to inadequate
inventory levels?
- What action should be taken to increase
or decrease inventory?

18
Components of working capital
— Accounts receivable is the balance of
money owed to a firm for goods or
services delivered or used but not yet
paid for by customers.
- What is the amount of accounts Receivable
Sale/Acc

receivable in relation to sales?

- How rapidly can be accounts receivable
converted into cash?
- Who are the doubtful customers?
- What action should be taken to speed up
collects?
High sale/ acc receivable<=> acc re convert to sale ( cash) quickly

19
Components of working capital
— Payable: Accounts Payable and Notes
Payable. Accounts Payable are the
suppliers of goods/services whose
invoices have not yet been paid.
- Is it worthwhile to delay payments and
forego discounts?
- What is the amount of bank borrowing
employed?
- When will principal and interest
payments fall due? Will funds be
available to meet these payments on
time?Acc Payable: pay suppliers ( short term liabilities)
Accrual: pay employee, gov (shorterm liabilities)
Note Payable: pay financial institutions (banks) ( short term liabilities 20
 2 kinds of debt
Liabilities don’t have
Assessment of working capital to pay interest
Liabilities have to
requirements pay interest<=> debt
Cash
— The investment in the operating cycle is
called the working capital requirement.
WCR = Inventory + Accounts Receivable -
Accounts Payable - Pre-paid Expenses
N WC = Inventory + Accounts Receivable +

Cash - Accounts Payable - Pre-paid

Expenses - Short-term Loans
=> WC = NWC- Cash+Short term Loan
- Cash: if company hold a lot of cash=>
don’t have to invest in WC
+ short term loan: financing WC by investing
short term loan
21
Factors influencing working capital
requirements
— Nature of business
— Seasonality of operations
— Level of activity
— Market conditions Boom time & crisis=> hold
more WC to sell when
— Supply conditions boom time ( crisis) or to
expand company ( boom
time)
In the crisis, price
become cheap

22
Working capital management
— Working capital management refers to a
company’s strategies to monitor and
utilize the components of working capital
to ensure the most financially efficient
operation of the company. The primary
purpose of working capital management
is to make sure the company always
maintains sufficient cash flow to meet its
short-term operating costs and short-
term debt obligation.
23
Working capital financing
— Commercial paper: is a money-market
security issued by large corporations
to obtain funds to meet short-term
debt obligations and is backed only by
an issuing bank or company promises
to pay the face amount on the maturity
date specified on the note.
Only high rated company can issue
commercial papers

24
Working capital financing
— Inter-corporate deposits: is an
unsecured borrowing by corporates
and financial institutions from other
corporate entities. The corporate
having surplus funds would lend to
another corporate in need of funds.

25
Working capital financing
— Accounts receivable financing:
- Pledging: A pledge of accounts
receivable is the use of a firm’s
receivables to secure a short-term loan.
- Factoring: Factoring accounts receivable
is a financial transaction and a type of
debtor finance in which a business sells
its accounts receivable to a third party
(called a factor) at a discount.

26
Working capital financing
— Spontaneous financing
- Accrued expenses: Accrued expenses
are periodically recurring short-term
liabilities such as wages accrued but
not yet paid to employees and taxes
owned but not yet paid. A firm can use
all the accruals it can since there is no
actual cost involved.

27
Working capital financing
— Spontaneous financing: The short-term
spontaneous financing is the financing that
arises from the normal operating cycle.
- Accounts payable (Trade credit): Trade credit
allows a firm to defer cash payments to its
suppliers in exchange for its promise to pay
them in the future. The purchasing firm pays
for the goods as per the supplier’s credit
terms. Credit terms usually express the
amount of the cash discount, the date of its
expiration, and the due date.

28
An example of credit terms
— 2/10, net 30: If the firm wants to have the 2%
discount then the firm should pay on 10th day.
Otherwise the payment is due on the 30th day after
the purchase.
— Interest rate
=
— Time period
=
=
— Annual interest rate
=

29
Working capital financing
— Inventory loans: are sources of short-
term secured credit. The loan is
secured against the inventory. The
amount of the loan that can be
obtained depends on the marketability
and life of the inventory.
Highest marketability inventory: raw material
Lowest marketability inventory: work in process

30
Working capital financing
— Bank credit
- Line of credit: is an agreement between
a commercial bank and a business that
states an amount of short-term
borrowing the bank will make available to
the firm over a given period of time.
- Revolving credit: is a guaranteed line of
credit.
- Bank overdraft: The account holder
withdraws more money from a bank
account than has been deposited in it.

31
 Working capital issues

Optimal Amount (Level) of Current Assets

Assumptions
— 50,000 maximum
units of production
— Continuous
production
— Three different
policies for current
asset levels are
possible

32
 Impact on liquidity

Optimal Amount (Level) of Current Assets

Liquidity Analysis
Policy Liquidity
A
B
C
Greater current asset
levels generate more
liquidity; all other factors
held constant.

33
Impact on Expected Profitability

Optimal Amount (Level) of Current Assets

Return on Investment =
Net Profit
Total Assets
Let Current Assets =
(Cash + Rec. + Inv.)

Return on Investment =
Net Profit
Current + Fixed Assets

34
Impact on Expected Profitability

Optimal Amount (Level) of Current Assets

Profitability Analysis
Policy Profitability
A
B
C
As current asset levels
decline, total assets will
decline and the ROI will
rise.

35
Impact on Risk

Optimal Amount (Level) of Current Assets

— 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 stockouts and
lost sales. More risk!

36
 Impact on Risk

Optimal Amount (Level) of Current Assets

Risk Analysis
Policy Risk
A
B
C

Risk increases as the

level of current assets are
reduced.

37
 Summary of the optimal amount of
current assets

Summary of optimal current asset analysis

Policy Liquidity Profitability Risk
A
B
C
1.
2.

Permanent Asset: Fixed Asset + Permanent Current Asset

38
Temporary asset: Temporary Current Asset
Permanent working capital
— The amount of current assets required to
meet a firm’s long-term minimum needs.

39
Temporary working capital
— The amount of current assets that
varies with seasonal requirements.

40
Hedging (or Maturity Matching)
Approach

41
Financing needs and the hedging
approach
— Fixed assets and the non-seasonal
portion of current assets are financed
with long-term debt and equity.
— Seasonal needs are financed with
short-term loans (under normal
operations sufficient cash flow is
expected to cover the short-term
financing cost).

42
Conservative approach Low risk

Using long term financing => safer

43
Conservative approach
— Long-term financing benefits
- Less worry in refinancing short-term
obligations.
- Less uncertainty regarding future interest
costs.
— Long-term financing risks
- Borrowing more than what is necessary.
- Borrowing at a higher overall cost.
— Results: Managers accept less expected
profits in exchange for taking less risk.
44
Aggressive approach High risk

45
Aggressive approach
— Short-term financing benefits
- Financing long-term needs with a lower
interest cost by short-term debt.
- Borrowing only what is necessary.
— Short-term financing risks
- Refinancing short-term obligations in the
future.
- Uncertain future interest costs.
— Result: Managers accept greater
expected profits in exchange for taking
greater risk.

46
Summary of short- vs. long-term
financing

47
Combining liability structure and current
asset decisions
— The level of current assets and the
method of financing those assets are
interdependent.
— A conservative policy of “high” levels
of current assets allows a more
aggressive method of financing
current assets.
— A conservative method of financing
(all-equity) allows an aggressive policy
of “low” levels of current assets.
48
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.
Value of firm= f( FCF,WACC)
FCF( free cash flow)= EBITx(1-T)+ Dep-NCS-
Change in NWC
If company has no debt=> EBITx(1-T)= Net Income

49
Example 1: The value of working capital
management
— Problem: The projected net income next
year for Emerald City Paints are given in
the following table in $thousands:

Net Income 20,000

Depreciation +5,000
Capital expenditures -5,000
Increases in working capital -1,000

50
Example 1: The value of working capital
management
— Problem (cont’d): Emerald City expects
capital expenditures and depreciation to
continue to offset each other and for both
net income and increase in working capital
to growth at 4% per year. Emerald City’s
cost of capital is 12%. If Emerald City were
able to reduce its annual increase in
working capital by 20% by managing its
working capital more efficiently without
adversely affecting any other part of the
business, what would be the effect on
Emerald City’s value?
51
Example 1: The value of working capital
management
— Solution: A 20% decrease in required
working capital increases would reduce the
starting point from $1,000,000 per year to
$800,000 per year. The working capital
increases would still growth at 4% per year,
but each increase would then be 20%
smaller because of the 20% smaller starting
point.

52
Example 1: The value of working capital
management
— We can value Emerald City using the
formula for a growing perpetuity:
CF1
PV =
r−g
—We can get to Emerald City’s free cash flow
as:
Net Income + Depreciation - Capital
Expenditures - Increases in Working Capital

53
Example 1: The value of working capital
management
— Currently, Emerald City’s value is:
(20 000 000 + 5 000 000 - 5 000 000 - 1 000 000)/
0.12-0.4= 237 500 000

— If they can manage their working

capital more efficiently, the value will
be:
(20 000 000 + 5 000 000 - 5 000 000 - 800 000)/
0.12-0.4=240 000

54
Example 1: The value of working capital
management
— Although the change will not affect
Emerald City’s earnings (net income),
it will increase the free cash flow
available to shareholders, increasing
the value of the firm by $2.5 million.

55
Example 2: The value of working capital
management
— Problem: The projected net income next
year for River City Games are given in the
following table in $ thousands:

Net Income 120,000

Depreciation 80,000
Capital Expenditure 80,000
Increase in Working Capital 40,000

56
Example 2: The value of working capital
management
— River City expects capital expenditures
and depreciation to continue to offset
each other and for both net income and
increase in working capital to grow at 6%
per year. River City’s cost of capital is
8%. If River City were able to reduce its
annual increase in working capital by
10% by managing its working capital
more efficiently without adversely
affecting any other part of the business,
what would be the effect on River City’s
value?

57
Working capital management - Ratio
analysis
— Liquidity
— Asset utilization
— Profitability
— Leverage
— Cash conversion cycle

58
Liquidity
— Current ratio = Current assets /
Current liabilities Inventory
— Quick ratio = (Current assets - Current
liabilities) / Current liabilities
— Cash ratio = Cash and cash
equivalents / Current liabilities
— Days of cash = Cash and marketable
securities / Daily expenses

59
Asset utilization
— Receivables turnover = Credit sales /
Accounts receivable
— Average collection period (ACP) = 360 days /
Receivables turnover
— Inventory turnover = Cost of good sold /
Inventory
— Inventory conversion period = 360 days /
Inventory turnover
— Payables turnover = Cost of good sold /
Accounts payable
— Payables conversion period (DPO) = 360
days / Payable turnover

60
Profitability
— Profit margin (ROS) = Net income /
Sales
— Return on equity (ROE) = Net
income / Total equity
— Return on assets (ROA) = Net
income / Total assets

61
Leverage
— Financial leverage = Total debt / Total
equity
— Times interest earned = EBIT /
Interest expense

62
Cash conversion cycle
— Cash conversion cycle = Inventory
conversion period + Average
collection period - Payables
conversion period
— Low cash conversion cycle:
Aggressive working capital
management strategy
— High cash conversion cycle:
Conservative working capital
management strategy
63
Academic papers about working capital
management
— Chang, C.C., 2018. Cash conversion
cycle and corporate performance:
Global evidence. International Review
of Economics and Finance, 56, pp.
568-581.

64
Chang (2018)
— Finance theory discussion is generally
related to one of the following categories:
Capital budgeting, capital structure,
dividend policy, or working capital
management. Although working capital
management is vital because of its
impact on a firm’s profitability and risk,
and consequently its value, it has
received less attention than the other
aforementioned categories.
65
Chang (2018)
— Related literature suggests that an
aggressive working capital management
policy can enhance a firm’ performance.
If the accounts receivable collection
period is too long, the firm may face the
risk of liquidity and payment recovery.
Similarly, the firm may lose its inventory-
carrying cost if the inventory conversion
period is excessively increase.

66
Chang (2018)
— Increasing the payable deferral period
may result in reduced payment stress.
In addition, maintaining a high level of
working capital leads to an opportunity
cost if the firm relinquishes more
profitable investment. Therefore,
several studies have indicated that a
reduce cash conversion cycle (CCC)
can improve operating performance.

67
Chang (2018)
— Other related studies have suggested
a different viewpoint; that is, a firm’s
performance can be improved by a
conservative working capital
management policy. A longer CCC
may increase a firm’s sale and
profitability for several reasons.

68
Chang (2018)
— First, a firm can increase its sales by
extending a higher trade credit that helps
the firm to strengthen its relationships
with its customers. Second, larger
inventories can prevent interruptions in
the production process and loss of
business because of the scarcity of
products. In terms of account payables,
company may take advantage of crucial
discounts for early payment.
69
Chang (2018)
— Based on the aforementioned findings,
empirical studies on liquidity
management have yielded mixed results.
Chang (2018) concludes that the reason
for this mixed result is that these studies
have not conducted sufficiently thorough
examinations and have not considered
changes in macroeconomic
environments, economic developments
status, financial crises, corporate
governance, financial constraints.

70
Chang (2018)
— Data: 46 countries, 31,612 companies
from 1994 to 2011.
— The results indicate that industry-
adjusted CCCs exhibit significantly
negative relationships with industry-
adjusted ROAs and industry-adjusted
Tobin’s Q, and that the negative
relationships diminish or reverse when
firms exist at the lower CCC level.
— Implication: Firms should follow an
aggressive working capital policy.
71
Academic papers about working capital
management
— Gill, A.S. and Biger, N. (2012). The
impact of corporate governance on
working capital management
efficiency of American manufacturing
firms. Managerial Finance, 39(2), pp.
116-132.

72
Gill and Biger (2012)
— The board of directors and the CEO are
responsible for formulating policies
regarding cash management, accounts
receivable, inventory purchases and
maintenance, accounts payable, and all
other policies in the organization. Poor
corporate governance can lead to an
inefficient working capital management
policy, which has a negative impact on
shareholders’ wealth.
73
Gill and Biger (2012)
— Gill and Biger (2012) study the
relationship between characteristics of
corporate governance such as CEO
tenure, CEO duality, board size, and
audit committee on various
characteristics of working capital
components.

74
Gill and Biger (2012)
— Data: 180 financial reports of U.S.
manufacturing companies from 2009
to 2011.
— A positive relationship between CEO
duality and accounts receivable.
— A positive relationship between CEO
duality and accounts payable.
— A negative relationship between board
size and cash conversion cycle.
75
Gill and Biger (2012)
— A negative relationship between board
size and cash conversion cycle.
— A positive relationships between CEO
tenure and cash holdings.
— A positive relationship between CEO
tenure and current ratio.

76
Academic papers about working capital
management
— Dbouk, W., Moussawi-Haidar, L. and
Jaber, M.Y., 2020. The effect of
economic uncertainty on inventory
and working capital for manufacturing
firms. International Journal of
Production Economics, 230.

77
Dbouk et al. (2020)
— Economic policy changes can
transform the economic environment
that firms face. Uncertainty about
future government policy, for example,
has the the potential to influence firm
decisions. It disrupts the flow of goods
and services in a supply chain and
puts pressure on firms’ working
capital, which may limit their access to
bank credit.

78
Dbouk et al. (2020)
— Research question: How does
uncertainty affect the development of
firms in a WC management context?
This question is crucial given that WC
drives the financial and operational
health of firms, especially for small
and medium-sized ones that depend
on efficient WC management to
survive.

79
Dbouk et al. (2020)
— Data: U.S. manufacturing firms from
1990 to 2018.
— A positive relationship between
uncertainty and days of inventory on
hand.
— A positive relationship between
uncertainty and days sales outstanding.
— A positive relationship between
uncertainty and days payable
outstanding.
— A positive relationship between
uncertainty and cash conversion cycle.
80
Dbouk et al. (2020)
— Implications:
- Uncertainty can adversely affect firm
performance via the adverse effects
on working capital management.
- Firm should particularly pay more
attention to working capital
management during the episodes of
high uncertainty.

81