Topic 4 Working Capital Management. 1. Concept of Working Capital 2. Measuring Working Capital and Net Working Capital. 4.

Topic 4

Working Capital Management

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1. Concept of Working Capital

2. Measuring Working Capital and Net Working Capital

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3. Optimization of Working Capital

4. Applications

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Learning objectives

This part helps ou to:

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This part helps you to:

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Define working capital and net working

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capital

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List the determinants of a firm’s net working

capital and highlight the risk-return trade-off

involved in net working capital management

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List the advantages and disadvantages of using

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current liabilities to finance a firm’s working

capital requirements

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Concept of working capital

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Working capital

y The firm’s total investment in current assets or assets that it

expects to be converted into cash within a year or less expects to be converted into cash within a year or less

y

Net working capital

y NWC = Inventories + Accounts receivable – Accounts payable y NWC reflects the outcomes of the short-term financing

decisions

y Warning: in practice, working capital means net working

capital Inventories Inventories A t bl Accounts receivable NWC Accounts receivable NWC Accounts payable

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Managing working capital

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Why does the management of working capital

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Why does the management of working capital

matter?

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Working capital management is a yardstick to measure

a firm’s operational and financial efficiency

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Short-term financing problems can arise from the

management of current assets and the uses of current

liabilities

liabilities

y Example: if NWC decreases, the firm’s profitability tends

to rise, but the firm must better manage its liquidities in , g q order to not waste money Risk-return trade-off

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Managing working capital

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The risk-return trade-off

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The risk-return trade-off

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Consider two cases:

y Case 1: the firm increases its NWC by adding to its

current assets relatively to its current liabilities current assets relatively to its current liabilities

y Case 2: the firm decreases its NWC by increasing its

current liabilities relatively to its assets

Fi ’ Fi ’

LOWER

Case 1: investing in

additional in entories

HIGHER

Firm’s profitability Firm’s Liquidity additional inventories

HIGHER

Case 2: increasing the use of short- vs. long-term

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LOWER

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Reasons:

y Case 1: no stoppage of production, no shortage of inventory, but

reduction of profitability due to higher cost of permanent sources

sources of financing

reduction of profitability due to higher cost of permanent sources

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Managing working capital

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Financing working capital with current liabilities

Financing working capital with current liabilities

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Advantages:

y More flexible than do the permanent sources of y More flexible than do the permanent sources of

capital (long-term debt and equity)

y Matched with the seasonal needs of funds

y Lower cost than that associated with long term debt y Lower cost than that associated with long-term debt

y

Disadvantages:

G t i k f illi idit d t th t d th

y Greater risk of illiquidity due to the nature and the

uncertainty of the short-term interest rate

y Nature: current liabilities must be repaid within a year

or less illiquidity appears if needed funds are not or less, illiquidity appears if needed funds are not available

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Managing working capital

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Working capital determination

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Working capital determination

Working Capital = Inventories + Accounts

receivable – Accounts payable

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Each component of working capital has two

dimensions:

receivable Accounts payable

dimensions:

y Time: the length of time over which each component is

available or unavailable

y Money:Money: the amount of money or cash flowing into, the amount of money or cash flowing into,

around and out of the business

y

Example:

Example:

y In 2007: Accounts receivable are €30,000 (thousands)

and the average payment terms (or actual payment period) granted to the clients are equal to 45 days period) granted to the clients are equal to 45 days.

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Managing working capital

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Assessment of working capital efficiency

y

Assessment of working capital efficiency

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Turnover of working capital’s components

sold

goods

of

Cost

turnover

Inventory

inventory

Average

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turnover

Inventory

=

sales

Net

turnover

receivable

Accounts

=

receivable

accounts

Average

turnover

receivable

Accounts

=

purchases

Inventory

turnover

payable

Accounts

=

Meanings

payable

accounts

Average

turnover

payable

Accounts

=

Meanings

y These ratios examine whether inventory, accounts

receivables and payables are excessive when compared to their benchmarks or not!

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Managing working capital

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Assessment of working capital efficiency

Assessment of working capital efficiency

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Time dimension of working capital’s components

days

365

held

inventory

Days

turnover

Inventory

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held

inventory

Days

=

days

365

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outstandin

receivable

accounts

Days

turnover

receivable

Accounts

y

g

outstandin

receivable

accounts

Days

=

days

365

g

outstandin

payable

accounts

Days

=

Meanings

turnover

payable

Accounts

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outstandin

payable

accounts

Days

=

y Days inventory: you turn over your stock every ‘x’ days y Days accounts receivable: it takes you on average ‘x’

days to collect monies due to you

y Days accounts payable: on average you pay your y Days accounts payable: on average, you pay your

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Managing working capital

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Assessment of working capital efficiency

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Assessment of working capital efficiency

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Working capital expressed in terms of days

outstanding

receivable

accounts

days

held

inventory

days

cycle

conversion

Cash

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=

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payable

accounts

days

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What to do for improving the management of

working capital?

y Collect receivables faster from customers y Turn over the inventories more quickly

y Get better credit (in terms of duration and amount) from

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Applications

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Liquidity and working capital policy

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y The balance sheet of two firms A and B are as follows:

Firm A

Cash $ 100,000 Accounts payable $ 200,000

A i bl 100 000 N bl 200 000

Accounts receivable 100,000 Notes payable 200,000

Inventories 300,000 Bonds 600,000

Net fixed assets 1,500,000 Common equity 1,000,000

Total 2,000,000 Total 2,000,000

Firm B

Cash $ 150,000 Accounts payable $ 400,000 Accounts receivable 50,000 Notes payable 200,000

Inventories 300,000 Bonds 400,000

Question 1 Calculate the working capital requirements for two firms A and B

, ,

Net fixed assets 1,500,000 Common equity 1,000,000

Total 2,000,000 Total 2,000,000

Question 1. Calculate the working capital requirements for two firms A and B.

Question 2. Which of the two firms follows the most aggressive working capital policy?

Why? Comment the results in question 1 with regard to the issue of profitability.

Question 3. The firm A’s net sales, cost of goods sold and total inventory purchases

are $1,000,000; $800,000 and $600,000. Determine the days of accounts receivable outstanding, days of accounts payable outstanding and days of inventory held.