Transcript Working Capital, PowerPoint Show

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CHAPTER 22
Working Capital Management
Alternative working capital policies
Cash, inventory, and A/R management
Accounts payable management
Short-term financing policies
Bank debt and commercial paper
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Introduction
Working capital management involves
two basic questions:
1. What is the appropriate amount of
current assets, both in total and for
each specific account.
2. How should those current assets be
financed.
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Basic Definitions
 Gross working capital:
Total current assets.
 Net working capital:
Current assets - Current liabilities.
 Net operating working capital (NOWC):
Operating CA – Operating CL =
(Cash + Inv. + A/R) – (Accruals + A/P)
Differentiate between net working capital and
(More…)
net operating working capital.
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Working capital management:
Includes both establishing working
capital policy and then the day-to-day
control of cash, inventories,
receivables, accruals, and accounts
payable.
Working capital policy:
The level of each current asset.
How current assets are financed.
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Cash Conversion Cycle
Firms typically follow a cycle in which they
purchase inventory, sell goods on credit,
and then collect accounts receivable.
The cash conversion cycle (CCC) focuses
on the length of time between payments
made for materials and labor and payments
received from sales:
Cash
Inventory Receivables Payables
conversion = conversion + collection - deferral
cycle
period
period
period
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Inventory conversion period,
The average time required to convert
materials into finished goods.
Inventory
=
Sales per day
Days per year
Inv. turnover
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Receivables collection period
=Average Collection Period” (ACP)=
Days sales outstanding (DSO)
the average length of time required to
convert the firm’s receivables into cash =
length of time firm must wait after making
a sale before receiving cash
Account
receivables
Receivables collection period =
Sales per day
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Payables deferral period
The average length of time between the
purchase of materials and labor and the
payment of cash for them.
Payables
deferral =
period
=
Payables
Purchases per day
Payables
Cost of goods sold/365
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Illustration Example 1
 We can illustrate the process with data from
Real Time Computer Corporation (RTC),
 RTC introduced a new minicomputer in early
2002 that will sell for $250,000.
 RTC expects to sell 40 computers in its first
year of production.
 The effects of this new product on RTC’s
working capital position were analyzed in
terms of the following five steps:
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Illustration Example 1
1.
2.
3.
4.
5.
RTC will order and then receive the materials it
needs to produce the 40 computers it expects to
sell.
Labor will be used to convert the materials into
finished computers.
The finished computers will be sold, but on credit.
At some point before cash comes in, RTC must pay
off its accounts payable and accrued wages. This
outflow must be financed.
The cycle will be completed when RTC’s
receivables have been collected.
What is cash conversion cycle (CCC)
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1- Inventory conversion period
if average inventories are $2 million and
sales are $10 million, then the inventory
conversion period is 73 days:
Inventory
Inventory conversion period =
Sales per day
2,000,000
= 73 days
10,000,000/365
Thus, it takes an average of 73 days to
convert materials into finished goods
and then to sell those goods
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2- receivables collection period
If receivables are $657,534 and sales
are $10 million, the receivables
collection period is
Receivables
Receivables collection period =
Sales per day
657,534
=
= 24 days.
10,000,000/365
Thus, it takes 24 days after a sale to
convert the receivables into cash.
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3- Payables deferral period
 if its cost of goods sold is $8 million per year,
and if its accounts payable average
$657,534, then its payables deferral period
can be calculated as follows:
Payables
Payables deferral period =
Cost of goods sold/365
657,534
= 30 days.
8,000,000/365
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Cash conversion cycle
 The length of time between the firm’s actual cash
expenditures to pay for productive resources and its
own cash receipts from the sale of products.
 The length of time between paying for labor and
materials and collecting on receivables.
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4- Cash conversion cycle
 The cash conversion cycle thus equals the average length
of time a dollar is tied up in current assets.
Cash
Inventory
Receivables Payables
conversion = conversion + collection cycle
CCC
period
= 73
= 67 days
period
+
24
deferral
period
-
30
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Illustration Example 2
Selected Ratios for SKI
Current
Quick
Debt/Assets
Turnover of cash
DSO (365-day basis)
Inv. turnover
F. A. turnover
T. A. turnover
Profit margin
ROE
Payables deferral
SKI
1.75x
0.83x
58.76%
16.67x
45.63
4.82x
11.35x
2.08x
2.07%
10.45%
30.00
Industry
2.25x
1.20x
50.00%
22.22x
32.00
7.00x
12.00x
3.00x
3.50%
21.00%
33.00
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How does SKI’s working capital policy
compare with the industry?
Working capital policy is reflected in
a firm’s current ratio, quick ratio,
turnover of cash and securities,
inventory turnover, Payables
deferral, and DSO.
These ratios indicate SKI has large
amounts of working capital relative
to its level of sales. Thus, SKI is
following a relaxed policy.
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Is SKI inefficient or just conservative?
A relaxed policy may be appropriate
if it reduces risk more than
profitability.
However, SKI is much less
profitable than the average firm in
the industry. This suggests that the
company probably has excessive
working capital.
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Cash Conversion Cycle
Firms typically follow a cycle in which they
purchase inventory, sell goods on credit,
and then collect accounts receivable.
The cash conversion cycle focuses on the
time between payments made for materials
and labor and payments received from
sales:
Cash
Inventory Receivables Payables
conversion = conversion + collection - deferral .
cycle
period
period
period
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Cash Conversion Cycle (Cont.)
Payables
CCC = Days per year + Days sales – deferral
Inv. turnover outstanding
period
CCC = 365 + 45.6 – 30
4.82
CCC = 75.7 + 45.6 – 30
CCC = 91.3 days.
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Shortening the Cash Conversion Cycle
 The firm’s goal should be to shorten its cash
conversion cycle as much as possible without hurting
operations.
 The cash conversion cycle can be shortened
1. By reducing the inventory conversion period by
processing and selling goods more quickly.
2. By reducing the receivables collection period by
speeding up collections.
3. By lengthening the payables deferral period by
slowing down the firm’s own payments.
 To the extent that these actions can be taken without
increasing costs or depressing sales, they should be
carried out.
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Benefits of shortening the Cash
Conversion Cycle
 Suppose RTC must spend approximately $197,250 on
materials and labor to produce one computer, and it
takes about 10 days to produce a computer.
 Thus, it must invest $197,250/9= $21,917 for each
day’s production.
 This investment must be financed for 67 days (the
length of the cash conversion cycle) so the company’s
working capital financing needs will be 67x $21,917 =
$1,468,439.
 If RTC could reduce the cash conversion cycle to 57
days, it could reduce its working capital financing
requirements by $219,170 ($21,917 x10).
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Alternative Net Operating
Working Capital Policies