Chapter 17
Working Capital Management
and Short-Term Financing
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Topics
• Overview of Working Capital Management
• Using and Financing Operating Current Assets
• The Cash Conversion Cycle (CCC)
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Overview of Working Capital
Management
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Overview of Working Capital
Management
• We must answer two basic questions:
1. What is the appropriate amount of working capital (both
in total and for each account)?
2. How should working capital be financed?
• Improving the firm’s working capital position requires
cooperation from all operating divisions of the firm,
such as experts in:
– Logistics (i.e. activate just in time, customer delivery, etc.).
– Operations management (i.e. reduce inventory, etc.).
– IT.
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Corporate Valuation and Working
Capital Management
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Role of Financial Managers
• Financial managers evaluate the effectiveness of the
firm’s operating departments relative to other firms
in its industry.
• They evaluate the profitability of alternative
proposals for improving working capital management
(i.e. credit / payment terms and conditions).
• They decide how much cash the company should
keep on hand and how much short-term financing
should be used to finance working capital.
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Basic Definitions
• (Gross) working capital: Total current assets.
• Net working capital:
– [Current assets (CA) – Current liabilities (CL)]
• Net operating working capital (NOWC):
– [Operating CA – Operating CL] = (Cash + A/R + Inv.) – (A/P +
Accruals)
Please note the difference between operating CA and CA
and between operating CL and CL.
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Cash Versus Short-Term Investments
• Cash is defined as the total value of the short-term
financial assets held to support ongoing operations
and is a part of NOWC
– Holdings that are easily converted into cash at prices close
to book value (i.e. chequing and savings accounts, treasury
bills, commercial paper, term deposits, etc.) used to
support current ongoing operations.
• Short-term investments are defined as the total
value of short-term financial assets held for future
purposes; thus it is not included in calculating
NOWC.
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Working Capital Management and
Policy
• Working capital management
– Establishing working capital policy and 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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Using and Financing Operating
Current Assets
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Using and Financing Operating CA
• Two issues to manage:
– Efficient use of operating current assets.
– Financing operating current assets.
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Issue 1 - Efficient Use of Operating
CA - Policies
• Relaxed
– Operating current assets are maximized while A/P and
accruals are minimized.
• Restricted
– Operating current assets are minimized while A/P and
accruals are maximized; NOWC is turned over more
frequently.
• Moderate
– This falls between the two extremes.
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Working Capital Management and
DuPont Equation relationship
• How working capital management affects
profitability?
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Policies Comparison
Policy Level of CA Total Assets ROA Risk
Turnover
Relaxed High Low Low Low
Restricted Low High High High
Moderate All are moderate.
• The optimal strategy is the one that management
believes will maximize the firm’s long-term free cash
flow and thus the stock’s intrinsic value.
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Issue 2 - Financing Operating Current
Assets
• Companies finance operating current assets with
bank loans, credit from suppliers, accruals, long term
debt and equity.
• Seasonality and cyclical fluctuations should be
accounted for.
– Permanent operating current asset (i.e. low point of
business cycle).
– Temporary operating current asset (i.e. cyclical upswing).
• Companies set an operating current assets financing
policy.
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Financing Policies – Moderate
• Moderate approach (Maturity matching, or “self-
liquidating” approach): Match the maturity of the
assets with the maturity of the financing (i.e. set the
maturity of a loan with inventory sales).
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Financing Policies – Aggressive
• Aggressive approach: Use short-term financing to
finance permanent assets (i.e. short tem loans to
finance permanent WC or purchase PP&E).
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Financing Policies – Conservative
• Conservative approach: Use long-term or permanent
capital for permanent assets and temporary assets.
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Choosing Among the Approaches
• In general, short-term debt has a lower cost than
long-term debt (i.e. interest rate upward sloping
yield curve).
• But short-term debt is riskier for the borrowing firm
for two reasons:
– Short-term debt cost fluctuates widely (i.e. short term
rates are more volatile than long term rates).
– Short-term debt may not be renewed (i.e. recession,
changes in financial conditions, etc.).
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Choosing Among the Approaches
(cont.)
• Short-term loans’ advantages over long-term loans
are as follows:
– Can be negotiated much faster (i.e. simple process, light
credit review, etc.).
– Offer greater flexibility (i.e. no prepayments fees /
penalty, no major covenants, etc.).
• Final decision on the approach depends on:
– The firm’s specific conditions (i.e. business model / cycle).
– Managers’ risk preferences (i.e. aggressive/conservative)
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The Cash Conversion Cycle (CCC)
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Cash Conversion Cycle (CCC)
A simple cycle of operations:
Collect account
receivables - cash
Sell finished goods / Purchase raw
inventory material / inventory
Pay suppliers
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Calculating Cash Conversion Cycle
Cash Inventory Receivables Payables
conversion = conversion + collection − deferral
cycle period period period
• Cash conversion cycle focuses on the time between
payments made for materials and labor and cash
received from sales:
– Inventory conversion period: average time to convert
materials into finished goods and sell those goods.
– Receivables collection period: average time to convert A/R
into cash.
– Payable deferral period: average time to pay for labor and
materials.
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Cash Conversion Cycle Model
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Inventory Conversion Period (ICP)
• ICP measures the average time required to process
materials into finished goods and then to sell them.
• It can be calculated as:
– ICP = Inventory/Average daily COGS (17-1)
• Alternatively,
– ICP = 365/Inventory turnover
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Receivables Collection Period
• This period measures the average length of time
required to collect cash following a sale.
• It is also called the days sales outstanding (DSO).
• It can be calculated as:
Receivables Receivables
collection = DSO = (17-2)
period Sales / 365
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Payables Deferral Period (PDP)
• PDP measures the average length of time between
the purchase of materials and labour and the
payment of cash for them.
• It can be calculated as:
– PDP = Payables/Purchases per day
• Alternatively,
Payables (17-3)
PDP =
Cost of goods sold / 365
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Overall - Cash Conversion Cycle
• The cycle starts with cash paid out for productive
resources until cash is received from the sale of
products.
• It represents the average length of time a dollar is
tied up.
• It measures management effectiveness.
• The shorter it is, the better. Why?
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Shortening Cash Conversion Cycle
• Equation defined CCC = ICP (inventory) + DSO
(A/R) – PDP (A/P)
– Processing and selling goods more quickly (i.e. keep
average inventory slim).
– Speeding up A/R collections (i.e. shorter terms / selling
conditions, avoid delay collection, etc.).
– Slowing down A/P payments (i.e. extend payment terms /
conditions, buy all supplies by credit, etc.).
– Any combination of the above.
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Benefits from Shortening CCC
• A shortened CCC leads to reduction in net operating
working capital (NOWC).
• A reduction in NOWC not only saves interest expense
but also frees up money to be used elsewhere (i.e.
reduce debt, purchase PP&E, etc.).
• An improvement in working capital management
creates a large one-time increase in FCF at the time of
the improvement as well as higher FCF in future years
(i.e. efficiencies in managing the cycle).
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Example – Economic Benefit
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