Working capital management
• Understand the components of the cash cycle and
why it is important.
• Understand the pros and cons of the various short-
term financing policies.
• Be able to prepare a cash budget.
• Understand the various options for short-term
financing.
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JSW steel Balance sheet
The value is created mainly
through investment
decisions
The value is destroyed if you
don’t make correct financing
decisions or working capital
decisions
Identify how much
liabilities that JSW has to
meet this year?
Will they be able to
meet them?
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Balance Sheet Model of the Firm
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© McGraw Hill, LLC 3
How management of CA and CL is related to firm
value?
1. Investments in current assets involve financing costs
2. But, they need to improve your business
3. So, there is a trade off between cost and benefits
FV=FCF/r
1. The management of working capital is closely
linked to liquidity risk.
2. Majority of the firms which went bankrupt did
not manage their working capital well!
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Carrying Costs and Shortage Costs
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26.1 Tracing Cash and Net Working Capital
Current assets are cash and other assets that are expected to
convert to cash within the year.
• Cash and cash equivalents.
• Marketable securities.
• Accounts receivable.
• Inventory.
Current liabilities are obligations that are expected to require cash
payment within one year.
• Accounts payable.
• Expenses payable (including accrued wages and taxes).
• Notes payable.
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Defining Cash in Terms of Other Elements of
the Balance Sheet - I
Net Working Capital + Fixed Assets = Long-Term Debt +
Equity
Net Working Capital = Cash + Other Current Assets −
Current Liabilities
Cash = Long-Term Debt + Equity − Current liabilities −
Current assets other than cash − Fixed assets
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Defining Cash in Terms of Other Elements of
the Balance Sheet - II
Cash = Long-Term Debt + Equity − Current liabilities −
Current assets other than cash − Fixed assets
An increase in long-term debt, equity, or current liabilities
leads to an increase in cash—as does a decrease in fixed
assets or a decrease in noncash current assets.
The sources and uses of cash follow from this reasoning.
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Figure 31.2 Operating and Cash Cycles
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26.2 The Operating Cycle and the Cash Cycle
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The Operating Cycle and the Cash Cycle
Cash cycle = Operating cycle − Accounts payable period
In practice, the inventory period, the accounts receivable
period, and the accounts payable period are measured by
days in inventory, days in receivables, and days in payables,
respectively.
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Cash Cycle Example – I
Inventory:
• Beginning = $200,000.
• Ending = $300,000.
Accounts Receivable:
• Beginning = $160,000.
• Ending = $200,000.
Accounts Payable:
• Beginning = $75,000.
• Ending = $100,000.
Net Sales = $1,150,000.
Cost of Goods sold = $820,000.
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Cash Cycle Example – II
Inventory period
Average inventory = ($200,000 + 300,000)/2 = $250,000
Inventory turnover = $820,000/$250,000 = 3.28 times
Inventory period = 365/3.28 = 111.3 days
Receivables period
Average receivables = ($160,000 + 200,000)/2 = $180,000
Receivables turnover = $1,150,000/$180,000 = 6.39 times
Receivables period = 365/6.39 = 57.1 days
Operating cycle = 111.3 days + 57.1 days = 168.4 days
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Cash Cycle Example – III
Payables Period
Average payables = ($75,000 + 100,000)/2 = $87,500
Payables turnover = $820,000/$87,500 = 9.37 times
Payables period = 365/9.37 = 38.9 days
Cash Cycle = 168.4 days − 38.9 days = 129.5 days
We have to finance our inventory for 129.5 days.
If we want to reduce our financing needs, we need to look
carefully at our receivables and inventory periods—they
both may be excessive.
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26.3 Some Aspects of Short-Term Financial
Policy
There are two elements of the policy that a firm adopts for short-
term finance.
The size of the firm’s investment in current assets, usually
measured relative to the firm’s level of total operating revenues.
• Flexible.
• Restrictive.
Financing of current assets, usually measured as the proportion of
short-term debt to long-term debt.
• Flexible.
• Restrictive.
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Size of Investment in Current Assets
A flexible short-term finance policy includes,
• Keeping large balances of cash and marketable securities.
• Making large investments in inventory.
• Granting liberal credit terms.
A restrictive short-term finance policy includes.
• Keeping low cash balances, no investment in marketable
securities.
• Making small investments in inventory.
• Allowing no credit sales and no accounts receivable.
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Alternative Financing Policies
A flexible short-term finance policy means a low proportion
of short-term debt relative to long-term financing.
A restrictive short-term finance policy means a high
proportion of short-term debt relative to long-term
financing.
In an ideal world, short-term assets are always financed
with short-term debt, and long-term assets are always
financed with long-term debt.
• In this world, net working capital is zero.
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Cash Budgeting Example – I
Pet Treats Inc. specializes in gourmet pet treats and receives all income from sales
Sales estimates (in millions)
• Q1 = 500; Q2 = 600; Q3 = 650; Q4 = 800; Q1 next year = 550.
Accounts receivable
• Beginning receivables = $250.
• Average collection period = 30 days.
Accounts payable
• Purchases = 50 percent of next quarter’s sales.
• Beginning payables = 125.
• Accounts payable period is 45 days.
Other expenses
• Wages, taxes, and other expense are 30 percent of sales.
• Interest and dividend payments are $50.
• A major capital expenditure of $200 is expected in the second quarter.
The initial cash balance is $80 and the company maintains a minimum balance of $50
© McGraw Hill, LLC 18
Cash Budgeting Example – II
2
ACP=30 days; this implies that of sales are collected in
3
1
the quarter made, and the remaining are collected the
3
following quarter.
Beginning receivables of $250 will be collected in the
first quarter.
Q1 Q2 Q3 Q4
Beginning Receivables $250 $167 $200 $217
Sales 500 600 650 800
Cash Collections 583 567 633 750
Ending Receivables $167 $200 $217 $267
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Cash Budgeting Example – III
Payables period is 45 days, so half of the purchases will be
paid for each quarter, and the remaining will be paid the
following quarter.
Beginning payables = $125
Q1 Q2 Q3 Q4
Payment of accounts $275 $313 $363 $338
Wages, taxes, and other expenses 150 180 195 240
Capital expenditures 200
Interest and dividend payments 50 50 50 50
Total cash disbursements $475 $743 $608 $628
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Cash Budgeting Example – IV
Q1 Q2 Q3 Q4
Total cash receipts $583 $567 $633 $750
Total cash disbursements 475 743 608 628
Net cash inflow $108 –$176 $26 $123
Beginning cash balance $80 $188 $12 $38
Net cash inflow 108 –176 26 123
Ending cash balance $188 $12 $38 $161
Minimum cash balance –50 –50 –50 –50
Cumulative surplus (deficit) $138 –$38 –$12 $111
© McGraw Hill, LLC 21
26.5 The Short-Term Financial Plan
The most common way to finance a temporary cash deficit is to
arrange a short-term loan.
Unsecured Loans
• Line of credit (at the bank).
Secured Loans
• Accounts receivable can be either assigned or factored.
• Inventory loans use inventory as collateral.
Other Sources
• Banker’s acceptance.
• Commercial paper.
© McGraw Hill, LLC 22
Quick Quiz
How do you compute the operating cycle and the
cash cycle?
What are the differences between a flexible short-
term financing policy and a restrictive one? What are
the pros and cons of each?
What are the key components of a cash budget?
What are the major forms of short-term borrowing?
© McGraw Hill, LLC 23
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