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

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1 Topic 4 Working Capital Management 1. Concept of Working Capital 2. Measuring Working Capital and Net Working Capital 3. Optimization i i of Working Capital 4. Applications 80

2 Learning objectives This part helps you to: Define working capital and net working capital List the determinants t of a firm s net working capital and highlight the risk-return trade-off involved in net working capital management List the advantages and disadvantages of using current liabilities to finance a firm s working capital requirements 81 Calculate the cash conversion cycle

3 Concept of working capital Working capital The firm s total investment in current assets or assets that it expects to be converted into cash within a year or less Net working capital NWC = Inventories + Accounts receivable Accounts payable NWC reflects the outcomes of the short-term financing decisions Warning: in practice, working capital means net working capital Inventories Accounts receivable NWC Accounts payable 82

4 Why does the management of working capital matter? Working capital management is a yardstick to measure a firm s operational and financial efficiency Short-term financing problems can arise from the management of current assets and the uses of current liabilities Example: if NWC decreases, the firm s profitability tends to rise, but the firm must better manage its liquidities in order to not waste money Risk-return trade-off 83

5 The risk-return trade-off Consider two cases: Case 1: the firm increases its NWC by adding to its current assets relatively to its current liabilities Case 2: the firm decreases its NWC by increasing its current liabilities relatively to its assets Case 1: investing in additional inventories Firm s Firm s profitability Liquidity LOWER HIGHER 84 Case 2: increasing the use of short- vs. long-term sources of financing i Reasons: HIGHER LOWER Case 1: no stoppage of production, no shortage of inventory, but reduction of profitability due to higher cost of permanent sources Case 2: higher profitability due to lower cost of short-term finance

6 Financing working capital with current liabilities Advantages: More flexible than do the permanent sources of capital (long-term debt and equity) Matched with the seasonal needs of funds Lower cost than that associated with long-term debt Disadvantages: Greater risk of illiquidity idit due to the nature and the uncertainty of the short-term interest rate Nature: current liabilities must be repaid within a year or less, illiquidity appears if needed funds are not available Uncertain interest rate: this changes from year to year 85

7 Working capital determination Working Capital = Inventories + Accounts receivable Accounts payable Each component of working capital has two dimensions: Time: the length of time over which each component is available or unavailable Money: the amount of money or cash flowing into, around and out of the business Example: 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. 86

8 Assessment of working capital efficiency Turnover of working capital s components Inventory turnover = Cost of goods sold Average inventory Accounts receivable turnover = Average Net sales accounts receivable Accounts payable turnover = Inventory purchases Average accounts payable 87 Meanings These ratios examine whether inventory, accounts receivables and payables are excessive when compared to their benchmarks or not! Remarks: raw materials, work-in-progress, and finished inventory turnovers for manufacturing firms

9 Assessment of working capital efficiency Time dimension of working capital s components Days inventory held = 365 days Inventory turnover Days accounts receivable outstanding = Accounts 365 days receivable turnover Days accounts payable outstanding = 365 days Accounts payable turnover 88 Meanings Days inventory: you turn over your stock every x days Days accounts receivable: it takes you on average x days to collect monies due to you Days accounts payable: on average, you pay your suppliers every x days

10 Assessment of working capital efficiency Working capital expressed in terms of days outstanding Cash conversion cycle = days inventory held + days accounts receivable - days accounts payable What to do for improving i the management of working capital? Collect receivables faster from customers Turn over the inventories more quickly Get better credit (in terms of duration and amount) from suppliers 89

11 Applications i Liquidity and working capital policy The balance sheet of two firms A and B are as follows: Firm A Cash $ 100,000 Accounts payable $ 200,000 Accounts receivable 100, Notes payable 200, 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 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. 90 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.

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