Case on Pepsi: Managing the Cash

Conversion Cycle

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Wor ki ng- Ca pi tal
Mana gement
 Working Capital Concepts

Net Working Capital

= Current Assets – Current Liabilities

Gross Working Capital:

The firm’s investment in current assets
Significance of Working Capital Management

• In a typical manufacturing firm, current assets

exceed one-half of total assets.
• Current liabilities are the principal source of
external financing for small firms.
• Requires continuous, day-to-day managerial
supervision.
• Working capital management affects the
company’s risk, return, and share price.
 TYPES OF WORKING CAPITAL

• Permanent working capital

• Temporary /Variable working
capital
Permanent Working Capital
The amount of current assets required to meet a
firm’s long-term minimum needs.
AMOUNT

Permanent current assets

TIME
 Temporary Working Capital

The amount of current assets that varies with

seasonal requirements.

Temporary current assets

AMOUNT

Permanent current assets

TIME
 Determining Financial
Mix
How current assets will be financed?

• Matching approach or Hedging approach

• Conservative approach
• Aggressive approach
 Balance Sheet
• Current Liabilities Current Assets
• Long-Term Debt
Preferred Stock Fixed Assets
Common Stock

• To illustrate, let’s finance all current

assets with current liabilities, and finance
all fixed assets with long-term financing.
 Balance Sheet
Current Liabilities Current Assets
Long-Term Debt
Preferred Stock Fixed
Assets
Common Stock
Suppose we use long-term
financing to finance some of our current
assets.
This strategy would be less risky, but more
expensive!
 Balance Sheet
Current Liabilities Current Assets

Long-Term Debt
Preferred Stock Fixed Assets
Common Stock
Suppose we use current liabilities to finance
some of our fixed assets.
This strategy would be less expensive, but more
risky!
 Financing Current Assets: Short-Term
and Long-Term Mix

Spontaneous Financing: Trade credit, and other

payables and accruals, that arise spontaneously in
the firm’s day-to-day operations.
 The Hedging Principle

• Permanent Assets
– Fixed assets and permanent current assets are
financed with long-term debt and equity and
spontaneous sources of financing
• Temporary Assets
--Seasonal needs are financed with short-term
loans
 Financing Needs and
the conservative Approach

• Permanent current assets and seasonal

portion of current assets are financed with
long-term debt and equity which is less
risky, but more expensive!

• Short term funds are used in emergency

situation
 Financing Needs and
the Aggressive Approach

• Permanent current assets and seasonal

portion of current assets are financed with
short term sources of financing but less
expensive, but more risky!
 Trade off between Profitability and Risk

Example: The three possible current assets

holdings of the firm are Rs.5,00,000/-, Rs.
4,00,000/- and Rs. 3,00,000/-. It is assumed that
fixed asset level is constant. The firm has the
following data:

Sales Rs.15,00,000/-
EBIT Rs. 1,50,000/-
Fixed Assets Rs. 5,00,000/-
Effect of Alternative working capital policies
 Impact on Liquidity

Liquidity Analysis
Policy Liquidity Policy A

ASSET LEVEL ($)

A High Policy B
B Average
Policy C
C Low
Greater current asset
Current Assets
levels generate more
liquidity; all other factors
held constant.
0
50,000 OUTPUT
(units)
 Impact on
Profitability

Profitability Analysis
Policy Profitability Policy A

ASSET LEVEL ($)

A Low Policy B
B Average Policy C
C High
As current asset levels
decline, total assets will Current Assets
decline and the ROI will
rise.
0
50,000 OUTPUT
(units)
 Impact on Risk

Risk Analysis
Policy Risk Policy A

ASSET LEVEL ($)

A Low Policy B
B Average Policy C
C High

Risk increases as the Current Assets

level of current assets are
reduced.
0
50,000 OUTPUT
(units)
 Summary of Current Assets

SUMMARY OF CURRENT ASSET ANALYSIS

Policy Liquidity Profitability Risk
A High Low Low
B Average Average Average
C Low High High

1. Profitability varies inversely with liquidity.

2. Profitability moves together with risk.
(risk and return go hand in hand!)
 The Operating Cycle and the Cash
Cycle
The Operating Cycle (OC) is the time between
ordering materials and collecting cash from receivables.

A firm’s operating cyc le (OC) is the time

from the beginning of the production process to
collection of cash from the sale of the finished product.
The operating cycle is the sum of the inventory period
and the accounts receivable period,
whereas the cash cycle is equal to the operating
cycle less the accounts payable period.
In vento ry convers io n period, which is
the average time required to convert materials into
finished goods and then to sell those goods. If average
inventories are 2,00,000 and sales are 10,00,000, then
the inventory conversion period is 73 days:
Inventory conversion period = __Inventory__
Sales per day
= __2,00,000___ = 73 days
10,00,000/365
Receivabl es col lect ion per iod, which is the
average length of time required to convert the firm’s receivables
into cash, that is, to collect cash following a sale. The receivables
collection period is also called the days sales outstanding (DSO). If
receivables are Rs.65754 and sales are Rs.10,00,000. The
receivable collection period is
Receivables collection period = ___Accounts receivable___
Average credit sales per day
or
Receivables collection period = DSO = Receivables
Sales/365
= _65754__ = 24 days
10,00,000/365
Payabl es peri od, which is the average length of time
between the purchase of materials and the payment of cash for
them. If the firm on average has 30 days to pay for materials, if its
cost of goods sold are 8,00,000 per year, and if its accounts payable
average 65754 then its payables deferral period can be calculated
as follows:
Payabl es peri od = ____Payables____
Purchases per day
= ______Payables_____ = __65754__ = 30 days
purchases/365 8,00,000/365
 The Operating Cycle

Cash cycle = Operating cycle – Account s

payabl e peri od
 Cash Conversion Cycle
Cash conversion cycle, the cash conversion
cycle can be expressed by this equation:

Days in Cash Conversion Cycle = 73 days + 24 days – 30 days =

67 days
THANK YOU