Chapter 14

Working
Capital Policy

Essentials of Managerial Finance by S. Besley & E. Brigham

Slide 1 of 20

Working Capital Policy: Overview

Financial management decisions are divided into the
management of assets (investments) and management
of liabilities (liabilities).
The short-term financial management (working capital
management) involves the management of a firms
current assets and current liabilities
The maximization of the firms value in the long run
depends on its survival in the short-run, i.e. meeting its
working capital needs.

Essentials of Managerial Finance by S. Besley & E. Brigham

Slide 2 of 20

Working Capital Policy: Definitions

Working capital, sometimes called gross working capital,
generally refers to current assets, while net working capital is
defined as current assets minus current liabilitiesthe amount
of current assets financed by long-term liabilities.
The current ratio, calculated as current assets divided by
current liabilities, is intended to measure a firms liquidity.
A high current ratio does not insure that a firm will have the cash
required to meet its needs.

The best and most comprehensive picture of a firms liquidity

position is obtained by examining its cash budget, which
forecasts a firms cash inflows and outflows. It focuses on what
really counts, the firms ability to generate sufficient cash
inflows to meet its required cash outflows.
Essentials of Managerial Finance by S. Besley & E. Brigham

Slide 3 of 20

Working Capital Policy: Definitions

Distinction should be made between current liabilities,
specifically used to finance current assets and current liabilities
that represent (a) current maturities of long-term debt; (b)
financing associated with a construction program, after its
completion will be funded with proceeds of a long-term security
issue; or (c) the use of short-term debt to finance fixed assets.
Even though we define long-term debt coming due in the next
accounting period as a current liability, it is not a working capital decision
variable in the current period.
Similarly, when construction is temporarily financed with a short-term
loan and later replaced with mortgage bonds, the construction loan
would not be considered part of working capital management.
Although such accounts are not part of the working capital decision
process, they cannot be ignored because they are due in the current
period, and they must be considered when the cash budget is
constructed and the firms ability to meet its current obligations is
assessed.
Essentials of Managerial Finance by S. Besley & E. Brigham

Slide 4 of 20

Relationship between the current asset

levels and financing requirements and
the business cycle
At the peak of a business cycle, business carry their
maximum amounts of current assets
Financing needs decline during recessions and
increase during booms

Essentials of Managerial Finance by S. Besley & E. Brigham

Slide 5 of 20

The firms accounts balance

Once a firms operations have stabilized and cash
collections from credit sales and cash payments for
credit purchases have begun, the balance in
accounts receivable and accounts payable can be
computed using the following equation:
A decision affecting one working capital account will
have an impact on other working capital accounts.

Essentials of Managerial Finance by S. Besley & E. Brigham

Slide 6 of 20

The cash conversion cycle

The cash conversion cycle focuses on the length
of time between when the company makes
payments, or invests in the manufacture of
inventory, and when it receives cash inflows, or
realizes a cash return from its investment in
production.

Essentials of Managerial Finance by S. Besley & E. Brigham

Slide 7 of 20

The cash conversion cycle - Definitions

Inventory conversion period is the average
length of time required to convert materials into
finished goods and then to sell these goods;
it is the amount of time the product remains in
inventory in various stages of completion.

Essentials of Managerial Finance by S. Besley & E. Brigham

Slide 8 of 20

The cash conversion cycle Inventory

conversion period
Inventory conversion period is the average length of time
required to convert materials into finished goods and
then to sell these goods;
it is the amount of time the product remains in inventory
in various stages of completion.

Inventory
Inventory

.
conversion period Cost of goods sold

360

Essentials of Managerial Finance by S. Besley & E. Brigham

Slide 9 of 20

The cash conversion cycle

Receivables collection period
Receivables collection period is the average length of
time required to convert the firms receivables into cash,
that is, to collect cash following a sale. It is also called
the days sales outstanding (DSO).

Receivables
Receivables
DSO
.
collection period
Credit sales

360

Essentials of Managerial Finance by S. Besley & E. Brigham

Slide 10 of 20

The cash conversion cycle Payables

deferral period
Payables deferral period is the average length of time
between the purchase of raw materials and labor and the
payment of cash for them.

Accounts payable
Payables
DPO
.
deferral period
Cost of goods sold

360

Essentials of Managerial Finance by S. Besley & E. Brigham

Slide 11 of 20

Analysis of the cash conversion cycle

The cash conversion cycle, which nets out the three
periods just defined, equals the length of time between
the firms actual cash expenditures to pay for (invest in)
productive resources (materials and labor) and its own
cash receipts from the sale of its products. Thus, the
cash conversion cycle equals the average length of time
a dollar is tied up in current assets.
Using these definitions, the cash conversion cycle is
defined as follows:

Inventory
Cash
Receivables Payables
conversion conversion collection deferral .
cycle
period
period
period
Essentials of Managerial Finance by S. Besley & E. Brigham

Slide 12 of 20

Analysis of the cash conversion cycle

If receivables (debtors) are collecred faster, then

cash is released from the cycle

If receivables (debtors) are collected slower

receivables soak up cash

If better credit (in terms of duration or amount) from

suppliers is obtained
cash resources are increased

If inventory (stocks) is shifted faster

Cash is freed up

If inventory (stocks) move slower

more cash is being consumed

Essentials of Managerial Finance by S. Besley & E. Brigham

Slide 13 of 20

The cash conversion cycle - Example

Suppose it takes a firm an average of 79.0 days
to convert raw materials and labor to widgets
and to sell them, and it takes another 43.2 days
to collect on receivables, while 8.8 days normally
lapse between the receipt of materials (and work
done) and payments for materials and labor. In
this case, the cash conversion cycle is 79.0 days
+ 43.2 days 8.8 days = 113.4 days.

Essentials of Managerial Finance by S. Besley & E. Brigham

Slide 14 of 20

The cash conversion cycle and the goal

of the corporation
The firms goal should be to shorten its cash conversion
cycle as much as possible without increasing costs or
depressing sales. This would maximize profits because
the longer the cash conversion cycle, the greater the
need for external, or nonspontaneous, financing and
such financing has a cost.
The cash conversion cycle can be shortened
by reducing the inventory conversion period by processing and
selling goods more quickly,
by reducing the receivables collection period by speeding up
collections
by lengthening the payables deferral period by slowing down its
own payments.
Essentials of Managerial Finance by S. Besley & E. Brigham

Slide 15 of 20

Cash conversion cycle: things to note

When taking actions to reduce the inventory conversion

period, a firm should be careful to avoid inventory
shortages that could cause good customers to buy from
competitors.
When taking actions to speed up the collection of
receivables, a firm should be careful to maintain good
relations with its good credit customers.
When taking actions to lengthen the payables deferral
period, a firm should be careful not to harm its own
credit reputation.
Actions that affect the inventory conversion period, the
receivables collection period, and the payables deferral
period all affect the cash conversion cycle; hence, they
influence the firms need for current assets and current
asset financing.

Essentials of Managerial Finance by S. Besley & E. Brigham

Slide 16 of 20

Cash conversion cycle: Example 1

A firm purchases raw materials on June 1st. It

converts the raw materials into inventory by the
last day of the month, June 30th. However, it
pays for the materials on June 20th. On July
10th, it sells the finished goods for inventory.
Then the firm collects cash from the sale one
month later on August 10th. If this sequence
accurately represents the firms average working
capital cycle, what is the firms cash conversion
cycle?

Essentials of Managerial Finance by S. Besley & E. Brigham

Slide 17 of 20

Cash conversion cycle: Solution 1

Payables deferral period = 20 days (June 1 to June 20).

Inventory conversion period = 40 days (June 1 to July 10).
Receivables collection period = 31 days (July 10 to August
10).
Cash conversion cycle = 40 + 31 20 = 51 days.
Essentials of Managerial Finance by S. Besley & E. Brigham

Slide 18 of 20

Cash conversion cycle: Example 2

The Cairn Corporation is trying to determine the

effect of its inventory turnover ratio and days
sales outstanding (DSO) on its cash flow cycle.
Cairns sales (which were all on credit) were
$750,000, and it earned a net profit margin of 12
percent, or $90,000. It turned over its inventory 9
times during the year, its DSO (receivables
collection period) was 45 days, and the firms
cost of goods sold (COGS) was two-thirds of
sales. The firm had fixed assets totaling
$60,000. Cairns payables deferral period is 30
days. What is Cairns cash conversion cycle?
Essentials of Managerial Finance by S. Besley & E. Brigham

Slide 19 of 20

Cash conversion cycle: Solution 2

DSO = 45 days; Payables deferral period = 30 days.

Because inventory is turned over 9 times during the year, the
inventory conversion period must be 40 days = (360 days)/9.
Alternatively, calculate the average inventory balance:
Cost of goods sold (COGS) = $750,000(2/3) = $500,000.
Inventory = ($500,000)/9 = $55,556. So, the inventory
conversion period is:

Inventory
Inventory
$55,556
conversion

40 days.
COGS
$500,000
period
360
360

Inventory
Payables
Cash conversion
Receivable
s

cycle
conversion period collection period deferral period
40 days 45 days - 30 days 55 days.
Essentials of Managerial Finance by S. Besley & E. Brigham

Slide 20 of 20