Topic 4

Working Capital Management 1. 2. 3 3. 4.

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Concept off Working k Capitall Measuring Working Capital and Net Working Capital O Optimization i i i off Working ki Capital C i l Applications

L Learning i objectives bj i y This part helps you ou to: y Define working g capital p and net working g

capital y List Li t the th determinants d t i t off a firm’s fi ’ nett working ki

capital and highlight the risk-return trade-off involved in net working g capital p management g y List the advantages and disadvantages of using

currentt liabilities li biliti to t fi finance a firm’s fi ’ working ki capital requirements 81

y Calculate the cash conversion cycle

C Concept off working ki capital i l y Working capital y The firm’s total investment in current assets or assets that it

expects to be converted into cash within a year or less

y Net working capital y NWC = Inventories + Accounts receivable – Accounts payable y NWC reflects the outcomes of the short-term financing

decisions y Warning: in practice, working capital means net working capital Inventories Accounts receivable NWC 82

A Accounts t payable bl

M Managing i working ki capital i l y Why does the management of working capital

matter? y Working capital management is a yardstick to measure

a firm’s operational and financial efficiency y Short-term financing problems can arise from the

management of current assets and the uses of current liabilities y Example: if NWC decreases, the firm’s profitability tends

to rise,, but the firm must better manage g its liquidities q in order to not waste money Risk-return trade-off

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M Managing i working ki capital i l y The risk-return trade-off y Consider two cases: y Case 1: the firm increases its NWC by adding to its

current assets relatively to its current liabilities y Case 2: the firm decreases its NWC by increasing its current liabilities relatively to its assets Firm’s Fi ’ profitability

Firm’s Fi ’ Liquidity

Case 1: investing in additional inventories in entories

LOWER

HIGHER

Case 2: increasing the use of short- vs. long-term sources off fi financing i

HIGHER

LOWER

y Reasons: y y

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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

M Managing i working ki capital i l y Financing working capital with current liabilities y Advantages: y More flexible than do the permanent sources of

capital (long-term debt and equity) y Matched with the seasonal needs of funds y Lower cost than that associated with long-term long term debt y Disadvantages: y Greater G t risk i k off illiquidity illi idit due d to t the th nature t and d the th

uncertainty of the short-term interest rate y Nature: current liabilities must be repaid within a year

or less, less illiquidity appears if needed funds are not available y Uncertain interest rate: this changes from year to year 85

M Managing i working ki capital i l y Working capital determination

Working Capital = Inventories + Accounts receivable – Accounts payable y Each component of working capital has two

dimensions: y Time: the length of time over which each component is

available or unavailable y Money: the amount of money or cash flowing into, around and out of the business

y Example: y 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. days 86

M Managing i working ki capital i l y Assessment of working capital efficiency y Turnover of working capital’s components

Inventory turnover =

Cost of g goods sold Average inventory

Accounts receivable turnover = Accounts payable turnover =

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Net sales Average accounts receivable

Inventory purchases Average accounts payable

y Meanings y These ratios examine whether inventory, accounts receivables and payables are excessive when compared to their benchmarks or not! y Remarks: raw materials, work-in-progress, and finished inventory turnovers for manufacturing firms

M Managing i working ki capital i l y Assessment of working capital efficiency

y Time dimension of working capital’s components

Days inventory held =

365 days y Inventory turnover

Days accounts receivable outstandin g = Days accounts payable outstanding =

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365 days y Accounts receivable turnover

365 days Accounts payable turnover

y Meanings y Days inventory: you turn over your stock every ‘x’ days y Days accounts receivable: it takes you on average ‘x’ days to collect monies due to you y Days accounts payable: on average, average you pay your suppliers every ‘x’ days

M Managing i working ki capital i l y Assessment of working capital efficiency y Working capital expressed in terms of days

outstanding Cash conversion cycle = days inventory held + days accounts receivable - days accounts payable y What Wh to d do ffor improving i i the h management off

working capital? y Collect receivables faster from customers y Turn over the inventories more quickly y Get better credit (in terms of duration and amount) from

suppliers 89

A li i Applications y Liquidity q y and working g capital p p policy y y The balance sheet of two firms A and B are as follows: Firm A Cash A Accounts receivable i bl Inventories Net fixed assets Total Firm B Cash Accounts receivable Inventories Net fixed assets Total

$ 100,000 100 000 100,000 300,000 1,500,000 2,000,000

Accounts payable N Notes payable bl Bonds Common equity Total

$ 200,000 200 000 200,000 600,000 1,000,000 2,000,000

$ 150,000 50,000 , 300,000 1,500,000 2,000,000

Accounts payable Notes payable Bonds Common equity Total

$ 400,000 200,000 400,000 , 1,000,000 2,000,000

Question 1. 1 Calculate the working capital requirements for two firms A and B. 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.

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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.