1. Chapter 5 Working Capital Management
EBD 301
Managing Money in an Entrepreneurial Venture
Dr. David P Echevarria
All Rights Reserved

2. Working Capital Management
In a large sense, WCM looks at how we deploy the cash we invest in the business.
From the owner/manager’s point of view, working capital is a proxy measure of a business's short-term financial strength.
Bankers consider the level of net working capital an important indicator of liquidity. The more liquid the business, the better they’re able to service short-term debt.
Dr. David P Echevarria
All Rights Reserved

3. Working Capital Management
Working Capital is also the first source of funds for financing growth, pay down debt and improve their competitive position.
Working capital management is important because investment in working capital items cannot be avoided.
Current assets comprise approximately half of most businesses' total assets and are the most volatile.
Dr. David P Echevarria
All Rights Reserved

4. Working Capital Management
Working Capital Definitions
Working Capital
Current assets of the firm.
Net Working Capital (NWC)
Current Assets minus Current Liabilities.
the unencumbered s-t assets of the business.
Working Capital Management
Efficient Allocation of capital resources to short-term asset investment as well as the use of current liabilities, debt, and owner’s capital to finance a portion of current asset investment.
Dr. David P Echevarria
All Rights Reserved

5. Working Capital Management
Significance of WCM
Current asset investment cannot be avoided
fixed assets can be leased.
current assets must be acquired.
Poor WCM frequently cited as major cause of business failure.
Insufficient liquidity
excessive inventory investment
Dr. David P Echevarria
All Rights Reserved

6. Working Capital Management
Business Strategy Objectives
To hold just enough cash to pay the bills,
just enough inventory to meet sales demands,
and just enough accounts receivable to support its credit policy.
Any increase above the optimal amounts would increase asset investment without a proportional increase in return.
To hold less than the optimal amounts would result in unpaid bills and lost sales opportunities.
Dr. David P Echevarria
All Rights Reserved

7. Working Capital Management
Composition of Current Assets
Permanent Portion: financed by permanent capital (LT debt and Equity)
Temporary Portion: financed by increases in current liabilities.
Three WCM Strategies
Conservative: current ratios > 2x
Moderate: current ratios ~ 2x
Aggressive: current ratios < 2x
Dr. David P Echevarria
All Rights Reserved

8. Working Capital Management
WCM as Risk Management
Operations risk is defined as the possibility that operations may occasionally "jump the tracks." Cash may be draining out of the business at a rate faster than expected. Dealing with Murphy’s Law
Examples:
Credit customers may be delaying payments.
Inventory may be accumulating due to a slow-down in sales activity.
Shipments from suppliers could be delayed.
Loan rates may be climbing due to inflationary pressures or increases in demand or monetary policy.
Dr. David P Echevarria
All Rights Reserved

9. Working Capital Management
WCM as Risk Management (cont.)
Financial Risk
Over-dependence on borrowing
Volatility of short-term rates
Effects of changes in Government Fiscal and Monetary policy
Dr. David P Echevarria
All Rights Reserved

10. Working Capital Management
Measuring Financial Strength
Ability to pay bills (liquidity)
Ability to fund short-term growth opportunities.
Ability to weather economic downturns.
Measuring Allocation Efficiency
WC Investment incurs opportunity cost
Inefficient WC investment degrades profitability
Dr. David P Echevarria
All Rights Reserved

11. Institutional Response
Merrill-Lynch - WCMA accounts for small and medium size businesses.
Automatic end-of-day sweep services.
Short-term Credit Facilities.
Investment Banking Services.
International Clearings.
Other financial services.
Dr. David P Echevarria
All Rights Reserved

12. Working Capital Accounts
Current Assets
Cash & Equivalents
demand deposits (checking account)
petty cash (cash register)
short-term liquid investments (MMAs)
Hold just enough cash to meet operational needs; payroll, wages, maturing obligations
Use excess cash to pay down debt – especially high interest rate debt (extra principal)
Dr. David P Echevarria
All Rights Reserved

13. Working Capital Accounts
Current Assets
Accounts Receivable
credit extended to customers
Credit/background checks to minimize bad debt
sales-marketing tool
Credit extends buying power
reported net of allowance for doubtful accounts
Some debt will not be collected
Timely collection is important
The longer the receivable, the less our profits
Dr. David P Echevarria
All Rights Reserved

14. Working Capital Accounts
Inventory
Raw material
Work-in-process
Finished goods
Investment a function of
Policy
Cycle time (turnover rate)
Carrying costs
Cost of capital
Dr. David P Echevarria
All Rights Reserved

15. Working Capital Accounts
Financing Working Capital
Accounts payable; magnitudes driven by
Inventory levels
Desired liquidity level
Institutional arrangements
Accrued Expenses and Taxes
accrued wages and salaries
payroll and sales taxes.
Notes Payable (s-t borrowing)
Permanent capital (debt, equity)
Dr. David P Echevarria
All Rights Reserved

16. Working Capital Cycle
The cycle time or turnover rate for current assets and current liabilities.
Cash turnover: the rate at which cash flows into and out of the business.
Inventory turnover: how quickly we acquire, store, and the sell merchandise or convert raw materials to finished goods.
Cycle times are directly related to profitability.
DuPont Analysis: ROA = NPM * TATO
Think of TATO as rate of transaction activity and NPM as the profit per transaction.
Dr. David P Echevarria
All Rights Reserved

17. Cash Conversion Cycle
The cash conversion cycle (CCC) measures the number of days between making payments for operating expenses and when the cash resulting from the sale (on credit) of the goods or services is received.
Three Distinct Parts
Inventory Conversion period
Receivables collection period
Payables deferral period
Dr. David P Echevarria
All Rights Reserved

18. Cash Conversion Cycle Inventory Conversion Period
ICP = [INV/COGS] * 365
The time from the acquisition of raw materials to the sale of the end product
Receivable Collection Period
RCP = [AR/Cr Sales]*365
The average length of time it takes to turn receivables into cash.
Dr. David P Echevarria
All Rights Reserved

19. Cash Conversion Cycle Payment Deferral Period CCC = ICP + RCP - PDP
PDP = {Payables+Accruals} / Cash Opng. Exp.] * 365
Represents the length of time between the incurring operating expenses and payment is made.
Cash Operating Expenses = Direct (Labor and Materials) and Indirect (Overhead) costs
CCC = ICP + RCP - PDP
Dr. David P Echevarria
All Rights Reserved

20. Spontaneous versus Planned S-T Financing
Accounts Receivable - Spontaneous
Inventory - Planned
Accounts Payable & Accruals - Spontaneous
Notes Payable - Planned.
Dr. David P Echevarria
All Rights Reserved

21. Chapter Summary
We defined working capital and the importance of working capital management.
We defined some of the strategies for WCM and how we use it to manage risk.
We identified all the relevant working capital accounts: cash, A/R, Inventory, Accounts Payable and Accrued Expenses
Dr. David P Echevarria
All Rights Reserved

22. Chapter Summary
We examined the Working capital Cycle, with special attention to the Cash Conversion Cycle.
We examined the impact of overhead expenses.
Dr. David P Echevarria
All Rights Reserved

23. Homework Questions
How does a financial manager define working capital?
What does Net Working Capital represent? (e.g. composition)
What are capital management objectives with respect to Cash, Accounts Receivable, and Inventory?
What do we mean by Liquidity when referring to working capital?
What is the Cash Conversion Cycle and why is it important business owner?
Describe the relationships of the three legs of the CCC.
Dr. David P Echevarria
All Rights Reserved