2. 23 Working Capital Management: General Issues
23.1 Explain why the management of net working capital is critical for the survival of a firm.
23.2 Explain how managing receivables, inventory, and payables is related in an integrated approach to net working capital management.
23.3 Explain how the financing and current asset investment decisions interact to determine a company’s overall working capital position.
23.4 List and describe some common ways to analyze a firm’s management of its net working capital.

3. 23.1 THE IMPORTANCE OF WORKING CAPITAL MANAGEMENT
Working capital management is the way in which a firm manages both its current assets and current liabilities
Good working capital management is characterized by:
Maintaining optimal cash balances
Investing any excess liquid funds in marketable securities that provide the best possible return, considering any liquidity or default-risk constraints
Effectively managing accounts receivable
Efficiently managing inventory
Maintaining an appropriate level of short-term financing in the least expensive and most flexible manner
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4. 23.2 AN INTEGRATED APPROACH TO NET WORKING CAPITAL MANAGEMENT
Cash flow management is important because the exhaustion of liquid resources can leave a firm insolvent (i.e., unable to pay its obligations as they come due)
Firms can deplete liquid financial resources for bad reasons:
Continuing to produce inventory even when sales are falling
Selling products and services for less than their variable cost of production
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5. 23.2 AN INTEGRATED APPROACH TO NET WORKING CAPITAL MANAGEMENT
Firms can also deplete liquid financial resources for seemingly good reasons:
Rapid growth in production and sales can cause a firm to use up all of its cash pursuing growth, leaving it invested in illiquid assets like inventories, accounts receivable and net fixed assets
A firm may be highly profitable in an accounting sense, but on the verge of bankruptcy if it cannot collect its receivables to generate the cash necessary to fund sales growth
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6. 23.2 AN INTEGRATED APPROACH TO NET WORKING CAPITAL MANAGEMENT
The cash flow cycle is a crucial part of understanding how a business functions because it gives managers an awareness of the dynamics of working capital management
The cash flow cycle can be used to help managers determine the impact of changes in variables on the cash account:
Examples:
Increasing sales requires additional investment in inventory
Increasing accounts receivable reduces cash
Delaying the payment of payables preserves cash
Speeding up collections of receivables improves the cash position
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7. 23.2 AN INTEGRATED APPROACH TO NET WORKING CAPITAL MANAGEMENT
Activities that Increase Cash
Increasing long-term debt
Increasing equity
Increasing current liabilities
Decreasing current assets other than cash
Decreasing fixed assets
Activities that Decrease Cash
Decreasing long-term debt
Decreasing equity
Decreasing current liabilities
Increasing current assets other than cash
Increasing fixed assets
Paying cash dividends
Booth • Cleary – 3rd Edition
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8. 23.2 AN INTEGRATED APPROACH TO NET WORKING CAPITAL MANAGEMENT
The Cash Budget
The monthly cash budget is a management tool for forecasting the timing, magnitude and duration of both cash surpluses and deficits and their cumulative impact over time
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9. 23.2 AN INTEGRATED APPROACH TO NET WORKING CAPITAL MANAGEMENT
Management can change plans before they are implemented to produce a more favourable cash result
Management can choose the best investment option for forecast cash surpluses, and arrange financing solutions for forecast cash deficits
Investing Forecast Surpluses
Small surpluses (i.e., less than $100,000) available for short periods of time (i.e., 30 to 90 days) can be kept in a current account
Small surpluses available for longer periods of time can be paid out as a cash dividend or used to retire debt obligations
Large surpluses (i.e., greater than $100,000) available for short periods of time (i.e., 30 to 90 days) can be invested in marketable securities with minimal risk like Treasury bills
Large surpluses available for longer periods of time can be used to pay cash dividends, or to invest in longer-maturity, higher-yielding investments
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10. 23.2 AN INTEGRATED APPROACH TO NET WORKING CAPITAL MANAGEMENT
Financing Forecast Deficits
Small deficits (i.e., less than $100,000) lasting for short periods of time (i.e., 30 to 90 days) can be resolved by delaying purchases, speeding up collections or trying to better synchronize cash flows; an operating line of credit could also be negotiated with a financial institution.
Small deficits lasting for longer periods of time must be financed by more permanent solutions to under-funding
Large deficits (i.e., greater than $100,000) lasting for short periods of time (i.e., 30 to 90 days) can be resolved with operating lines of credit or other longer-term permanent capital solutions, particularly if large cash flow deficits are likely to reoccur
Large deficits lasting for longer periods of time must be financed with permanent increases in capital in the form of debt and/or equity
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11. 23.3 ANALYZING CASH INFLOWS AND OUTFLOWS
Equation 23-1 analyzes the impact of sales growth on the firm’s cash position:
where:
g = monthly sales growth
b = the cash production cost and (1 – b) = unit contribution margin
St – 1 = Sales in the previous time period
The sensitivity of cash to sales growth is strongly related to the firm’s inventory and accounts receivable policies
Booth • Cleary – 3rd Edition
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12. 23.3 ANALYZING CASH INFLOWS AND OUTFLOWS
Equation 23-2 shows that the change in cash each month depends on credit, inventory management and payables policies:
where:
α = the proportion of sales collected this month (credit policy)
1 – α = the proportion of sales collected next month (only two periods)
β = the proportion of this month’s production costs paid this month
1 - β = the proportion of production costs paid next month
γ = the proportion of the firm’s monthly sales tied up in inventory
Booth • Cleary – 3rd Edition
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13. 23.3 ANALYZING CASH INFLOWS AND OUTFLOWS
We can simplify Equation 23-2 into Equation 23-3 by including the sales growth rate and removing the different sales levels:
Equation 23-4 solves Equation 23-3 for the sales growth rate at which the firm can grow without either needing or generating cash:
A firm can grow faster if:
It has a higher gross margin (1 – b)
It lowers production costs b
It collects receivables more quickly α
It pays its bills more slowly β
It has less inventory γ
Booth • Cleary – 3rd Edition
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14. 23.3 ANALYZING CASH INFLOWS AND OUTFLOWS
The slope of the line is determined by the firm’s credit, inventory and payables policies
A shallower slope reduces the sensitivity of cash to changes in sales
A shallower slope can be achieved by: collecting AR more quickly, delaying AP payments, and increasing inventory turnover.
Booth • Cleary – 3rd Edition
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15. 23.4 WORKING CAPITAL MANAGEMENT
Ratios are commonly used to assess or summarize a firm’s working capital management, focusing on:
Liquidity management
Asset utilization
Current liability management
Liquidity Ratios
The current ratio and the quick ratio assess a firm’s liquidity
Excessive liquidity reduces ROI and ROE, and can also indicate credit policy is too lenient or excess inventories
Booth • Cleary – 3rd Edition
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16. 23.4 WORKING CAPITAL MANAGEMENT
Working Capital Ratios: Accounts Receivable
Changes in receivables turnover and average collection period can indicate deteriorating or improving collection efforts
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17. 23.4 WORKING CAPITAL MANAGEMENT
Working Capital Ratios: Inventory
Cost of goods sold is unlikely to be comparable across firms, so an alternative is to use revenues in the numerator
Higher receivables turnover and higher inventory turnover are generally indicative of more efficient management of current assets
Booth • Cleary – 3rd Edition
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18. 23.4 WORKING CAPITAL MANAGEMENT
Working Capital Ratios: Accounts Payable
Payables turnover shows how many times per year, on average, a firm pays its suppliers
ADRP shows how long, in days, a firm defers payments to its suppliers, on average
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19. 23.4 WORKING CAPITAL MANAGEMENT
Operating and Cash Conversion Cycles
The operating cycle (OC) is the time period between the acquisition of inventory and the collection of cash from receivables, and is defined by Equation 23-14:
The operating cycle is the sum of average days revenues in inventory (ADRI) and the average collection period (ACP)
The cash conversion cycle (CCC) is the time between cash disbursement and cash collection, or an estimate of the average time between when a firm pays cash for its inventory purchases and when it receives cash for its sales.
The cash conversion cycle is the average number of days of revenues that must be financed outside the use of trade credit, and is defined by Equation 23-15: or
Booth • Cleary – 3rd Edition
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Booth • Cleary – 3rd Edition
© John Wiley & Sons Canada, Ltd.