[SEMINAR]

2010

A
REPORT
ON

WORKING CAPITAL MANAGEMENT

[CASH IS KING]

SUBMITTED TO: SIR YASIN ZIA

SUBMITTED BY: MUBASHAR SHARIF
2008-ag-152
MBA®

DEPARTMENT OF BUSINESS
MANAGEMENT & SCIENCE
EXECUTIVE SUMMARY

Traditional analysis of working capital is defensive; it asks

"Can the company meet its short-term cash obligations?"

Working capital accounts tell about the operational efficiency of the

company.

The length of the cash conversion cycle (DSO+DIO-DPO) tells how much
working capital is tied up in ongoing operations. And trends in each of the
days-outstanding numbers may foretell improvements or declines in the
health of the business.

The three reasons why the firms hold cash are for the purpose of
speculation, for the purpose of precaution, and for the purpose of making
transactions.
WORKING CAPITAL MANAGEMENT
Involves the relationship between firm short-term assets and its short-term
liabilities. The goal of working capital management is to ensure that a firm is
able to continue its operations and that it has sufficient ability to satisfy both
maturing short-term debt and upcoming operational expenses. The
management of working capital involves managing inventories, accounts
receivable and payable, and cash.

Cash is the lifeline of a company. If this lifeline deteriorates, so does the

company's ability to fund operations, reinvest and meet capital requirements
and payments. Understanding a company's cash flow health is essential to
making investment decisions. A good way to judge a company's cash flow
prospects is to look at its working capital management (WCM).

 What Is Working Capital?

Working capital refers to the cash a business requires for day-to-day

operations, or, more specifically, for financing the conversion of raw
materials into finished goods, which the company sells for payment. Among
the most important items of working capital are levels of inventory, accounts
receivable, and accounts payable. Analysts look at these items for signs of a
company's efficiency and financial strength.

Working capital is the difference between current assets and current liabilities:

Net working capital (NWC) = current assets – current liabilities

Current assets are assets which are expected to be sold or otherwise used
within one fiscal year. Typically, current assets include:
• Cash
• Cash equivalents
• Accounts receivable
• Inventory
• Prepaid accounts which will be used within a year
• short-term investments

Current liabilities are considered as liabilities of the business that are to be

settled in cash within the fiscal year. Current liabilities include:
• Accounts payable for goods, Services or supplies
• Short-term loans
• Long-term loans with maturity within one year
• Dividends and interest payable or accrued liabilities such
as accrued taxes.
Working capital, on the one hand, can be seen as a metric for evaluating a
company’s operating liquidity. A positive working capital position indicates
that a company can meet its short-term obligations. On the other hand, a
company’s working capital position signals its operating efficiency.
Comparably high working capital levels may indicate that too much money is
tied up in the business.

The most important positions for effective working capital management are
inventory, accounts receivable, and accounts payable. Depending on the
industry and business, prepayments received from customers and
prepayments paid to suppliers may also play an important role in the
company’s cash flow. Excess cash and nonoperational items may be
excluded from the calculation for better comparison.
As a measure for effective working capital management, therefore, another
more operational metric definition applies:

(Operative) net working capital = Inventories + Receivables –

Payables – Advances received + Advances Made
Where:
• Inventory is raw materials plus work in progress (WIP) plus
finished goods
• Receivables are trade receivables
• Payables are non-interest-bearing trade payables
• Advances received are prepayments received from customers
• Advances made are prepayments paid to suppliers

A frequently used measure for the effectiveness of working capital

management is the so-called cash conversion cycle, or cash-to-cash
cycle (CCC). It reflects the time (in days) it takes a company to get back one
monetary unit spent in operations. The operative NWC positions are
translated into “days outstanding”—the number of days during which cash is
bound in inventory and receivables or financed by the suppliers in accounts
payable. It is defined as follows:
CCC = DIO + DSO – DPO
Where:

• Days inventories outstanding (DIO) = (average inventories ÷ cumulative

cost of sales) × 365
(Average number of days that inventory is held)

• Days sales outstanding (DSO) = (average receivables ÷ cumulative sales)

× 365
(Average number of days until a company is paid by its customers)
• Days payables outstanding (DPO) = (average payables ÷ cumulative
purchases) × 365
(Average number of days until a company pays its suppliers)

Optimizing the three components of operative NWC simultaneously not only

accelerates the CCC, but also goes hand in hand with further improvements.

 Why Firms Hold Cash

The three reasons are for the purpose of speculation, for the purpose of
precaution, and for the purpose of making transactions. All three of these
reasons stem from the need for companies to possess liquidity.

• Speculation

Holding cash as creating the ability for a firm to take advantage of special
opportunities that if acted upon quickly will favor the firm. An example of this
would be purchasing extra inventory at a discount that is greater than the
carrying costs of holding the inventory.

• Precaution

Holding cash as a precaution serves as an emergency fund for a firm. If

expected cash inflows are not received as expected, cash held on a
precautionary basis could be used to satisfy short-term obligations that the
cash inflow may have been bench marked for.

• Transaction

Firms are in existence to create products or provide services. The providing

of services and creating of products results in the need for cash inflows and
outflows. Firms hold cash in order to satisfy the cash inflow and cash outflow
needs that they have.

 Ways To Manage Cash

Firms can manage cash in virtually all areas of operations that involve the
use of cash. The goal is to receive cash as soon as possible while at the same
time waiting to pay out cash as long as possible.

• Float

Float is defined as the difference between the book balance and the bank
balance of an account.
 • Policy For Cash Being Held

Here a firm already is holding the cash so the goal is to maximize the
benefits from holding it and wait to pay out the cash being held until the last
possible moment.

• Sales

The goal for cash management here is to shorten the amount of time before
the cash is received. Firms that make sales on credit are able to decrease
the amount of time that their customers wait until they pay the firm by
offering discounts.

For example, credit sales are often made with terms such as 3/10 net 60.
The first part of the sales term "3/10" means that if the customer pays for
the sale within 10 days they will receive a 3% discount on the sale. The
remainder of the sales term, "net 60," means that the bill is due within 60
days. By offering an inducement, the 3% discount in this case, firms are able
to cause their customers to pay off their bills early. This results in the firm
receiving the cash earlier.

• Lock Box System

The customer payments are sent to post office box maintained by bank and
bank personnel retrieve the payments and deposit them into the firm’s bank
account. (Collection centers at different locations).

• Inventory

The goal here is to put off the payment of cash for as long as possible and to
manage the cash being held. By using a JIT inventory system, a firm is able
to avoid paying for the inventory until it is needed while also avoiding
carrying costs on the inventory. JIT is a system where raw materials are
purchased and received just in time, as they are needed in the production
lines of a firm.
How Do We Value Inventory?
The accounting method that a company decides to use to determine
the costs of inventory can directly impact the balance sheet, income
statement and statement of cash flow. There are three inventory-costing
methods that are widely used by both public and private companies:
FIFO
• FIFO gives us a better indication of the value of ending inventory
(on the balance sheet), but it also increases net income because
inventory that might be several years old is used to value the cost
 of goods sold. Increasing net income sounds good, but it also has
the potential to increase the amount of taxes that a company
must pay.
LIFO
• LIFO isn't a good indicator of ending inventory value because the
left over inventory might be extremely old and, perhaps, obsolete.
This results in a valuation that is much lower than today's prices.
LIFO results in lower net income because cost of goods sold is
higher.

Average Cost
• Average cost produces results that fall somewhere between FIFO
and LIFO.

Conclusion

Cash is the lifeline of a company. If this lifeline deteriorates, so does the

company's ability to fund operations, reinvest and meet capital requirements
and payments. Understanding a company's cash flow health is essential to
making investment decisions. A good way to judge a company's cash flow
prospects is to look at its working capital management (WCM).

The most important positions for effective working capital management are
inventory, accounts receivable, and accounts payable. Depending on the
industry and business, prepayments received from customers and
prepayments paid to suppliers may also play an important role in the
company’s cash flow.