Working Captain and Current Asset MGT

Chapter 14
Working Capital
and Current
Asset
Management
Copyright 2009 Pearson Prentice Hall. All rights reserved.

Learning Goals
1. Understand short-term financial management,

net working capital, and the related trade-off
between profitability and risk.
2. Describe the cash conversion cycle, its funding
requirements, and the key strategies for
managing it.
Copyright 2009 Pearson Prentice Hall. All rights reserved. 14-2

Learning Goals (cont.)
3. Explain the credit selection process and the

quantitative procedure for evaluating changes in credit
standards.
Review the procedures for quantitatively considering
cash discount changes, other aspects of credit terms,
and credit monitoring.
Understand the management of receipts and
disbursements, including float, speeding up
collections, slowing down payments, cash
concentration, zero balance accounts, and investing in
marketable securities.
Long & Short Term Assets & Liabilities
Current Assets: Current Liabilities:

Cash Accounts Payable
Marketable Securities Accruals
Prepayments Short-Term Debt
Accounts Receivable Taxes Payable
Inventory
Fixed Assets: Long-Term Financing:

Investments Debt
Plant & Machinery Equity
Land and Buildings

Net Working Capital
Working Capital includes a firms current assets,

which consist of cash and marketable securities in
addition to accounts receivable and inventories.
It also consists of current liabilities, including accounts
payable (trade credit), notes payable (bank loans), and
accrued liabilities.
Net Working Capital is defined as total current assets
less total current liabilities.

The Tradeoff Between
Profitability & Risk
Positive Net Working Capital (low return and low risk)

Current Current
low
Assets Liabilities cost
low
return
Net Working
Capital > 0
high
Long-Term cost
Debt
high
return
highest
Fixed cost
Assets Equity
Profitability & Risk (cont.)
Negative Net Working Capital (high return and high risk)

Current Current
low Assets Liabilities
return low
Net Working
cost
Capital < 0
high Long-Term high

return Debt cost
Fixed highest
Assets Equity cost
Profitability & Risk (cont.)
Table 14.1 Effects of Changing Ratios

on Profits and Risk

The Cash Conversion Cycle
Short-term financial managementmanaging current

assets and current liabilitiesis on of the financial
managers most important and time-consuming activities.
The goal of short-term financial management is to
manage each of the firms current assets and liabilities to
achieve a balance between profitability and risk that
contributes positively to overall firm value.
Central to short-term financial management is an
understanding of the firms cash conversion cycle.

Calculating the Cash Conversion Cycle
The Operating Cycle (OC) is the time between

ordering materials and collecting cash from
receivables.
The Cash Conversion Cycle (CCC) is the time

between when a firm pays its suppliers (payables)
for inventory and collecting cash from the sale of the
finished product.

Calculating the Cash
Conversion Cycle (cont.)
Both the OC and CCC may be computed as

shown below.

MAX Company, a producer of paper dinnerware, has

annual sales of $10 million, cost of goods sold of 75% of
sales, and purchases that are 65% of cost of goods sold.
MAX has an average age of inventory (AAI) of 60 days,
an average collection period (ACP) of 40 days, and an
average payment period (APP) of 35 days.
Using the values for these variables, the cash conversion

cycle for MAX is 65 days (60 + 40 - 35) and is shown on
a time line in Figure 14.1.
Figure 14.1 Time Line for MAX Companys Cash

Conversion Cycle

The resources MAX has invested in the cash

conversion cycle assuming a 365-day year are:
Obviously, reducing AAI or ACP or lengthening APP will

reduce the cash conversion cycle, thus reducing the amount
of resources the firm must commit to support operations.
Funding Requirements of the CCC
Permanent vs. Seasonal Funding Needs

If a firms sales are constant, then its investment in operating
assets should also be constant, and the firm will have only a
permanent funding requirement.
If sales are cyclical, then investment in operating assets will
vary over time, leading to the need for seasonal funding
requirements in addition to the permanent funding
requirements for its minimum investment in operating assets.

Funding Requirements
of the CCC (cont.)

Nicholson Company holds, on average, $50,000 in cash and
marketable securities, $1,250,000 in inventory, and $750,000
in accounts receivable. Nicholsons business is very stable
over time, so its operating assets can be viewed as
permanent. In addition, Nicholsons accounts payable of
$425,000 are stable over time. Nicholson has a permanent
investment in operating assets of $1,625,000 ($50,000 +
$1,250,000 + $750,000 - $425,000). This amount would also
equal the companys permanent funding requirement.
of the CCC (cont.)

In contrast, Semper Pump Company, which produces bicycle pumps, has
seasonal funding needs. Semper has seasonal sales, with its peak sales
driven by purchases of bicycle pumps. Semper holds, at minimum,
$25,000 in cash and marketable securities, $100,000 in inventory, and
$60,000 in accounts receivable. At peak times, Sempers inventory
increases to $750,000 and its accounts receivable increase to $400,000.
To capture production efficiencies, Semper produces pumps at a
constant rate throughout the year. Thus, accounts payable remain at

of the CCC (cont.)

$50,000 throughout the year. Accordingly, Semper has a permanent
funding requirement for its minimum level of operating assets of
$135,000 ($25,000 + $100,000 + $60,000 - $50,000) and peak
seasonal funding requirements of $900,000 [($125,000 + $750,000 +
$400,000 - $50,000) - $135,000]. Sempers total funding
requirements for operating assets vary from a minimum of $135,000
(permanent) to a a seasonal peak of $1,125,000 ($135,000 +
$900,000) as shown in Figure 14.2.

of the CCC (cont.)
Figure 14.2
Semper Pump
Companys
Total Funding
Requirements

of the CCC (cont.)
Aggressive vs. Conservative Funding Strategies

Semper Pump has a permanent funding requirement of $135,000 and
seasonal requirements that vary between $0 and $990,000 and
average $101,250. If Semper can borrow short-term funds at 6.25%
and long term funds at 8%, and can earn 5% on any invested surplus,
then the annual cost of the aggressive strategy would be:

of the CCC (cont.)
Alternatively, Semper can choose a conservative strategy under which

surplus cash balances are fully invested. In Figure 13.2, this surplus would
be the difference between the peak need of $1,125,000 and the total need,
which varies between $135,000 and $1,125,000 during the year.

of the CCC (cont.)

Clearly, the aggressive strategys heavy reliance on short-term
financing makes it riskier than the conservative strategy because of
interest rate swings and possible difficulties in obtaining needed
funds quickly when the seasonal peaks occur.
The conservative strategy avoids these risks through the locked-in

interest rate and long-term financing, but is more costly. Thus the
final decision is left to management.

Strategies for Managing the CCC
1. Turn over inventory as quickly as possible without

stock outs that result in lost sales.
2. Collect accounts receivable as quickly as possible
without losing sales from high-pressure collection
techniques.
3. Manage, mail, processing, and clearing time to reduce
them when collecting from customers and to increase
them when paying suppliers.
4. Pay accounts payable as slowly as possible without
damaging the firms credit rating.
Accounts Receivable Management
The second component of the cash conversion cycle is

the average collection period the average length of
time from a sale on credit until the payment becomes
usable funds to the firm.
The collection period consists of two parts:
the time period from the sale until the customer mails
payment, and
the time from when the payment is mailed until the firm
collects funds in its bank account.

Accounts Receivable Management:
The Five Cs of Credit
Character: The applicants record of meeting past

obligations.
Capacity: The applicants ability to repay the requested
credit.
Capital: The applicants debt relative to equity.
Collateral: The amount of assets the applicant has
available for use in securing the credit.
Conditions: Current general and industry-specific
economic conditions.

Credit Scoring
Credit scoring is a procedure resulting in a

score that measures an applicants overall credit
strength, derived as a weighted-average of
scores of various credit characteristics.
The procedure results in a score that measures
the applicants overall credit strength, and the
score is used to make the accept/reject decision
for granting the applicant credit.

Credit Scoring (cont.)
The purpose of credit scoring is to make a

relatively informed credit decision quickly and
inexpensively.
For a demonstration of credit scoring, including
the use of a spreadsheet for that purpose, see the
books Web site at www.aw.com/gitman.

Changing Credit Standards
The firm sometimes will contemplate changing its

credit standards to improve its returns and generate
greater value for its owners.

Changing Credit Standards

Changing Credit Standards Example
Dodd Tool, a manufacturer of lathe tools, is currently selling a product

for $10/unit. Sales (all on credit) for last year were 60,000 units. The
variable cost per unit is $6. The firms total fixed costs are $120,000.
Dodd is currently contemplating a relaxation of credit standards that is

anticipated to increase sales 5% to 63,000 units. It is also anticipated
that the ACP will increase from 30 to 45 days, and that bad debt
expenses will increase from 1% of sales to 2% of sales. The
opportunity cost of tying funds up in receivables is 15%.
Given this information, should Dodd relax its credit standards?

Changing Credit
Standards Example (cont.)
Additional Profit Contribution from Sales
Dodd Tool Company

Analysis of Rexaxing Credit Standards
Additional Profit Contribution from Sales
Old Sales Level 60,000 Price/Unit $ 10.00
New Sales Level 63,000 Variable Cost/Unit $ 6.00
Increase in Sales 3,000 Contribution Margin/Unit $ 4.00
Additional Profit Contribution from Sales (sales incr x cont margin) $ 12,000

Changing Credit
Cost of marginal investment in A/R:

Changing Credit

Changing Credit
Cost of marginal bad debts:

Changing Credit
Table 14.2
Effects on Dodd
Tool of a
Relaxation of
Credit Standards

Changing Credit Terms
A firms credit terms specify the repayment terms

required of all of its credit customers.
Credit terms are composed of three parts:
The cash discount
The cash discount period
The credit period
For example, with credit terms of 2/10 net 30, the

discount is 2%, the discount period is 10 days, and the
credit period is 30 days.

Changing Credit Terms Example
MAX Company has an average collection period of 40

days (turnover = 365/40 = 9.1). In accordance with the
firms credit terms of net 30, this period is divided into 32
days until the customers place their payments in the mail
(not everyone pays within 30 days) and 8 days to receive,
process, and collect payments once they are mailed.
MAX is considering initiating a cash discount by changing

its credit terms from net 30 to 2/10 net 30. The firm
expects this change to reduce the amount of time until the
payments are placed in the mail, resulting in an average
collection period of 25 days (turnover = 365/25 = 14.6).
Changing Credit
Terms Example (cont.)
Table 14.3
Analysis of
Initiating a Cash
Discount for MAX
Company

Credit Monitoring
Credit monitoring is the ongoing review of a firms

accounts receivable to determine whether customers are
paying according to the stated credit terms.
Slow payments are costly to a firm because they
lengthen the average collection period and increase the
firms investment in accounts receivable.
Two frequently used techniques for credit monitoring
are the average collection period and aging of accounts
receivable.

Credit Monitoring:
Average Collection Period
The average collection period is the average number of

days that credit sales are outstanding and has two parts:
The time from sale until the customer places the payment in
the mail, and
The time to receive, process, and collect payment.

Credit Monitoring:
Aging of Accounts Receivable

Credit Monitoring:
Collection Policy
The firms collection policy is its procedures for

collecting a firms accounts receivable when they are
due.
The effectiveness of this policy can be partly evaluated
by evaluating at the level of bad expenses.
As seen in the previous examples, this level depends
not only on collection policy but also on the firms
credit policy.

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Chapter 14

Copyright 2009 Pearson Prentice Hall. All rights reserved.

1. Understand short-term financial management,

Copyright 2009 Pearson Prentice Hall. All rights reserved. 14-2

3. Explain the credit selection process and the

Current Assets: Current Liabilities:

Fixed Assets: Long-Term Financing:

Copyright 2009 Pearson Prentice Hall. All rights reserved. 14-4

Working Capital includes a firms current assets,

Copyright 2009 Pearson Prentice Hall. All rights reserved. 14-5

Positive Net Working Capital (low return and low risk)

Negative Net Working Capital (high return and high risk)

high Long-Term high

Table 14.1 Effects of Changing Ratios

Copyright 2009 Pearson Prentice Hall. All rights reserved. 14-8

Short-term financial managementmanaging current

Copyright 2009 Pearson Prentice Hall. All rights reserved. 14-9

The Operating Cycle (OC) is the time between

The Cash Conversion Cycle (CCC) is the time

Copyright 2009 Pearson Prentice Hall. All rights reserved. 14-10

Both the OC and CCC may be computed as

Copyright 2009 Pearson Prentice Hall. All rights reserved. 14-11

MAX Company, a producer of paper dinnerware, has

Using the values for these variables, the cash conversion

Figure 14.1 Time Line for MAX Companys Cash

Copyright 2009 Pearson Prentice Hall. All rights reserved. 14-13

The resources MAX has invested in the cash

Obviously, reducing AAI or ACP or lengthening APP will

Permanent vs. Seasonal Funding Needs

Copyright 2009 Pearson Prentice Hall. All rights reserved. 14-15

Permanent vs. Seasonal Funding Needs

Permanent vs. Seasonal Funding Needs

Copyright 2009 Pearson Prentice Hall. All rights reserved. 14-17

Permanent vs. Seasonal Funding Needs

Copyright 2009 Pearson Prentice Hall. All rights reserved. 14-18

Permanent vs. Seasonal Funding Needs

Copyright 2009 Pearson Prentice Hall. All rights reserved. 14-19

Aggressive vs. Conservative Funding Strategies

Copyright 2009 Pearson Prentice Hall. All rights reserved. 14-20

Aggressive vs. Conservative Funding Strategies

Alternatively, Semper can choose a conservative strategy under which

Copyright 2009 Pearson Prentice Hall. All rights reserved. 14-21

Aggressive vs. Conservative Funding Strategies

The conservative strategy avoids these risks through the locked-in

Copyright 2009 Pearson Prentice Hall. All rights reserved. 14-22

1. Turn over inventory as quickly as possible without

The second component of the cash conversion cycle is

Copyright 2009 Pearson Prentice Hall. All rights reserved. 14-24

Character: The applicants record of meeting past

Copyright 2009 Pearson Prentice Hall. All rights reserved. 14-25

Credit scoring is a procedure resulting in a

Copyright 2009 Pearson Prentice Hall. All rights reserved. 14-26

The purpose of credit scoring is to make a

Copyright 2009 Pearson Prentice Hall. All rights reserved. 14-27

The firm sometimes will contemplate changing its

Copyright 2009 Pearson Prentice Hall. All rights reserved. 14-28

Copyright 2009 Pearson Prentice Hall. All rights reserved. 14-29

Dodd Tool, a manufacturer of lathe tools, is currently selling a product

Dodd is currently contemplating a relaxation of credit standards that is

Given this information, should Dodd relax its credit standards?

Copyright 2009 Pearson Prentice Hall. All rights reserved. 14-30

Additional Profit Contribution from Sales

Dodd Tool Company