c17: working capital management + cash conversion cycle

• The supply chain consists of the network of organizations that convert materials & labour into products to be purchased by consumers.
• Financial managers evaluate the effectiveness of the firm’s operating departments relative to other firms in its industry. They decide how much cash should be kept on hand and how much short-term financing should be used to finance working capital.
• (Gross) working capital = Total current assets
• Cash is a part of NOWC and is defined as the total value of the short-term financial assets held to support ongoing operations. Short-term investments is the total value of short-term financial assets held for future purposes, so it's not included in NOWC.
• Working capital management consists of Establishing working capital policy and then the day-to-day control of cash, inventories, receivables, accruals, and accounts payable
• Working capital policy determines The level of each current asset and How current assets are financed
• issues with issuing and financing current assets:

  1. Efficient use of operating current assets
  2. Financing operating current assets
• a Relaxed working capital policy maximizes Current assets, while A/P and accruals are minimized
• a Restricted working capital policy minimizes current assets, while A/P and accruals are maximized. NOWC is turned over more frequently
• asset management ratios measure how effectively the firm is managing its assets. it tells us if the firm has the right amount of each type of assets in view of sales levels
• Profitability Ratios Show the combined effects of liquidity, asset management, and debt on operating results
• Profitability is the net result of a number of policies (including accounting) and decisions
• 3 approaches for financing operating current assets:

  1. maturing matching / "liquidating" approach
  2. aggressive approach
  3. conservative approach
• Maturity matchingis when we Match the maturity of the assets with the maturity of the financing
• the Aggressive approach Uses short-term financing to finance permanent assets
• the Conservative approach Uses long-term or permanent capital for permanent and temporary assets
• generally, short-term debt has a lower cost than long-term debt
• short-term debt is riskier for the borrowing firm for 2 reasons:

  1. Short-term debt cost fluctuates widely
  2. Short-term debt may not be renewed
• advantages of a Short-term loans over a long-term one are:

  • able to negotiate much faster
  • Offer greater flexibility
• inventory conversion period (iCP) measures the average time required to process materials into finished goods and then to sell them. calculated asInventory/Average daily COGS
• the receivables collection period is the period that measures the average length of time required to collect cash following a sale. also referred to days sales outstanding (dso).
• payables deferral period (PDP) measures the average length of time between the purchase of materials and labour and the payment of cash for them
• the cash conversion cycle (ccc) focuses on the time between payments made for materials and labour and cash received from sales. it represents the average time a dollar is tied up. the ccc measures management effectiveness, the shorter the better
• The cash conversion cycle starts with cash paid out for productive resources until cash is received from the sale of products
• ways to shorten the cash conversion cycle:

  1. Processing and selling goods more quickly
  2. Speeding up A/R collections
  3. Slowing down A/P payments
  4. combination of the above
• A shortened CCC reduces net operating working capital (NOWC). A reduction in NOWC saves interest expense and also frees up money to be used elsewhere
• An improvement in working capital management creates a large one-time increase in FCF at the time of the improvement as well as higher FCF in future years