WORKING CAPITAL MANAGEMENT

• Working capital management


  Involves finding the optimal levels for cash, marketable securities, accounts receivable, and inventory, and then financing that working capital at the least cost
• Effective working capital management can generate considerable amounts of cash
• Current assets


  Often called working capital because these assets "turn over"
• Net working capital


  When a firm buys inventory on credit, its suppliers in effect lend it the money used to finance the inventory
• Accounts payable are typically "free" because they do not bear interest
• Current asset investment policies


  • Relaxed
  • Restricted
  • Moderate
• Relaxed current asset investment policy


  Large amounts of cash, marketable securities, and inventories are carried; and a liberal credit policy results in a high level of receivables
• Restricted current asset investment policy


  Holdings of cash, marketable securities, inventories, and receivables are constrained
• Moderate current asset investment policy


  Between the relaxed and restricted policies
• How working capital management affects ROE using DuPont equation

  ROE = Profit margin x Assets turnover x Leverage Factor or Equity Multiplier
• Cash conversion cycle


  The length of time where funds are tied up in working capital
• Inventory conversion period


  The average time required to convert raw materials into finished goods and then to sell them
• Average collection period


  The average length of time required to convert the firm's receivables into cash, that is, to collect cash following a sale
• Payables deferral period


  The average length of time between the purchase of materials and labor and the payment of cash for them
• Cash conversion cycle

  Inventory conversion period + Average collection period - Payables deferral period
• Inventory / Cost of goods sold per day


  Or 365 / Inventory turnover
• Receivables / Sales per day


  Or 365 / Receivables turnover
• Trade payables / Cost of goods sold per day


  Or 365 / Payables turnover
• Techniques used to optimize demand deposit holdings

  • Hold marketable securities rather than demand deposits to provide liquidity
  • Borrow on short notice
  • Forecast payments and receipts better
  • Speed up payments
  • Use credit cards, debit cards, wire transfers and direct deposits
  • Synchronize cash flows
• Lockbox


  A post office box operated by a bank to which payments are sent ; used to speed up effective receipt of cash
• Credit policy consists of 4 variables

  • Credit period
  • Discounts
  • Credit standards
  • Collection policy
• Credit period


  The length of time customers have to pay for purchases
• Discounts


  Price reductions given for early payment
• Credit standards


  The financial strength customers must exhibit to qualify for credit
• Collection policy


  The degree of toughness in enforcing the credit terms
• Monitoring of accounts receivable

  1. Accounts receivable = Sales per day x Length of collection period

  2. Days sales outstanding (DSO) = Receivables / Average sales per day
• Trade credit


  Credit furnished by a firm's suppliers, often the largest source of short-term credit, especially for small firms
• Free trade credit


  Credit received during the discount period, without a cost
• Costly trade credit


  Credit taken in excess of free trade credit, whose cost is equal to the discount lost
• Nominal annual cost of trade credit


  Discount % / (100% - Discount %) x (365 days / Days credit outstanding - Discount Period)