November 26, 2014

Chapter 15. Working Capital Management

Chapter 15 -- Working Capital Management

. Working capital, net working capital, and net operating working capital
. Current asset investment and financing policies
. Cash conversion cycle
. Cash and marketable securities
. Inventories
. A/R and A/P (trade credit)
. Bank loans

. Working capital, net working capital, and net operating working capital

 Working capital refers to current assets

Net working capital = currents assets - current liabilities

Net operating working capital = current assets - (current liabilities - notes payable)

. Current assets investment and financing policies

Current assets investment policy: how much current assets a firm should have

 Relaxed current asset policy: carry a relatively large amount of current assets

 along with a liberal credit policy with a high level of A/R

 Restricted current asset policy: carry constrained amount of current assets along
with restricted credit policy

Moderate current asset policy: in between the relaxed and restricted policies

 Current asset financing policy: the way current assets are financed

Permanent assets vs. temporary assets

 Permanent assets: to be held for more than one year

 Temporary assets: to be held for less than one year

 Maturity matching approach: a policy that matches asset and liability maturities
and it is a moderate policy

 Aggressive approach: uses more short-term, non-spontaneous debt financing

 Conservative approach: uses more long-term debt and equity financing

Permanent assets should be financed by intermediate and long-term debt,
preferred stock, and common stock.

Temporary assets should be financed by notes and short-term loans.

. Cash conversion cycle

 (1) The cash conversion cycle (CCC)

 The average length of time funds are tied up in working capital or the length of
time between paying for working capital and collecting cash from the sale of the
working capital

(2) Inventory conversion period (days of sales in inventory, DSI)

The average time required to convert materials into finished goods and then sell

(3) Average collection period (ACP)

The average length of time required to convert the firm’s receivables into cash

(4) Payables deferral period (days of payable outstanding, DPO)

The average length of time between the purchase of materials and labor and
the payment of cash for them

The relationship is: DPO + CCC = DSI + ACP, or CCC = DSI + ACP - DPO

Minimizing working capital: speeding cash collection (reducing ACP), increasing
inventory turnovers (reducing DSI), and slowing down cash disbursement
(increasing DPO)

. Cash and marketable securities

 Refer to currency and demand deposits in addition to very safe and highly liquid
marketable securities that can be sold quickly at a predictable price and thus be
converted to bank deposits

. Inventories

 Include supplies, raw materials, work-in-process, and finished goods

. A/R and A/P (trade credit)

 A/R: funds due from customers

 Credit policy: a set of rules that includes credit period, discounts, credit standards,
and collection policy

 Credit terms: for example, 2/10, net 30 means that the firm allows a 2% price
discount if payment is received within 10 days of the purchase; if the discount is
not taken, the full payment is due in 30 days

 Credit score: a numerical score from 1 to 10 that indicates the likelihood that a
person or business will pay on time

 A/P (trade credit): debt arising from credit sales and recorded as an account
receivable by the seller and as an account payable by the buyer

 Trade credit may be free or it may be costly. For example, the terms 2/10, net 30 are offered when a firm makes the purchase on its credit card. Assuming 365 days per year,

 discount % 365

Nominal annual cost of trade credit = --------------------*-------------------------------

 100-discount % credit days-discount days

 2 365

 = ------------- * ------------- = 37.24%

 100 - 2 30 - 10

. Bank loans

 Promissory note: a document specifying the terms and conditions of a loan

 Line of credit: an agreement in which a bank agrees to lend up to a specified

 maximum amount of funds during a designated period

 Cost of bank loans:

 interest 1

 Annual Percentage Rate (APR) = -------------*-------

 principal time

Accrued wages and taxes

Commercial papers: unsecured, short-term promissory notes issued by large firms

MBA Core Management Knowledge - One Year Revision Schedule


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