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
them
(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
.
. 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
them
(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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