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时间：2022-04-05
Week 05
Working Capital Management
FINS2615 Intermediate Business Finance
Dr. Ian Kwan
i.kwan@unsw.edu.au
See Berk (2018) Chapter 19: Working Capital Management
1How the Story of Corporate Finance will be explained:
Cash
Flows
Discount
rate
(Risk & Return)
Financial Mathematics
Cash Flow Forecasting
Working capital
management
Capital Asset Pricing Model
Cost of capital
Capital structure
Week 01
Week 02
Weeks 03 and 04
Week 05
Week 07
Week 08
Week 09
Types
of CF
Debt
Equity
= �
=1
1 + − 0
Important: As you take this course, clarify how to connect the different parts of the story!
Week 10:
Payout policy
2• Learning Objectives
• Overview of Working Capital
• Trade Credit
• Receivables Management
• Payable Management
• Inventory Management
• Cash Management
Contents of lecture
3Learning objectives
Following Berk Ch19, after this lecture, students should be able to
• Explain the Cash Conversion Cycle and why managing working capital is important
• Use trade credit to the firm’s advantage
• Make decisions on extending credit and adjusting credit terms
• Manage accounts payable
• Determine the costs and benefits of holding additional inventory
• Contrast the different instruments available to a financial manager for investing cash balances
Overview of Working Capital
5Review: What is Net Working Capital?
Net Working Capital includes all the materials and services you need to run the daily operations of the firm.
From Finance perspective, these include:
• Current Assets: Cash (excluding excess cash not needed in daily operations)
Inventory, Accounts Receivable (A/Rec)
• Current Liabilities: Accounts Payable (A/Pay)
• NWC = Current Assets – Current Liabilities
• Increases in NWC Cash Outflow
• Decreases in NWC Cash Inflow
Industry Inventory A/Rec A/Pay
Retail supermarkets High Low High
Pharmaceuticals High High High
Airlines Low Low-Med High
Consumer white goods High High High
NWC composition depends on industry characteristics
Affect firm valuation
6Operating Cycle vs. Cash Conversion Cycle
=
=
=
Components of Working Capital can be measured in DAYS:
The number of days it takes to use up the inventory and turn it into sales
• The more days, the longer it takes to sell existing inventory
• Is the firm operating efficiently as it should be? Can inventory be reduced?
The number of days it takes for customers to pay you cash for credit sales
• The more days, the longer it takes to receive customers’ cash payments
• Is the firm offering trade credit terms that are too generous? Should it change?
The number of days for your firm to pay suppliers in cash
• The more days, the longer it takes you to pay suppliers
• Is the firm paying too early or too late? Both can be bad! How do we know?
= 365
= 365
7Operating Cycle vs. Cash Conversion Cycle
Cash Conversion Cycle = Inventory Days + Accounts receivable days – Accounts Payable Days
= Average days from the time cash goes out to the time cash comes in
Operating Cycle = Inventory Days + Accounts receivable days
= Average days from purchasing inventory to receiving cash for goods/services
With the Working Capital components measured in days, we define:
From a finance perspective, investors need to fund the Cash Conversion Cycle!
The longer the cycle, the more capital is tied up, the greater the funding cost.
A Poll Question:
Which is better from a finance
perspective:
A short CCC or long one?
Poll
8Berk Example 19.1 Calculating Cash Conversion Cycle
Woolworths partial Income Statement
& Balance Sheet:
Using the following information, calculate the CCC for Woolworths
Sales 58,276
Cost of Good Sold 42,677
Total Accounts Receivable 519
Total Inventory 4,559
Total Accounts Payable 6,266
=
= 4559
116.9 = 39.0 days
A/Rec days =
= 519
159.7 = 3.2 days
A/Pay days =
= 6266
116.9 = 53.6 days
=
365
= 42677
365
= 116.9 $/days
=
365
= 58276
365
= 159.7 $/day
Cash Conversion Cycle = Inventory Days + Accounts receivable days – Accounts Payable Days
Woolworths’ CCC = 39 + 3.2 – 53.6 = -11.4 days
Woolworths has a NEGATIVE CCC!
• It’s customers on average pay in cash 11 days BEFORE it pays its suppliers in cash!
• This accounts for its market dominance in offering low price guarantees
9Working capital needs depend on industry characteristics
A/Rec
A/Pay
Invent.
Airlines
Qantas
Customers pay up-front
before starting trip
Firm pays suppliers many
days after trip is finished
Very little. Only sufficient
inventory for a trip (fuel, tray
meals, drinks, movies!)
Remark Main expense is depreciation of aircraft and labour costs
White goods
Harvey Norman
To commit customers, firm
offers interest-free purchases
or financing
Firm will get suppliers to help
finance customers’ purchases,
stretching out payments
Hold inventory in showrooms
for customers to give variety
and choice
Large holding costs
Pharmaceuticals
CSL
Customers (pharmacies, labs,
hospitals) pay on credit after
receiving goods
Firm pays suppliers later than
it receives payment from
customers, stretching paymt
Batch manufacturing means
holding large inventories that
are sold seasonally
Special handling and storage.
Main cost is R&D expense.
In the Team Assignment, analyse your Stock’s industry characteristics or norms to understand
the effect on Working Capital Requirements. Compare with major competitors.
For example, we compare and contrast the Working Capital Needs of three industries:
10
Firm value and managing working capital
We know that Changes in NWC affect cash flows because:
• FCF = EBIT(1 – T) + Depr – Chg NWC – Capex
• Decrease in NWC increase in FCF increase in firm value
• BUT BY HOW MUCH VALUE?
Berk Example 19.2
Expected FCF Improvement
Net Profit (earnings) 20 000
+ Depreciation +5 000
- Capital Expenditure -5 000
- Incr in working capital -1 000 Reduce by 20%
= FCF = 19 000
A firm next year expects the following FCF but wants to investigate the
impact of improvements it can make to its need for more working capital.
If the cost of capital is 12% and the working capital is projected to
grow at 4% annually, what impact would a one-time 20%
permanent reduction in its annual working capital requirement
have to the stock’s valuation?
New FCF
20 000
+5 000
-5 000
-800
= 19 200
0 = −
0 = 190000.12 − 0.04 = 237 500 000
0 = 192000.12 − 0.04 = 240 000 000
Current stock price:
New price if WC reduced
by one-time 20%:
Conclusion: A one-time $200K permanent reduction in Working Capital
does not affect earnings, but results in a $2.5 million increase in stock price!
In $ thousands
11
Team Assignment: Questions for Reflection
A firm that manages well its Work Capital requirements generates enormous value for customers!
Especially permanent decreases in Working Capital requirements.
Is working capital management a strategic advantage for firms in the same industry as your target company?
If so, how well does your Team’s company manage its Work Capital requirements compared with competitors?
As an investor in the company, can you suggest changes that it could make to increase its competitiveness in
Working Capital Management?
We have seen that:
Questions for Reflection in your Team Assignment Target Company:
12
Learning objectives
Following Berk Ch19, after this lecture, students should be able to
• Explain the Cash Conversion Cycle and why managing working capital is important
• Use trade credit to the firm’s advantage
• Make decisions on extending credit and adjusting credit terms
• Manage accounts payable
• Determine the costs and benefits of holding additional inventory
• Contrast the different instruments available to a financial manager for investing cash balances
Trade Credit
14
Berk 19.2 Trade Credit
When a firm allows a customer to purchase on credit is said to “extend their customer trade credit”.
• The firm and customer respectively generate entries in accounts receivable and accounts payable.
• Note: a customer purchase on credit does NOT mean purchasing with their credit card or BNPL account! Why?
When a firm buys on credit from suppliers, each respectively generates accounts payable and receivable entries.
• The net difference between a firm’s a/rec and a/pay is the “capital required by trade credit”.
To find optimal credit policies, financial
managers analyze trade credit according to:
1. Trade credit terms
2. Trade credit market frictions
3. Float management
Let’s look at this first
Examples of Trade Credit Terms:
• Supplier offers customer “Net 30”
• Or maybe “2/10, Net 30”
Means “Pay the full amount within
30 calendar days”
Say “Two - ten, Net 30”
Means “Get a 2% discount on the full amount if
paid within 10 days, otherwise pay in full within 30
calendar days”
10 days is
“discount period”
30 days is
“credit period”
Day
10
Day
30
$100
purchase
Discount period
Pay $98 for $100 purchase
Net credit period
Must pay $100 by Day 30
1. Trade credit terms
15
Berk 19.2 Trade Credit
Day
10
Day
30
$100
purchase
Discount period Net credit period
2. Trade Credit Market Frictions
For example, “2/10, Net 30”
If customer decides to take the 2% discount offer,
what benefit interest rate is the customer getting?
• Trade credit is essentially a loan from the supplier to customer.
• If like a loan, what is the trade credit interest rate?
Pay nothing now and repay $100 loan at end (day 30)
Get $2 discount and pay $98 now (day 10)
By taking the $2 discount, the customer is
tying up $98 in funds that could be used
elsewhere. This is an opportunity cost.
• $2 / $98 is the interest rate over 20 days
Think: “A cost of $2 ties up $98 for 20 days”
• i.e., 2.040816% over 20 days
• What rate is this over 365 days?
• i.e., what is the Effective Annual Rate?
• 365/20 = 18.25 20-day periods in one year
• = 1 + − 1= 1 + 2.040816% 36520 − 1= 44.59%
• By taking the discount, the customer is
getting a benefit interest rate of 44.6%!
This would be hard to get anywhere!
• What are the benefits of trade credit?
1. Trade credit is simple and convenient to access.
- Often standard terms, little paperwork involved
- Few things to negotiate
- Flexible arrangement
2. Lower cost of fund compared with alternative sources
- For customer, lower than getting a bank loan
- Collateral on trade credit are the goods provided
- Often the only source of funding for the customer
• What market frictions does Trade Credit overcome?
1. Provides cheaper prices to selected customers
- Trade credit helps a firm discriminate between
customers, providing favourable ones better terms
2. Provides a check on customer credit quality
- Trade credit is built on trust and information sharing
between a firm and its customer. This relationship is
perhaps of better quality in gauging credit worthiness.
16
Berk 19.2 Trade Credit
3. Trade Credit Float Management
• A significant friction in trade credit is the management of collection float.
• Collection float is the amount of time it takes for a firm to be able to use
the funds after a customer has paid for its goods or services. The longer
the collection float, the greater is the need to invest in working capital.
• Collection float is determined by three factors: mail float, processing
float, and availability float
Because of financial technologies, direct customer bank transfers
to supplier bank have significantly speeded up these processes
and even eliminated them.
17
Learning objectives
Following Berk Ch19, after this lecture, students should be able to
• Explain the Cash Conversion Cycle and why managing working capital is important
• Use trade credit to the firm’s advantage
• Make decisions on extending credit and adjusting credit terms
• Manage accounts payable
• Determine the costs and benefits of holding additional inventory
• Contrast the different instruments available to a financial manager for investing cash balances
Receivables Management
19
Berk 19.3 Receivables Management
When a firm allows a customer to purchase on credit, it generates accounts receivable.
But before it does so,
the firm should determine a credit policy by:
• Establishing credit standards
• Establishing credit terms
• Establishing a collection policy
To whom will credit be extended? Everyone? Select customers? Based on what?
- On credit worthiness? Past volume of sales? Potential sales? Repeat customer?
- Potentially higher sales margin?
Establishing standards is about getting the right balance between High margin
Receivables vs. High volume of Receivables
How long to extend credit for? E.g. Net 20? Net 30? Or Net 40?
Offer a discount? Over what discount period? E.g., 1/15, Net 40 or 2/10, Net 20, etc
Are your credit terms comparable with other companies in the same industry?
What do you do if the customer begins delaying payment?
- Do nothing? (probably not)
- Send a reminder?
- Start charging interest or a late fee?
- Threaten legal action?
- Sell delinquent receivables to a collection agency for $0.50 for each $1 of receivable?
As an analyst or consultant, you need to ask these questions to find out the appropriateness of the client’s credit policy
20
Berk 19.3 Receivables Management
After generating accounts receivable,
Accounts Receivable needs to be monitored using:
• Account Receivable Days
• Aging Schedule
Accounts receivable days is the average days the firm takes to collect cash on its sales.
= Annual accounts receivable / average daily sales
• Compare actual accounts receivable days vs. Credit Terms better / worse?
• Compare actual accounts receivable days over past years following trend?
• Careful! Accounts receivable days is an average that may hide seasonality in a year
• E.g., School holidays drives seasonality in movie theatre sales
• E.g., Summer season drives ice cream and sunscreen sales
An aging schedule categorises accounts by days outstanding since the credit sale, by number of accounts and by amount.
E.g. In the tables below, a firm has trade credit terms of 2/15, net 30. Average daily sales of $65 000.
• Accounts receivable days is 25 ( = 1 600 000 / 65 000).
• 28% by number of accounts are late; but 39% by amount in account are late
• Analysis of monthly payment patterns may provide better forecasting of late accounts, e.g., 10%, 40%, 25%, 20%,
and 5% of prior sales were collected in the month of sales, 1 month, 2 months, 3 months, and 4 months after.
• Knowing these monthly patterns allows financial managers to plan working capital requirements
Late
28%
Late
38.8%
Berk Table 19.2
21
Practice Berk Example 19.5: Ageing Schedules
The Financial Training Centre bills its accounts on terms of 3/10, net 30.
The average daily sales is $20 000. An Ageing Schedule has been
partially prepared below.
Complete the schedule. With the information given, what conclusions
can you make about the firm’s accounts receivables?
Days outstanding Amt Outstanding ($)
1-10 100 000
11-30 300 000
31-40 100 000
41-50 20 000
51-60 10 000
60+ 2 000
532 000
% Outstanding
100.0%
Soln
=
=
Payables Management
23
Berk 19.4 Payables Management
How can firms manage their accounts payable?
1. Firms should choose to borrow using accounts payable if
it is the cheapest source of funding. How do you know?
• The higher the discount, the more attractive it is
• For the same discount, the shorter the term the
more attractive it is
2. Firms should always pay on the lastest day possible
• E.g., Terms are 2/10, net 30.
• If discount is taken, pay on day 10 not earlier
• If discount is foregone, pay on day 30 not
earlier
Berk Example 19.6
Rowdy Co has an average acc pay balance of $250 000. Its daily average COGS is $14 000. The terms from its suppliers are 2/15, net 40.
If it chooses to forego the discount and pay at the end of 40 days, is it managing its accounts payable well? What should it do?
=
= 25000014000 = 17.9 • On average Rowdy is paying on Day 18, 3 days after the 2% discount period. If it could pay 3 days earlier, it would take advantage of the discount
• Also, it is paying on Day 18 means it is tying up cash that could have been
used for 22 days more up to Day 40.
• CONCLUSION: Rowdy is not managing Acc Pay well. It either should pay 3
days earlier and take the discount or wait 22 days more and pay on Day 40.
24
Berk 19.4 Payables Management
How else can firms manage their accounts payable?
3. Firms should monitor their accounts payable days to
ensure payment at the optimal time
• Like in previous example, making small adjustments
can help make accounts payment reduce the burden
on your Working Capital requirements
4. Firms should avoid stretching accounts payable
• Stretching accounts payable is deliberately paying late and
risking penalties
• Stretching accounts payable can lead to suppliers imposing
harsher terms, e.g., COD or CBD or discontinuing business.
• It is unethical business practice to systematically break the
agreed terms with your supplier and may also affect your firm’s
credit rating.
Berk Example 19.7
If a firm stretches its accounts payable to 60 days on credit terms of 1/15, net 40, what is the effective annual cost of its credit?
If the firm pays according to the credit terms, then by taking the $1
discount, the firm ties up $99 for 25 days (=40 – 15).
• 1/99 over 25 days
• 1.0101% over 25 days
• n = 365/25 = 14.6 25-day periods in 1 year
• = 1 + − 1= 1 + 1.0101% 36525 − 1= 15.80%
If the firm pays stretches accounts payable by taking the $1 discount,
the firm ties up $99 for 45 days (=60 – 15).
• 1/99 over 45 days
• 1.0101% over 45 days
• n = 365/45 = 8.1111 45-day periods in 1 year
• = 1 + − 1= 1 + 1.0101% 36545 − 1= 8.49%
Conclusion: By stretching acc payable,
the firm reduces its borrowing cost
7.31%, although it does so unethically.
25
Learning objectives
Following Berk Ch19, after this lecture, students should be able to
• Explain the Cash Conversion Cycle and why managing working capital is important
• Use trade credit to the firm’s advantage
• Make decisions on extending credit and adjusting credit terms
• Manage accounts payable
• Determine the costs and benefits of holding additional inventory
• Contrast the different instruments available to a financial manager for investing cash balances
Inventory Management
27
Berk 19.5 Inventory Management
Inventory management aims to balance the costs and benefits of holding inventory.
• Excessive inventory is inefficient use of capital tied up for no benefit
• BUT, insufficient inventory can mean lost opportunities for sales
• Efficient use of inventory creates increased value for the firm.
Benefits of holding inventory
• (Raw materials) Inventory minimizes the risk of
not having production inputs when required. This
situation is called a stock-out. Stock-outs may
result in customers switching to a competitor and
not coming back.
• (Finished goods) Inventory reduces the risk that
demand seasonality does not match production
cycles
Costs of holding inventory
• Three direct costs of holding inventory:
• Acquisitions costs are the total costs of the
inventory itself over the year
• Order costs are the total costs over the year of
placing an order, getting it shipped, maybe
expedited
• Carrying costs are the costs of storage, insurance,
taxes, spoilage, obsolescence, and opportunity cost
of keeping inventory ready for production or sale.
An extreme example of super-efficient inventory management is “Just-in-time” (JIT). In JIT, inventory is reduced to (almost) zero. Production is so
well coordinated that just as one unit of input is used up, the next one arrives in-time. There is no slack in the production process. Timing is key.
E.g. JIT inventory management of local petrol production and distribution large predictable price swings at the petrol bowser.
28
Learning objectives
Following Berk Ch19, after this lecture, students should be able to
• Explain the Cash Conversion Cycle and why managing working capital is important
• Use trade credit to the firm’s advantage
• Make decisions on extending credit and adjusting credit terms
• Manage accounts payable
• Determine the costs and benefits of holding additional inventory
• Contrast the different instruments available to a financial manager for investing cash balances
Cash Management
30
19.6 Cash Management
Firms hold cash for three reasons
1. Transaction balance – to meet the day-to-
day needs of the firm’s operations
2. Precautionary balance – to meet uncertain
needs or opportunities that arise
3. Compensating balance – to satisfy the
requirements of the firm’s bank
• Firms need to hold sufficient cash to pay their daily bills depending on the cash
conversion cycle and the size of the average transaction.
• As the firm grows, this balance needs to grow in proportion.
• Uncertainties such as unexpected fire or property damage, competitor makes
threatening move or wants to sell-out, a new technology arises that must be
incorporated, a lawsuit that requires defense, etc.
• Having “reserve cash” allows firms the flexibility to respond to these uncertainties
and not have to go through a lengthy process of seeking funding and approval.
• Start-up and growing firms, especially have cash reserves set aside for such
opportunities.
• Banks provide firms financial services, such as over-draft facilities, letters of credit,
capital expenditure lines of credit, etc.
• But to have these services, the bank requires a minimum amount of cash reserve as
compensation, i.e., insurance for these services.
Cash is the most liquid of assets. Excess liquidity, however, may result in below-market return rates. Holding too much
cash is therefore inefficient use of this resource. Holding a sufficient cash balance depends on various reasons.
31
Practice: What is the end cash balance each month?
Month: 1 2 3 4 5 6
Beginning Invent. 200.0
Beginning Acc Rec 100.0
Beginning Acc Pay 50.0
Beginning Cash 100.0
New inventory 230.0 230.0 230.0 230.0 230.0 230.0
Sales 200.0 250.0 300.0 325.0 200.0 150.0
Cash collections
Cash payments
Net Cash Flow
End Inventory
End Acc Receiv.
End Acc Payable
End Cash
Question parameters
Credit terms: Net 20
Assume every month has 30 days
Each sale reduces inventory by 1
Sales: 1/3 pay cash in the same month, 2/3 pay cash next month
Inventory: 1/3 payable this month, 2/3 pay next month
Q. Complete the spreadsheet
Soln
32
Learning objectives
Following Berk Ch19, after this lecture, students should be able to
• Explain the Cash Conversion Cycle and why managing working capital is important
• Use trade credit to the firm’s advantage
• Make decisions on extending credit and adjusting credit terms
• Manage accounts payable
• Determine the costs and benefits of holding additional inventory
• Contrast the different instruments available to a financial manager for investing cash balances
33
At what level is Working Capital Management?
Cash
Flows
Discount
rate
(Risk & Return)
Project level CF
= �
=1
1 + − 0
Security level CF
Project level
discount rate
Portfolio level
discount rate
CF that affect only a small part of the
company E.g. replacing production
machines in a manufacturing plant
CF that affect a big part of the company
E.g. introducing new product that
changes the company strategy
Rate depends on the risk of the
project compared with the average
risk of the company
Rate depends on the risk of the company
compared with other companies that
have the same types of risks,
i.e. portfolio view
Important: As you take this course, be aware of which level of the story you are referring to!
34
• Learning Objectives
• Overview of Working Capital
• Trade Credit
• Receivables Management
• Payable Management
• Inventory Management
• Cash Management
What we covered
Appendix: Solutions to Practice Problems
36
Practice Berk Example 19.5: Ageing Schedules SOLN
The Financial Training Centre bills its accounts on terms of 3/10, net 30.
The average daily sales is $20 000. An Ageing Schedule has been
partially prepared below.
Complete the schedule. With the information given, what conclusions
can you make about the firm’s accounts receivables?
% Outstanding
18.8%
56.4%
18.8%
3.8%
1.9%
0.4%
100.0%
Days outstanding Amt Outstanding ($)
1-10 100 000
11-30 300 000
31-40 100 000
41-50 20 000
51-60 10 000
60+ 2 000
532 000
=
= 532 00020 000 = 26.6 days
By amount of accounts,
18.8% + 56.4% = 75.2% of accounts pay according to the terms
Hence, less than 25% are paying late
Only 6.1% (=3.8% + 1.9% + 0.4%) are paying 40 days or later. Very small!
On average, the accounts pay within 30 days:
Conclusion:
FTC’s Accounts Receivables are reasonably healthy Back
37
Practice: What is the end cash balance each month? Soln
Question paramaters
Credit terms: Net 20
Assume every month has 30 days
Each sale reduces inventory by 1
Sales: 1/3 pay cash in the same month, 2/3 pay cash next month
Inventory: 1/3 payable this month, 2/3 pay next month
Q. Complete the spreadsheet
Month: 1 2 3 4 5 6
Beginning Invent. 200.0 230.0 210.0 140.0 45.0 75.0
Beginning Acc Rec 100.0 133.3 166.7 200.0 216.7 133.3
Beginning Acc Pay 50.0 153.3 153.3 153.3 153.3 153.3
Beginning Cash 100.0 140.0 126.7 163.3 241.7 295.0
New inventory 230.0 230.0 230.0 230.0 230.0 230.0
Sales 200.0 250.0 300.0 325.0 200.0 150.0
Cash collections 166.7 216.7 266.7 308.3 283.3 183.3
Cash payments 126.7 230.0 230.0 230.0 230.0 230.0
Net Cash Flow 40.0 -13.3 36.7 78.3 53.3 -46.7
End Inventory 230.0 210.0 140.0 45.0 75.0 155.0
End Acc Receiv. 133.3 166.7 200.0 216.7 133.3 100.0
End Acc Payable 153.3 153.3 153.3 153.3 153.3 153.3
End Cash 140.0 126.7 163.3 241.7 295.0 248.3
Back
Working Capital Management
FINS2615 Intermediate Business Finance
Dr. Ian Kwan
i.kwan@unsw.edu.au
See Berk (2018) Chapter 19: Working Capital Management
1How the Story of Corporate Finance will be explained:
Cash
Flows
Discount
rate
(Risk & Return)
Financial Mathematics
Cash Flow Forecasting
Working capital
management
Capital Asset Pricing Model
Cost of capital
Capital structure
Week 01
Week 02
Weeks 03 and 04
Week 05
Week 07
Week 08
Week 09
Types
of CF
Debt
Equity
= �
=1
1 + − 0
Important: As you take this course, clarify how to connect the different parts of the story!
Week 10:
Payout policy
2• Learning Objectives
• Overview of Working Capital
• Trade Credit
• Receivables Management
• Payable Management
• Inventory Management
• Cash Management
Contents of lecture
3Learning objectives
Following Berk Ch19, after this lecture, students should be able to
• Explain the Cash Conversion Cycle and why managing working capital is important
• Use trade credit to the firm’s advantage
• Make decisions on extending credit and adjusting credit terms
• Manage accounts payable
• Determine the costs and benefits of holding additional inventory
• Contrast the different instruments available to a financial manager for investing cash balances
Overview of Working Capital
5Review: What is Net Working Capital?
Net Working Capital includes all the materials and services you need to run the daily operations of the firm.
From Finance perspective, these include:
• Current Assets: Cash (excluding excess cash not needed in daily operations)
Inventory, Accounts Receivable (A/Rec)
• Current Liabilities: Accounts Payable (A/Pay)
• NWC = Current Assets – Current Liabilities
• Increases in NWC Cash Outflow
• Decreases in NWC Cash Inflow
Industry Inventory A/Rec A/Pay
Retail supermarkets High Low High
Pharmaceuticals High High High
Airlines Low Low-Med High
Consumer white goods High High High
NWC composition depends on industry characteristics
Affect firm valuation
6Operating Cycle vs. Cash Conversion Cycle
=
=
=
Components of Working Capital can be measured in DAYS:
The number of days it takes to use up the inventory and turn it into sales
• The more days, the longer it takes to sell existing inventory
• Is the firm operating efficiently as it should be? Can inventory be reduced?
The number of days it takes for customers to pay you cash for credit sales
• The more days, the longer it takes to receive customers’ cash payments
• Is the firm offering trade credit terms that are too generous? Should it change?
The number of days for your firm to pay suppliers in cash
• The more days, the longer it takes you to pay suppliers
• Is the firm paying too early or too late? Both can be bad! How do we know?
= 365
= 365
7Operating Cycle vs. Cash Conversion Cycle
Cash Conversion Cycle = Inventory Days + Accounts receivable days – Accounts Payable Days
= Average days from the time cash goes out to the time cash comes in
Operating Cycle = Inventory Days + Accounts receivable days
= Average days from purchasing inventory to receiving cash for goods/services
With the Working Capital components measured in days, we define:
From a finance perspective, investors need to fund the Cash Conversion Cycle!
The longer the cycle, the more capital is tied up, the greater the funding cost.
A Poll Question:
Which is better from a finance
perspective:
A short CCC or long one?
Poll
8Berk Example 19.1 Calculating Cash Conversion Cycle
Woolworths partial Income Statement
& Balance Sheet:
Using the following information, calculate the CCC for Woolworths
Sales 58,276
Cost of Good Sold 42,677
Total Accounts Receivable 519
Total Inventory 4,559
Total Accounts Payable 6,266
=
= 4559
116.9 = 39.0 days
A/Rec days =
= 519
159.7 = 3.2 days
A/Pay days =
= 6266
116.9 = 53.6 days
=
365
= 42677
365
= 116.9 $/days
=
365
= 58276
365
= 159.7 $/day
Cash Conversion Cycle = Inventory Days + Accounts receivable days – Accounts Payable Days
Woolworths’ CCC = 39 + 3.2 – 53.6 = -11.4 days
Woolworths has a NEGATIVE CCC!
• It’s customers on average pay in cash 11 days BEFORE it pays its suppliers in cash!
• This accounts for its market dominance in offering low price guarantees
9Working capital needs depend on industry characteristics
A/Rec
A/Pay
Invent.
Airlines
Qantas
Customers pay up-front
before starting trip
Firm pays suppliers many
days after trip is finished
Very little. Only sufficient
inventory for a trip (fuel, tray
meals, drinks, movies!)
Remark Main expense is depreciation of aircraft and labour costs
White goods
Harvey Norman
To commit customers, firm
offers interest-free purchases
or financing
Firm will get suppliers to help
finance customers’ purchases,
stretching out payments
Hold inventory in showrooms
for customers to give variety
and choice
Large holding costs
Pharmaceuticals
CSL
Customers (pharmacies, labs,
hospitals) pay on credit after
receiving goods
Firm pays suppliers later than
it receives payment from
customers, stretching paymt
Batch manufacturing means
holding large inventories that
are sold seasonally
Special handling and storage.
Main cost is R&D expense.
In the Team Assignment, analyse your Stock’s industry characteristics or norms to understand
the effect on Working Capital Requirements. Compare with major competitors.
For example, we compare and contrast the Working Capital Needs of three industries:
10
Firm value and managing working capital
We know that Changes in NWC affect cash flows because:
• FCF = EBIT(1 – T) + Depr – Chg NWC – Capex
• Decrease in NWC increase in FCF increase in firm value
• BUT BY HOW MUCH VALUE?
Berk Example 19.2
Expected FCF Improvement
Net Profit (earnings) 20 000
+ Depreciation +5 000
- Capital Expenditure -5 000
- Incr in working capital -1 000 Reduce by 20%
= FCF = 19 000
A firm next year expects the following FCF but wants to investigate the
impact of improvements it can make to its need for more working capital.
If the cost of capital is 12% and the working capital is projected to
grow at 4% annually, what impact would a one-time 20%
permanent reduction in its annual working capital requirement
have to the stock’s valuation?
New FCF
20 000
+5 000
-5 000
-800
= 19 200
0 = −
0 = 190000.12 − 0.04 = 237 500 000
0 = 192000.12 − 0.04 = 240 000 000
Current stock price:
New price if WC reduced
by one-time 20%:
Conclusion: A one-time $200K permanent reduction in Working Capital
does not affect earnings, but results in a $2.5 million increase in stock price!
In $ thousands
11
Team Assignment: Questions for Reflection
A firm that manages well its Work Capital requirements generates enormous value for customers!
Especially permanent decreases in Working Capital requirements.
Is working capital management a strategic advantage for firms in the same industry as your target company?
If so, how well does your Team’s company manage its Work Capital requirements compared with competitors?
As an investor in the company, can you suggest changes that it could make to increase its competitiveness in
Working Capital Management?
We have seen that:
Questions for Reflection in your Team Assignment Target Company:
12
Learning objectives
Following Berk Ch19, after this lecture, students should be able to
• Explain the Cash Conversion Cycle and why managing working capital is important
• Use trade credit to the firm’s advantage
• Make decisions on extending credit and adjusting credit terms
• Manage accounts payable
• Determine the costs and benefits of holding additional inventory
• Contrast the different instruments available to a financial manager for investing cash balances
Trade Credit
14
Berk 19.2 Trade Credit
When a firm allows a customer to purchase on credit is said to “extend their customer trade credit”.
• The firm and customer respectively generate entries in accounts receivable and accounts payable.
• Note: a customer purchase on credit does NOT mean purchasing with their credit card or BNPL account! Why?
When a firm buys on credit from suppliers, each respectively generates accounts payable and receivable entries.
• The net difference between a firm’s a/rec and a/pay is the “capital required by trade credit”.
To find optimal credit policies, financial
managers analyze trade credit according to:
1. Trade credit terms
2. Trade credit market frictions
3. Float management
Let’s look at this first
Examples of Trade Credit Terms:
• Supplier offers customer “Net 30”
• Or maybe “2/10, Net 30”
Means “Pay the full amount within
30 calendar days”
Say “Two - ten, Net 30”
Means “Get a 2% discount on the full amount if
paid within 10 days, otherwise pay in full within 30
calendar days”
10 days is
“discount period”
30 days is
“credit period”
Day
10
Day
30
$100
purchase
Discount period
Pay $98 for $100 purchase
Net credit period
Must pay $100 by Day 30
1. Trade credit terms
15
Berk 19.2 Trade Credit
Day
10
Day
30
$100
purchase
Discount period Net credit period
2. Trade Credit Market Frictions
For example, “2/10, Net 30”
If customer decides to take the 2% discount offer,
what benefit interest rate is the customer getting?
• Trade credit is essentially a loan from the supplier to customer.
• If like a loan, what is the trade credit interest rate?
Pay nothing now and repay $100 loan at end (day 30)
Get $2 discount and pay $98 now (day 10)
By taking the $2 discount, the customer is
tying up $98 in funds that could be used
elsewhere. This is an opportunity cost.
• $2 / $98 is the interest rate over 20 days
Think: “A cost of $2 ties up $98 for 20 days”
• i.e., 2.040816% over 20 days
• What rate is this over 365 days?
• i.e., what is the Effective Annual Rate?
• 365/20 = 18.25 20-day periods in one year
• = 1 + − 1= 1 + 2.040816% 36520 − 1= 44.59%
• By taking the discount, the customer is
getting a benefit interest rate of 44.6%!
This would be hard to get anywhere!
• What are the benefits of trade credit?
1. Trade credit is simple and convenient to access.
- Often standard terms, little paperwork involved
- Few things to negotiate
- Flexible arrangement
2. Lower cost of fund compared with alternative sources
- For customer, lower than getting a bank loan
- Collateral on trade credit are the goods provided
- Often the only source of funding for the customer
• What market frictions does Trade Credit overcome?
1. Provides cheaper prices to selected customers
- Trade credit helps a firm discriminate between
customers, providing favourable ones better terms
2. Provides a check on customer credit quality
- Trade credit is built on trust and information sharing
between a firm and its customer. This relationship is
perhaps of better quality in gauging credit worthiness.
16
Berk 19.2 Trade Credit
3. Trade Credit Float Management
• A significant friction in trade credit is the management of collection float.
• Collection float is the amount of time it takes for a firm to be able to use
the funds after a customer has paid for its goods or services. The longer
the collection float, the greater is the need to invest in working capital.
• Collection float is determined by three factors: mail float, processing
float, and availability float
Because of financial technologies, direct customer bank transfers
to supplier bank have significantly speeded up these processes
and even eliminated them.
17
Learning objectives
Following Berk Ch19, after this lecture, students should be able to
• Explain the Cash Conversion Cycle and why managing working capital is important
• Use trade credit to the firm’s advantage
• Make decisions on extending credit and adjusting credit terms
• Manage accounts payable
• Determine the costs and benefits of holding additional inventory
• Contrast the different instruments available to a financial manager for investing cash balances
Receivables Management
19
Berk 19.3 Receivables Management
When a firm allows a customer to purchase on credit, it generates accounts receivable.
But before it does so,
the firm should determine a credit policy by:
• Establishing credit standards
• Establishing credit terms
• Establishing a collection policy
To whom will credit be extended? Everyone? Select customers? Based on what?
- On credit worthiness? Past volume of sales? Potential sales? Repeat customer?
- Potentially higher sales margin?
Establishing standards is about getting the right balance between High margin
Receivables vs. High volume of Receivables
How long to extend credit for? E.g. Net 20? Net 30? Or Net 40?
Offer a discount? Over what discount period? E.g., 1/15, Net 40 or 2/10, Net 20, etc
Are your credit terms comparable with other companies in the same industry?
What do you do if the customer begins delaying payment?
- Do nothing? (probably not)
- Send a reminder?
- Start charging interest or a late fee?
- Threaten legal action?
- Sell delinquent receivables to a collection agency for $0.50 for each $1 of receivable?
As an analyst or consultant, you need to ask these questions to find out the appropriateness of the client’s credit policy
20
Berk 19.3 Receivables Management
After generating accounts receivable,
Accounts Receivable needs to be monitored using:
• Account Receivable Days
• Aging Schedule
Accounts receivable days is the average days the firm takes to collect cash on its sales.
= Annual accounts receivable / average daily sales
• Compare actual accounts receivable days vs. Credit Terms better / worse?
• Compare actual accounts receivable days over past years following trend?
• Careful! Accounts receivable days is an average that may hide seasonality in a year
• E.g., School holidays drives seasonality in movie theatre sales
• E.g., Summer season drives ice cream and sunscreen sales
An aging schedule categorises accounts by days outstanding since the credit sale, by number of accounts and by amount.
E.g. In the tables below, a firm has trade credit terms of 2/15, net 30. Average daily sales of $65 000.
• Accounts receivable days is 25 ( = 1 600 000 / 65 000).
• 28% by number of accounts are late; but 39% by amount in account are late
• Analysis of monthly payment patterns may provide better forecasting of late accounts, e.g., 10%, 40%, 25%, 20%,
and 5% of prior sales were collected in the month of sales, 1 month, 2 months, 3 months, and 4 months after.
• Knowing these monthly patterns allows financial managers to plan working capital requirements
Late
28%
Late
38.8%
Berk Table 19.2
21
Practice Berk Example 19.5: Ageing Schedules
The Financial Training Centre bills its accounts on terms of 3/10, net 30.
The average daily sales is $20 000. An Ageing Schedule has been
partially prepared below.
Complete the schedule. With the information given, what conclusions
can you make about the firm’s accounts receivables?
Days outstanding Amt Outstanding ($)
1-10 100 000
11-30 300 000
31-40 100 000
41-50 20 000
51-60 10 000
60+ 2 000
532 000
% Outstanding
100.0%
Soln
=
=
Payables Management
23
Berk 19.4 Payables Management
How can firms manage their accounts payable?
1. Firms should choose to borrow using accounts payable if
it is the cheapest source of funding. How do you know?
• The higher the discount, the more attractive it is
• For the same discount, the shorter the term the
more attractive it is
2. Firms should always pay on the lastest day possible
• E.g., Terms are 2/10, net 30.
• If discount is taken, pay on day 10 not earlier
• If discount is foregone, pay on day 30 not
earlier
Berk Example 19.6
Rowdy Co has an average acc pay balance of $250 000. Its daily average COGS is $14 000. The terms from its suppliers are 2/15, net 40.
If it chooses to forego the discount and pay at the end of 40 days, is it managing its accounts payable well? What should it do?
=
= 25000014000 = 17.9 • On average Rowdy is paying on Day 18, 3 days after the 2% discount period. If it could pay 3 days earlier, it would take advantage of the discount
• Also, it is paying on Day 18 means it is tying up cash that could have been
used for 22 days more up to Day 40.
• CONCLUSION: Rowdy is not managing Acc Pay well. It either should pay 3
days earlier and take the discount or wait 22 days more and pay on Day 40.
24
Berk 19.4 Payables Management
How else can firms manage their accounts payable?
3. Firms should monitor their accounts payable days to
ensure payment at the optimal time
• Like in previous example, making small adjustments
can help make accounts payment reduce the burden
on your Working Capital requirements
4. Firms should avoid stretching accounts payable
• Stretching accounts payable is deliberately paying late and
risking penalties
• Stretching accounts payable can lead to suppliers imposing
harsher terms, e.g., COD or CBD or discontinuing business.
• It is unethical business practice to systematically break the
agreed terms with your supplier and may also affect your firm’s
credit rating.
Berk Example 19.7
If a firm stretches its accounts payable to 60 days on credit terms of 1/15, net 40, what is the effective annual cost of its credit?
If the firm pays according to the credit terms, then by taking the $1
discount, the firm ties up $99 for 25 days (=40 – 15).
• 1/99 over 25 days
• 1.0101% over 25 days
• n = 365/25 = 14.6 25-day periods in 1 year
• = 1 + − 1= 1 + 1.0101% 36525 − 1= 15.80%
If the firm pays stretches accounts payable by taking the $1 discount,
the firm ties up $99 for 45 days (=60 – 15).
• 1/99 over 45 days
• 1.0101% over 45 days
• n = 365/45 = 8.1111 45-day periods in 1 year
• = 1 + − 1= 1 + 1.0101% 36545 − 1= 8.49%
Conclusion: By stretching acc payable,
the firm reduces its borrowing cost
7.31%, although it does so unethically.
25
Learning objectives
Following Berk Ch19, after this lecture, students should be able to
• Explain the Cash Conversion Cycle and why managing working capital is important
• Use trade credit to the firm’s advantage
• Make decisions on extending credit and adjusting credit terms
• Manage accounts payable
• Determine the costs and benefits of holding additional inventory
• Contrast the different instruments available to a financial manager for investing cash balances
Inventory Management
27
Berk 19.5 Inventory Management
Inventory management aims to balance the costs and benefits of holding inventory.
• Excessive inventory is inefficient use of capital tied up for no benefit
• BUT, insufficient inventory can mean lost opportunities for sales
• Efficient use of inventory creates increased value for the firm.
Benefits of holding inventory
• (Raw materials) Inventory minimizes the risk of
not having production inputs when required. This
situation is called a stock-out. Stock-outs may
result in customers switching to a competitor and
not coming back.
• (Finished goods) Inventory reduces the risk that
demand seasonality does not match production
cycles
Costs of holding inventory
• Three direct costs of holding inventory:
• Acquisitions costs are the total costs of the
inventory itself over the year
• Order costs are the total costs over the year of
placing an order, getting it shipped, maybe
expedited
• Carrying costs are the costs of storage, insurance,
taxes, spoilage, obsolescence, and opportunity cost
of keeping inventory ready for production or sale.
An extreme example of super-efficient inventory management is “Just-in-time” (JIT). In JIT, inventory is reduced to (almost) zero. Production is so
well coordinated that just as one unit of input is used up, the next one arrives in-time. There is no slack in the production process. Timing is key.
E.g. JIT inventory management of local petrol production and distribution large predictable price swings at the petrol bowser.
28
Learning objectives
Following Berk Ch19, after this lecture, students should be able to
• Explain the Cash Conversion Cycle and why managing working capital is important
• Use trade credit to the firm’s advantage
• Make decisions on extending credit and adjusting credit terms
• Manage accounts payable
• Determine the costs and benefits of holding additional inventory
• Contrast the different instruments available to a financial manager for investing cash balances
Cash Management
30
19.6 Cash Management
Firms hold cash for three reasons
1. Transaction balance – to meet the day-to-
day needs of the firm’s operations
2. Precautionary balance – to meet uncertain
needs or opportunities that arise
3. Compensating balance – to satisfy the
requirements of the firm’s bank
• Firms need to hold sufficient cash to pay their daily bills depending on the cash
conversion cycle and the size of the average transaction.
• As the firm grows, this balance needs to grow in proportion.
• Uncertainties such as unexpected fire or property damage, competitor makes
threatening move or wants to sell-out, a new technology arises that must be
incorporated, a lawsuit that requires defense, etc.
• Having “reserve cash” allows firms the flexibility to respond to these uncertainties
and not have to go through a lengthy process of seeking funding and approval.
• Start-up and growing firms, especially have cash reserves set aside for such
opportunities.
• Banks provide firms financial services, such as over-draft facilities, letters of credit,
capital expenditure lines of credit, etc.
• But to have these services, the bank requires a minimum amount of cash reserve as
compensation, i.e., insurance for these services.
Cash is the most liquid of assets. Excess liquidity, however, may result in below-market return rates. Holding too much
cash is therefore inefficient use of this resource. Holding a sufficient cash balance depends on various reasons.
31
Practice: What is the end cash balance each month?
Month: 1 2 3 4 5 6
Beginning Invent. 200.0
Beginning Acc Rec 100.0
Beginning Acc Pay 50.0
Beginning Cash 100.0
New inventory 230.0 230.0 230.0 230.0 230.0 230.0
Sales 200.0 250.0 300.0 325.0 200.0 150.0
Cash collections
Cash payments
Net Cash Flow
End Inventory
End Acc Receiv.
End Acc Payable
End Cash
Question parameters
Credit terms: Net 20
Assume every month has 30 days
Each sale reduces inventory by 1
Sales: 1/3 pay cash in the same month, 2/3 pay cash next month
Inventory: 1/3 payable this month, 2/3 pay next month
Q. Complete the spreadsheet
Soln
32
Learning objectives
Following Berk Ch19, after this lecture, students should be able to
• Explain the Cash Conversion Cycle and why managing working capital is important
• Use trade credit to the firm’s advantage
• Make decisions on extending credit and adjusting credit terms
• Manage accounts payable
• Determine the costs and benefits of holding additional inventory
• Contrast the different instruments available to a financial manager for investing cash balances
33
At what level is Working Capital Management?
Cash
Flows
Discount
rate
(Risk & Return)
Project level CF
= �
=1
1 + − 0
Security level CF
Project level
discount rate
Portfolio level
discount rate
CF that affect only a small part of the
company E.g. replacing production
machines in a manufacturing plant
CF that affect a big part of the company
E.g. introducing new product that
changes the company strategy
Rate depends on the risk of the
project compared with the average
risk of the company
Rate depends on the risk of the company
compared with other companies that
have the same types of risks,
i.e. portfolio view
Important: As you take this course, be aware of which level of the story you are referring to!
34
• Learning Objectives
• Overview of Working Capital
• Trade Credit
• Receivables Management
• Payable Management
• Inventory Management
• Cash Management
What we covered
Appendix: Solutions to Practice Problems
36
Practice Berk Example 19.5: Ageing Schedules SOLN
The Financial Training Centre bills its accounts on terms of 3/10, net 30.
The average daily sales is $20 000. An Ageing Schedule has been
partially prepared below.
Complete the schedule. With the information given, what conclusions
can you make about the firm’s accounts receivables?
% Outstanding
18.8%
56.4%
18.8%
3.8%
1.9%
0.4%
100.0%
Days outstanding Amt Outstanding ($)
1-10 100 000
11-30 300 000
31-40 100 000
41-50 20 000
51-60 10 000
60+ 2 000
532 000
=
= 532 00020 000 = 26.6 days
By amount of accounts,
18.8% + 56.4% = 75.2% of accounts pay according to the terms
Hence, less than 25% are paying late
Only 6.1% (=3.8% + 1.9% + 0.4%) are paying 40 days or later. Very small!
On average, the accounts pay within 30 days:
Conclusion:
FTC’s Accounts Receivables are reasonably healthy Back
37
Practice: What is the end cash balance each month? Soln
Question paramaters
Credit terms: Net 20
Assume every month has 30 days
Each sale reduces inventory by 1
Sales: 1/3 pay cash in the same month, 2/3 pay cash next month
Inventory: 1/3 payable this month, 2/3 pay next month
Q. Complete the spreadsheet
Month: 1 2 3 4 5 6
Beginning Invent. 200.0 230.0 210.0 140.0 45.0 75.0
Beginning Acc Rec 100.0 133.3 166.7 200.0 216.7 133.3
Beginning Acc Pay 50.0 153.3 153.3 153.3 153.3 153.3
Beginning Cash 100.0 140.0 126.7 163.3 241.7 295.0
New inventory 230.0 230.0 230.0 230.0 230.0 230.0
Sales 200.0 250.0 300.0 325.0 200.0 150.0
Cash collections 166.7 216.7 266.7 308.3 283.3 183.3
Cash payments 126.7 230.0 230.0 230.0 230.0 230.0
Net Cash Flow 40.0 -13.3 36.7 78.3 53.3 -46.7
End Inventory 230.0 210.0 140.0 45.0 75.0 155.0
End Acc Receiv. 133.3 166.7 200.0 216.7 133.3 100.0
End Acc Payable 153.3 153.3 153.3 153.3 153.3 153.3
End Cash 140.0 126.7 163.3 241.7 295.0 248.3
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