1Topic 8: Managing Working Capital and the
Balanced Scorecard.
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ACCT5906
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2Working Capital Management
Working Capital Management concerns the
management of current assets and current
liabilites :
Working Capital includes:
Cash, Accounts Receivable and Inventory.
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3Working Capital and Cash
Customers/Debtors Suppliers/Creditors
Cash
Inventory
Used to pay
Who supply
Which is sold to
Who pay
OutflowInflow
Timing
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4Return on Equity– a function of
Return on Assets
Profit
Total Assets
Leverage
Total Assets
SE
x
Return on Equity
Profit
SE
Profit Margin
Profit
Sales
Asset Turnover
Sales
Total Assets
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5Concepts Covered
1.Working Capital and the Current Ratio
2.Cash Conversion Cycle: Shows the average length
of time a dollar is tied up in current assets.
3.Turnover Ratios: Shows number of times Accounts
Receivable, Inventory and Accounts Payable are turned over
per year.
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61. Current Ratio
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71. Current Ratio
Also known as Working Capital ratio (Current Assets /
Current Liabilities)
➢ Is a measure of an entity’s liquidity/solvency.
➢ If low, company may have a cash flow problem, - is
company able to cover its short term debt
obligations?
➢ It is important to consider the composition of the current
assets (i.e. a high level of cash is more liquid than AR)
➢ Industry type will impact ratio (i.e. high fashion clothing
business may have higher Current Assets than a
grocery store)
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82. Cash Conversion Cycle
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92. Cash Conversion Cycle =
Receivable
Collection
Period:
Average time required to
convert AR into cash
Av. Account Rec.
Sales / 365
Inventory
Conversion
Period:
Average time required to
convert materials into finished
goods and then sell the goods
Av. Inventory
Sales / 365
Payables
Deferral
Period
Average time between
purchase of material and labor
and the payment of cash for
them
Av. Account Pay.
COGS / 365
What is the preferred objective for each? And for the entire cycle?
+ -
-+
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Cash Conversion Cycle - Example
Receivable
Collection
Period:
Inventory
Conversion
Period:
Payables
Deferral
Period
+ -
It takes Real Time 24 days to collect AR, 73 days to concert raw material
into computer and sell them, and 30 days to pay suppliers. How many days
does it take to convert current assets into cash?
Days required to convert assets into cash =
-+
24 73 30
67 days
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3. Turnover Ratios
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Accounts Receivables Turnover
Shows how frequently (quickly) Accounts Receivables are
collected during year.
Expressed as:
Sales
Average AR
1. What is the AR turnover with sales of 250,000 and an average AR
balance of 40,000?
2. What is the collection period in days?
3. What is the average level of receivables if sales revenue is 800,000 and
the AR turnover is 13 (i.e. collections are made 13 times a year?)
6.25. Shows that AR are collected 6.25 times a year.
365 / 6.25 = 58.4 days. A proxy for the
time before customers pay for goods.
800,000/13 = 61,538
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Inventory Turnover
Shows number of times inventory was turned over during year.
Expressed as:
Sales
Average Inventory
1. What is the inventory turnover with sales of 450,000 and average Inventory
balance of 65,000?
2. What is the inventory turnover period in days?
3. What is the average level of inventory if sales revenue is 200,000 and
inventory turnover is 8? 200,000 / 8 = 25,000
365 / 6.9 = 52.9 days. A
proxy for the average time
goods are held in inventory.
6.9. Shows that inventory is turned over 6.9 times a year.
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Payables Turnover
Shows how frequently (quickly) Accounts Payable (AP) are paid
during year. Expressed as:
COGS
Average AP
1. What is the AP turnover with COGS of 350,000 and an average AP balance
of 45,000?
2. What is the AP turnover period in days?
3. What is the average level of AP if COGS is 285,000 and AP turnover is 10?
285,000 / 10 = 28,500
365 / 7.7 = 47.4 days. A proxy for the
time it takes the firm to pay creditors.
7.7. Shows that AP is paid 7.7 times a year
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Relevance of WC to ROA / ROE
Return on Assets
Profit
Total Assets
Leverage
Total Assets
SE
x
Return on Equity
Profit
SE
Profit Margin
Profit
Sales
Asset Turnover
Sales
Total Assets
Current Assets
Fixed Assets
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Example
Sales: $250,000 (credit sales)
Cost of Goods Sold: $220,000
Inventory conversion period: 38 days
Receivable turnover: 8
Payable deferral period: 45 days
Non Current Assets: $50,000
1. What is the Cash Conversion Cycle?
2. What is Asset Turnover and ROA?
3. What would be the effect on Asset Turnover and
ROA, if
receivable turnover is increased to 10?
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Q1. What is the Cash Conversion Cycle?
Receivables Collection Period: 365/8 = 46 days
Inventory Conversion Period = 38 days
Payables Deferral Period = (45 days)
Cash Conversion Cycle = 39 days
Shows that in average each dollar is tied up in current
assets for 39 days.
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Q2. What is Asset Turnover & ROA?
Asset Turnover: Sales 250,000
Total Asset 50,000 + CA (??)
=
Asset Turnover: 250,000 / 107,277 (50,000+57,277) = 2.33
ROA: Profit / Total Asset = 30,000 / 107,277 = 28%
First, calculate
TO ratio
CA:
Average AR: 250,000/8 = 31,250
Average Inventory: 38days x (250,000/ 365) = 26,027
Total CA = 57,277
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Relevance of Working Capital to
Return on Assets and Return on Equity
Return on Assets
Profit
Total Assets
Leverage
Total Assets
SE
x
Return on Equity
Profit
SE
Profit Margin
Profit
Sales
Asset Turnover
Sales
Total Assets
28%
2.3312%
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Q3. What If Accounts Receivable
Turnover goes to 10?
Asset Turnover: Sales 250,000
Total Asset: 50,000 + CA (??)
CA:
Average AR: 250,000/10 = 25,000
Average Inventory: 38days x (250,000/ 365) = 26,027
Total CA = 51,027
=
Asset Turnover: 250,000 / 101,027 (51,027+50,000) = 2.47
ROA: Profit / Total Asset = 30,000 / 101,027 = 30%
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Relevance of WC to ROA / ROE
Return on Assets
Profit
Total Assets
Leverage
Total Assets
SE
x
Return on Equity
Profit
SE
Profit Margin
Profit
Sales
Asset Turnover
Sales
Total Assets
30%
2.4712%
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4. Working Capital Policy
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4. Working Capital Policy
1. Relaxed CA Investment Policy (fat cat):
Inventory:
AR:
Cash:
2. Restricted CA Investment Policy (lean & mean):
Inventory:
AR:
Cash
3. Moderate CA Investment Policy (in-between)
Large amounts of inventory – low turnover, low ROA
High. Sales stimulated by liberal credit to customers
Carry high level of cash
Minimise inventories – high turnover – high ROA
Minimise AR. Strict credit policy
Carry low level of cash
But – what
does this
policy do to
our risk
profile?
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Why hold cash? Why reduce cash levels?
Cash – how much is too much?
1. Meet short term debt obligations
and transaction requirements
2. Maintain credit rating by
keeping current ratio in line
with industry average
3. Take advantage of trade
discounts given for early
payments
4. Safety deposit required by bank;
5. Speculation
6. Safety stock to meet
emergencies or cyclical
downturns.
1. Earns no interests. What is
the opportunity cost?
2. Increases working capital
ratios which reduces ROA.
What is the impact on
ROE?
3. Signals laziness and lack
of creativity.
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Why hold inventory? Why reduce inventory levels?
Inventory – how much is too
much?
1. Ability to quickly meet
customer demand
2. Less forecasting and planning
required as inventory stock
serves as buffer
3. Reduced risk.
1. Unproductive assets – impacts
on ROA and ROE?
2. Costly to store
3. Risk of not selling stocks
4. Reduces liquidity and
negatively impacts cash
conversion cycle, possibly
leading to a funding gap, which
reduces growth opportunities.
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Why extend credit sales? Why reduce the balance?
Accounts Receivable Policy?
1. Boost sales by providing
favorable credit terms to
customers
2. Can help reduce inventories
3. Industry norms – must retain
competitive position
1. Riskiness – are customers
able to pay?
2. Credit ratings may be
negatively affected if AR
makes up a high % of total
revenue
3. Reduces liquidity and
negatively impacts cash
conversion cycle, possibly
leading to a funding gap.
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Credit Policy – how to reduce
Accounts Receivable?
◼ Credit Period: Length of time given to
customers to pay for goods
◼ Discounts: Provide discounts for early
payments
◼ Credit Standard: Critically assess the
financial strength of customer
◼ Collection Policy: Toughness in attempting
to collect on slow-paying customers (letter,
call, collection agency).
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5. A Practical Example
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◼ Following are the abridged financial
statements for Lisa’s Liquor.
◼ Lisa suspects she has a working capital
problem.
◼ Can you help her?
Lisa’s Liquor
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Profit and Loss Statement
Sales revenue $12,000,000
Less cost of goods sold (COGS) 7,200,000
Gross profit 4,800,000
Operating expenses 2,200,000
Net profit 2,600,000
Balance Sheet
Cash $1,000,000
Accounts receivable 4,000,000
Inventory 4,000,000
Plant and equipment 12,000,000
Accounts payable 2,000,000
Mortgage loan at 12% 10,000,000
Owner’s equity 9,000,000
Lisa’s Liquor
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◼ Appears to be excessive working capital
◼ Current assets are $9,000,000
◼ Current liabilities are $2,000,000
◼ Net working capital is thus $7,000,000
◼ Current ratio is 4.50
◼ At an interest rate of 12%, this is costing
Lisa $840,000 annually in interest
Lisa’s Liquor
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We can check the cash conversion cycle to assess impact
◼ Days receivables 122 days
◼ Days inventory 203 days (using COGS)
◼ Less days payable 101 days
◼ Cash conversion cycle 224 days
Lisa’s Liquor
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Cash
◼ An average cash holding of $1 million is costing
the company interest and may be excessive.
◼ Need to conduct forecast of cash needs (and
variability in cash needs) to determine
appropriate holding level.
◼ Reduce cash holdings and use cash to repay
some of the loan or invest in securities.
Lisa’s Liquor – Solutions?
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Receivables
◼ A large proportion of sales are credit sales and
there is over 120 days on average before cash is
received.
◼ Receivables can be shortened by offering
discounts for cash payments (or earlier
payments) or by stepping up collection efforts.
◼ But - need to first assess costs of these
strategies - particularly lower sales revenue.
Lisa’s Liquor – Solutions?
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Inventory
◼ Lisa’s average inventory holding is 203 days and
this appears excessive for liquor. She needs to
increase turnover.
◼ If she orders inventory more often she can
reduce average inventory holding, but she will
incur higher transaction (order) costs which need
to be offset against gains.
◼ Lower inventory holdings may result in delays for
customers.
Lisa’s Liquor – Solutions?
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Payables
◼ Accounts payable are essentially an interest free
loan and Lisa may not be maximising this
advantage.
◼ Is it possible for Lisa to delay payments to
suppliers without losing trade discounts or
hurting her reputation with suppliers?
Lisa’s Liquor – Solutions?
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Suppose Lisa takes these actions and achieves the following:
◼ Cash reduced to $500,000
◼ Receivables reduced to $2,000,000
◼ Inventory reduced to $2,000,000
◼ Payables increased to $3,000,000
Assuming no change in sales revenue, what is the impact
on Working Capital of these changes?
Lisa’s Liquor – A hypothetical outcome
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◼ These changes will result in a fall in average net
working capital from $7,000,000 to $1,500,000.
◼ This will reduce annual interest costs by
$660,000 and lower the cash conversion cycle to
approximately 10 days.
◼ It may help if Lisa puts in place a credit line with
her bank to cover for unanticipated cash
demands.
◼ Regular cash forecasts will also help.
Lisa’s Liquor – A hypothetical outcome
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The Balanced Scorecard
Source: Kaplan and Norton
The BSC is a performance
management and
measurement system that
identifies and reports on
performance measures for
each strategic area of the
business
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Components of BSC
Strategic Theme
Financial
Customer
Internal
Learning
Goal
What does the y-
axis tell us?
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➢ “How do the customers see us?”
➢ Shows organisation’s ability to create value for the
customer.
➢ The objective is to understand what the customers value,
want, and need. An organisation must align its goals
and performance to meet those needs.
➢ Examples:
• Product quality
• Service quality (i.e. knowledgeable staff)
• Timeliness of delivery
Customer Perspective
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1. “What must we do to meet customer expectations?” (i.e.
improve product and service performance and thereby
increase revenue)
• Examples: Marketing, sales, customer service
processes, product design, call centre etc.
2. “What must we do to meet shareholder expectations?”
(i.e. improve productivity and thereby reduce costs)
• Examples: Internal processes, efficiency levels, IT
systems, knowledge sharing etc
Internal Business Perspective
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➢ “What must we do to continue to improve and create
value for our shareholders, customers, employees etc.
now and in the future?”
➢ Future value depends on the company’s ability to
innovate, improve and learn.
➢ The objective is to ensure long-term growth and
success.
• Examples: New product development, employee
learning, vision, leadership, innovative / creative
skills etc.
Learning and Growth
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➢ “How do the shareholders see us?”
➢ Summarises the financial outcomes of organisational
performance and management decisions and actions.
• Examples: Revenue management, cost
management, cost of capital, working capital
management, project appraisals and investments
etc.
Financial Perspective
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Components of BSC
Strategic Theme
Financial
Customer
Internal
Learning
Goal
What does the x-
axis tell us?
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1. Objectives: What do we seek to achieve relative to
our strategy?, i.e. increase customer retention
2. Measures: How do we measure our performance
relative to the objective? i.e. # of repeat customers
3. Goal: What is our target performance? i.e. to retain
75% of all customers
4. Initiatives: What initiatives to do implement to
achieve the objective and reach our goal? i.e.
loyalty scheme.
What does the X-axis show?
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What does the X-axis shown (cont’d)?
Remember – the four components are linked:
• Objectives are set relative to strategy
• Measures are set relative to objectives
• Goals are set relative to objectives and measures
• Initiatives are set relative to objectives, measures and
goals.
They are all set relative to strategy. Remember that strategy is unique to
the organisation. Therefore, the objectives, measures, goals and initiatives
you develop to implement the strategy must also be unique.
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Characteristics of a Poorly Designed BSC
• Not linked to strategy
• Imposed in a top down fashion, not driven by employees
• Unbalanced - favors one perspective over the others (i.e. a
strong focus on financial outcomes and no focus on what
drivers the financial outcomes, i.e. the human aspects)
• Unrealistic and complex objectives and goals – may dis-
incentivise employees
• Untimely.
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Exercise
• You are the Strategy and Operations Manager of a luxury cruise
line based in Florida, USA.
• You have been told to implement the company’s strategy across a
fleet of 5 cruise ships. You will use the BSC.
Company information
We offer 6 star luxury cruising on worldwide itineraries. The product is all-inclusive.
The accommodation is based on suites with private balcony
Our customers are US celebrity guests, who are very demanding
and require customised services
Per diem rate: US$5,000-10,000
• The key strategic objective is to increase shipboard revenue and
ensure Service Excellency by customising services to meet the
individual needs of cruise travellers.
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You should now be able to:
1. Apply the Working Capital concepts
➢Cash Conversion Cycle
➢Turnover Ratios
2. Examine effect of Working Capital decisions
on Asset Turnover and Return on Assets.
3. Assess and Design Working Capital Policy
4. Understand, create and apply the principles
of the Balanced Scorecard.