Working Capital is the firm’s investment in short term assets, i.e. cash, inventory, accounts receivable, marketable securities


Net working capital is the amount of current assets minus the amount of current liabilities.  Another way to look at it is the amount of current assets financed by long term sources.


A high level of working capital doesn’t insure that the firm will be able to meet its obligations.   Inventory must be liquid, accounts receivable must be collectible in a reasonable amount of time.



The cash conversion cycle is the period of time from when payment is made on inventories until cash is received from accounts receivable.  Its how long the firm must finance the inventory itself.


-  We purchase raw materials, but we don’t have to pay for them at time of purchase. 


-  We have to pay for the inventories based on the terms offered by our suppliers.


-  We convert the raw materials into finished goods.


-  We sell the finished goods, but we don’t get paid for them yet, we get accounts receivable.


-  Once we finally collect the accounts, the cash conversion cycle is complete.


Inventory conversion cycle is the time span between purchasing raw materials and selling the finished inventory.


The inventory conversion cycle is the same as the average age of inventory:


Inventory conversion period = Inventory / COGS per day.


The receivables collection period is the amount of time from selling the finished goods until the receivable is collected.  It is also called the average collection period or days sales outstanding.


Receivables collection period:  receivables / average daily credit sales.


Payments deferral period:  amount of time between buying inventory and having to pay for it.


Payables deferral period = accounts payable / avg daily credit purchases


Therefore:  cash conversion cycle = inventory conversion period + receivables collection period - payables deferral period.





                          Inventory                                   Receivables

¬---------------- conversion ----------------® ¬----- Collection ----®

                            period                                          Period


           Payables                                         Cash

¬------ deferral -------® ¬----------------- conversion ---------------®

              period                                           cycle


Purchase Raw        Pay for                                                 Collect

Materials               purchased                                           accounts

                               Materials                                          receivable


                             CASH OUT                                          CASH IN



¬--- their money -----® ¬----------------  our money ---------------®




The longer the cash conversion cycle, the higher our financing costs will be.  Holding less inventory will reduce the inventory collection period, but may result in stockouts.  Tougher credit policies could also reduce the amount of funding needed by reducing the days sales outstanding, but may result in lower sales.  Also, we could delay payment on the accounts payable, but that may have adverse effects on our relationships with our suppliers.


Holding lower amounts of inventory and accounts receivable is called a restricted current asset policy.  Holding higher amounts of inventory and accounts receivable is called a relaxed current asset policy.



Alternative Net Operating Working Capital Policies


          Relaxed:  high percentage of working capital to sales

          Moderate:  moderate percentage

          Restricted:  low percentage


          Relaxed:  less risk of stockouts, etc.

          Restricted:  more risk of stockouts, etc.




Reasons for holding cash:





          Compensating balances


Cash budget


Cash management

          Cash flow synchronization

          Speeding up check clearing

              Check 21





          Speeding up receipts




Inventory control



Receivables Management

          Credit policy

              Credit period


              Credit standards

              Collection period




          Aging schedules

              Time periods


Accruals and Accounts Payable


          Cost or trade credit


          2/10 n30


          2%/98% x 365/20 = 37.2%


          EAR = 1.020418.25 - 1 = 1.4459 – 1 = 44.6%


          “stretching” accounts payable




Alternative short-term financing policies


So far we’ve looked at the level of assets that need financed.  Now we will look at how to finance them.


Of course, part of our inventory is financed by our suppliers.  But cash, the remaining part of inventory and accounts receivable need to be financed also.


Permanent current assets is the level that current assets never fall below, does not vary with season.


Temporary current assets is the amount of current assets over the permanent amount, varies with season.







The first strategy for financing working capital is the matching maturities, self liquidating approach.  Permanent current assets are financed by long-term sources, temporary current assets by current liabilities.


Usually long term financing costs more than short-term financing.  Therefore this approach has some higher cost liabilities financing current assets.


The aggressive strategy for financing working capital finances has some permanent current assets financed by current liabilities.  Since current liabilities have a lower cost, this increases the profits of the firm.


For the conservative approach, all permanent current assets are financed by long term sources along with some of the temporary current assets.  Risk is decreased but costs increase.


Advantages and disadvantages of short-term financing:


- Speed

- Flexibility

- Cost

- Risk


Sources of short-term financing (maturities within 1 year)


Accruals are spontaneous and have no explicit interest rate.


- accounts payable, also called trade credit

- taxes payable


Short-term bank loans


- promissory note

- compensating balance requirements

- line of credit

- revolving credit agreement

- commitment fee


Secured loans


- collateral

- pledging and factoring accounts receivable

- blanket lien

- trust receipt, i.e. floorplanning

- warehousing





Costs of short-term borrowing


Note:  APR is nominal rate, EAR includes compounding.


The amount of usable funds may be less than the total amount borrowed because of compensating balances, discount loans, etc..


The dollar cost of borrowing may be more than just the interest due to other charges. 


For example:


Trade credit with discount period:


With credit terms of 2/10, n30, the total amount is due in 30 days, but if we pay within the first 10 days we only have to pay 98% of amount.  In effect, we are paying 2% of the original amount in order to borrow 98% for 20 days.


First, how much are we paying in interest per period?


(discount amount) / (full amount - discount amount)


in our case:   2% / 98% = 2.041%


How many periods in a year?


360 / (Net due period - discount period) = 18 periods per year


2.041% x 18 = 36.74%


Therefore, the implicit rate of interest paid to borrow the money for the remaining 20 days is over 37%, much greater than bank loans.

Discount interest loans


On a discount loan the interest is deducted from the total loan amount in determining the net proceeds of the loan.


What if the bank charged a fee also?  Any fee would increase the numerator and decrease the denominator as it would increase the borrowing cost and decrease the net proceeds of the loan.


Cash management


Reasons for holding cash:


- transactions

- precautionary

- speculative


Cash management techniques


- Cash forecasts, aka cash budgets

- Cash flow synchronization

- Float




Acceleration of receipts


- Lockbox arrangements



Marketable securities


- substitute for cash, funds put to work temporarily

- temporary investment


Credit management


Credit policy


- credit standards

- terms

  - credit period

  - cash discount

- collection policy


Receivables monitoring



- Aging