Chapter 14

Working Capital
and Current Asset
Management
Long & Short Term Assets & Liabilities

Current Assets: Current Liabilities:

Cash Accounts Payable
Marketable Securities Accruals
Prepayments Short-Term Debt
Accounts Receivable Taxes Payable
Inventory

Fixed Assets: Long-Term Financing:

Investments Debt
Plant & Machinery Equity
Land and Buildings

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Net Working Capital

• Working Capital includes a firm’s current

assets, which consist of cash and marketable
securities in addition to accounts receivable
and inventories.
• It also consists of current liabilities, including
accounts payable (trade credit), notes payable
(bank loans), and accrued liabilities.
• Net Working Capital is defined as total current
assets less total current liabilities.

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The Tradeoff Between
Profitability & Risk
• Positive Net Working Capital (low return and low risk)
Current Current
low
Assets Liabilities cost
low
return
Net Working
Capital > 0
high
Long-Term cost
Debt
high
return
highest
Fixed cost
Assets Equity
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The Tradeoff Between
Profitability & Risk (cont.)
• Negative Net Working Capital (high return and high risk)
Current Current
low Assets Liabilities
return low
Net Working
cost
Capital < 0

high Long-Term high

return Debt cost

Fixed highest
Assets Equity cost
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The Tradeoff Between
Profitability & Risk (cont.)

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The Cash Conversion Cycle

• Short-term financial management—managing current

assets and current liabilities—is on of the financial
manager’s most important and time-consuming
activities.
• The goal of short-term financial management is to
manage each of the firms’ current assets and liabilities
to achieve a balance between profitability and risk that
contributes positively to overall firm value.
• Central to short-term financial management is an
understanding of the firm’s cash conversion cycle.

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Calculating the Cash Conversion Cycle

The Operating Cycle (OC) is the time between ordering

materials and collecting cash from receivables.

The Cash Conversion Cycle (CCC) is the time between

when a firm pays it’s suppliers (payables) for inventory
and collecting cash from the sale of the finished product.

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Calculating the Cash
Conversion Cycle (cont.)
• Both the OC and CCC may be computed
as shown below.

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Calculating the Cash
Conversion Cycle (cont.)
MAX Company, a producer of paper dinnerware, has
annual sales of $10 million, cost of goods sold of 75% of
sales, and purchases that are 65% of cost of goods sold.
MAX has an average age of inventory (AAI) of 60 days,
an average collection period (ACP) of 40 days, and an
average payment period (APP) of 35 days.

Using the values for these variables, the cash

conversion cycle for MAX is 65 days (60 + 40 - 35) and
is shown on a time line in Figure 14.1.
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Calculating the Cash
Conversion Cycle (cont.)

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Calculating the Cash
Conversion Cycle (cont.)
The resources MAX has invested in the cash
conversion cycle assuming a 365-day year are:

Obviously, reducing AAI or ACP or lengthening APP will

reduce the cash conversion cycle, thus reducing the amount
of resources the firm must commit to support operations.
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Strategies for Managing the CCC

1. Turn over inventory as quickly as possible

without stock outs that result in lost sales.
2. Collect accounts receivable as quickly as
possible without losing sales from high-
pressure collection techniques.
3. Manage, mail, processing, and clearing time to
reduce them when collecting from customers
and to increase them when paying suppliers.
4. Pay accounts payable as slowly as possible
without damaging the firm’s credit rating.
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Inventory Management:
Inventory Fundamentals
• Classification of inventories:
– Raw materials: items purchased for use in
the manufacture of a finished product
– Work-in-progress: all items that are currently
in production
– Finished goods: items that have been
produced but not yet sold

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Inventory Management:
Differing Views About Inventory
• The different departments within a firm (finance,
production, marketing, etc.) often have differing views
about what is an “appropriate” level of inventory.
• Financial managers would like to keep inventory levels
low to ensure that funds are wisely invested.
• Marketing managers would like to keep inventory
levels high to ensure orders could be quickly filled.
• Manufacturing managers would like to keep raw
materials levels high to avoid production delays and to
make larger, more economical production runs.

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Techniques for Managing Inventory

• The ABC System

– The ABC system of inventory management divides
inventory into three groups of descending order of
importance based on the dollar amount invested
in each.
– A typical system would contain, group A would
consist of 20% of the items worth 80% of the total
dollar value; group B would consist of the next largest
investment, and so on.
– Control of the A items would intensive because of the
high dollar investment involved.

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Techniques for Managing
Inventory (cont.)
• The Economic Order Quantity (EOQ) Model

EOQ = 2 x S x O
C

• Where:
– S = usage in units per period (year)
– O = order cost per order
– C = carrying costs per unit per period (year)
– Q = order quantity in units

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Techniques for Managing
Inventory (cont.)
• The Economic Order Quantity (EOQ) Model
Assume that RLB, Inc., a manufacturer of electronic test
equipment, uses 1,600 units of an item annually. Its order
cost is $50 per order, and the carrying cost is $1 per unit per
year. Substituting into the above equation we get:

EOQ = 2(1,600)($50) = 400

$1
The EOQ can be used to evaluate the total cost of inventory
as shown on the following slides.

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Techniques for Managing
Inventory (cont.)
• The Economic Order Quantity (EOQ) Model

Ordering Costs = Cost/Order x # of Orders/Year

Ordering Costs = $50 x 4 = $200
Carrying Costs = Carrying Costs/Year x Order Size
2

Carrying Costs = ($1 x 400)/2 = $200

Total Costs = Ordering Costs + Carrying Costs

Total Costs = $200 + $200 = $400
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Techniques for Managing
Inventory (cont.)
• The Reorder Point
– Once a company has calculated its EOQ, it must
determine when it should place its orders.
– More specifically, the reorder point must consider
the lead time needed to place and receive orders.
– If we assume that inventory is used at a constant rate
throughout the year (no seasonality), the reorder
point can be determined by using the
following equation:
Reorder point = lead time in days x daily usage

Daily usage = Annual usage/360

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Techniques for Managing
Inventory (cont.)
• The Reorder Point
Using the RIB example above, if they know that it requires 10 days to
place and receive an order, and the annual usage is 1,600 units per
year, the reorder point can be determined as follows:

Daily usage = 1,600/360 = 4.44 units/day

Reorder point = 10 x 4.44 = 44.44 or 45 units

Thus, when RIB’s inventory level reaches 45 units, it should place an

order for 400 units. However, if RIB wishes to maintain safety stock
to protect against stock outs, they would order before inventory
reached 45 units.
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Techniques for Managing
Inventory (cont.)
• Just-In-Time (JIT) System
– The JIT inventory management system minimizes
the inventory investment by having material inputs
arrive exactly at the time they are needed
for production.
– For a JIT system to work, extensive coordination
must exist between the firm, its suppliers, and
shipping companies to ensure that material inputs
arrive on time.
– In addition, the inputs must be of near perfect quality
and consistency given the absence of safety stock.

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Techniques for Managing
Inventory (cont.)
• Computerized Systems for
Resource Control
– MRP systems are used to determine what to
order, when to order, and what priorities to
assign to ordering materials.
– MRP uses EOQ concepts to determine how
much to order using computer software.
– It simulates each product’s bill of materials
structure all of the product’s parts), inventory
status, and manufacturing process.
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Techniques for Managing
Inventory (cont.)
• Computerized Systems for Resource Control
– Like the simple EOQ, the objective of MRP systems
is to minimize a company’s overall investment in
inventory without impairing production.
– Manufacturing resource planning II (MRP II) is an
extension of MRP that integrates data from numerous
areas such as finance, accounting, marketing,
engineering, and manufacturing suing a sophisticated
computer system.
– This system generates production plans as well as
numerous financial and management reports.

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Techniques for Managing
Inventory (cont.)
• Computerized Systems for Resource Control
– Unlike MRP and MRP II, which tend to focus on
internal operations, enterprise resource planning
(ERP) systems can expand the focus externally to
include information about suppliers and customers.
– ERP electronically integrates all of a firm’s
departments so that, for example, production can call
up sales information and immediately know how
much must be produced to fill certain
customer orders.

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Inventory Management:
International Inventory Management
• International inventory management is
typically much more complicated for exporters
and MNCs.
• The production and manufacturing economies of
scale that might be expected from selling
globally may prove elusive if products must be
tailored for local markets.
• Transporting products over long distances often
results in delays, confusion, damage, theft, and
other difficulties.
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Accounts Receivable Management

• The second component of the cash conversion

cycle is the average collection period – the
average length of time from a sale on credit until
the payment becomes usable funds to the firm.
• The collection period consists of two parts:
– the time period from the sale until the customer mails
payment, and
– the time from when the payment is mailed until the
firm collects funds in its bank account.

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Accounts Receivable Management:
The Five Cs of Credit
• Character: The applicant’s record of meeting
past obligations.
• Capacity: The applicant’s ability to repay the
requested credit.
• Capital: The applicant’s debt relative to equity.
• Collateral: The amount of assets the applicant
has available for use in securing the credit.
• Conditions: Current general and industry-
specific economic conditions.
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Accounts Receivable Management:
Credit Scoring
• Credit scoring is a procedure resulting in a
score that measures an applicant’s overall credit
strength, derived as a weighted-average of
scores of various credit characteristics.
• The procedure results in a score that measures
the applicant’s overall credit strength, and the
score is used to make the accept/reject decision
for granting the applicant credit.

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Accounts Receivable Management:
Credit Scoring (cont.)
• The purpose of credit scoring is to make a
relatively informed credit decision quickly
and inexpensively.
• For a demonstration of credit scoring,
including the use of a spreadsheet for that
purpose, see the book’s Web site at
www.aw.com/gitman.

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Accounts Receivable Management:
Changing Credit Standards
• The firm sometimes will contemplate changing
its credit standards to improve its returns and
generate greater value for its owners.

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Changing Credit Standards Example

Dodd Tool, a manufacturer of lathe tools, is currently selling a product

for $10/unit. Sales (all on credit) for last year were 60,000 units. The
variable cost per unit is $6. The firm’s total fixed costs are $120,000.

Dodd is currently contemplating a relaxation of credit standards that is

anticipated to increase sales 5% to 63,000 units. It is also anticipated
that the ACP will increase from 30 to 45 days, and that bad debt
expenses will increase from 1% of sales to 2% of sales. The
opportunity cost of tying funds up in receivables is 15%.

Given this information, should Dodd relax its credit standards?

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Changing Credit
Standards Example (cont.)
Dodd Tool Company
Analysis of Relaxing Credit Standards
Relevant Data
Present Sales Level (units) 60,000
Proposed Sales Level (units) 63,000
Price/unit ($) $ 10.00
Variable Cost/unit ($) $ 6.00
Contributin Margin/unit ($) $ 4.00
Old Receivables Level (days) 30.0

New Receivables Level (days) 45.0

Present A/R Turnover (365/AR) 12.2
Proposed A/R Turnover (365/AR) 8.1
Present Bad Debt Level (% of sales) 1.0%
Proposed Bad Debt Level (% of sales) 2.0%
Opportunity Cost (%) 15.0%
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Changing Credit
Standards Example (cont.)
• Additional Profit Contribution from Sales

Dodd Tool Company

Analysis of Rexaxing Credit Standards
Additional Profit Contribution from Sales
Old Sales Level 60,000 Price/Unit $ 10.00
New Sales Level 63,000 Variable Cost/Unit $ 6.00
Increase in Sales 3,000 Contribution Margin/Unit $ 4.00
Additional Profit Contribution from Sales (sales incr x cont margin) $ 12,000

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Changing Credit
Standards Example (cont.)
Dodd Tool Company
Analysis of Rexaxing Credit Standards
Cost of Marginal Investment in Accounts Receivable
Cost of Marginal Investment in A/R = Total VC/Turnover of A/R
Total VC = VC/Unit X # of Units
Total VC Under the Present Plan $ 360,000
Total VC Under the Proposed Plan $ 378,000
Average Investment Under Present Plan $ 29,508
Average Investment Under Proposed Plan $ 46,667
Marginal Investment in Accounts Receivable $ 17,158
Opportunity Cost 15.0%
Cost of Marginal Investment in Accounts Receivable $ 2,574
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Changing Credit
Standards Example (cont.)
Dodd Tool Company
Analysis of Relaxing Credit Standards
Cost of Marginal Bad Debt
Cost of Bad Debt = Bad Debt % x Total Sales
Total Sales under Present Plan $ 600,000
Total Sales under Proposed Plan $ 630,000
Bad Debt % under Present Plan 1.0%
Bad Debt % under Proposed Plan 2.0%

Cost of Bad Debt under Present Plan $ 6,000

Cost of Bad Debt under Proposed Plan $ 12,600
Cost of Marginal Bad Debts $ 6,600
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Changing Credit
Standards Example (cont.)

Dodd Tool Company

Analysis of Relaxing Credit Standards
Making the Credit Standard Decision
Additional Profit Contribution from Sales $ 12,000
Cost of Marginal Investment in Accounts Receivable (2,574)
Cost of Marginal Bad Debts (6,600)
Net Profit From Implementation of Proposed Plan $ 2,826

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Changing Credit Terms

• A firm’s credit terms specify the repayment

terms required of all of its credit customers.
• Credit terms are composed of three parts:
– The cash discount
– The cash discount period
– The credit period

• For example, with credit terms of 2/10 net 30,

the discount is 2%, the discount period is 10
days, and the credit period is 30 days.

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Changing Credit Terms Example
MAX Company has an average collection period of 40
days (turnover = 365/40 = 9.1). In accordance with the
firm’s credit terms of net 30, this period is divided into 32
days until the customers place their payments in the mail
(not everyone pays within 30 days) and 8 days to receive,
process, and collect payments once they are mailed.

MAX is considering initiating a cash discount by changing

its credit terms from net 30 to 2/10 net 30. The firm
expects this change to reduce the amount of time until the
payments are placed in the mail, resulting in an average
collection period of 25 days (turnover = 365/25 = 14.6).
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Changing Credit
Terms Example (cont.)

Insert Table 14.3 here

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Credit Monitoring

• Credit monitoring is the ongoing review of a

firm’s accounts receivable to determine whether
customers are paying according to the stated
credit terms.
• Slow payments are costly to a firm because
they lengthen the average collection period
and increase the firm’s investment in
accounts receivable.
• Two frequently used techniques for credit
monitoring are the average collection period and
aging of accounts receivable.
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Credit Monitoring:
Average Collection Period
• The average collection period is the average
number of days that credit sales are outstanding
and has two parts:
– The time from sale until the customer places the
payment in the mail, and
– The time to receive, process, and collect payment.

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Credit Monitoring:
Aging of Accounts Receivable

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Credit Monitoring:
Collection Policy
• The firm’s collection policy is its
procedures for collecting a firm’s accounts
receivable when they are due.
• The effectiveness of this policy can be
partly evaluated by evaluating at the level
of bad expenses.
• As seen in the previous examples, this
level depends not only on collection policy
but also on the firm’s credit policy.
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Collection Policy

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Spontaneous Liabilities

• Spontaneous liabilities arise from the normal

course of business.
• The two major spontaneous liability sources are
accounts payable and accruals.
• As a firm’s sales increase, accounts payable
and accruals increase in response to the
increased purchases, wages, and taxes.
• There is normally no explicit cost attached to
either of these current liabilities.

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Spontaneous Liabilities: Accounts
Payable Management
• Accounts payable are the major source of
unsecured short-term financing for
business firms.
• The average payment period has two parts:
– The time from the purchase of raw materials until the
firm mails the payment
– Payment float time (the time it takes after the firm
mails its payment until the supplier has withdrawn
spendable funds from the firm’s account

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Spontaneous Liabilities: Accounts
Payable Management (cont.)
• The firm’s goal is to pay as slowly as possible
without damaging its credit rating.

In the demonstration of the cash conversion cycle in Chapter 14,

MAX Company had an average payment period of 35 days, which
resulted in average accounts payable of $467,466. Thus, the daily
accounts payable generated is $13,356. If MAX were to mail its
payments in 35 days instead of 30, it would reduce its investment in
operations by $66,780. If this did not damage MAX’s credit rating, it
would clearly be in its best interest to pay later.

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Spontaneous Liabilities: Analyzing
Credit Terms
• Credit terms offered by suppliers allow a firm to
delay payment for its purchases.
• However, the supplier probably imputes the cost
of offering terms in its selling price.
• Therefore, the firm should analyze credit terms
to determine its best credit strategy.
• If a cash discount is offered, the firm has two
options—to take the cash discount or to give
it up.
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Spontaneous Liabilities: Analyzing
Credit Terms (cont.)
• Taking the Cash Discount
– If a firm intends to take a cash discount, it should
pay on the last day of the discount period.
– There is no cost associated with taking a
cash discount.

Lawrence Industries, operator of a small chain of video stores,

purchased $1,000 worth of merchandise on February 27 from a
supplier extending terms of 2/10 net 30 EOM. If the firm takes the
cash discount, it will have to pay $980 [$1,000 - (.02 x $1,000)] on
March 10th saving $20.

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Spontaneous Liabilities: Analyzing
Credit Terms (cont.)
• Giving Up the Cash Discount
– If a firm chooses to give up the cash discount, it
should pay on the final day of the credit period.
– The cost of giving up a cash discount is the implied
rate of interest paid to delay payment of an account
payable for an additional number of days.

If Lawrence gives up the cash discount, payment can be made on

March 30th. To keep its money for an extra 20 days, the firm must
give up an opportunity to pay $980 for its $1,000 purchase, thus
costing $20 for an extra $20 days.

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Spontaneous Liabilities: Analyzing
Credit Terms (cont.)
• Giving Up the Cash Discount

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Spontaneous Liabilities: Analyzing
Credit Terms (cont.)
• Giving Up the Cash Discount

Cost = % discount x 365

100% - %discount credit pd - discount pd

Cost = 2% x 365 = 37.24%

100% - 2% 30 - 10

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Spontaneous Liabilities: Analyzing
Credit Terms (cont.)
• Giving Up the Cash Discount

The preceding example suggest that the firm should take

the cash discount as long as it can borrow from other
sources for less than 37.24%. Because nearly all firms
can borrow for less than this (even using credit cards!)
they should always take the terms 2/10 net 30.

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Spontaneous Liabilities: Analyzing
Credit Terms (cont.)
• Using the Cost of Giving Up the Cash Discount

Mason Products, a large building-supply company, has four possible

suppliers, each offering different credit terms. Table 15.1 on the
following slide presents the credit terms offered by its suppliers and
the cost of giving up the cash discount in each transaction.

If the firm needs short-term funds, which it can borrow from its bank
at 13%, and if each of the suppliers is viewed separately, which (if
any) of the suppliers discounts should the firm give up?

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Spontaneous Liabilities: Analyzing
Credit Terms (cont.)
• Using the Cost of Giving Up the Cash Discount

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Spontaneous Liabilities: Effects of
Stretching Accounts Payable
• Stretching accounts payable simply involves paying
bills as late as possible without damaging credit rating.
• This can reduce the cost of giving up the discount.

Lawrence Industries was extended credit terms of 2/10 net 30 EOM.

The cost of giving up the cash discount is 36.5%. If Lawrence were
able to stretch its accounts payable to 70 days without damaging its
credit rating, the cost of giving up the cash discount would fall from
36.5% to only 12.2% [2% x (365/60)].

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Spontaneous Liabilities: Accruals

• Accruals are liabilities for services received for

which payment has yet to be made.
• The most common items accrued by a firm are
wages and taxes.
• While payments to the government cannot be
manipulated, payments to employees can.
• This is accomplished by delaying payment of
wages, or stretching the payment of wages for
as long as possible.

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Unsecured Sources of Short-Term
Loans: Bank Loans
• The major type of loan made by banks to businesses is
the short-term, self-liquidating loan which are
intended to carry firms through seasonal peaks in
financing needs.
• These loans are generally obtained as companies
build up inventory and experience growth in
accounts receivable.
• As receivables and inventories are converted into cash,
the loans are then retired.
• These loans come in three basic forms: single-
payment notes, lines of credit, and revolving
credit agreements.
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Unsecured Sources of Short-Term
Loans: Bank Loans (cont.)
• Loan Interest Rates
– Most banks loans are based on the prime
rate of interest which is the lowest rate of
interest charged by the nation’s leading banks
on loans to their most reliable business
borrowers.
– Banks generally determine the rate to be
charged to various borrowers by adding a
premium to the prime rate to adjust it for the
borrowers “riskiness.”
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Unsecured Sources of Short-Term
Loans: Bank Loans (cont.)
• Fixed & Floating-Rate Loans
– On a fixed-rate loan, the rate of interest is
determined at a set increment above the prime rate
and remains at that rate until maturity.
– On a floating-rate loan, the increment above the
prime rate is initially established and is then allowed
to float with prime until maturity.
– Like ARMs, the increment above prime is generally
lower on floating rate loans than on fixed-rate loans.

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Unsecured Sources of Short-Term
Loans: Bank Loans (cont.)
• Method of Computing Interest
– Once the nominal (stated) rate of interest is
established, the method of computing interest
is determined.
– Interest can be paid either when a loan matures or
in advance.
– If interest is paid at maturity, the effective (true) rate
of interest—assuming the loan is outstanding for
exactly one year—may be computed as follows:
Interest
Amount Borrowed
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Unsecured Sources of Short-Term
Loans: Bank Loans (cont.)
• Method of Computing Interest
– If the interest is paid in advance, it is deducted from
the loan so that the borrower actually receives less
money than requested.
– Loans of this type are called discount loans. The
effective rate of interest on a discount loan assuming
it is outstanding for exactly one year may be
computed as follows:

Interest
Amount Borrowed - Interest

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Unsecured Sources of Short-Term
Loans: Bank Loans (cont.)
• Method of Computing Interest

Booster Company, a manufacturer of athletic

apparel, wants to borrow $10,000 at a stated rate of
10% for 1 year. If interest is paid at maturity, the
effective interest rate may be computed as follows:

(10% X $10,000) = 10.0%

$10,000

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Unsecured Sources of Short-Term
Loans: Bank Loans (cont.)
• Method of Computing Interest
Booster Company, a manufacturer of athletic
apparel, wants to borrow $10,000 at a stated rate of
10% for 1 year. If interest is paid at maturity, the
effective interest rate may be computed as follows:

If this loan were a discount loan, the effective rate of

interest would be:
(10% X $10,000) = 11.1%
$10,000 - $1,000
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Unsecured Sources of Short-Term
Loans: Bank Loans (cont.)
• Single Payment Notes
– A single-payment note is a short-term, one-time
loan payable as a single amount at its maturity.
– The “note” states the terms of the loan, which include
the length of the loan as well as the interest rate.
– Most have maturities of 30 days to 9 or more months.
– The interest is usually tied to prime and may be either
fixed or floating.

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Unsecured Sources of Short-Term
Loans: Bank Loans (cont.)
• Single Payment Notes
Gordon Manufacturing recently borrowed $100,000 from each of 2
banks—A and B. Loan A is a fixed rate note, and loan B is a floating
rate note. Both loans were 90-day notes with interest due at the end
of 90 days. The rates were set at 1.5% above prime for A and 1.0%
above prime for B when prime was 6%.

Based on this information, the total interest cost on loan A is $1,849

[$100,000 x 7.5% x (90/365)]. The effective cost is 1.85% for 90
days. The effective annual rate may be calculated as follows:

EAR = (1 + periodic rate)m - 1 = (1+. 0185)4.06 - 1 = 7.73%

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Unsecured Sources of Short-Term
Loans: Bank Loans (cont.)
• Single Payment Notes
During the 90 days that loan B was outstanding, the prime rate
was 6% for the first 30 days, 6.5% for the next 30 days, and
6.25% for the final 30 days. As a result, the periodic rate was
.575% [7% x (30/365)] for the first 30 days, .616% for the second
30 days, and .596% for the final 30 days. Therefore, its total
interest cost was $1,787 [$100,000 x (.575% + .616% + .596%)].

Thus, the effective cost is 1.787% for 90 days. The effective

annual rate may be calculated as follows:

EAR = (1 + periodic rate)m - 1 = (1+.01787)4.06 - 1 = 7.46%

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