FINC 331-WEEK 7: Cash Collections
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Chapter17-IntroductiontoWorkingCapital.pdf
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C h a p te r 17
In tr od
uc tio
n to
W or ki ng
C ap
ita l
ht tp s: // w w w .b ou
nd le ss .c om
/ na
nc e/ in tr od
uc tio
n- to -w
or ki ng
-
ca p ita
l/
C al cu
la tin
g W or ki ng
C ap
ita l
C on
tr ol lin
g th e C om
p on
en ts
of W or ki ng
C ap
ita l
Im p or ta nc
e of
W or ki ng
C ap
ita l
Se ct io n 1
W or ki ng
C ap
ita l
85 3
ht tp s: // w w w .b ou
nd le ss .c om
/ na
nc e/ in tr od
uc tio
n- to -w
or ki ng
-c ap
ita l/w
or ki ng
-c ap
ita l/
C al cu
la tin
g W or ki ng
C ap
ita l
W or ki ng
C ap
ita l=
cu rr en
t as
se ts
- cu
rr en
t lia b ili tie
s.
K E Y P O IN TS
• W C is cu rr en t as se ts m in u s cu rr en t li ab il it ie s. C om p an ie s
w an t p os it iv e W C .
• W C is an si gn al of w h et h er or n ot th e co m p an y h as en ou gh
as se ts to tu rn in to ca sh to p ay u p co m in g ex p en se s or d eb ts .
• W C is a m ea su re m en t of li qu id it y an d is n ot a gu ar an te e th at
a co m p an y ca n p ay fo r it s li ab il it ie s.
W or ki n g ca p it al (W C ) is a fi n an ci al m et ri c w h ic h re p re se n ts
op er at in g li qu id it y av ai la bl e to a bu si n es s, or ga n iz at io n ,o r ot h er
en ti ty ,i n cl u d in g go ve rn m en ta le n ti ty .A lo n g w it h fi xe d as se ts ,s u ch
as p la n t an d eq u ip m en t, w or ki n g ca p it al is co n si d er ed a p ar t of
op er at in g ca p it al .
W or ki n g ca p it al ca n be fo u n d th ro u gh th e fo ll ow in g fo rm u la :
W C = C A -C L (W or ki n g C ap it al = cu rr en t as se ts - cu rr en t li ab il it ie s)
C u rr en t as se ts (C A ) is an ac co u n ti n g te rm th at re fe rs to as se ts th at
ca n ea si ly be tu rn ed in to ca sh .F or ex am p le ,c as h is a cu rr en t as se t,
bu t so ar e m os t ac co u n ts re ce iv ab le .
C u rr en t li ab il it ie s (C L ) is an ac co u n ti n g te rm si m il ar to C A :C L is
th e am ou n t of li ab il it ie s th at ar e ex p ec te d to be se tt le d in ca sh
w it h in a ye ar (o r th e op er at in g cy cl e of th e co m p an y) .
T h e d if fe re n ce be tw ee n th e tw o (W C ) is a m ea su re m en t of li qu id it y.
It si gn al s w h et h er or n ot th e co m p an y h as en ou gh as se ts to tu rn
in to ca sh to p ay of fu p co m in g li ab il it ie s. It is n ot a p er fe ct si gn al ,
h ow ev er .
Si n ce m os t ex p en se s an d d eb t m u st be p ai d in ca sh (F ig u re 17 .1 ),
h av in g p os it iv e W C sh ow s th at th e co m p an y h as th e ab il it y to p ay
of fe xp en se s an d d eb t th at w il la ri se or co m e d u e in th e sh or t- te rm .
W C ,t h ou gh ,d oe s n ot gu ar an te e th at a co m p an y ca n p ay of fa ll
sh or t- te rm ex p en se s or li ab il it ie s. Si m p ly h av in g p os it iv e W C d oe s
85 4
M os
t p ur ch
as es
, in cl ud
in g fo od
, m us
t b e m ad
e w ith
a sp
ec i c as
se t–
ca sh
.N ot
al lc
ur re nt
as se
ts ca
n b e us
ed to
p ay
o ex
p en
se s
of d eb
ts .
Fi g ur e 17
.1 B uy in g
Fo od
n ot m ea n n ec es sa ri ly th at a co m p an y w il lb e ab le to p ay of fa ll
ex p en se s. Su p p os e th at a co m p an y h as cu rr en t as se ts of $ 10 0 :$ 20
of ca sh an d $ 8 0 of ac co u n ts re ce iv ab le .T h ey al so h av e $ 50 of
cu rr en t li ab il it ie s. T h at m ea n s th at th ey h av e W C of + $ 50 .O n e of
th ei r ac co u n ts p ay ab le co m es d u e to m or ro w ,s o th e co m p an y ow es
$ 40 .T h ey h av e $ 20 of ca sh on h an d ,b u t ca n 't ge t th e ot h er $ 20 by
to m or ro w be ca u se th ey ca n 't co ll ec t $ 20 of ac co u n ts re ce iv ab le by
to m or ro w .T h e co m p an y ca n n ot p ay a sh or t- te rm ex p en se ,e ve n
th ou gh a p os it iv e W C sa ys th at th e co m p an y sh ou ld be ab le to p ay
of fm os t ex p en se s an d lo an s in th e sh or t- te rm .
W C is n ot a gu ar an te e th at th e co m p an y w il lh av e en ou gh ca sh fo r
ea ch ex p en se ,m er el y th at th ey h av e op er at in g li qu id it y.
So u rc e: ht tp s: // w w w .b ou n d le ss .c om /f in a n ce /i n tr od u ct io n -t o-
w or ki n g -c a p it a l/ w or ki n g -c a p it a l/ ca lc u la ti n g -w or ki n g -c a p it a l/
C C -B Y -S A
B ou n d le ss is a n op en ly li ce n se d ed u ca ti on a lr es ou rc e
C on
tr ol lin g th e C om
p on
en ts
of W or ki ng
C ap
ita l
W or ki ng
ca p ita
l( W C )c
an b e co
nt ro lle d b y ch
an gi ng
th e
le ve
ls of
cu rr en
t as
se ts
an d /o r cu
rr en
t lia b ili tie
s th ro ug
h a nu
m b er
of m ec
ha ni sm
s.
K E Y P O IN TS
• In cr ea si n g cu rr en t as se ts or d ec re as in g cu rr en t li ab il it ie s
in cr ea se s W C ,a n d vi ce ve rs a.
• F ou r co m m on m ec h an is m s fo r co n tr ol li n g W C ar e ca sh
m an ag em en t, in ve n to ry m an ag em en t, d eb to rs m an ag em en t,
an d fi n an ci n g m an ag em en t.
• H av in g to o li tt le W C im p ai rs a co m p an y' s ab il it y to m ee t it 's
fi n an ci al ob li ga ti on s, w h il e h av in g to o m u ch W C ca n al so be
ba d be ca u se it m ea n s th at th er e ar e as se ts th at ar e n ot be in g
in ve st ed in th e lo n g- te rm .
C o n tr o ll in g th e C o m p o n e n ts o f W o rk in g C a p it a l
E ac h co m p an y h as d if fe re n t d em an d s fo r h ow m u ch W or ki n g
C ap it al (W C ) th ey n ee d ,b u t al lc om p an ie s p re fe r to h av e p os it iv e
W C (r ec al lt h at W C = cu rr en t as se ts - cu rr en t li ab il it ie s) .H av in g to o
li tt le W C im p ai rs a co m p an y' s ab il it y to m ee t it 's fi n an ci al
85 5
ob li ga ti on s. It is h ar d to p ay ex p en se s or d eb ts th at co m e d u e in th e
sh or t- te rm .H av in g to o m u ch W C ca n al so be ba d be ca u se it m ea n s
th at th er e ar e as se ts th at ar e n ot be in g in ve st ed .H ol d in g to o m an y
sh or t te rm as se ts sl ow s fu tu re gr ow th of th e co m p an y. T h u s,
m an ag in g W C to an ac ce p ta bl e le ve li s on e of th e m os t im p or ta n t
jo bs of m an ag em en t (F ig u re 17 .2 ).
W C ca n be ad ju st ed by in cr ea si n g or d ec re as in g it s tw o
co m p on en ts :c u rr en t as se ts (C A ) an d cu rr en t li ab il it ie s (C L ).
In cr ea si n g C A or d ec re as in g C L in cr ea se s W C ,a n d vi s ve rs a.
M an ag em en t ca n en ac t a n u m be r of p ol ic ie s, so m e of w h ic h ar e
h ig h li gh te d be lo w :
• C as h m an ag em en t: Id en ti fy th e ca sh ba la n ce th at al lo w s th e
bu si n es s to m ee t d ay to d ay ex p en se s, bu t re d u ce s ca sh
h ol d in g co st s. C as h is a C A .
• In ve n to ry m an ag em en t: Id en ti fy th e le ve lo fi n ve n to ry w h ic h
al lo w s fo r u n in te rr u p te d p ro d u ct io n bu t re d u ce s th e
in ve st m en t in ra w m at er ia ls — an d m in im iz es re or d er in g co st s
— an d h en ce in cr ea se s ca sh fl ow .I n ve n to ry is a C A .
• D eb to rs m an ag em en t: Id en ti fy th e ap p ro p ri at e cr ed it p ol ic y,
su ch as cr ed it te rm s, th at w il la tt ra ct cu st om er s, su ch th at an y
im p ac t on ca sh fl ow s an d th e ca sh co n ve rs io n cy cl e w il lb e
of fs et by in cr ea se d re ve n u e an d h en ce R et u rn on C ap it al (o r
vi ce ve rs a) .C re d it ex te n d ed to cu st om er s (a cc ou n ts
re ce iv ab le ) is a C A .
• F in an ci n g m an ag em en t: Id en ti fy th e ap p ro p ri at e so u rc e of
fi n an ci n g. Sh or t- te rm fi n an ci n g (a s w el la s lo n g- te rm
fi n an ci n g th at co m es d u e in th e n ex t ye ar or op er at in g cy cl e) is
a C L .
B y ad ju st in g th es e fo u r p ri m ar y in fl u en ce rs on C A an d C L ,
m an ag em en t ca n ch an ge W C to a d es ir ab le le ve l.
So u rc e: ht tp s: // w w w .b ou n d le ss .c om /f in a n ce /i n tr od u ct io n -t o-
w or ki n g -c a p it a l/ w or ki n g -c a p it a l/ co n tr ol li n g -t he -c om p on en ts -o f-
w or ki n g -c a p it a l/
C C -B Y -S A
B ou n d le ss is a n op en ly li ce n se d ed u ca ti on a lr es ou rc e
85 6
W al m at 's
C FO
, C ha
rle s H ol le y, is
re sp
on si b le
fo r
W al m ar t ha
vi ng
an ac
ce p ta b le
le ve
lo f
w or ki ng
ca p ita
l.
Fi g ur e 17
.2
W al m ar t C FO
Im p or ta nc
e of
W or ki ng
C ap
ita l
W or ki ng
ca p ita
l( W C )i s a m ea
su re m en
t of
a co
m p an
y' s
op er at in g liq
ui d ity .
K E Y P O IN TS
• W C is im p or ta n t fo r la rg e co m p an ie s' ab il it y to bo rr ow ,
in cr ea se th ei r sh ar e p ri ce ,p ay ex p en se s an d sh or t- te rm
d eb ts .
• W C is im p or ta n t fo r sm al lc om p an ie s th at ca n n ot ac ce ss
fi n an ci al m ar ke ts to bo rr ow ,a n d fo r st ar t- u p s th at n ee d to
su rv iv e u n ti lt h ey br ea k ev en .
• W C ca n n ot gu ar an te e w h et h er a co m p an y is fi n an ci al ly
so u n d ,b u t it gi ve s so m e in si gh t.
W or ki n g ca p it al (W C ) is an im p or ta n t m et ri c fo r al lb u si n es se s,
re ga rd le ss of th ei r si ze .W C is a si gn al of a co m p an y' s op er at in g
li qu id it y (F ig u re 17 .3 ). H av in g en ou gh W C m ea n s th at th e co m p an y
sh ou ld be ab le to p ay fo r al lo fi ts sh or t- te rm ex p en se s an d
li ab il it ie s.
L ar ge co m p an ie s p ay at te n ti on to W C fo r th e sa m e re as on as sm al l
on es d o: W C is a m ea su re of li qu id it y, an d th u s is a m ea su re of th ei r
fu tu re cr ed it -w or th in es s. C om p an ie s w h o w an t to bo rr ow by is su in g
bo n d s or p u rc h as in g co m m er ci al p ap er (a m ar ke t of la rg e, sh or t-
te rm lo an s fo r bi g co m p an ie s) w il lf in d it m or e ex p en si ve if th ey d o
n ot h av e en ou gh W C .I ft h ey ar e a p u bl ic co m p an y, th ei r st oc k p ri ce
m ay fa ll if th e m ar ke t d oe sn 't be li ev e th ey h av e ad eq u at e W C .
F or sm al lb u si n es se s an d st ar t- u p s, u n ab le to ac ce ss fi n an ci al
m ar ke ts fo r bo rr ow in g, W C h as m or e d ir e im p li ca ti on s. W C ca n al so
be d es cr ib ed as th e am ou n t of m on ey th at a sm al lb u si n es s or st ar t-
u p n ee d s to st ay in op er at io n .S ta rt -u p s n ee d to p ay at te n ti on to
th ei r W C be ca u se it is th e am ou n t of m on ey th ey n ee d to ke ep th e
bu si n es s ru n n in g u n ti lt h ey br ea k- ev en (s ta rt ea rn in g a n et p ro fi t) .
85 7
Li q ui d ity
is a
m ea
su re m en
t of
a co
m p an
y' s ab
ili ty
to q ui ck
ly tu rn
as se
ts in to
ca sh
.
Fi g ur e 17
.3 C as h
O n on e h an d ,W C is im p or ta n t to be ca u se it is a m ea su re of a
co m p an y' s ab il it y to p ay of fs h or t- te rm ex p en se s or d eb ts .O n th e
ot h er h an d ,t oo m u ch w or ki n g ca p it al m ea n s th at so m e as se ts ar e
n ot be in g in ve st ed fo r th e lo n g- te rm ,s o th ey ar e n ot be in g p u t to
go od u se in h el p in g th e co m p an y gr ow as m u ch as p os si bl e.
W C is on ly on e m ea su re of a co m p an y' s op er at in g li qu id it y. It is n ot
th e on ly m ea su re ,a n d it is ce rt ai n ly n ot a gu ar an te e of a co m p an y' s
ab il it y to p ay .A co m p an y m ay h av e p os it iv e W C ,b u t n ot en ou gh
ca sh to p ay an ex p en se to m or ro w .S im il ar ly ,a co m p an y m ay h av e
n eg at iv e W C ,b u t m ay be ab le to ad ju st so m e of th ei r d eb t in to lo n g-
te rm d eb t in or d er to re d u ce th ei r cu rr en t li ab il it ie s.
W C is an im p or ta n t m et ri c, bu t is n ot th e w h ol e st or y of a
co m p an y' s fi n an ci al h ea lt h .
So u rc e: ht tp s: // w w w .b ou n d le ss .c om /f in a n ce /i n tr od u ct io n -t o-
w or ki n g -c a p it a l/ w or ki n g -c a p it a l/ im p or ta n ce -o f- w or ki n g -c a p it a l/
C C -B Y -S A
B ou n d le ss is a n op en ly li ce n se d ed u ca ti on a lr es ou rc e
85 8
U nd
er st an
d in g th e B us
in es
s N ee
d s
Lo ng
-T er m
A p p ro ac
h
S ho
rt -T er m
A p p ro ac
h
C ho
os in g a P ol ic y
Se ct io n 2
A p p ro ac
he s to
W or ki ng
C ap
ita lF
in an
ci ng
85 9
ht tp s: // w w w .b ou
nd le ss .c om
/ na
nc e/ in tr od
uc tio
n- to -w
or ki ng
-c ap
ita l/a
p p ro ac
he s- to -w
or ki ng
-c ap
ita l- n
an ci ng
/
U nd
er st an
d in g th e B us
in es
s N ee
d s
W or ki ng
ca p ita
ln ee
d s w ill va
ry d ep
en d in g on
th e ty p e
of th e b us
in es
s an
d its
op er at io na
lr eq
ui re m en
ts .
K E Y P O IN TS
• Su ff ic ie n t w or ki n g ca p it al is re qu ir ed to en su re th at a fi rm is
ab le to co n ti n u e it s op er at io n s an d th at it h as su ff ic ie n t fu n d s
to sa ti sf y bo th m at u ri n g sh or t- te rm an d lo n g- te rm d eb t an d
u p co m in g op er at io n al ex p en se s.
• T h e m an ag em en t of w or ki n g ca p it al in vo lv es m an ag in g
in ve n to ri es ,a cc ou n ts re ce iv ab le an d p ay ab le ,a n d ca sh .
• W h en ca lc u la ti n g w or ki n g ca p it al w e th in k in te rm s of n et
w or ki n g ca p it al ,w h ic h is ca lc u la te d as cu rr en t as se ts m in u s
cu rr en t li ab il it ie s.
• In an y co m p an y, la rg e or sm al l, th er e is an in h er en t tr ad eo ff
be tw ee n li qu id it y an d p ro fi ta bi li ty .
U n d e rs ta n d in g th e B u si n e ss N e e d s
W or ki n g ca p it al is a fi n an ci al m et ri c w h ic h re p re se n ts th e op er at in g
li qu id it y av ai la bl e to a bu si n es s. W or ki n g ca p it al is co n si d er ed a
p ar t of op er at in g ca p it al al on g w it h fi xe d as se ts ,s u ch as p la n t an d
eq u ip m en t. Su ff ic ie n t w or ki n g ca p it al is re qu ir ed to en su re th at a
fi rm is ab le to co n ti n u e it s op er at io n s an d th at it h as su ff ic ie n t
fu n d s to sa ti sf y bo th m at u ri n g sh or t- te rm an d lo n g- te rm d eb t an d
ta ke ca re of u p co m in g op er at io n al ex p en se s. H ow ev er ,t oo m u ch
w or ki n g ca p it al ca n ca rr y w it h it a h ig h er co st of ca p it al .A co m p an y
ca n be en d ow ed w it h as se ts an d p ro fi ta bi li ty bu t sh or t of li qu id it y if
it s as se ts ca n n ot re ad il y be co n ve rt ed in to ca sh .T h e m an ag em en t of
w or ki n g ca p it al in vo lv es m an ag in g in ve n to ri es ,a cc ou n ts re ce iv ab le
an d p ay ab le ,a n d ca sh .
C a lc u la ti o n o f W o rk in g C a p it a l
W h en ca lc u la ti n g w or ki n g ca p it al ,w e th in k in te rm s of n et w or ki n g
ca p it al ,w h ic h is ca lc u la te d as cu rr en t as se ts m in u s cu rr en t
li ab il it ie s. T h is is th e fi gu re co m m on ly u se d in va lu at io n te ch n iq u es
su ch as d is co u n te d ca sh fl ow s. If cu rr en t as se ts ar e le ss th an cu rr en t
li ab il it ie s, an en ti ty h as a w or ki n g ca p it al d ef ic ie n cy ,a ls o ca ll ed a
w or ki n g ca p it al d ef ic it .C u rr en t as se ts an d cu rr en t li ab il it ie s in cl u d e
th re e ac co u n ts w h ic h ar e of sp ec ia li m p or ta n ce .T h es e ac co u n ts
re p re se n t th e ar ea s of th e bu si n es s w h er e m an ag er s h av e th e m os t
d ir ec t im p ac t:
1. A cc ou n ts re ce iv ab le (c u rr en t as se t)
2. In ve n to ry (c u rr en t as se t)
3. A cc ou n ts p ay ab le (c u rr en t li ab il it y)
86 0
A co m p an y id ea ll y w an ts ac co u n ts re ce iv ab le to be co ll ec te d as
qu ic kl y as p os si bl e in or d er to h av e as m u ch u se of th e fu n d s as
p os si bl e. C on ve rs el y, a fi rm st ri ve s to p u t of ft h e se tt le m en t of
ac co u n ts p ay ab le as lo n g as p os si bl e fo r th e sa m e re as on .T h e
cu rr en t p or ti on of d eb t is al so cr it ic al ,b ec au se it re p re se n ts a sh or t-
te rm cl ai m to cu rr en t as se ts an d is of te n se cu re d by lo n g te rm
as se ts .C om m on ty p es of sh or t- te rm d eb t ar e ba n k lo an s an d li n es
of cr ed it .I n ve n to ry is a sp ec ia lc as e in w h ic h ev en n on -f in an ci al
m an ag er s h av e a st ag e. T oo m u ch in ve n to ry on h an d w il lr ed u ce th e
ri sk of a co m p an y fa il in g to sa ti sf y cu st om er n ee d s, bu t it ca n al so
re d u ce p ro fi ta bi li ty .A n ex am p le of re d u ce d p ro fi ta bi li ty w ou ld be in
th e co m p u te r in d u st ry ,w h er e in ve n to ri es re gu la rl y lo se va lu e
be ca u se of th e fa st -m ov in g n at u re of th e in d u st ry ( F ig u re 17 .4 ).
P ro fi ta b il it y a n d L iq u id it y T ra d e o ff
In an y co m p an y, la rg e or sm al l, th er e is an in h er en t tr ad eo ff
be tw ee n li qu id it y an d p ro fi ta bi li ty .L ar ge co m p an ie s p os se ss
re so u rc es to h el p th em m an ag e th is tr ad eo ff ,s u ch as an ac co u n ti n g
d ep ar tm en t, n eg ot ia ti n g p ow er w it h th ei r su p p li er s, or ac ce ss to th e
ca p it al m ar ke ts .F or th e en tr ep re n eu r, h ow ev er ,w h o is of te n
re so u rc e- st ar ve d an d d oe sn ’t h av e en ou gh op er at in g h is to ry to
se cu re ad d it io n al cr ed it ,m an ag in g th is tr ad eo ff ca n fe el li ke w al ki n g
a ti gh tr op e. C on si d er th e ca se of a n ew cu st om er fo r a sm al l
co m p an y. T h is n ew cu st om er h as th e p ot en ti al to of fe r h u ge gr ow th
in th e co m p an y' s sa le s, bu t th is gr ow th in sa le s w il lb e ac co m p an ie d
by a su bs eq u en t gr ow th in va ri ab le co st s. T h e co m p an y m ay n ot
h av e th e re so u rc es ,i .e ., w or ki n g ca p it al ,t o m ee t th es e va ri ab le co st s
th at co m e w it h in cr ea se d sa le s.
86 1
Th is is an
ex am
p le
of m od
er n in ve
nt or y so
ft w ar e th at
en ab
le s m an
ag er s to
p re ci se
ly tr ac
k or d er s an
d in ve
nt or y le ve
ls .
Fi g ur e 17
.4 In ve nt or y S of tw ar e
So u rc e: ht tp s: // w w w .b ou n d le ss .c om /f in a n ce /i n tr od u ct io n -t o-
w or ki n g -c a p it a l/ a p p ro a ch es -t o- w or ki n g -c a p it a l- fi n a n ci n g /
u n d er st a n d in g -t he -b u si n es s- n ee d s/
C C -B Y -S A
B ou n d le ss is a n op en ly li ce n se d ed u ca ti on a lr es ou rc e
Lo ng
-T er m
A p p ro ac
h Th
e id ea
th at
w or ki ng
ca p ita
le nc
om p as
se s th e
re la tio
ns hi p b et w ee
n sh
or t- te rm
as se
ts an
d sh
or t- te rm
lia b ili tie
s m ay
no t b e en
tir el y tr ue
.
K E Y P O IN TS
• T h e cl as si fi ca ti on of as se ts as 'c u rr en t' or 'n on -c u rr en t' m ay
n ot be ap p ro p ri at e fo r d es cr ib in g th e op er at io n s of a fi rm
be ca u se d if fe re n t op er at io n s ar e cl as si fi ed to ge th er .
• D if fi cu lt ie s in w or ki n g ca p it al m an ag em en t ca n ar is e fr om th e
co m p le xi ty of m an y bu si n es s en te rp ri se s an d th e re su lt an t
in ab il it y to d et er m in e th e le n gt h of th e op er at in g cy cl e.
• W or ki n g ca p it al is a st at ic co n ce p t, an d d eb t- p ay in g ab il it y is
d yn am ic .T h er ef or e, w or ki n g ca p it al is n ot n ec es sa ri ly a go od
in d ic at io n of th e ab il it y of th e fi rm to p ay cu rr en t li ab il it ie s.
L o n g -T e rm A p p ro a ch to W o rk in g C a p it a l
R ec al lt h at w or ki n g ca p it al m an ag em en t is ge n er al ly th ou gh t of as
th e m an ag em en t of th e re la ti on sh ip be tw ee n sh or t- te rm as se ts an d
sh or t- te rm li ab il it ie s. H ow ev er ,t h e sh or t- te rm n at u re of w or ki n g
ca p it al ,a s w el la s th e cl as si fi ca ti on of as se ts an d li ab il it ie s in to
cu rr en t an d n on -c u rr en t, h as re ce n tl y co m e u n d er sc ru ti n y. T h e
'c u rr en t' an d 'n on -c u rr en t' cl as si fi ca ti on ca n be se en as d ef ec ti ve fo r
86 2
d es cr ib in g th e op er at io n s of a fi rm be ca u se d if fe re n t op er at io n s ar e
cl as si fi ed to ge th er .F or ex am p le ,a ss et s su ch as in te re st re ce iv ab le
d o n ot ar is e fr om th e sa m e ty p e of op er at io n s as ac co u n ts re ce iv ab le
an d in ve n to ri es ,b u t th ey ar e al lg ro u p ed to ge th er as cu rr en t as se ts .
T h e 'c u rr en t' an d 'n on -c u rr en t' cl as si fi ca ti on ca n al so be cr it ic iz ed
fo r it s as su m p ti on th at w or ki n g ca p it al it em s ar e cl os el y re la te d to
cu rr en t op er at io n s, an d th at lo n g- te rm as se ts an d li ab il it ie s ar e
re la te d to th e lo n g- te rm p la n n in g fu n ct io n s of th e or ga n iz at io n .I n
m os t fi rm s, th er e is li tt le re la ti on sh ip be tw ee n w or ki n g ca p it al an d
cu rr en t op er at io n s. C as h fl ow s be co m in g av ai la bl e fo r th e p ay m en t
of li ab il it ie s m ay be as cl os el y re la te d to th e u se of lo n g- te rm
re so u rc es as to th e sa le of in ve n to ri es .T h is is p ar ti cu la rl y tr u e in th e
se rv ic e in d u st ry ,w h er e in ve n to ri es m ay be re la ti ve ly sm al lo r
n on ex is te n t. T h er ef or e, cu rr en t ob li ga ti on s w il lb e p ai d fr om th e
re ve n u es d er iv ed fr om th e u se or le as in g of lo n g- te rm as se ts .
P ro b le m s W it h th e O p e ra ti n g C yc le
(F ig u re 17 .5 ) T h e d if fi cu lt y of as so ci at in g w or ki n g ca p it al w it h th e
op er at in g cy cl e is co m p ou n d ed by th e w ay th e co n ce p t of th e
op er at in g cy cl e is ap p li ed in p ra ct ic e. G en er al ly ,a rb it ra ry ru le s,
su ch as th e on e- ye ar ru le ,d ic ta te h ow lo n g a co m p an y' s op er at in g
cy cl e w il lb e. T h is in co n si st en cy d oe s n ot fo ll ow th e m at ch in g
p ri n ci p le ,w h ic h st at es th at sh or t- te rm ca sh n ee d s sh ou ld be
fi n an ce d w it h sh or t- te rm d eb t an d lo n g- te rm ca sh n ee d s sh ou ld be
fi n an ce d w it h lo n g- te rm so u rc es of fu n d s. M or e d if fi cu lt ie s ar is e
be ca u se of th e co m p le xi ty of m an y bu si n es s en te rp ri se s an d th e
re su lt an t in ab il it y to d et er m in e th e le n gt h of th e op er at in g cy cl e.
A lt h ou gh th e fr eq u en cy of th e ci rc u la ti on of as se ts m ay be re le va n t
to th e p re d ic ti on of ca sh fl ow s, it is d if fi cu lt to co n n ec t th is
in fo rm at io n to th e in co m e an d ca sh fl ow w h en al lc u rr en t as se ts ar e
cl as si fi ed as if th ey h ad th e sa m e fr eq u en cy of ci rc u la ti on .
T h e S ta ti c N a tu re o f W o rk in g C a p it a l
T h e p re se n ta ti on of w or ki n g ca p it al m ay p ro vi d e so m e va li d
in fo rm at io n to th e gr an to rs of sh or t- te rm cr ed it be ca u se it in d ic at es
86 3
A b ov
e is a o
w ch
ar t fo r a sa
m p le
op er at in g cy
cl e fo r
a r m .
Fi g ur e 17
.5 Th e
O p er at in g C yc le
th e d eg re e of p ro te ct io n ,o r th e am ou n t of bu ff er ,c ar ri ed by lo n g-
te rm cr ed it or s an d st oc kh ol d er s. H ow ev er ,t h e am ou n t of w or ki n g
ca p it al is n ot n ec es sa ri ly a go od in d ic at or of th e ab il it y of th e fi rm to
p ay cu rr en t li ab il it ie s as th ey co m e d u e. W or ki n g ca p it al is a st a ti c
co n ce p t, an d d eb t- p ay in g ab il it y is d yn am ic .C as h be co m es
av ai la bl e fo r th e p ay in g of sh or t- te rm li ab il it ie s p ri m ar il y fr om
op er at io n s, n ot fr om th e li qu id at io n of p ar ti cu la r as se ts su ch as
ac co u n ts re ce iv ab le .I n sh or t, th e ab il it y of a fi rm to m ee t it s d eb ts
as th ey m at u re d ep en d s p ri m ar il y on th e ou tc om e of p ro je ct ed
op er at io n s. F u rt h er m or e, n on -l iq u id cu rr en t as se ts be co m e li qu id
se qu en ti al ly - th at is ,f ro m ra w m at er ia li n ve n to ri es to w or k in
p ro ce ss to fi n is h ed in ve n to ri es to ac co u n ts re ce iv ab le to ca sh - bu t
cu rr en t li ab il it ie s be co m e d u e si m u lt an eo u sl y or at d at es th at ar e
u n re la te d to ea ch ot h er .T h er ef or e, if re ve n u es ar e co n tr ac ti n g, th e
li qu id at io n of as se ts th ro u gh n or m al op er at io n s w il lb e d el ay ed ,b u t
th e d u e d at es fo r li ab il it ie s w il ln ot ch an ge .I t is al so ar gu ed th at th e
cl as si fi ca ti on of as se ts an d li ab il it ie s as 'c u rr en t' an d 'n on -c u rr en t'
as a m et h od of p re se n ti n g th e so lv en cy of th e fi rm is le ss im p or ta n t
to d ay th an in th e p as t fo r a n u m be r of re as on s. O th er st at em en ts ,
p ar ti cu la rl y th e in co m e st at em en t an d th e ca sh fl ow st at em en t, m ay
p ro vi d e be tt er in fo rm at io n re ga rd in g ex p ec ta ti on s of so lv en cy .
A d d it io n al ly ,b u si n es s en te rp ri se s ar e be co m in g m or e h ig h ly
co m p le x, so th at n o p re d et er m in ed w or ki n g ca p it al ra ti o ca n be
d ee m ed to be n ec es sa ry fo r ad eq u at e so lv en cy .M or eo ve r, th e
in cr ea se d en tr y of m an y fi rm s in to th e se rv ic e in d u st ri es h as m ad e
th e so lv en cy of fi rm s le ss d ep en d en t u p on re so u rc es cl as si fi ed as
cu rr en t.
So u rc e: ht tp s: // w w w .b ou n d le ss .c om /f in a n ce /i n tr od u ct io n -t o-
w or ki n g -c a p it a l/ a p p ro a ch es -t o- w or ki n g -c a p it a l- fi n a n ci n g /l on g -t er m -
a p p ro a ch /
C C -B Y -S A
B ou n d le ss is a n op en ly li ce n se d ed u ca ti on a lr es ou rc e
86 4
S ho
rt -T er m
A p p ro ac
h D ec
is io ns
re la tin
g to
w or ki ng
ca p ita
la re
us ua
lly sh
or t-
te rm
,s in ce
it is
th e d i er en
ce b et w ee
n cu
rr en
t as
se ts
an d cu
rr en
t lia b ili tie
s.
K E Y P O IN TS
• T h e m ai n co n si d er at io n s fo r w or ki n g ca p it al ar e ca sh fl ow /
li qu id it y an d p ro fi ta bi li ty / re tu rn s on ca p it al .
• T h e m os t w id el y u se d m ea su re of ca sh fl ow is th e n et
op er at in g cy cl e or ca sh co n ve rs io n cy cl e.
• T h e ca sh co n ve rs io n cy cl e m ea su re s h ow lo n g a fi rm w il lb e
d ep ri ve d of ca sh if it in cr ea se s it s in ve st m en t in re so u rc es in
or d er to ex p an d cu st om er sa le s.
• T h e ai m of th e st u d y an d ca lc u la ti on of th e ca sh co n ve rs io n
cy cl e is to ch an ge th e p ol ic ie s re la ti n g to cr ed it p u rc h as e an d
cr ed it sa le s.
S h o rt -T e rm A p p ro a ch to W o rk in g C a p it a l M a n a g e m e n t
W or ki n g ca p it al is th e am ou n t of ca p it al th at is re ad il y av ai la bl e to
an or ga n iz at io n .W or ki n g ca p it al is th e d if fe re n ce be tw ee n ca sh
re so u rc es or as se ts re ad il y co n ve rt ib le in to ca sh (c u rr en t as se ts ) an d
ca sh ob li ga ti on s (c u rr en t li ab il it ie s) .A s a re su lt ,t h e d ec is io n s
re la ti n g to w or ki n g ca p it al ar e al m os t al w ay s cu rr en t, i.e ., sh or t
te rm ,d ec is io n s. In ot h er w or d s, w or ki n g ca p it al m an ag em en t
d if fe rs fr om ca p it al in ve st m en t d ec is io n s - sp ec if ic al ly in te rm s of
d is co u n ti n g an d p ro fi ta bi li ty .W or ki n g ca p it al m an ag em en t ap p li es
d if fe re n t cr it er ia in d ec is io n m ak in g. T h e m ai n co n si d er at io n s ar e
ca sh fl ow / li qu id it y an d p ro fi ta bi li ty / re tu rn s on ca p it al .T h e m os t
w id el y u se d m ea su re of ca sh fl ow is th e n et op er at in g cy cl e or ca sh
co n ve rs io n cy cl e. T h is m ea su re s h ow lo n g a fi rm w il lb e d ep ri ve d of
ca sh if it in cr ea se s it s in ve st m en t in re so u rc es in or d er to ex p an d
cu st om er sa le s.
T h e ca sh co n ve rs io n cy cl e in d ic at es th e fi rm 's ab il it y to co n ve rt it s
re so u rc es in to ca sh an d in fo rm s m an ag em en t of th e li qu id it y ri sk
en ta il ed by gr ow th ( F ig u re 17 .6 ). B ec au se th is n u m be r ef fe ct iv el y
co rr es p on d s to th e ti m e th at th e fi rm 's ca sh is ti ed u p in op er at io n s
an d u n av ai la bl e fo r ot h er ac ti vi ti es ,m an ag em en t ge n er al ly ai m s at
sh or te n in g th e ca sh co n ve rs io n cy cl e as m u ch as p os si bl e. H ow ev er ,
86 5
A b ov
e is a ch
ar t sh
ow in g a sa
m p le
ca sh
co nv
er si on
cy cl e.
Fi g ur e 17
.6 C as h C on ve rs io n C yc le
sh or te n in g th e cy cl e cr ea te s it s ow n ri sk s. W h il e a fi rm co u ld ev en
ac h ie ve a n eg at iv e ca sh co n ve rs io n by co ll ec ti n g fr om cu st om er s
be fo re p ay in g su p p li er s, a p ol ic y of st ri ct co ll ec ti on s an d la x
p ay m en ts is n ot ty p ic al ly su st ai n ab le .T h e ai m of th e st u d y an d
ca lc u la ti on of th e ca sh co n ve rs io n cy cl e is to ch an ge th e p ol ic ie s
re la ti n g to cr ed it p u rc h as e an d cr ed it sa le s. A fi rm ca n ch an ge it s
st an d ar d s fo r p ay m en t on cr ed it p u rc h as es an d ge tt in g p ay m en t
fr om d eb to rs on th e ba si s of ca sh co n ve rs io n cy cl e. If th e fi rm is in
an ef fe ct iv e ca sh li qu id it y p os it io n ,i t ca n m ai n ta in it s p as t cr ed it
p ol ic ie s.
So u rc e: ht tp s: // w w w .b ou n d le ss .c om /f in a n ce /i n tr od u ct io n -t o-
w or ki n g -c a p it a l/ a p p ro a ch es -t o- w or ki n g -c a p it a l- fi n a n ci n g /s ho rt -
te rm -a p p ro a ch /
C C -B Y -S A
B ou n d le ss is a n op en ly li ce n se d ed u ca ti on a lr es ou rc e
C ho
os in g a P ol ic y
A r m
w ill us
e a co
m b in at io n of
p ol ic ie s fo r m an
ag in g
w or ki ng
ca p ita
l, fo cu
si ng
on ca
sh o
w ,l iq ui d ity ,
p ro t ab
ili ty ,a
nd ca
p ita
lr et ur n.
K E Y P O IN TS
• W or ki n g ca p it al p ol ic ie s ai m at m an ag in g cu rr en t as se ts -
ge n er al ly ,c as h an d ca sh eq u iv al en ts ,i n ve n to ri es ,a n d d eb to rs
- an d sh or t te rm fi n an ci n g, su ch th at ca sh fl ow s an d re tu rn s
ar e ac ce p ta bl e.
• O n e of th e ob je ct iv es w it h in w or ki n g ca p it al m an ag em en t
an d ge n er al fi n an ci n g d ec is io n s is to m at ch th e m at u ri ty of
li ab il it ie s w it h th e li fe ex p ec ta n cy of as se ts .
• If th e m at u ri ty of li ab il it ie s is le ss th an th e li fe ex p ec ta n cy of
as se ts ,a fi rm fa ce s re fi n an ci n g ri sk si n ce it w il lh av e to ra is e
n ew ca p it al to p ay of fl ia bi li ti es .
C h o o si n g a P o li cy
G u id ed by cr it er ia m ea su ri n g ca sh fl ow ,l iq u id it y, p ro fi ta bi li ty ,a n d
re tu rn on ca p it al ,t h e m an ag em en t of a fi rm w il lu se a co m bi n at io n
of p ol ic ie s an d te ch n iq u es fo r th e m an ag em en t of w or ki n g ca p it al .
T h es e p ol ic ie s ai m to m an ag e th e cu rr en t as se ts - ge n er al ly ,c as h
an d ca sh eq u iv al en ts ,i n ve n to ri es an d d eb to rs - an d th e sh or t te rm
86 6
fi n an ci n g, su ch th at ca sh fl ow s an d re tu rn s ar e ac ce p ta bl e. A s w it h
an y d ec is io n in vo lv in g th e m an ag em en t of ca p it al ,t h e fi rm 's go al
sh ou ld be to m in im iz e th e ov er al lc os t of ca p it al an d m ax im iz e va lu e
to th e sh ar eh ol d er s (F ig u re 17 .7 ). In or d er to ef fe ct iv el y m an ag e
ca sh fl ow ,a fi rm sh ou ld id en ti fy th e ca sh ba la n ce w h ic h al lo w s fo r
th e bu si n es s to m ee t d ay to d ay ex p en se s, bu t re d u ce s ca sh h ol d in g
co st s - i.e ., th e op p or tu n it y co st of h ol d in g ca sh as op p os ed to
in ve st in g it .
A co m p an y sh ou ld al so id en ti fy th e le ve lo fi n ve n to ry w h ic h al lo w s
fo r u n in te rr u p te d p ro d u ct io n ,b u t re d u ce s th e in ve st m en t in ra w
m at er ia ls – an d m in im iz es re or d er in g co st s – an d th er ef or e
in cr ea se s ca sh fl ow .A n ot h er ar ea of co n ce rn fo r a fi rm w il lb e
m an ag in g d eb to rs .M an ag em en t sh ou ld id en ti fy th e ap p ro p ri at e
cr ed it p ol ic y so th at an y im p ac t on ca sh fl ow s an d th e ca sh
co n ve rs io n cy cl e w il lb e of fs et by in cr ea se d re ve n u e an d re tu rn on
ca p it al .M or eo ve r, m an ag em en t sh ou ld im p le m en t ap p ro p ri at e
cr ed it sc or in g p ol ic ie s an d te ch n iq u es so th at th e ri sk of d ef au lt on
an y n ew bu si n es s is ac ce p ta bl e gi ve n th es e cr it er ia .
A fi n al ar ea m an ag em en t sh ou ld be co n ce rn ed w it h w h en d ec id in g
on a w or ki n g ca p it al p ol ic y is sh or t- te rm fi n an ci n g. A fi rm sh ou ld
id en ti fy th e ap p ro p ri at e so u rc e of fi n an ci n g, gi ve n th e ca sh
co n ve rs io n cy cl e. In ve n to ry is id ea ll y fi n an ce d by cr ed it gr an te d by
th e su p p li er .H ow ev er ,i t m ay be n ec es sa ry to u ti li ze a ba n k lo an .
R e fi n a n ci n g R is k
O n e of th e ob je ct iv es w it h in w or ki n g ca p it al m an ag em en t an d
ge n er al fi n an ci n g d ec is io n s is to m at ch th e m at u ri ty of li ab il it ie s
w it h th e li fe ex p ec ta n cy of as se ts .T h is al lo w s li ab il it ie s to be se lf -
li qu id at in g. If th e m at u ri ty of li ab il it ie s is le ss th an th e li fe
ex p ec ta n cy of as se ts ,a fi rm fa ce s re fi n an ci n g ri sk si n ce it w il lh av e
to ra is e n ew ca p it al to p ay of fl ia bi li ti es .I ft h e m at u ri ty of li ab il it ie s
is lo n ge r th an th e li fe ex p ec ta n cy of as se ts ,t h en th er e sh ou ld be
su ff ic ie n t w or ki n g ca p it al av ai la bl e to p ay of fd eb ts .T h e
86 7
Th is ch
ar t la ys
ou t sa
m p le
w or ki ng
ca p ita
li ss ue
s an
d so
m e p os
si b le
so lu tio
ns .
Fi g ur e 17
.7 P ol ic ie s R eg ar d in g Li q ui d ity
m is m at ch in g of li ab il it ie s w it h as se ts ca n oc cu r if fi n an ci n g is n ot
av ai la bl e.
F or ex am p le ,s u p p os e lo n g- te rm fi n an ci n g is n ot av ai la bl e. Sh or t-
te rm so u rc es of fi n an ci n g m ay h av e to be u se d .M is m at ch in g ca n
al so be in te n ti on al .F or ex am p le ,s u p p os e a co m p an y ex p ec ts lo n g-
te rm in te re st ra te s to fa ll .T h e fi rm m ay w an t to fi n an ce as se ts w it h
sh or t- te rm m at u ri ti es si n ce it ca n re fi n an ce in a fe w ye ar s at m u ch
lo w er ra te .
So u rc e: ht tp s: // w w w .b ou n d le ss .c om /f in a n ce /i n tr od u ct io n -t o-
w or ki n g -c a p it a l/ a p p ro a ch es -t o- w or ki n g -c a p it a l- fi n a n ci n g /c ho os in g -
a -p ol ic y/
C C -B Y -S A
B ou n d le ss is a n op en ly li ce n se d ed u ca ti on a lr es ou rc e
86 8
E va
lu at in g In te re st
R at es
D ec
is io n C rit er ia
Id en
tif yi ng
Va ry in g C on
d iti on
s
C al cu
la tin
g E xp
ec te d Va
lu e
Se ct io n 3
W or ki ng
C ap
ita lF
in an
ci ng
D ec
is io n
O ve
rv ie w
86 9
ht tp s: // w w w .b ou
nd le ss .c om
/ na
nc e/ in tr od
uc tio
n- to -w
or ki ng
-c ap
ita l/w
or ki ng
-c ap
ita l- n
an ci ng
-d ec
is io n- ov
er vi ew
/
E va
lu at in g In te re st
R at es
M an
ag em
en t of
w or ki ng
ca p ita
lr eq
ui re s ev
al ua
tin g
fa ct or s a
ec tin
g ca
sh o
w s —
in cl ud
in g th e ev
al ua
tio n
of ap
p ro p ria
te in te re st
ra te s.
K E Y P O IN TS
• T h e in te re st ra te m os t co m m on ly u se d in w or ki n g ca p it al
m an ag em en t is th e co st of ca p it al .
• F ir m va lu e is en h an ce d w h en ,a n d if ,t h e re tu rn on ca p it al ,
w h ic h re su lt s fr om w or ki n g- ca p it al m an ag em en t, ex ce ed s th e
co st of ca p it al ,w h ic h re su lt s fr om ca p it al in ve st m en t
d ec is io n s.
• W or ki n g ca p it al d ec is io n cr it er ia th at fo cu s on in te re st ra te s
in cl u d e d eb to rs m an ag em en t an d sh or t- te rm fi n an ci n g.
E va lu a ti n g In te re st R a te s
T h e m an ag em en t of w or ki n g ca p it al ta ke s p la ce in th e re al m of
sh or t- te rm d ec is io n -m ak in g. T h es e d ec is io n s ar e, th er ef or e, ba se d
p ri m ar il y on p ro fi ta bi li ty ,c as h fl ow s an d th ei r m an ag em en t. M an y
cr it er ia go in to th e m an ag em en t of ca sh fl ow s an d su bs eq u en tl y th e
m an ag em en t of w or ki n g ca p it al — in cl u d in g th e ev al u at io n of
ap p ro p ri at e in te re st ra te s (F ig u re 17 .8 ).
T h e in te re st ra te m os t co m m on ly u se d in w or ki n g ca p it al
m an ag em en t is th e co st of ca p it al .T h e co st of ca p it al ,i n a fi n an ci al
m ar ke t eq u il ib ri u m ,w il lb e th e sa m e as th e m ar ke t ra te of re tu rn on
th e fi n an ci al as se t m ix tu re th e fi rm u se s to fi n an ce ca p it al
in ve st m en t. In ot h er w or d s, a co m p an y' s co st of ca p it al is th e co st of
ob ta in in g fu n d s fo r op er at io n th ro u gh th e sa le of eq u it y or d eb t in
th e m ar ke tp la ce .I n m ar ke t eq u il ib ri u m ,i n ve st or s w il ld et er m in e
w h at re tu rn th ey ex p ec t fr om p ro vi d in g fu n d s to a co m p an y. T h e
re tu rn ex p ec te d on d eb t d ep en d s u p on th e cr ed it ra ti n g of th e
co m p an y, w h ic h ta ke s in to ac co u n t a n u m be r of fa ct or s to
d et er m in e h ow ri sk y lo an in g fu n d s to a co m p an y w il lb e. T h e re tu rn
ex p ec te d fr om eq u it y al so in vo lv es a n u m be r of fa ct or s, u su al ly
ce n te re d ar ou n d th e op er at io n of th e co m p an y an d it s p ro sp ec ts fo r
87 0
In te re st
ra te s of
w or ki ng
ca p ita
l n
an ci ng
ca n b e
la rg el y a
ec te d b y
d is co
un t ra te ,W
A C C
an d co
st of
ca p ita
l.
Fi g ur e 17
.8 In te re st
p ro fi ta bi li ty .S om e co n ve n ti on al ra te s of re tu rn ex p ec te d fo r va ri ou s
ty p es of co m p an ie s in cl u d e:
• St ar tu p s se ek in g m on ey :5 0 % – 10 0 %
• E ar ly st ar tu p s: 40 % – 60 %
• L at e st ar tu p s: 30 % – 50 %
• M at u re co m p an ie s: 10 % – 25 %
W h en ev al u at in g sh or t- te rm p ro fi ta bi li ty ,c om p an y' s m ay u se
m ea su re s su ch as re tu rn on ca p it al .R O C is sh ow n as a p er ce n ta ge ,
d et er m in ed by d iv id in g re le va n t in co m e fo r th e 12 m on th s by
ca p it al em p lo ye d .F ir m va lu e is en h an ce d w h en ,a n d if ,t h e re tu rn
on ca p it al ,w h ic h re su lt s fr om w or ki n g- ca p it al m an ag em en t,
ex ce ed s th e co st of ca p it al ,w h ic h re su lt s fr om ca p it al in ve st m en t
d ec is io n s. R O C m ea su re s ar e th er ef or e u se fu la s a m an ag em en t
to ol ,i n th at th ey li n k sh or t- te rm p ol ic y w it h lo n g- te rm d ec is io n
m ak in g.
A s m en ti on ed ,w or ki n g ca p it al d ec is io n s ar e m ad e w it h th e sh or t-
te rm in m in d .T h u s, w or ki n g ca p it al p ol ic ie s ai m at m an ag in g th e
cu rr en t as se ts (g en er al ly ca sh an d ca sh eq u iv al en ts ,i n ve n to ri es an d
d eb to rs ) an d th e sh or t te rm fi n an ci n g, su ch th at ca sh fl ow s an d
re tu rn s ar e ac ce p ta bl e. D ec is io n cr it er ia th at fo cu s on in te re st ra te s
in cl u d e d eb to rs m an ag em en t an d sh or t- te rm fi n an ci n g.
D eb to rs m an ag em en t in vo lv es id en ti fy in g th e ap p ro p ri at e cr ed it
p ol ic y — i.e .c re d it te rm s w h ic h w il la tt ra ct cu st om er s — su ch th at
an y im p ac t on ca sh fl ow s an d th e ca sh co n ve rs io n cy cl e w il lb e
of fs et by in cr ea se d re ve n u e an d ,h en ce ,r et u rn on ca p it al (o r vi ce
ve rs a) .I n te re st ra te s ca n af fe ct th is d ec is io n be ca u se of th e ti m e
va lu e of m on ey .I fi n fl at io n is at a h ig h le ve lo r th er e ar e
op p or tu n it ie s fo re go n e be ca u se of la ck of w or ki n g ca p it al ,a fi rm
w il lm or e th an li ke ly h av e a st ri ct er cr ed it p ol ic y.
Sh or t- te rm fi n an ci n g in vo lv es id en ti fy in g th e ap p ro p ri at e so u rc e of
fi n an ci n g, gi ve n th e ca sh co n ve rs io n cy cl e. F or in st an ce ,i n ve n to ry
is id ea ll y fi n an ce d by cr ed it gr an te d by th e su p p li er ;h ow ev er ,i t m ay
be n ec es sa ry to u ti li ze a ba n k lo an or to "c on ve rt d eb to rs to ca sh ." .
A n ot h er p os si bl e so lu ti on is to u se se rv ic es fr om co m p an ie s se ll
ou ts ta n d in g in vo ic es to ra is e w or ki n g ca p it al fo r th ei r cl ie n ts .
O bv io u sl y in te re st ra te s w il lp la y a vi ta lr ol e in d et er m in in g w h et h er
an op ti on su ch as a ba n k lo an is vi ab le fo r ob ta in in g sh or t- te rm
fi n an ci n g.
So u rc e: ht tp s: // w w w .b ou n d le ss .c om /f in a n ce /i n tr od u ct io n -t o-
w or ki n g -c a p it a l/ w or ki n g -c a p it a l- fi n a n ci n g -d ec is io n -o ve rv ie w /
ev a lu a ti n g -i n te re st -r a te s/
C C -B Y -S A
B ou n d le ss is a n op en ly li ce n se d ed u ca ti on a lr es ou rc e
87 1
D ec
is io n C rit er ia
Th e m ai n co
ns id er at io ns
of w or ki ng
ca p ita
l m an
ag em
en t d ec
is io ns
ar e (1 )c
as h o
w / liq
ui d ity
an d
(2 )p
ro t ab
ili ty /r et ur n on
ca p ita
l.
K E Y P O IN TS
• T h e d ec is io n s re la ti n g to w or ki n g ca p it al ar e al w ay s cu rr en t
(i .e ., sh or t- te rm d ec is io n s.
• T h e m os t u se fu lm ea su re of p ro fi ta bi li ty is re tu rn on ca p it al
(R O C ).
• O n e m ea su re of ca sh fl ow is p ro vi d ed by th e ca sh co n ve rs io n
cy cl e (C C C )– th e n et n u m be r of d ay s fr om th e ou tl ay of ca sh
fo r ra w m at er ia lt o re ce iv in g p ay m en t fr om th e cu st om er .
W or ki n g ca p it al is th e am ou n t of ca p it al w h ic h is re ad il y av ai la bl e
to an or ga n iz at io n .T h at is ,w or ki n g ca p it al is th e d if fe re n ce
be tw ee n re so u rc es in ca sh or re ad il y co n ve rt ib le in to ca sh (c u rr en t
as se ts ), an d ca sh re qu ir em en ts (c u rr en t li ab il it ie s) .A s a re su lt ,t h e
d ec is io n s re la ti n g to w or ki n g ca p it al ar e al w ay s cu rr en t (i .e ., sh or t-
te rm d ec is io n s) .I n ad d it io n to th e ti m e h or iz on ,w or ki n g ca p it al
d ec is io n s d if fe r fr om ca p it al in ve st m en t d ec is io n s in te rm s of
d is co u n ti n g an d p ro fi ta bi li ty co n si d er at io n s; th ey ar e al so
"r ev er si bl e" to so m e ex te n t.
W or ki n g ca p it al m an ag em en t d ec is io n s ar e, th er ef or e, n ot m ad e on
th e sa m e ba si s as lo n g- te rm d ec is io n s, an d w or ki n g ca p it al
m an ag em en t ap p li es d if fe re n t cr it er ia in d ec is io n m ak in g: th e m ai n
co n si d er at io n s ar e (1 ) ca sh fl ow /l iq u id it y an d (2 ) p ro fi ta bi li ty /
re tu rn on ca p it al (o fw h ic h ca sh fl ow is ge n er al ly th e m os t
im p or ta n t) .
1. C a sh C o n ve rs io n C yc le (C C C )
O n e m ea su re of ca sh fl ow is p ro vi d ed by th e ca sh co n ve rs io n cy cl e—
th e n et n u m be r of d ay s fr om th e ou tl ay of ca sh fo r ra w m at er ia lt o
re ce iv in g p ay m en t fr om th e cu st om er .A s a m an ag em en t to ol ,t h is
m et ri c m ak es ex p li ci t th e in te rr el at ed n es s of d ec is io n s re ga rd in g
in ve n to ri es ,a cc ou n ts re ce iv ab le an d p ay ab le ,a n d ca sh .B ec au se th is
n u m be r ef fe ct iv el y co rr es p on d s to th e ti m e th at th e fi rm 's ca sh is
ti ed u p in op er at io n s an d u n av ai la bl e fo r ot h er ac ti vi ti es ,
m an ag em en t ge n er al ly ai m s at a lo w n et co u n t (F ig u re 17 .9 ).
87 2
C as
h co
nv er si on
cy cl e is a m ai n
cr ite
ria fo r w or ki ng
ca p ita
l m an
ag em
en t.
Fi g ur e 17
.9 C as h
cy cl e
2 . R e tu rn O n C a p it a l (R O C )
In th is co n te xt ,t h e m os t u se fu lm ea su re of p ro fi ta bi li ty is re tu rn on
ca p it al (R O C ). T h e re su lt is sh ow n as a p er ce n ta ge ,d et er m in ed by
d iv id in g re le va n t in co m e fo r th e 12 m on th s by ca p it al em p lo ye d ;
re tu rn on eq u it y (R O E ) sh ow s th is re su lt fo r th e fi rm 's
sh ar eh ol d er s. F ir m va lu e is en h an ce d w h en ,a n d if ,t h e re tu rn on
ca p it al ,w h ic h re su lt s fr om w or ki n g- ca p it al m an ag em en t, ex ce ed s
th e co st of ca p it al ,w h ic h re su lt s fr om ca p it al in ve st m en t d ec is io n s
as ab ov e. R O C m ea su re s ar e, th er ef or e, u se fu la s a m an ag em en t
to ol ,i n th at th ey li n k sh or t- te rm p ol ic y w it h lo n g- te rm d ec is io n
m ak in g.
C re d it p o li cy
A n ot h er fa ct or af fe ct in g w or ki n g ca p it al m an ag em en t is cr ed it
p ol ic y of th e fi rm .I t in cl u d es bu yi n g of ra w m at er ia ls an d se ll in g of
fi n is h ed go od s ei th er in ca sh or on cr ed it .T h is af fe ct s th e ca sh
co n ve rs io n cy cl e.
So u rc e: ht tp s: // w w w .b ou n d le ss .c om /f in a n ce /i n tr od u ct io n -t o-
w or ki n g -c a p it a l/ w or ki n g -c a p it a l- fi n a n ci n g -d ec is io n -o ve rv ie w /
d ec is io n -c ri te ri a /
C C -B Y -S A
B ou n d le ss is a n op en ly li ce n se d ed u ca ti on a lr es ou rc e
Id en
tif yi ng
Va ry in g
C on
d iti on
s M an
ag em
en t us
es p ol ic ie s an
d te ch
ni q ue
s fo r th e
m an
ag em
en t of
w or ki ng
ca p ita
ls uc
h as
ca sh
, in ve
nt or y, d eb
to rs
an d sh
or t te rm
n an
ci ng
.
K E Y P O IN TS
• T h e go al of w or ki n g ca p it al m an ag em en t is to en su re th at th e
fi rm is ab le to co n ti n u e it s op er at io n s an d th at it h as
su ff ic ie n t ca sh fl ow to sa ti sf y bo th m at u ri n g sh or t- te rm d eb t
an d u p co m in g op er at io n al ex p en se s.
• Id en ti fy th e ca sh ba la n ce w h ic h al lo w s fo r th e bu si n es s to
m ee t d ay to d ay ex p en se s, bu t re d u ce s ca sh h ol d in g co st s.
• Id en ti fy th e le ve lo fi n ve n to ry w h ic h al lo w s fo r u n in te rr u p te d
p ro d u ct io n bu t re d u ce s th e in ve st m en t in ra w m at er ia ls - an d
m in im iz es re or d er in g co st s - an d h en ce in cr ea se s ca sh fl ow .
• Id en ti fy th e ap p ro p ri at e cr ed it p ol ic y an d th e ap p ro p ri at e
so u rc e of fi n an ci n g, gi ve n th e ca sh co n ve rs io n cy cl e.
D ec is io n s re la ti n g to w or ki n g ca p it al an d sh or t- te rm fi n an ci n g ar e
re fe rr ed to as w or ki n g ca p it al m an ag em en t. T h es e in vo lv e
m an ag in g th e re la ti on sh ip be tw ee n a fi rm 's sh or t- te rm as se ts an d
87 3
it s sh or t- te rm li ab il it ie s. T h e go al of w or ki n g ca p it al m an ag em en t is
to en su re th at th e fi rm is ab le to co n ti n u e it s op er at io n s an d th at it
h as su ff ic ie n t ca sh fl ow to sa ti sf y bo th m at u ri n g sh or t- te rm d eb t
an d u p co m in g op er at io n al ex p en se s.
M an ag em en t w il lu se a co m bi n at io n of p ol ic ie s an d te ch n iq u es fo r
th e m an ag em en t of w or ki n g ca p it al .T h e p ol ic ie s ai m at m an ag in g
th e cu rr en t as se ts (g en er al ly ca sh an d ca sh eq u iv al en ts ,i n ve n to ri es
an d d eb to rs ) an d th e sh or t- te rm fi n an ci n g, su ch th at ca sh fl ow s an d
re tu rn s ar e ac ce p ta bl e.
T h er e ar e fo u r m ai n ar ea s of va ri ab il it y th at m u st be m an ag ed .
1. C a sh m a n a g e m e n t
Id en ti fy th e ca sh ba la n ce th at al lo w s fo r th e bu si n es s to m ee t d ay -
to -d ay ex p en se s, bu t re d u ce s ca sh h ol d in g co st s.
2 . In ve n to ry m a n a g e m e n t
Id en ti fy th e le ve lo fi n ve n to ry th at al lo w s fo r u n in te rr u p te d
p ro d u ct io n bu t re d u ce s th e in ve st m en t in ra w m at er ia ls an d
m in im iz es re or d er in g co st s an d ,h en ce ,i n cr ea se s ca sh fl ow .B es id es
th is ,t h e le ad ti m es in p ro d u ct io n sh ou ld be lo w er ed to re d u ce w or k
in p ro ce ss (W IP ) an d si m il ar ly ,t h e fi n is h ed go od s sh ou ld be ke p t
on as lo w le ve la s p os si bl e to av oi d ov er p ro d u ct io n (F ig u re 17 .1 0 ).
3 . D e b to rs m a n a g e m e n t
Id en ti fy th e ap p ro p ri at e cr ed it p ol ic y (i .e ., cr ed it te rm s w h ic h w il l
at tr ac t cu st om er s su ch th at an y im p ac t on ca sh fl ow s an d th e ca sh
co n ve rs io n cy cl e w il lb e of fs et by in cr ea se d re ve n u e an d h en ce
re tu rn on ca p it al or vi ce ve rs a) .
4 . S h o rt -t e rm fi n a n ci n g
Id en ti fy th e ap p ro p ri at e so u rc e of fi n an ci n g, gi ve n th e ca sh
co n ve rs io n cy cl e. T h e in ve n to ry is id ea ll y fi n an ce d by cr ed it gr an te d
87 4
Id en
tif y th e le ve
lo f
in ve
nt or y w hi ch
al lo w s fo r
un in te rr up
te d
p ro d uc
tio n b ut
re d uc
es th e
in ve
st m en
t in
ra w
m at er ia ls an
d m in im
iz es
re or d er in g
co st s an
d ,h
en ce
, in cr ea
se s ca
sh o
w .
Fi g ur e 17
.1 0
In ve nt or y
by th e su p p li er ;h ow ev er ,i t m ay be n ec es sa ry to u ti li ze a ba n k lo an
(o r ov er d ra ft ), or to "c on ve rt d eb to rs to ca sh " th ro u gh "f ac to ri n g. "
So u rc e: ht tp s: // w w w .b ou n d le ss .c om /f in a n ce /i n tr od u ct io n -t o-
w or ki n g -c a p it a l/ w or ki n g -c a p it a l- fi n a n ci n g -d ec is io n -o ve rv ie w /
id en ti fy in g -v a ry in g -c on d it io n s/
C C -B Y -S A
B ou n d le ss is a n op en ly li ce n se d ed u ca ti on a lr es ou rc e
C al cu
la tin
g E xp
ec te d Va
lu e
Th e m ai n ac
co un
ts w hi ch
a ec
t th e va
lu e of
w or ki ng
ca p ita
la re
ac co
un ts
re ce
iv ab
le ,i nv
en to ry ,a
nd ac
co un
ts p ay
ab le .
K E Y P O IN TS
• P os it iv e w or ki n g ca p it al is re qu ir ed to en su re th at a fi rm is
ab le to co n ti n u e it s op er at io n s an d th at it h as su ff ic ie n t fu n d s
to sa ti sf y bo th m at u ri n g sh or t- te rm d eb t an d u p co m in g
op er at io n al ex p en se s.
• T h e m an ag em en t of w or ki n g ca p it al in vo lv es m an ag in g
in ve n to ri es ,a cc ou n ts re ce iv ab le an d p ay ab le ,a n d ca sh .
• C u rr en t as se ts an d cu rr en t li ab il it ie s in cl u d e th re e ac co u n ts
w h ic h ar e of sp ec ia li m p or ta n ce :a cc ou n ts re ce iv ab le ,
in ve n to ry ,a n d ac co u n ts p ay ab le .
• W or ki n g ca p it al is eq u al to ac co u n ts re ce iv ab le p lu s th e va lu e
of in ve n to ry ,m in u s ac co u n ts p ay ab le .
W or ki n g ca p it al (W C ) is a fi n an ci al m et ri c w h ic h re p re se n ts
op er at in g li qu id it y av ai la bl e to a bu si n es s, or ga n iz at io n ,o r ot h er
en ti ty - in cl u d in g a go ve rn m en ta le n ti ty .A lo n g w it h fi xe d as se ts
su ch as p la n t an d eq u ip m en t, w or ki n g ca p it al is co n si d er ed a p ar t of
op er at in g ca p it al .N et w or ki n g ca p it al is ca lc u la te d as cu rr en t as se ts
m in u s cu rr en t li ab il it ie s. It is a d er iv at io n of w or ki n g ca p it al th at is
87 5
co m m on ly u se d in va lu at io n te ch n iq u es ,s u ch as D C F s (D is co u n te d
C as h F lo w s) .I fc u rr en t as se ts ar e le ss th an cu rr en t li ab il it ie s, an
en ti ty h as a
w or ki n g ca p it al d ef ic ie n cy ,a ls o ca ll ed a "w or ki n g ca p it al d ef ic it ."
A co m p an y ca n be en d ow ed w it h as se ts an d p ro fi ta bi li ty bu t sh or t
on li qu id it y if it s as se ts ca n n ot re ad il y be co n ve rt ed in to ca sh .
P os it iv e w or ki n g ca p it al is re qu ir ed to en su re th at a fi rm is ab le to
co n ti n u e it s op er at io n s an d th at it h as su ff ic ie n t fu n d s to sa ti sf y
bo th m at u ri n g sh or t- te rm d eb t an d u p co m in g op er at io n al ex p en se s.
T h e m an ag em en t of w or ki n g ca p it al in vo lv es m an ag in g in ve n to ri es ,
ac co u n ts re ce iv ab le an d p ay ab le ,a n d ca sh .
C a lc u la ti o n
C u rr en t as se ts an d cu rr en t li ab il it ie s in cl u d e th re e ac co u n ts w h ic h
ar e of sp ec ia li m p or ta n ce .T h es e ac co u n ts re p re se n t th e ar ea s of th e
bu si n es s w h er e m an ag er s h av e th e m os t d ir ec t im p ac t:
• ac co u n ts re ce iv ab le (c u rr en t as se t)
• in ve n to ry (c u rr en t as se ts )
• ac co u n ts p ay ab le (c u rr en t li ab il it y)
T h er ef or e, in th is co n te xt ,w e ca lc u la te av ai la bl e w or ki n g ca p it al
u si n g th e fo ll ow in g fo rm u la (F ig u re 17 .1 1) :
T h es e va lu es ca n be re ad il y fo u n d on a co m p an y' s ba la n ce sh ee t.
T h e cu rr en t p or ti on of d eb t (p ay ab le w it h in 12 m on th s) is cr it ic al ,
be ca u se it re p re se n ts a sh or t- te rm cl ai m to cu rr en t as se ts an d is
of te n se cu re d by lo n g- te rm as se ts .C om m on ty p es of sh or t- te rm
d eb t ar e ba n k lo an s an d li n es of cr ed it .
A s an ex am p le ,i m ag in e a co m p an y h as ac co u n ts re ce iv ab le of
$ 10 ,0 0 0 ,c u rr en t in ve n to ry th at h as a va lu e of $ 5, 0 0 0 ,a n d ac co u n ts
p ay ab le of $ 7, 0 0 0 .W e ca n fi n d w or ki n g ca p it al by :
W or ki n g C ap it al = $ 10 ,0 0 0 + $ 5, 0 0 0 - $ 7, 0 0 0 = $ 8 ,0 0 0
A n in cr ea se in w or ki n g ca p it al in d ic at es th at th e bu si n es s h as ei th er
in cr ea se d cu rr en t as se ts (t h at it h as in cr ea se d it s re ce iv ab le s, or
ot h er cu rr en t as se ts ) or h as d ec re as ed cu rr en t li ab il it ie s, fo r
ex am p le ,h as p ai d of fs om e sh or t- te rm cr ed it or s.
Im p li ca ti o n s o n M & A
T h e co m m on co m m er ci al d ef in it io n of w or ki n g ca p it al fo r th e
p u rp os e of a w or ki n g ca p it al ad ju st m en t in a m er ge rs an d
ac qu is it io n s tr an sa ct io n (i .e ., fo r a w or ki n g ca p it al ad ju st m en t
m ec h an is m in a sa le an d p u rc h as e ag re em en t) is eq u al to :
87 6
W or ki ng
ca p ita
li s eq
ua lt o ac
co un
ts re ce
iv ab
le ,p
lu s cu
rr en
t in ve
nt or y, m in us
ac co
un ts
p ay
ab le .
Fi g ur e 17
.1 1 W or ki ng
C ap ita lE q ua tio n
C u rr en t A ss et s - C u rr en t li ab il it ie s (e xc lu d in g d ef er re d ta x as se ts /
li ab il it ie s, ex ce ss ca sh ,s u rp lu s as se ts ,a n d /o r d ep os it ba la n ce s) .
C as h ba la n ce it em s of te n at tr ac t a on e- fo r- on e p u rc h as e- p ri ce
ad ju st m en t.
So u rc e: ht tp s: // w w w .b ou n d le ss .c om /f in a n ce /i n tr od u ct io n -t o-
w or ki n g -c a p it a l/ w or ki n g -c a p it a l- fi n a n ci n g -d ec is io n -o ve rv ie w /
ca lc u la ti n g -e xp ec te d -v a lu e/
C C -B Y -S A
B ou n d le ss is a n op en ly li ce n se d ed u ca ti on a lr es ou rc e
87 7
