FINC 331-WEEK 7: Cash Collections

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Module 3-Working Capital Management

Having examined the capital budgeting process, the main process by which the firm selects

which long-term investments to undertake to best position itself for the future, we now shift to

examining the firm's decisions regarding short-term investments, or working capital.

Working Capital Definition and Objectives

Working Capital Definition

As explained earlier in our discussion of financial reporting, a firm's working capital is defined

technically as its current assets. Working capital as it is technically defined is, however, seldom

used alone in financial management because it ignores current liabilities, which can offset in part

the current asset financing requirements. Net working capital (current assets – current liabilities)

is what is usually used in financial management. Unfortunately, in practice the two terms are

frequently used interchangeably, with the net working capital meaning being understood.

Working capital, or short-term capital, differs from fixed capital, or long-term capital, primarily

in the time it takes the firm to recover the initial investment in assets. Consider that fixed capital

and long-term assets [plant, property, and major equipment (PP&E)] generally require years to

recover the (capital) investment, whereas working capital expenditures (receivables, payables,

inventories, and so forth) are normally recovered many times in a single year via normal turnover

of the firm's products and services. The accounting definition of the time difference between

short-term and long-term is one year. Specifically, if the asset will be converted to cash or the

liability paid within one year from the date of report, it is a short-term investment.

Working Capital Management Objectives

Theoretically, the ideal financial objective in managing working capital is to maintain the net

working capital balances (current assets – current liabilities) at that optimum level where the

marginal benefit to be received from that next dollar of working capital would not be equal to the

marginal cost of the next dollar.

In practice, the management objective is usually much simpler. A typical working capital policy

might be to minimize net working capital (i.e., minimize current assets and maximize current

liabilities) to the point where the actions undertaken do not create undue operational constraints,

such as stock outs or bad debt write-offs, or provide the competition a competitive advantage via

better trade terms or faster delivery. Other working policies or rules of thumb might include (1)

making every effort to offset current asset funding requirements with current liability financing

or (2) minimizing net working capital to free up all available cash for more lucrative investment

or to avoid financing costs.

Working Capital Components and Objectives

As discussed earlier, working capital consists of two categories, both of which are balance sheet

items—current assets and current liabilities. The art and science of working capital management

is balance.

Current Assets Management Objectives

Current assets represent the use of cash by the firm to procure short-term assets, either by

purchasing for future use (prepaid and inventory) or by delaying receipt of payments due for

products and services sold (accounts received). Where possible, the firm wants to minimize these

purchases and avoid extending trade terms to its customers. Recall that current assets consist of

the following accounts:

• cash and marketable securities

• accounts receivable

• inventory

• prepaid expense

Current Liabilities Management Objectives

Current liabilities represent a source of cash to the firm, generally obtained by authorized

delayed payment for goods and services received. Where possible, the firm wants to maximize

these account balances. Recall that current liabilities consist of the following accounts:

• accounts payable

• accrued liability

• taxes payable

• notes payable

The following are the four working capital accounts that receive the most scrutiny from financial

managers, along with the working capital manager's objective for controlling each account:

1. cash interest—invest all excess cash in safe short-term investments to earn some interest

2. accounts receivable—collect all trade receivables to terms

3. inventory—minimize raw material, in-process, and finished goods inventory

4. accounts payable—maximize all trade credit terms offered by suppliers

The Importance of Working Capital and Its Management

The Operational Requirements

A firm must have working capital to operate efficiently and to survive in a flexible and

competitive market. On average, for manufacturing companies, current assets represent

approximately 40 percent of the company's total assets. For wholesale and distribution

companies, working capital represents 50–60 percent of total assets. Why the difference?

Consider the weighting effect of manufacturing's higher requirement for capital assets, which

results in higher total assets in the denominator of the equation.

Combined, on average, U.S. companies spend 15 cents of each sales dollar for working capital.

With this level of spending, proper control of working capital is critical for efficient business

management.

Externally, working capital is also considered critical tbyo the firm's investors, analysts,

creditors, and suppliers, all of whom are concerned about getting their money back. Finally,

many consider working capital to be a measure of the firm's risk, and therefore, it affects directly

the company's ability to raise financing and the interest charged, on that financing. Many loan

agreements require maintaining either a minimum level of working capital or valid working

capital relationships. Remember the current ratio and acid test ratio for liquidity.

In most businesses, the finance or treasury departments usually have primary responsibility for

setting or controlling working capital policy. This is a difficult task because no single business

function is directly responsible for all aspects of working capital, and the functions are often at

odds on the objectives resulting in many trade-offs. For example, the sales function often wants

easy credit terms to gain sales, and the finance function wants tight credit terms to conserve cash.

The manufacturing function wants low inventory to save storage and handling costs, whereas the

sales function wants high inventories for quick response to customer orders.

Operational Exposures Inherent in Working Capital

Too low a level of working capital can be harmful and place the firm in a noncompetitive

situation. For example:

• if inventory is too low, it can result in a stock out and sales lost to the competition

• if receivables are too low, the firm can lose customers to the competitor that has better

terms

Too high a level of working capital can also be harmful and place the firm at a disadvantage in

capital financing. For example:

• if receivables are too high, the firm must obtain more financing to cover cash shortages

• if inventories are too high, the firm must obtain more financing to cover costs

Working Capital Policy Considerations

Remember, the objective of working capital management is to determine the proper aggregate

amount and composition of all the components of working capital. Working capital management

is a balancing act between profitability and risk. This risk-profitability trade off is shown below:

• Higher working capital equals decreases in both profitability and risk.

• Lower working capital equals increases in both profitability and risk.

In most companies, working capital management concentrates on the following working capital

actions:

• setting minimum levels for cash

• investing all excess cash in short-term marketable securities

• controlling accounts receivable by policy, terms, and collection

• controlling inventory by setting inventory levels and controls

• controlling accounts payable by setting payment policies

• using notes payable to assure adequate cash availability

Note that taxes payable, although a working capital item, is usually managed separately based on

the company's tax position and strategy.