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Financial Management MGT201

Lesson 39

WORKING CAPITAL MANAGEMENT

Learning Objectives:

After going through this lecture, you would be able to have an understanding of the following topic:

· Working Capital Management

Working Capital Management is another important area of financial management.

· Financial Management Course

Earlier in the course we studied:

Capital Budgeting: Focuses on Fixed Assets side of Balance Sheet

Capital Structure (& Corporate Financing): Focuses Liabilities Side (Long Term Debt

& Equity) of Balance Sheet

Now another important area is:

Working Capital Management: Focuses Current Assets & Liabilities of Balance Sheet

in day-to-day operation

· Generally Working Capital (Gross) = Current Assets

Current Assets = Inventory + Accounts Receivables + Cash + Marketable Securities +

...(The mentioned items are four major items)

Working Capital is different from "Capital" (as used in Capital Budgeting) which refers

to Capital Expenditure in Fixed Assets

Also it is different from "Capital" (as used in Capital Structure) which refers to

Financing in the form of Debt or Equity (Loans or share capital)

· Net Working Capital = Current Assets Current Liabilities

Net working capital is slightly different from gross working capital.

working capital is different from Net Worth

= Assets Liabilities = Equity

= Stock + Retained Earnings

Current Liabilities

= Accounts Payables + Accruals + Short Term Loans + ... (as well as other minor

items)

· Important Measure of the Short-term Liquidity of a Firm

Working capital is a measure of how easy it is for a firm to convert short-term assets

into "Liquid" Cash in order to meet the Current Obligations by selling assets

Some ratios to measure liquidity of firm are:

Current Ratio = Current Assets / Current Liabilities

Acid Test or Quick Ratio = Quick Assets / Current Liabilities

· Quick Assets = Current Assets Inventory

· Fundamental Tradeoff in Working Capital (or Current Assets)

Decision in working capital management is how much working capital should be maintained by

a firm. It requires how much money needs to be invested in Inventory, Accounts Receivables,

Marketable Securities and how much cash should be maintained.

Advantages of Large Current Assets: less risk of shortages & interruptions and less loss

of sales due to availability of funds for loan payments and purchases and inventory.

High Liquidity so better CREDIT Rating.

Advantages of Small Current Assets: Less investment in current assets means less

amount of money tied to the assets which are generating no return. So lower

Opportunity Cost of Capital.

Find the Optimum Current Assets (working capital) At Any Given Time and for a

Given Level of Sales & Growth:

· For this Alternative Investment Policies have been proposed and a good

business judgment is required

Working Capital Policies:

· What is the Optimum Working Capital (or Current Assets) for a Firm at any given time given in

level of Sales and Growth Strategy? This requirement fluctuates with time depending on sales

and seasons.

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Financial Management MGT201

Practically the following policies are used by the mangers to decide what is the best amount of

current assets or mix of assets to be kept for the firm:

· "Fat Cat" or Relaxed Policy

It requires Large Amount of Current Assets not to loose any sales i.e. when a customer

places order for a large amount, there is no shortage of inventory

Occurs when High sales driven by lot of credit facility to buyers

Good Credit Rating because High Liquidity and good Current Ratio

Case: Wall Mart retail chain during New Year and Christmas

"Lean & Mean" or Restricted Policy

Small Amount of Current Assets

It increases turnover and therefore Profits

· Current Asset Turnover = Sales / Current Assets. Higher than 20.

· Lowers Carrying Costs of Inventory

Frees up cash and speeds up production (operational efficiency)

Small Current Assets means Lower Opportunity Cost of Capital. Firms have raised

Capital from Investors (Debt Holders and Shareholders) which comes at a Cost (the

WACC includes Interest paid to Debt Holders and Dividends paid to Shareholders).

Firms must mobilize the capital in high-return investments in order to repay their

investors.

"Zero Working Capital Policy" (Extreme form of Lean & Mean Policy)

It can not be 0 in reality but its objective is to minimize.

· Japanese Just in Time (JIT) i.e. Toyota Motor Co. It means the spare partsreach

just a few hours ago from the assembly time.

· Moderate Policy

In between the Fat Cat and Lean & Mean Policies

Impact of working capital on Firm Value:

There is a link between working capital policy and our basic objective of financial management of

maximizing shareholder's wealth.

EVA (Economic Value Added)

EVA (in Rupees)

= Net Operating Income discounted by the Tax (WACC x Total Capital)

= (NOI x (1-Tc)) - (WACC % x Tot Capital)

In other words, EVA (in Rupees)

= Revenues generated by firm Cost of capital by firm

Total Capital = Market Value of Debt + Market Value of Equity

If Working Capital is reduced, then cash is freed up from the assets to which it was tied

up and can be used to reduce dependence on External Financing (Debt and Equity).

Total External Capital is reduced and WACC is reduced. It raises EVA of the firm.

Higher EVA means Higher Market Value of Firm (V) and Maximization of Shareholder

Wealth which is a fundamental objective of Financial Management.

ROE (Return on Equity)

DuPont Formula:

ROE

= Profit Margin x Asset Turnover x Leverage Factor (or Equity Multiplier)

= (Net Income/Sales) x (Sales/Assets) x (Total Assets/Equity)

= Net Income / Equity

If Working Capital is reduced, then cash which is freed up can be used to reduce

requirement for External Capital and Total Liabilities. By Total Assets reduced, Asset

Turnover Rises, and ROE Rises

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Financial Management MGT201

Objective is to keep ROE Higher than rE (Required Return) and this means keeping

capital mobilized and invested at all times to generate returns higher than WACC

(which can not be done by simple cash holdings).

Cash Management:

First we talk about first item of working capital in balance sheet i.e. cash

· Advantages of Cash

Need cash for Liquidity, Good Credit Rating, and Meet Unexpected Expenses & to Get

Trade Discounts. "Need Cash to Pay the Bills."

BUT cash (and even Current Business Accounts in banks) earns NO RETURN (i.e.

Interest or Markup)

· When Interest Rates are high, the Opportunity Cost of holding cash rises.

Business Competition forces firms to sell on CREDIT but that leads to Problems in

RECOVERY of Receivables (i.e. Bad Debts and Write-offs).

· Balance Sheet Perspective

"Cash is King" and "Only Cash Can Pay the Bills"

Cash Budget (Detailed Short Term)

Projected Cash Inflows and Outflows to estimate Monthly Cumulative Net cash Surplus

or Shortfall

· Take into account Credit Purchases and Credit Sales and Expected Collection

(Cash Recovery) Time

· Shortfall tells you how much Short-term Financing is required

Importance of Timing of Collections and Payments and Target Cash Balance

Monthly Cash Budget

Jan

Feb

Mar

Apr

Sales (Expected Forecasts `000 Rs.)

100

200

300

400

Collections (`000 Rs.)

-Current month Sales (30%)

120

-Previous month Sales (70%)

140

210

TOTAL COLLECTIONS

230

330

Purchases Raw Material (`000 Rs.)

-70% of Next Month Sales

140

210

280

-Payments (paid next month)

140

210

280

Other Expenses (`000 Rs.)

-Wages

-Rent

-Taxes

- Interest & Dividends

TOTAL PAYMENTS

170

380

240

310

Net Cash for Month

(140)

(299)

(10)

Cumulative Cash

(439)

(449)

(429)

Target Cash Balance

Net Cumulative Cash

(459)

(469)

(449)

The above is the cash budget for a firm for a period of four months with the most important

items. We have forecasted the cash in the form of cash receipts from sales and in the form of cash

payments for expenses. Shortfall or negative balance tells you how much Short-term Financing is

required to fill the gap.

Cash Management Policies:

· Interest-based Policy (Minimize Cash holdings when Interest rates are High)

When Interest Rates are high, the Opportunity Cost of keeping capital in form of Cash

(generating zero returns) is higher.

Try to make Collections quickly and keep as much cash as possible in profit-earning

Marketable securities and Investments in Projects

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Financial Management MGT201

Cash Flow Synchronization Policy

Use "Billing Cycles" to time the Cash Outflows just after the Cash Inflows

Example: Salaries paid on 3rd of Every Month. Electricity Bill paid on the 18th of

Every Month. Aim for Cash Collections on the 1st and 15th of every month just few

days before Cash Outflows.

Speed up Cash Collection Policy

Business Competition forces firms to Sell on CREDIT but that leads to Problems in

RECOVERY of Receivables (i.e. Bad Debts and Write offs).

Collection Staff, Letters, Collection Agency

Use Technology: Electronic Wire Transfer, Automatic Debit, Credit Cards

Float Policy (Keep Track of Cheques Clearance)

Takes 1-2 days in Pakistan for cheque to turn into cash in your account from the date of

deposit.

Aim to make your own Cheque Clearing process quicker (minimize your Collections

Float) than your Supplier's. That way, you will encash cheques before others can

encash yours.

So, you will have a Positive Net Float in your Bank account. This cash can be used for

emergency expenses.

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