WORKING CAPITAL MANAGEMENT
Working capital refers to the firm’s investment in short-term assets (cash,
marketable securities, accounts receivable and inventories). Net working capital is the
difference between a firm’s current assets and its current liabilities. Working capital
management involves administering to both short-term assets and short-term liabilities.
Assets and liabilities must be matched and coordinated in order to keep costs to a
minimum and to control risks. Generally, we want to match the firm’s financing with the
lives of its assets. If we consider a company that is growing over time, then its assets
can be decomposed into three categories – fixed assets, permanent current assets and
fluctuating current assets.
Current Assets Long-term
Fixed assets should be financed long-term, either equity or long-term debt, since
the assets are long-lived and need financing for a long period of time. The current
assets can be broken down into two portions, permanent current assets and fluctuating
current assets. The permanent current assets represent base levels of inventories,
receivables, etc., that will always be on hand. The fluctuating current assets represent
the seasonal build-ups that occur, such as inventories before Christmas and receivables
after Christmas. The fluctuating current asset levels should be financed short-term since
we don’t want to pay financing charges all year if we only need the money for a four-
While the permanent current assets are, individually, short-lived assets, as a
category they are always there (hence, permanent) and will always need to be financed.
Thus, the permanent current assets should also be financed long-term, just like the fixed
assets. While it is possible to finance some of our permanent needs using short-term
debt, it is risky to do so. (Such financing is described as an “aggressive” working capital
financing policy in your text – aggressive being associated with risky.) The risk of
financing permanent needs with short-term financing is twofold: first, short-term interest
rates fluctuate much more than long-term interest rates. Rolling over short-term debt
year after year will subject you to greater fluctuation in your financing costs as a result.
Probably a bigger risk is the inability to roll over the short-term debt every year. You
may have a bad year and find that lenders are unwilling to refund the debt (forcing you to
Of course, some companies take the opposite approach – they will finance some
of their seasonal needs of the fluctuating current assets with long-term financing. This is
a conservative approach, but the financing is there when it is needed – but it costs
money during those times when it is not needed.
Banks generally do not want companies to utilize them as a source of permanent
financing. For this reason, many banks will require that a company’s line of credit be
completely paid off for at least one month each year. This is to prevent the company
from using the bank for permanent financing. Of course, banks are essentially matching
their assets and liabilities as well. The difference is that a banks assets are its loans
which it matches to its sources of financing – while firms match their financing to their
assets. Since a bank’s financing source is predominantly short-term deposits, it wants
its loan portfolio to be predominantly short-term as well.
Life insurance companies and pension funds, on the other hand, have liabilities
that are many years in the future. They would prefer to make longer term loans so that
there isn’t the need to reinvest the money every year.
COMPONENTS OF WORKING CAPITAL
Cash is probably the least productive asset you can have. Not only does it not
earn anything, it actually loses purchasing power as a consequence of inflation. So why
do firms hold cash? The three Keynsian motives for holding cash balances are
• Transactions motive – to conduct day-to-day business of paying for
purchases, labor, etc.
• Precautionary motive – to cover unexpected expenditures. If the delivery
truck breaks down, it must be repaired or replaced if you want to stay in
• Speculative motive – unusually good opportunities occasionally arise. If you
have the money available, you can take advantage of these opportunities.
While cash is necessary to cover the transactions motive, the precautionary and
speculative motives can be covered with the near money (or near cash) of marketable
In order to maximize your cash balances, you can do one of two things; either
accelerate the inflow of funds (ask for an advance on your salary) or delay the outflow of
funds (postpone paying the phone bill until next month). But why would we want to
maximize our cash holdings if it is the least productive asset? Because idle cash, either
sitting in a checking account or tied-up in accounts receivable is extremely costly.
For example, suppose we have a client who owes us payment of $1,000,000 that
is due. The opportunity cost of not collecting is the interest we could earn on the money.
$1,000,000 Receivable due
5% Treasury bill rate
$ 50,000 Annual interest
$50,000/365 days = $137 per day
Can you invest money for one day? Absolutely. In fact, for a large enough amount of
money, someone will meet you at the bank on Sunday in order to accept your deposit.
This also illustrates the concept of “float”. Bank float is the period of time
between when a check is written to pay an obligation and when the funds are actually
deducted from your checking account. Within a city, it is common practice to have a
local check clearing system where banks meet each day to exchange checks written on
one another’s accounts. When the bank where a check is deposited is in a different city
from the bank on which the check is drawn, the deposited check first goes to the
regional Federal Reserve Bank, (Dallas in the case of Texas), and is then forwarded to
the issuing bank. This adds a day or two to the float period. If the check is drawn on a
bank account in another Federal Reserve District, then another day or so is added as
the local Fed must forward the check to the Fed in the issuing bank’s district which then
forwards the check to the bank. Exxon used to pay suppliers west of the Mississippi
river with checks written on a small bank in North Carolina, while suppliers east of the
Mississippi were paid with checks on a small bank in Arizona. One day’s worth of float
to the U.S. government is worth over $1 billion (which is one reason government
employees now get paid on the first of the following month rather than the last day of the
Most of us have probably played the float on at least one occasion (and probably
gotten caught!) It should be noted, however, that using float to cover up a deficit (i.e.,
hot check) is illegal.
Another means of extending the float is through the use of drafts. A draft is like a
check, but must be returned to the issuer for verification prior being deposited. This,
again, adds 2-3 days to the float period. Insurance companies are most noted for using
drafts within the U.S. The type of draft that insurance companies use are known as
sight drafts since they are paid upon presentation. Time drafts are those which are
payable upon a specific future date. Time drafts are an important financing instrument in
international trade and will be discussed later.
While bank float and drafts delay the outflow of funds, cash balances can also be
increased by speeding up the inflow of funds. The primary means of accomplishing this
is through the use of a lock-box system. A lock-box is a post office box in a local city
where payments from customers in the area are sent. The lock-box is cleared daily and
the checks are deposited in a local bank and then wired to the company’s main bank
account. Referred to as concentration banking, it cuts 2-3 days off of the time it takes
the checks to cross several states and allows funds to be concentrated in one bank for
investment in short-term securities. The larger amount of funds that can be invested
yields higher interest rates and lower transactions costs.
The local bank will offer the lock-box system if a local office is not available or
does not want to devote the personnel to tend to the system. Banks, however, charge
for the services that they provide through either a direct service charge, or by requiring
that a minimum compensating balance be maintained. A compensating balance is one
that does not pay any interest. The minimum balance can be either an absolute
minimum or an average minimum.
Marketable securities are a way of holding cash but with the attribute of earning
interest. Market securities have three characteristics:
1. Short-term maturity (less than one year, or “money market instruments”
2. High marketability
3. Virtually no risk of default
Several types of marketable securities exist, the major ones being
• U.S. Treasury bills
Treasury bills are auctioned every Monday by the government. Most
have maturities of 91 or 181 days, although some 9-month (270 days)
and 12-month (360 days) bills are sold. The t-bills, generally with a face
value of $10,000 each, are sold at a discount to the highest bidders. The
difference between the amount paid and the face value at maturity
represents the interest that is earned.
• Anticipation notes
Anticipation notes are issued by municipalities and school districts. Since
their revenues come from tax sources, the notes are “in anticipation” of
future tax receipts.
• Commercial paper
Commercial paper is the promissory notes of a major national firms. Most
of the firms that issue commercial paper sell it directly to investors
(insurance companies, money market funds, pension funds) although
sometimes it will be sold through investment bankers. Commercial paper
is a substitute for bank debt, but at a rate of interest that is one-fourth to
on-half of a percent higher than t-bills (currently about 4.3%) but
significantly less than what banks would charge (prime is currently about
• Banker’s Acceptances
A banker’s acceptance is a time draft that evolves from international
export/import financing. An exporter is paid by a time draft issued by a
foreign bank. Since the draft is not payable until some future date (1-3
months, typically) the company that receives it will often sell it to its local
bank at a discount. The local bank bundles the discounted drafts
(banker’s acceptances) and then resells them in the money markets.
Accounts receivable are generated when a firm offers credit to its customers.
The first thing that needs to be addressed when establishing a credit policy is to set the
standards by which a firm is judged in determining whether or not credit will be
extended. There is what’s known as the 5 Cs of credit:
1. Character – the willingness of the borrower to repay the obligation
2. Capacity – the capability of the borrower to earn the money to repay the
3. Capital – sufficient assets available to support operations (as opposed to a
firm that is undercapitalized). Sometimes capital is interpreted to mean
equity capital; i.e., to make sure the owners of the firm have sufficient money
at stake to give them proper incentive to repay the loan and not let the
company go bankrupt.
4. Collateral – assets to support the loan which can be liquidated if default
5. Conditions – current and future anticipated conditions of the firm and the
Once the credit standards have been set, the terms of credit need to be
established. When must the customer pay? If they pay early, will they receive a
discount? If they pay late, do they get charged a penalty?
While the whole purpose of extending credit is to increase sales and, thus, gross
profits, the expected increase in gross profits must be compared with the costs
associated with extending credit to customers. These costs include
• The time value of money tied up in accounts receivable
• Bad debts that occur
• Credit checks (to minimize bad debts)
• Collection costs
• Discounts for early payment (reduces revenues)
• Clerical costs associated with maintaining a credit department
Competitors will respond very quickly to a change in price. How many times
have we seen the claims that “We will meet or beat any advertised price”? A change in
credit policy, on the other hand, is a more subtle means of competing for customers and
one that the competition will not necessarily respond to. In fact, many firms base their
business on easy credit. How many times have we seen the advertisements where they
tell us “Good credit? Bad credit? No credit? We don’t care!” Of course, these firms will
have larger bad debt expenses and larger financing costs, etc. Obviously, they will also
need to have higher prices (higher gross profit margins) in order to cover these costs.
Inventories (raw materials, work-in-process, finished goods) make up a large
portion of most firm’s current assets, and for many, total assets. As such, the extent to
which a firm efficiently manages its inventories can have a large influence on its
profitability. Thus, keeping abreast of inventory policy is critical to the profitability (and
value) of the firm.
Several factors influence the amount of inventory that a firm maintains. The most
important of these include
• Level of sales – typically, the more sales a firm has, the more inventory it
• Length of time and technical nature of the production process – The longer it
takes to produce finished goods inventories from raw materials, the larger the
amount of finished goods that a firm will typically hold (a safety stock). Also,
if the production process is highly technical, requiring that retooling be
performed prior to each production run in order to assure that production is
meeting specifications, larger amounts of inventory will be produced with
each production run in order to minimize the set-up costs associated with
• Durability vs. Perishability – If an inventory item is highly perishable, such as
fresh vegetables, a small amount will be held. Similarly, fashions of clothes
and car styles are “perishable” and will result in smaller inventories than
durable goods such as tools and hardware.
• Costs – Cost of holding inventories as well as costs of obtaining inventories
will influence inventory sizes.
Inventory costs can be broken down into three major categories:
A. Ordering Costs
1. Fixed costs – stocking, clerical
2. Shipping costs – often fixed
3. Missed quantity discounts – an opportunity cost
B. Carrying Costs
1. Time value of money tied-up in inventories
2. Warehousing costs
5. Obsolescence, breakage, “shrinkage”
C. Stock-out Costs
1. Lost sales
2. Loss of goodwill
3. Special shipping costs
Ideally, we want to balance these costs against each other so that our total costs
The major source of short-term financing for firms is that of trade credit. While it
is an account payable on our balance sheet, it is an account receivable on the balance
sheet of our supplier.
The terms of credit can vary quite a bit:
1. Cash on Delivery (i.e., no credit)
2. Net amount due within a certain period of time
3. Net amount with a discount if paid within a certain period of time, net amount
within another period.
For example, 2/10 net 30 means that if you pay within the first ten days, you can
deduct 2% from the bill; otherwise the full amount of the bill is due within 30 days.
Discounts are offered by suppliers to keep their A/R balances down and minimize the
funds that are tied-up.
Not taking the discount can be a very expensive means of financing. For
example, suppose we do not pay within the first ten days. Then, if we pay on the
thirtieth day, we have paid 2% (approximately) for an additional twenty days’ use of the
funds (the first ten days were free anyway). Since there are 18 twenty-day periods in a
year, this is approximately
2% * 18 = 36%
Actually, the cost is a little higher since we are paying 2% on top of the 98% we would
otherwise have to pay:
* = 36. 7%
Of course, if you miss payment by day 10 for taking the discount, don’t pay the full
amount of day 11 or you have paid
2%*360 = 720%
Do banks charge 36% interest on loans? Not in Texas or most states. It is a violation of
the usury laws. Then why do many companies forego the discounts if the cost is so
high? It is the only source of funding that they can get. To reduce the effective cost,
firms will often stretch payment out past the due date. Of course, this subjects the firm
to risk of its credit being completely cut off by the supplier and possibly damages the
credit reputation since other suppliers will often request references before extending
Some firms will offer post-dated billing, typically in a seasonal industry. For
example, if a manufacturer’s primary sales are to retailers for the Christmas season they
may encourage retailers to order in June and July rather than waiting until September.
The encouragement is that if an order is placed in June or July, the manufacturer will not
bill them until September and even then regular credit terms will apply. The advantage
here is that it allows the manufacturer to smoothe out sale and thus production. The
manufacturer can then save on overtime with employees as well as not incur many of
the carrying costs associated with holding the inventories since the retailer takes
possession and ownership earlier.
The second major source of short-term financing for firms is commercial banks.
A firm wants to establish a close relationship with its bank and obtain a line of credit. In
order to get a credit line, you will want to show them your income statements, balance
sheets, financial ratios, etc. The bank will then allow a certain amount of credit with a
set rate of interest (usually prime plus). This can be renegotiated every year. In fact,
commercial banks’ bread and butter is their business accounts and they are very
competitive with one another in trying to attract corporate clients. The amount of the
credit line is typically tied to the amount of accounts receivable that the firm has and
sometimes to the amount of inventories that it holds.
Another type of credit line is referred to as a revolving line of credit. With a
revolving line of credit, the bank provides a written agreement guaranteeing loans up to
a certain amount. The firm will pay a normal rate of interest on the amounts of funds
that it borrows plus a commitment fee of one-half to one percent on any unborrowed
funds. Unlike a regular line of credit which can be changed, a revolving line of credit
guarantees that the bank will always make the amount available if needed. Additionally,
a revolving line of credit will often be extended jointly by several banks when the
amounts used are larger than a single bank can (or wants to) handle alone.
Types of Loans
Loans come in a variety of shapes. A simple loan requires that the firm maintain
a non-interest-bearing account at the bank. While compensating balances are not used
as much as they have been in the past, they are still encountered frequently.
Suppose a bank offers a one-year loan for $100,000 at an 8% rate of interest
with a compensating balance of 20%. Then,
Less: 20,000 compensating balance
$ 80,000 net proceeds
At the end of one year, the firm repays the bank $88,000. $8,000 is interest on the loan
and the other $80,000 (with the $20,000 in the compensating balance for a total of
$100,000) is the principal. Thus, the firm has effectively paid $8,000 interest on the use
of $80,000 for an annual rate of interest of 10%.
Alternatively, the bank may offer a discounted loan where the interest is
deducted up-front. Using our same example,
Less: 8,000 interest
$ 92,000 net proceeds
At the end of the year, the firm repays the $100,000 of principal (since the interest was
paid up-front). Effectively, the firm paid $8,000 of interest for the use of $92,000 of funds
for a rate of interest of 8.7% on the loan.
Of course, your banker is there to help you and may express concern that the
need to come up with $100,000 at the end of the year could be difficult. He/she may
suggest, instead, an interest add-on loan where the amount of interest is added to the
principal and then repaid in a series of installments. Our example loan would then
required that monthly payments of $9,000 be made ($100,000 principal + $8,000 interest
= $108,000/12 months = $9,000 per month).
As an approximation, the amount of the loan that was outstanding during the
year was, on average, only $50,000. The $8,000 of interest thus represents an
approximately 16% rate of interest on the average amount of the loan.
More precisely, this loan appears as
0 1 - - - - - - - - - - - - - - - - - 11 12
100,000 (9,000) - - - - - - - - - - - - - - (9,000) (9,000)
Of course, if you were the bank, the cash flows would be the same, only the
signs would be reversed. So as a bank officer, how would you determine the rate of
interest that you were earning on this investment?
The true cost of debt of any loan is the internal rate of return between what you
receive and what you have to pay back. Suppose we use our calculators and determine
the IRR of this interest add-on loan. We determine that the IRR is 1.2%. But remember
that his is 1.2% per month. Using simple interest, 1.2%*12 = 14.4% annual rate of
Security for Bank Loans
Banks like some sort of collateral for loans to ensure repayment of the loan, at
least in part. The preferred collateral for bank loans is accounts receivable. The reason,
of course, is that collecting money is what banks do. Typically, a bank will loan up to
75-80% of the receivables that are not over 60 days. There are two ways to obtain
financing with receivables:
Pledging of Accounts Receivable – This is the most common form. A lender will
loan up to 80% of the amount of the invoice. Upon payment, the borrower has “pledged”
to use the proceeds to reduce the amount of the loan. If the customer does not pay the
invoice, the borrower is still obligated to repay the loan.
Factoring of Accounts Receivable – The receivable is sold to a factoring
institution. Typically, this is used prior to making a sale on credit. The seller will go to a
factor who will run a credit check on the potential buyer. If the buyer has a good credit
rating, the factor will give the go-ahead to sell on credit and then buy the receivable (at a
discount) from the seller. The buyer is notified in writing to pay the factor directly for the
receivable. Then, if the invoice is not paid, it is up to the factor to collect from the buyer
and the factor takes the risk of bad debt. Sometimes, the factor may withhold 10% from
the seller to make them share in the risk of non-payment. Then, when payment is
received, the 10% reserve will be refunded to the seller.
The use of factoring is considerably more expensive than the pledging of
accounts receivable. This is due to the fact that, in addition to lending money for a
period of 30-90 days, the factor also must run a credit check, incur the cost of collection,
and undertake the risk of nonpayment.
Banks will also use inventories as collateral for short-term loans. A blanket lien
(or floating lien) is one that covers all inventories. Even then, the lender will only loan
40-50% of the cost of those goods. This is because, if default occurs, the lender will
have to hire someone to sell the inventories as well as substantially discounting them in
order to liquidate the inventories.
A warehouse receipts loan is where a third party holds the inventory as collateral
for the lender. A warehouse receipts loan is most commonly used in the canning
industry or where production of inventory is seasonal. For example, the cotton season
runs from June to October. Denim jeans, on the other hand, are purchased year-round.
Thus, a denim manufacturer might buy cotton in June and produce denim but not have
enough for the estimated annual demand. The producer could then go to a bank and
borrow against the bolts of denim that have been produced. These bolts of denim would
then be stored in a public warehouse as collateral and funds would be made available
for the producer to purchase more cotton and produce more denim. As inventories are
sold, the loan could be paid down, in which case the lender would notify the public
warehousing company to release X number of bolts of denim to the producer and the
process reverses itself.
If the inventories are too bulky to transport to a public warehouse, a field
warehouse arrangement may be set up where the public warehousing company goes to
the producer’s place of business and physically segregates the inventories that are
being held as collateral for the lender. Only the public warehousing company would
have access to the collateral and would only release it upon notification by the lender.
A borrower can pledge their inventories of securities of another company (bonds,
notes payable) as collateral for a loan as well. Thus, if you hold a note payable from a
creditworthy firm, many lenders will loan money against it. (This is similar, in a sense, to
what happens with a margin purchase.)
In short, if a firm has assets of virtually any kind, it can use them as collateral for
short-term loans to meet its short-term cash needs.