This document summarizes key concepts about working capital management. It discusses working capital terminology like net working capital and cash conversion cycle. The cash conversion cycle measures the average number of days from paying for inventory to collecting from sales. It then discusses factors like inventory, accounts receivable, accounts payable, and cash budgets that influence working capital management policies. Finally, it covers short-term financing sources for working capital like bank loans, commercial paper, and accounts payable.

1. CHAPTER 3 WORKING
CAPITAL
MANAGEMENT
BAF2023 FFM

2. Introduction
 What is the appropriate amount of current
assets for the firm to carry?
 How should current assets be financed?

3. Working Capital Terminology
 Working capital –refers to current assets used in
operations
 Net working capital –defined as current assets minus
current liabilities (CA-CL)
 Net operating working capital –defined as current assets
minus non-interest bearing current liabilities (Cash
+Marketable Securities + Account Receivables +
Inventories –Account Payable –Accruals)
 Working capital policy –refers to the firm’s policies
regarding target levels for each category of current
assets and how current assets will be financed
 Working capital management –involves both setting
working capital policy and carrying out the policy in day-

4. Cash Conversion Cycle
 Refers to cycle of purchasing inventory, sell goods on credit,
and then collect accounts receivable
 Cash conversion cycle model focuses on the length of time
between when the company makes payments and when it
receives cash inflows
 Inventory conversion period –average time period required to
convert materials into finished goods and sell those goods
 Receivables collection period –average length of time required to
convert the firm’s receivables into cash
 Payables deferral period –average length of time between the
purchase of materials and labours and the payment of cash for
them
 Cash Conversion Cycle nets out the three periods
 Length of time between the firm’s actual cash expenditures to pay
for productive resources and its own cash receipts from the sale of
products

6. Income Statement
Sales 20,500,600
Cost of Goods Sold 15,200,100
Balance Sheet
Inventory 2,000,500
Accounts Receivable 1,500,800
Accounts Payable 1,200,000
What is the cash conversion cycle for above firm?

7.  Step 1
 Average inventory period = average inventory / daily cost of
goods sold
 = 2,000,500 / (20,500,600/365)
 = 35.62 days
 Step 2
 Average Receivables Period = average accounts receivable /
sales
 = 1,500,800 / (20,500,600/365)
 = 26.72 days
 Step 3
 Average payables period = average accounts payable / daily
cost of goods sold
 = 1,200,000 / (15,200,100/365)
 = 28.82 days
 Cash conversion cycle = (inventory period + receivables
period) – accounts payable period
 = 35.62 days + 26.72 days - 28.82 days
 = 33.52 days

8. Alternative Current Asset
Investment Policy
 Relaxed Current Asset Investment Policy
 Large amounts of cash, marketable securities and
inventories are carried and where sales are stimulated
by the use of credit policy that provides liberal
financing to customers and a corresponding high level
of receivables
 Restricted Current Asset Investment Policy
 Holdings of cash, securities, inventories and
receivables are minimized
 Currents assets are turned over more frequently so
each dollar of current assets is forced to “work hard”
 Moderate Current Asset Investment Policy

9. Reasons for Holding Cash
 Transactions
 Cash balances are necessary in business
operations
 Associated with routine payments and collections
 Compensations to banks for providing loans and
services
 Precautionary
 Cash balance held in reserve for random,
unforeseen fluctuations in cash inflows and outflows
 Speculative
 Enable the firm to take advantage of any bargain

10. Reasons Holding Adequate Cash
and Near-Cash Assets
 Trade discount
 Help firm to maintain its credit rating by
keeping its current and acid test ratios
 Useful for taking favorable business
opportunities
 Meet emergencies e.g. strikes, fires or
competitors’ marketing campaigns, weather
seasonal and cyclical downturns

11. Cash Budgets
 Estimates its needs for cash
 Forecast sales, its fixed assets and inventory
requirement, and the times when payments
must be made
 Cash budget –a table showing cash flows
(receipts, disbursements and cash
balances) for a firm over a specified period
 Target cash balance
 The desired cash balance that a firm plans to
maintain in order to conduct business

13. Marketable Securities
 Securities that can be sold on short notice
 Can be converted to cash in short notice

14. Inventory
 Classified as
 Supplies
 Raw materials
 Work-in-process
 Finished goods
 Inventory levels depend heavily upon sales
 Inventory must be acquired ahead of sales
 Errors lead either to lost sales or excessive
carrying costs
 Proper inventory management requires close
coordination among the sales, purchasing,
production and finance department

15. Inventory Costs
 Goals inventory management
 Ensure the inventories needed to sustain
operations are available
 Hold costs of ordering and carrying costs
inventories to the lowest possible level
 Inventory is costly to store
 E.g. carrying cost : storage and handling costs,
insurance, property taxes, depreciation and
obsolescence
 E.g. ordering, shipping and receiving cost :
cost of placing orders, shipping

16. Receivables Management
 Account receivable is a balance due from a
customer
 When customer pay,
 Firm will receive cash
 Receivables will decline
 Receivable management begins with the
decision of whether or not to grant credit
 Need to monitor receivables or else it will build
up to excessive levels, cash flow will decline
and bad debts will offset the profits on sales

17. Days Sales Outstanding (DSO)
 The average length of time required to collect
credit sales
 E.g. Super Sets Inc. a television manufacturer,
sells 200,000 television sets a year at a price of
RM198 each. Assume that all sales are on credit
with the following terms: if payment is made
within 10 days, customers will receive 2%
discount; otherwise full amount is due within 30
days. Assume that 70% of the customers take
discounts and pay on Day 10, while the other
30% pay on Day 30.

18.  DSO=ACP=0.7(10 days) +0.3(30 days)=16 days
 ADS (average daily sales)=Annual sales/365 =
200,000(RM198)/365 =RM108,493
 Receivables =ADSxDSO =RM108,493 x 16
=RM1,735,888

19. Aging Schedules
 Breaks down a firm’s receivables by age of account
 A report showing how long accounts receivables have
been outstanding
 Cannot be constructed from the type of summary data
reported in financial statements; must be developed
from the firm’s accounts receivables ledger
 Management should constantly monitor both DSO and
aging schedule to detect trends
 To see how the firm’s collection experience compares with
its credit
 To see how effectively the credit department is operating in
comparison with other firms in the industry
 If DSO starts lengthen, aging schedule begins to show
an increasing percentage of past0due accounts, then
firm’s credit policy may need to be tightened

21. Credit Policy
 A set of decisions that include a firm’s credit
period, credit standards, collection procedures
and discount offered.
 4 variables
 Credit period is the length of time buyers are given
to pay for their purchases
 Discounts given for early payment
 Credit standards refer to the required financial
strength of acceptable credit customers
 Collection policy is measured by its toughness or
laxity in attempting to collect on slow-paying

22. Alternative Current Asset Financing
Policies
 Permanent current assets –current assets that a firm
must carry even at the trough of its cycle
 Temporary current assets –current assets that
fluctuate with seasonal or cyclical variations in sales
 Maturity matching/Self-Liquidating Approach –a
financing policy that matches asset and liability
maturities
 Aggressive Approach –finances all of its fixed assets
with long term capital and part of its permanent
current assets with short-term and no spontaneous
credit
 Conservative Approach –permanent capital is being
used to finance all permanent asset requirements

23. Advantages and Disadvantages of
Short-Term Financing
 Speed
 Short-term loan can be obtained much faster than
long-term credit
 Flexibility
 If its seasonal/cyclical , firm may not want to commit
to long-term debt because
 Flotation costs are higher
 prepayment provision, prepayment penalties can be
expensive
 Short term generally less restrictive
 Cost of long-term versus short-term debt

24. Sources of Short-Term
Financing
 Accruals
 Continually recurring short-term liabilities, especially
accrued wages and accrued taxes
 Increase automatically if firm’s operations expand
 No explicit interest
 Firm cannot ordinarily control its accruals
 Accounts Payable
 Debt arising from credit sales and recorded as an
account receivable by the seller and as an account
payable by the buyer
 Stretching accounts payable-the practice of
deliberately paying late
 Free trade credit –credits received during discount
period
 Costly trade credit –credit taken in excess of free

25. Sources of Short-Term
Financing
 Short-term bank loans
 Maturity –the bulk lending is on a short-term basis
 Promissory note –a document specifying the terms
and conditions of a loan
 Compensating balance –a minimum checking account
balance that a firm must maintain with a commercial
bank
 Line of credit –an informal arrangement in which a
bank agrees to lend up to a specified maximum
amount of funds during a designated period
 Revolving credit management –a formal, committed
line of credit extended by a bank or other lending
institution

26. Sources of Short-Term
Financing
 Commercial paper
 Unsecured, short-term promissory notes of large,
strong firms and sold primarily to other business
firms
 Usually issued in denomination of RM100,000 or
more

27. Use of Security in Short-Term
Financing
 Secured loan –a loan backed by collateral,
often inventories or receivables

28. END OF
CHAPTERS
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