This document discusses key concepts in working capital and current assets/liabilities management from Chapter 2 of a financial management textbook. It covers the components of working capital, including cash, marketable securities, accounts receivable, inventory, accounts payable, and short-term debt. It discusses managing the cash conversion cycle by reducing inventory holding periods, collection periods, and payment periods. Methods for managing inventory like the ABC classification system and economic order quantity model are explained. The document also covers accounts receivable management techniques like credit scoring and changing credit standards. Strategies for funding working capital requirements like aggressive versus conservative approaches are presented.

1. Financial management chapter 2
•Chapter 2 :
• CURRENT
ASSETS MANAGEMENT ..
• CURRENT
LIABILITIES MANAGEMENT
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2. Financial management chapter 2
Current Assets
Cash & Bank
Marketable securities
Accounts Receivables
Notes Receivables
Inventory
Current Liabilities
Accounts Payable
Notes Payable
Short term loans
Non Current Assets
Property , Plant and Equipment
Non current Liabilities
Long term Loans
Bonds
Owner’ Equity
Maximizing
Wealth
Financial Manager
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3. Financial management chapter 2
WORKING CAPITAL AND
CURRENT ASSETS MANAGEMENT
benefit from working capital management for various
department:
ACCOUNTING :
the cash conversion cycle and the management of inventory,
accounts receivable, and receipts and disbursements of cash.
INFORMATION SYSTEMS :
the cash conversion cycle, inventory, accounts receivable,
and receipts and disbursements of cash to design financial
information systems that facilitate effective working capital
management.
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4. Financial management chapter 2
MANAGEMENT
manage current assets and decide whether to finance the
firm’s funds requirements aggressively or conservatively.
MARKETING
credit selection and monitoring because sales will be
affected by the availability of credit to purchasers; sales will
also be affected by inventory management.
OPERATIONS
the cash conversion cycle because you will be responsible
for reducing the cycle through the efficient management of
production, inventory, and costs.
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5. Financial management chapter 2
Short-term financial decisions
Working capital management focuses on
the management of short-term cash flows
by evaluating their timing, risk, and impact
on firm value.
long- term financial decisions
ultimately determine the firm’s ability to
maximize shareholder wealth .
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6. Financial management chapter 2
Current
Liabilities
Management
current liabilities,
including accounts
payable, accruals,
lines of credit,
commercial paper,
and short-term
loans, to finance
current assets.
Successful
working capital
management will
help ensure that
the firm can meet
its operating
obligations and
maximize its long-
term investments.
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7. Financial management chapter 2
WoRKING CAPITAL MANAGEMENT
The goal of
working capital (or
short-term
financial)
management is to
manage each of
the firm’s current
assets (inventory,
accounts
receivable,
marketable
securities, and
cash)
and current
liabilities (notes
payable,
accruals, and
accounts
payable)
to achieve a
balance between
profitability and
risk
that contributes
positively to the
firm’s value.
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8. Financial management chapter 2
NET WORKING CAPITAL
• NET WORKING CAPITAL
•
• CURRENT ASSETS CURRENT LIABILITIES
•
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9. Financial management chapter 2
TRADE-OFF BETWEEN PROFITABILITY AND RISK
Profits achieve from
(1) increasing revenues or
(2) decreasing costs.
Risk,
probability that a firm will
be unable to pay its bills as
they come due
(insolvent ).
Using these
definitions of
profitability and
risk, we can
demonstrate the
tradeoff between
them by
considering changes
in current assets
and current
liabilities separately.
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10. Financial management chapter 2
Changes in Current Assets
using the ratio of current assets to total assets.
when current assets increase—profitability decreases.
Why? Because current assets are less profitable than fixed
assets. Fixed assets are more profitable because they add more
value to the product than that provided by current assets.
Without fixed assets, the firm could not produce the product.
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11. Financial management chapter 2
The increase in current assets increases net
working capital, thereby reducing the risk
of insolvency.
Investment in cash and marketable
securities is less risky than investment
in accounts receivable, inventories, and
fixed assets.
Accounts receivable investment is
less risky than investment in
inventories and fixed assets.
Investment in inventories is less risky
than investment in fixed assets.
The nearer an asset is to cash, the less
risky it is.
The opposite effects on profit and risk result from a
decrease in the ratio of current assets to total assets
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12. Financial management chapter 2
Changes in Current Liabilities
using the ratio of
current liabilities to
total assets.
When the ratio
increases, profitability
increases.
Why?
Because the firm uses more
of the less-expensive current
liabilities financing and less
long-term financing.
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13. Financial management chapter 2
Current liabilities are less
expensive because only notes
payable, which represent about
20 percent of the typical
manufacturer’s current liabilities,
have a cost....
The other current liabilities
are basically debts on
which the firm pays no
charge or interest
if the ratio of current liabilities to total
assets increases, the risk of insolvency
also increases because the increase in
current liabilities in turn decreases net
working capital
The opposite effects on profit
and risk result from a decrease
in the ratio of current liabilities
to total assets.
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14. Financial management chapter 2
Cash Conversion Cycle (CCC)
measures the length of
time required for a
company to convert cash
invested in its operations
to cash received as a
result of its operations.
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15. Financial management chapter 2
CALCULATING THE CASH CONVERSION CYCLE
CCC = AAI + ACP – APP
OC= AAI +ACP
CCC= OC- APP
average age of inventory (AAI)
average collection period (ACP)
operating cycle (OC)
the average payment period (APP)
.
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16. Financial management chapter 2 16

17. Financial management chapter 2
FUNDING REQUIREMENTS OF THE CASH CONVERSION
CYCLE
first the differentiate between
permanent and seasonal funding needs and
then describe aggressive and conservative
seasonal funding strategies.
Permanent versus Seasonal Funding needs If the
firm’s sales are constant, then its investment in
operating assets should also be constant, and the
firm will have only a permanent funding
requirement. 17

18. Financial management chapter 2
• Example :
Nicholson Company holds, on average,
$50,000 in cash and marketable securities,
$1,250,000 in inventory, and
$750,000 in accounts receivable.
Nicholson’s business can be viewed as permanent.
In addition, Nicholson’s
accounts payable of $425,000 are stable over time.
Thus Nicholson has a permanent investment in operating assets of
$1,625,000 =($50,000 + $1,250,0000 + $750,000 - $425,000).
That amount would also equal its permanent funding requirement.
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19. Financial management chapter 2
• seasonal funding needs.
Semper has seasonal sales, with its peak sales being driven by the
summertime purchases of bicycle pumps.
Semper holds, at minimum,
$25,000 in cash and marketable securities,
$100,000 in inventory,
and $60,000 in accounts receivables
• At peak times, Semper’s
inventory increases to $750,000, and its
accounts receivable increase to $400,000.
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20. Financial management chapter 2
• To capture production efficiencies, Semper produces pumps at a
constant rate throughout the year.
Thus accounts payable remain at $50,000 throughout the year.
Accordingly, Semper has a permanent funding requirement for its
minimum level of operating assets of
$135,000 = ($25,000 + $100,000 + $60,000 - $50,000)
and peak seasonal funding requirements (in excess of its permanent
need) of
$990,000=($25,000 + $750,000 + $400,000 - $50,000) - $135,000.
Semper’s total funding requirements for operating assets vary from a
minimum of $135,000
(permanent) to a seasonal peak of
$1,125,000 = ($135,000 + $990,000).
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21. Financial management chapter 2
aggressive funding
strategy,
the firm funds its seasonal
requirements with short-
term debt and its
permanent requirements
with long-term debt.
conservative funding
strategy, the
firm funds both its
seasonal and its
permanent requirements
with long-term debt.
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22. Financial management chapter 2
• Example :
Semper Pump Company has a permanent funding requirement of
$135,000 in operating assets and
seasonal funding requirements that vary between
$0 and $990,000 and average $101,250
If Semper can
borrow short-term funds at 6.25% and long-term funds at 8%, and
if it can earn 5% on the investment of any surplus balances,
then
the annual cost of an aggressive strategy for seasonal funding will
be Cost of
short-term financing = 0.0625 * $101,250 = $ 6,328.13 + Cost of
long-term financing = 0.0800 * 135,000 = 10,800.00 - Earnings on
surplus balances = 0.0500 * 0 = 0 Total cost of aggressive strategy
17128.13
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23. Financial management chapter 2
• Because under this strategy
the amount of financing exactly equals the estimated funding need,
no surplus balances exist.
Alternatively, Semper can choose a conservative strategy, under
which surplus cash balances are fully invested.
(this surplus will be the difference between the peak need of
$1,125,000 and the total need, which varies between $135,000 and
$1,125,000 during the year.) The cost
of the conservative strategy will be Cost of short-
term financing = 0.0625 * $ 0 = $ 0 + Cost of long-
term financing = 0.0800 * 1,125,000 = 90,000.00 -Earnings on
surplus balances = 0.0500 * 888,750 = 44,437.50 Total cost of
conservative strategy $45,562.50
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24. Financial management chapter 2
• The average surplus balance would be calculated by subtracting the
sum of the permanent need ($135,000) and the average seasonal
need ($101,250) from the seasonal peak need ($1,125,000) to get
$888,750 = ($1,125,000 - $135,000 - $101,250).
This represents the surplus amount of financing that on average
could be invested in short-term assets that earn a 5% annual return.
It is clear from these calculations that for Semper,
the aggressive strategy is far less expensive than the conservative.
However, it is equally clear that Semper has substantial peak-season
operating-asset needs and that it must have adequate funding
available to meet the peak needs and ensure ongoing operations.
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25. Financial management chapter 2
• Clearly, the aggressive strategy’s heavy reliance on short-term
financing makes it riskier than the conservative strategy because of
interest rate swings and possible difficulties in obtaining needed
short-term financing quickly when seasonal peaks occur.
The conservative strategy avoids these risks through the locked-in
interest rate and long-term financing, but it is more costly because of
the negative spread between the earnings rate on surplus funds
(5 percent in the example) and the cost of the long-term funds that
create the surplus (8 percent in the example).
Where the firm operates, between the extremes of the aggressive
and conservative seasonal funding strategies, depends on
management’s disposition toward risk and the strength of its
banking relationships.
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26. Financial management chapter 2
STRATEGIES FOR MANAGING THE CASH CONVERSION CYCLE
The goal is to
minimize the
length of the cash
conversion cycle,
which minimizes
negotiated
liabilities. This
goal can be
realized through
use of the
following
strategies:
AAI ( - )
ACP ( - )
APP ( + )
1. Turn over inventory as quickly as possible
without stock outs that result in lost sales.
2. Collect accounts receivable as quickly as
possible without losing sales from high-pressure
collection techniques.
3. Manage mail, processing, and clearing time to
reduce them when collecting from customers
and to increase them when paying suppliers.
4. Pay accounts payable as slowly as possible
without damaging the firm’s credit rating.
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27. Financial management chapter 2
Inventory Management
The first component of
the cash conversion
cycle is the average age
of inventory.
The objective for managing
inventory, as noted earlier, is to
turn over inventory as quickly as
possible without losing sales
from stock outs.
The financial manager tends to act
as an advisor or “watchdog” in
matters concerning inventory.
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28. Financial management chapter 2
DIFFERING VIEWPOINTS ABOUT INVENTORY LEVEL
Finance
managers
Marketing
managers
manufacturing
managers
purchasing
managers
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29. Financial management chapter 2
COMMON TECHNIQUES FOR MANAGING INVENTORY
ABC System .
divides inventory
into three groups:
A, B, and C..
Group A
consists of 20 %
items but 80 %
investment.
Group B consists
of items that
account for the next
largest investment
in inventory.
Group C
consists of a large
number of items
and small
investment.
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30. Financial management chapter 2
ABC inventory system
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31. Financial management chapter 2
Economic Order Quantity (EOQ) Model
determines what
order size
minimizes total
inventory
cost EOQ assumes
that the relevant
costs of inventory
can be divided
into order costs
and carrying costs.
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32. Financial management chapter 2
•S = usage in units per period
O = order cost per order C
= carrying cost per unit per period Q =
order quantity in units The
first step is to derive the cost functions for order cost and
carrying cost.
The order cost can be expressed as the product of the cost per
order and the number of orders. Because
the number of orders equals the usage during the period
divided by the order quantity (S/Q), the order cost can be
expressed as follows: Order cost = O * (S , Q)
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33. Financial management chapter 2
• The carrying cost is defined as the cost of carrying a unit of
inventory per period multiplied by the firm’s average inventory.
The average inventory is the order quantity divided by 2 (Q/2),
because inventory is assumed to be depleted at a constant rate.
Thus carrying cost can be expressed as follows:
Carrying cost = C * (Q , 2)
The firm’s total cost of inventory is found by summing the order
cost and the carrying cost.
Thus the total cost function is:
Total cost = [O * (S , Q)] + [C * (Q , 2)]
Because the EOQ is defined as the order quantity that minimizes
the total cost function, we must solve the total cost function for
the EOQ.
The resulting equation is: EOQ = 2 * S * B/ O 33

34. Financial management chapter 2
•Example :
MAX Company, a producer of dinnerware, has an A group
inventory item that is vital to the production process.
This item costs $1,500, and MAX uses 1,100 units of the
item per year.
MAX wants to determine its optimal order strategy for the
item.
To calculate the EOQ,
we need the following inputs:
Order cost per order = $150
Carrying cost per unit per year = $200
Substituting into Equation 15.7,
we get 2 * 1,100 * $150 / 200
B
EOQ = 41 units
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35. Financial management chapter 2
•The reorder point for MAX depends on the number of
days MAX operates per year.
Assuming that
MAX operates 250 days per year
and uses 1,100 units of this item,
its daily usage is 4.4 units (1,100/250).
If its lead time is 2 days and MAX wants to maintain a
safety stock of 4 units,
the reorder point for this item is
12.8 units 3(2 * 4.4) + 4
However, orders are made only in whole units, so the
order is placed when the inventory falls to 13 units.
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36. Financial management chapter 2
JUST-IN-TIME
(JIT) system is used to
minimize inventory
investment.
The philosophy is
that materials
should arrive at
exactly the time
they are needed for
production.
Ideally, the firm would have only work-in-
process inventory.
Failure of materials to arrive on time
results in a shutdown of the production
line until the materials arrive.
a JIT system requires high-
quality parts from.
suppliers.
When quality problems
arise, production must be
stopped until the
problems are resolved.
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37. Financial management chapter 2 37

38. Financial management chapter 2
Account Receivable Management
Decrease in
“ACP “
AND
Collection
period is less
than “ APP “
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39. Financial management chapter 2
Five C’s of Credit
The five C’s are
1. Character 2. Capacity 3. Capital
4. Collateral 5. Conditions
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40. Financial management chapter 2
Credit scoring
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41. Financial management chapter 2
Credit scoring
If bad debts from
scoring decisions
increase, then
the scoring
system must be
reevaluated.
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42. Financial management chapter 2
Changing Credit Standards
The firm sometimes
will contemplate
changing its credit
standards in an effort
to improve its returns
and create greater
value for its owners.
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43. Financial management chapter 2
Changing Credit Standards
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44. Financial management chapter 2
Cost of Marginal Bad Debts
• Cost of Marginal Bad Debts We find
the cost of marginal bad debts by taking the difference between the levels of
bad debts before and after the proposed relaxation of credit standards. Cost of
marginal bad debts Under proposed
plan: (0.02 * $10/unit * 63,000 units) = $12,600 Under present
plan:(0.01 * $10/unit * 60,000 units) 6600 Cost
of marginal bad debts Note that the
bad-debt costs are calculated by using the sale price per unit ($10) to deduct not
just the true loss of variable cost ($6) that results when a customer fails to
pay its account but also the profit contribution per unit (in this case $4)
that is included in the “additional profit contribution from sales.” Thus the
resulting cost of marginal bad debts is $6,600.
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45. Financial management chapter 2
• Example
Making the Credit Standard Decision: To
decide whether to relax its credit standards, the firm must compare
the additional profit contribution from sales to the added costs of the
marginal investment in accounts receivable and marginal bad debts.
If the additional profit contribution is greater than marginal costs,
credit standards should be relaxed. The
results and key calculations related to Dodd Tool’s decision whether to
relax its credit standards are summarized in . The net addition
to total profits resulting from such an action will be $2,826 per year.
Therefore, the firm should relax its credit standards as proposed.
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46. Financial management chapter 2
CREDIT MONITORING
Credit monitoring is an ongoing
review of the firm’s accounts
receivable
to determine whether customers
are paying according to the stated
credit terms.
If they are not paying in a timely
manner, credit monitoring will alert
the firm to the problem.
Slow payments are costly to a firm because
they lengthen the average collection
period and thus increase the firm’s
investment in accounts receivable.
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47. Financial management chapter 2
Average Collection Period
has two components:
(1) the time from sale until
the customer places the
payment in the mail and
(2) the time to receive,
process, and collect the
payment once it has been
mailed by the customer.
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48. Financial management chapter 2
• Example,
• a firm that has credit terms of net 30 would expect its average
collection period (minus receipt, processing, and collection time) to
equal about 30 days.
If the actual collection period is significantly greater than 30 days, the
firm has reason to review its credit operations.
If the firm’s average collection period is increasing over time, it has
cause for concern about its accounts receivable management.
A first step in analyzing an accounts receivable problem is to “age” the
accounts receivable. By this
process the firm can determine whether the problem exists in its
accounts receivable in general or is attributable to a few specific
accounts
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49. Financial management chapter 2
Aging of Accounts Receivable
•The purpose of the aging schedule is to enable the firm to
pinpoint problems. A simple
example will illustrate the form and evaluation of an aging
schedule. Age of
account Balance outstanding Percentage of total balance
outstanding 0–30 days $ 80,000 48%
• 31–60 days 36,000 21%
• 61–90 days 52,000 31%
• TOTAL 168000 100%
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50. Financial management chapter 2
Popular Collection Techniques
•A number of collection techniques, ranging from letters
to legal action, are employed. As an
account becomes more and more overdue, the
collection effort becomes more personal and more
intense.
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51. Financial management chapter 2
CURRENT LIABILITIES MANAGEMENT
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52. Financial management chapter 2
Current Assets
Cash & Bank
Marketable securities
Accounts Receivables
Notes Receivables
Inventory
Current Liabilities
Accounts Payable
Notes Payable
Short term loans
Non Current Assets
Property , Plant and Equipment
Non current Liabilities
Long term Loans
Bonds
Owner’ Equity
Maximizing
Wealth
Financial Manager
52

53. Financial management chapter 2
CURRENT LIABILITIES MANAGEMENT
ACCOUNTING
how to analyze supplier credit terms to decide whether the firm should take or
give up cash discounts;
MANAGEMENT
know the sources of short-term loans so that, if short-term financing is needed,
you will understand its availability and cost.
MARKETING
how accounts receivable and inventory can be used as loan collateral.
OPERATIONS
The use of accounts payable as a form of short-term financing and uses inventory
as collateral 53

54. Financial management chapter 2
ACCOUNTS PAYABLE MANAGEMENT
Accounts payable are the
major source of short-term
financing for business
firms.
They result from
transactions in which
merchandise is purchased
but no formal note is
signed to show the
purchaser’s liability to the
seller.
The purchaser in effect
agrees to pay the supplier
the amount required in
accordance with credit
terms normally stated on the
supplier’s invoice.
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55. Financial management chapter 2
Role in the Cash Conversion Cycle
• The average payment period has two parts:
• The time from the
purchase of raw materials until the firm mails the payment and
payment float time.
• Here we discuss the firm’s
management of the time that elapses between its purchase of raw
materials and its mailing payment to the supplier.
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56. Financial management chapter 2
• Example In 2009,
Hewlett-Packard Company (HPQ), the world’s largest technology company, had
annual revenue of $114,552 million,
cost of revenue of $87,524 million, and
accounts payable of $14,809 million. HPQ
had an average age of inventory (AAI) of 29.2 days, an
average collection period (ACP) of 53.3 days, and
an average payment period (APP) of 60.4 days (HPQ’s
purchases were $89,492 million). Thus, the
cash conversion cycle for HPQ was 22.1 days (29.2 + 53.3 - 60.4). The
resources HPQ had invested in this cash conversion cycle (assuming a 365-day year)
were Inventory = $ 87,524 million * (29.2 , 365) = $ 7,001,920,000 +
Accounts receivable = 114,552 million * (53.3 , 365) = 16,727,730,4 11 -
Accounts payable = 89,492 million * (60.4 , 365) = 14,809,087,12 3 =
Resources invested = $ Based on HPQ’s APP and
average accounts payable, 8,920,563,288
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57. Financial management chapter 2
• the daily accounts payable
generated by HPQ is $245,183,562 ($14,809,087,123, 60.4).
If HPQ were to increase its average payment period by 5 days,
its accounts payable would increase by about $1,226 million (5 * $245,183,562).
• As a result, HPQ’s cash conversion cycle would decrease by 5 days, and the firm
would reduce its investment in operations by $1,226 million.
Clearly, if this action
did not damage HPQ’s credit rating, it would be in
the company’s best interest.
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58. Financial management chapter 2
Analyzing Credit Terms
• The credit terms that a firm is offered by its suppliers enable it to delay
payments for its purchases.
Because the supplier’s cost of having its money tied up in merchandise
after it is sold is probably reflected in the purchase price,
the purchaser is already indirectly paying for this benefit.
Sometimes a supplier will offer a cash discount for early payment.
In that case, the purchaser should carefully analyze credit terms to
determine the best time to repay the supplier. The
purchaser must weigh the benefits of paying the supplier as late as
possible against the costs of passing up the discount for early payment.
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59. Financial management chapter 2
Effects of Stretching Accounts Payable
•Effects of Stretching Accounts Payable A
strategy that is often employed by a firm is
stretching accounts payable—that is, paying bills as
late as possible without damaging its credit rating.
Such a strategy can reduce the cost of giving up a
cash discount.
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60. Financial management chapter 2
ACCRUALS
The second source of
short-term business
financing is accruals.
Accruals are liabilities for
services received for which
payment has yet to be
made.
The most common items accrued by
a firm are wages and taxes.
Because taxes are payments to the
government, their accrual cannot be
manipulated by the firm.
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61. Financial management chapter 2
Unsecured Sources of Short-Term Loans
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62. Financial management chapter 2
Sources of Short-Term Loans
short-term loans has two
sources,
banks
sales of
commercial
paper.
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63. Financial management chapter 2
BANK LOANS
Banks are a major
source of short-term
loans to businesses.
The major type of
loan made by banks
to businesses is the
short term.
we consider loan
interest rates. Fixed-
and Floating-Rate
Loans:
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64. Financial management chapter 2
Example
•An assignment
• ( X ) got a loan $100,000 for 5 months at rate 2% /month
• Prepare the schedule of loan amortization according
• 1 ) Simple interest .
• 2 ) Accumulated interest .
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