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FMP Lecture - Workings Capitals (2).pptx
- 1. Working Capital Management IQRA University Gulshan Campus. Raheel Bhagar raheel.bhagar@iuk.edu.pk March 12, 2024 1 Finance For Managers - 0387
- 2. Working Capital Management • Working capital = current assets – current liabilities • Working capital management refers to choosing the levels and mix of: – cash, marketable securities, receivables and inventories. – different types of short-term financing.
- 3. Considerations in Working Capital Management • Sales impact • Liquidity • Relations with stakeholders – suppliers – customers • Short-term financing mix – profitability – risk considerations
- 4. Working Capital Management • Maturity matching approach • Conservative approach • Aggressive approach
- 5. Maturity Matching Approach • Hedge risk by matching the maturities of assets and liabilities. • Permanent current assets are financed with long-term financing, while temporary current assets are financed with short-term financing. • There are no excess funds.
- 6. Maturity Matching Approach Temporary Current Assets Time $ Long Term Financing Short Term Financing
- 7. Conservative Approach • Long-term funds are used to finance both permanent as well as some temporary short- term assets. • When there are excess funds, they are invested in marketable securities.
- 8. Conservative Approach Temporary Current Assets Time $ Marketable securities Long Term Financing Short Term Financing
- 9. Aggressive Approach • Use less long-term and more short-term financing than the conservative approach.
- 10. Aggressive Approach Temporary Current Assets Time $ Long Term Financing Short Term Financing
- 11. Cost and Risk Considerations • Yield curve is usually upward sloping. • Short-term rates are more volatile than long- term rates. • Firm's ability to obtain needed short-term financing.
- 12. Cash Conversion Cycle The cash conversion cycle is the length of time between payment of accounts payable and the receipt of cash from accounts receivable.
- 13. Cash Conversion Cycle Purchase Inventory Sale on Credit Collect Acct. Receivable Payment of Accts. Payable Inventory Conversion Period Cash Conversion Cycle Time Payables Deferral Period Receivables Collection Period
- 15. Inventory Conversion Period • The inventory conversion period is the length of time from the purchase of inventory to the time the sales are made on credit. turnover Inventory 365 Sales/365 of Cost Inventory period conversion Inventory
- 16. Receivables Collection Period • The receivables collection period is the average number of days it takes to collect on accounts receivable. – Equal to days sales outstanding (DSO) turnover s Receivable 365 Sales/365 s Receivable period collection s Receivable
- 17. Payables Deferral Period • The payables deferral period is the average length of time between the purchase of materials and labor and the payment of cash for the same. 𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠 𝐷𝑒𝑓𝑒𝑟𝑟𝑎𝑙 𝑃𝑒𝑟𝑖𝑜𝑑 = 𝐴𝑐𝑐𝑜𝑢𝑛𝑡 𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑 𝑆𝑜𝑙𝑑 /365 𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠 𝐷𝑒𝑓𝑒𝑟𝑟𝑎𝑙 𝑃𝑒𝑟𝑖𝑜𝑑 = 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠 + 𝑜𝑡ℎ𝑒𝑟 𝑝𝑎𝑦𝑎𝑏𝑙𝑒𝑠 (𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑 𝑆𝑜𝑙𝑑 + 𝑆𝑒𝑙𝑙𝑖𝑛𝑔 + 𝐺𝑒𝑛𝑒𝑟𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠)/365
- 18. Cash Conversion Cycle Given the following information about Vision Opticals, compute the firm’s cash conversion cycle. Inventory Accounts Receivable Accounts Payable Wages, Benefits, Payroll Taxes Sales Cost of Sales Selling & Other Expenses $19,000 $21,000 $5,600 $9,000 $227,000 $93,000 $22,000
- 23. Another illustration • We can illustrate the process with data from Real Time Computer Corporation (RTC), which in early 2001 introduced a new minicomputer that can perform one billion instructions per second and that will sell for $250,000. RTC expects to sell 40 computers in its first year of production. The effects of this new production RTC’s working capital position were analyzed in terms of the following • five steps: 1. RTC will order and then receive the materials it needs to produce the 40 computers it expects to sell. Because RTC and most other firms purchase materials on credit, this transaction will create an account payable. However, the purchase will have no immediate cash flow effect. 2. Labor will be used to convert the materials into finished computers. However, wages will not be fully paid at the time the work is done, so, like accounts payable, accrued wages will also build up. 3. The finished computers will be sold, but on credit. Therefore, sales will create receivables, not immediate cash inflows. 4. At some point before cash comes in, RTC must pay off its accounts payable and accrued wages. This outflow must be financed. 5. The cycle will be completed when RTC’s receivables have been collected. At that time, the company can pay off the credit that was used to finance production, and it can then repeat the cycle.
- 24. CCC Example - RTC 1. Selling price 250,000 2. Cost = 197,250 3. Annual Sales = $ 10 million 4. Average inventory $ 2 million 5. Receivables = $ 657,534 6. 1 month credit from suppliers 7. 1 month to pay labor 8. CGS = $ 8 million 9. Payables = $ 657,534 10. Calculate CCC
- 25. Inventory conversion period • Inventory conversion period, which is the average time required to convert materials into finished goods and then to sell those goods. Note that the inventory conversion period is calculated by dividing inventory by sales per day. For example, if average inventories are $2 million and sales are $10 million, then the inventory conversion period is 73 days Thus, it takes an average of 73 days to convert materials into finished goods and then to sell those goods Inventory turnover = cost of goods sold Inventory Days of Inventory on hand = 365 Inventory turnover
- 26. Receivables collection period • Receivables collection period, which is the average length of time required to convert the firm’s receivables into cash, that is, to collect cash following a sale. The receivables collection period is also called the days sales outstanding (DSO), and it is calculated by dividing accounts receivable by the average credit sales per day. If receivables are $657,534 and sales are $10 million, the receivables collection period is Thus, it takes 24 days after a sale to convert the receivables into cash.
- 27. Payables deferral period • Payables deferral period, which is the average length of time between the purchase of materials and labor and the payment of cash for them. For example, if the firm on average has 30 days to pay for labor and materials, if its cost of goods sold are $8 million per year, and if its accounts payable average $657,534, then its payables deferral period can be calculated as follows: • The calculated figure is consistent with the stated 30-day payment period.
- 28. Cash conversion cycle • Cash conversion cycle, which nets out the three periods, therefore equals the length of time between the firm’s actual cash expenditures to pay for productive resources (materials and labor) and its own cash receipts from the sale of products (that is, the length of time between paying for labor and materials and collecting on receivables). The cash conversion cycle thus equals the average length of time a dollar is tied up in current assets. • Days in Cash Conversion Cycle = 73 days + 24 days - 30 days = 67 days. • To look at it another way • Cash inflow delay - Payment delay = Net delay • (73 days + 24 days) - 30 days = 67 days.
- 29. SHORTENING THE CASH CONVERSION CYCLE • Given these data, RTC knows when it starts producing a computer that it will have to finance the manufacturing costs for a 67-day period. The firm’s goal should be to shorten its cash conversion cycle as much as possible without hurting operations. This would improve profits, because the longer the cash conversion cycle, the greater the need for external financing, and that financing has a cost. • The cash conversion cycle can be shortened 1. by reducing the inventory conversion period by processing and selling goods more quickly 2. by reducing the receivables collection period by speeding up collections, 3. By lengthening the payables deferral period by slowing down the firm’s own payments. • To the extent that these actions can be taken without increasing costs or depressing sales, they should be carried out.
- 30. Goal: Shortening the CCC • Process & sell more quickly • Shorten the receivables period, improve collections • Slow down payables, delay payments Desirable if: 1. Don’t increase cost 2. Doesn’t decrease sales
- 31. BENEFITS • The benefits of shortening the cash conversion cycle by looking again at Real Time Computer Corporation. • Suppose RTC must spend approximately $197,250 on materials and labor to produce one computer, and it takes about nine (9) days to produce a computer. • It must invest $197,250/9 = $21,917 for each day’s production. • This investment must be financed for 67 days—the length of the cash conversion cycle—so the company’s working capital financing needs will be 67 * $21,917 = $1,468,439 • If RTC could reduce the cash conversion cycle to 57 days, say, by deferring payment of its accounts payable an additional 10 days, or by speeding up either the production process or the collection of its receivables, it could reduce its working capital financing requirements by $219,170.