Working Capital Current Asset Mgt Prepared by Keldon Bauer Net Working Capital Working Capital includes a firm s current assets which consist of cash and marketable securities in addition to accounts receivable and inventories It also consists of current liabilities including accounts payable trade credit notes payable bank loans and accrued liabilities Net Working Capital is defined as total current assets less total current liabilities The Tradeoff Between Profitability Risk Positive Net Working Capital low return and low risk Current Current low Assets Liabilities cost low Net Working return Capital 0 Long Term Debt high return Fixed Assets Equity high cost highest cost The Tradeoff Between Profitability Risk cont Negative Net Working Capital high return and high risk Current Current low Assets Liabilities return low Net Working cost Capital 0 high return Fixed Assets Long Term Debt high cost Equity highest cost The Tradeoff Between Profitability Risk cont The Cash Conversion Cycle Short term financial management managing current assets and current liabilities is one of the financial manager s most important and time consuming activities The goal of short term financial management is to manage each of the firms current assets and liabilities to achieve a balance between profitability and risk that contributes positively to overall firm value Central to short term financial management is an understanding of the firm s cash conversion cycle Cash Conversion Cycle Purpose is to assess how well the firm is managing assets Inventory turnover ratio IT Cost of Goods 131 924 IT 3 56 Inventory 37 009 365 365 Inventory Days 102 days IT 3 56 Cash Conversion Cycle Accounts receivable turnover ART Sales 169 565 ART 9 05 Acct Rec 18 735 365 365 Average Collection Period 40 days ART 9 05 Cash Conversion Cycle Accounts payable turnover APT Cost of Goods 131 924 APT 24 22 Accts Payable 5 448 365 365 Average Payment Period 15 days APT 24 22 Calculating the Cash Conversion Cycle cont Both the OC and CCC may be computed as shown below OC Inventory Days ACP OC 102 40 142 days CCC OC Average Payment Period CCC 142 15 127 days Cash Conversion Cycle Chromcraft Revington s Operating Cycle Average Collection Period ACP Average Age of Inventory AAI Days 0 102 142 Chromcraft Revington s Cash Conversion Cycle Pay Accounts Payable Days 0 15 Collect on Sale of Inventory 127 Days Later 142 Funding Requirements of the CCC Permanent vs Seasonal Funding Needs If a 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 If sales are cyclical then investment in operating assets will vary over time leading to the need for seasonal funding requirements in addition to the permanent funding requirements for its minimum investment in operating assets Funding Requirements of the CCC cont Permanent vs Seasonal Funding Needs Funding Requirements of the CCC cont Aggressive vs Conservative Funding Strategies Semper Pump has a permanent funding requirement of 135 000 and seasonal 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 can earn 5 on any invested surplus then the annual cost of the aggressive strategy would be Funding Requirements of the CCC cont Aggressive vs Conservative Funding Strategies Alternatively Semper can choose a conservative strategy under which surplus cash balances are fully invested In Figure 13 2 this surplus would 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 Funding Requirements of the CCC cont Aggressive vs Conservative Funding Strategies 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 funds quickly when the seasonal peaks occur The conservative strategy avoids these risks through the locked in interest rate and long term financing but is more costly Thus the final decision is left to management Strategies for Managing the CCC 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 Inventory Management Inventory Fundamentals Classification of inventories Raw materials items purchased for use in the manufacture of a finished product Work in progress all items that are currently in production Finished goods items that have been produced but not yet sold Inventory Management Differing Views About Inventory The different departments within a firm finance production marketing etc often have differing views about what is an appropriate level of inventory Financial managers would like to keep inventory levels low to ensure that funds are wisely invested Marketing managers would like to keep inventory levels high to ensure orders could be quickly filled Manufacturing managers would like to keep raw materials levels high to avoid production delays and to make larger more economical production runs Techniques for Managing Inventory The ABC System The ABC system of inventory management divides inventory into three groups of descending order of importance based on the dollar amount invested in each A typical system would contain group A would consist of 20 of the items worth 80 of the total dollar value group B would consist of the next largest investment and so on Control of the A items would intensive because of the high dollar investment involved Techniques for Managing Inventory cont The Economic Order Quantity EOQ Model EOQ 2 x S x O C Where S O C Q usage in units per period year order cost per order carrying costs per unit per period year order quantity in units Techniques for Managing Inventory cont The Economic Order Quantity EOQ Model Assume that RLB Inc a manufacturer of electronic test equipment uses 1 600 units of an item annually Its order cost is 50 per order and the carrying cost is 1 per unit per year Substituting into the above equation we get EOQ 2 1 600 50 400 1 The EOQ can be used to evaluate the total cost of