Financial Management subject For undergraduate students (semester 4)

1. Working Capital
Meeting 2

2. • 1. Explain the term working capital and the importance of working
capital management.
• 2. Understand the need for external sources to finance working
capital
• 3. Understand the approach of funding sources (sources of short-
term, medium-term, and long-term funds)
• 4. Explain the working capital cashflow cycle

3. Long-term vs short-term decisions
• While long-term financial decisions like buying capital equipment or
issuing debentures involve cash flows over an extended period of
time (5 to 15 years or even more)
• Short-term financial decisions typically involve cash flows within a
year or within the operating cycle of the firm

4. The definition of working capital
• Working capital is money available to a company for day-to-day
operations.
• Working capital is a measure of both a company's efficiency and its
short-term financial health. Working capital is calculated as:
• Working Capital = Current Assets - Current Liabilities
• WC = CA - CL

5. How to find CA (open Balance Sheet)

6. • Cash balances may be held for a week or two
• Accounts receivable may have a life span of 30 to 90 days
• Inventories may be held for 1 to 60 days
CA have a short life span

7. How to find CL (open Balance Sheet)

8. WC term
• WC involves short-term asset accounts such as cash, inventory, and
accounts receivable, as well as short-term liability accounts such as
accounts payable
• The level of these accounts depends on factors such as the type
of business and industry standards

9. WC term
• A company must have or be able to generate enough cash to meet its
short-term needs if it is to continue in business
• Therefore, working capital management is a key factor in the
company’s long-term success

10. Positive/Negative WC:
• Positive working capital generally indicates that a company is able to
pay off its short-term liabilities almost immediately
• Negative working capital generally indicates a company is unable to
do so
• The greater the extent to which current assets exceed current
liabilities, the more solvent or liquid a company is likely to be

11. The objectives of WC management
• The two main objectives of working capital management are to
increase the profitability of a company and to ensure that it has
sufficient liquidity to meet short-term obligations
• Profitability is related to the goal of shareholder wealth maximisation.
While liquidity is needed for a company to continue in business.
• However
• Cash kept in a safe will not generate a return, for example, while a six-
month bank deposit will earn interest in exchange for loss of access
for the period.

12. WC cashflow cycle
• The level of WC reflects the length of time between when cash goes
out of a firm at the beginning of the production process and when it
comes back in

13. The Cash and Operating Cycles for a Firm

14. WC cashflow cycle
• A company first buys inventory from its suppliers, in the form of either
raw materials or finished goods.
• A firm typically buys its inventory on credit, which means that the firm
does not have to pay cash immediately.
• After receiving the inventory, even if the inventory is in the form of finished
goods, it may sit on the shelf for some time.
• Finally, when the inventory is ultimately sold, the firm may extend credit
to its customers, delaying when it will receive the cash.
• A firm’s cash cycle is the length of time between when the firm pays cash
to purchase its initial inventory and when it receives cash from the sale of
the output produced from that inventory.

15. Cash conversion cycle
• The firm is not out of cash for the entire length of the operating cycle.
Although it starts by purchasing raw materials, it does not generally
pay for them immediately
• This accounts payable period reduces the amount of time that the
firm is out of cash. The interval between the firm’s payment for its
raw materials and the collection of payment from the customer is
known as the firm’s cash conversion cycle:
• Cash conversion cycle = operating cycle - accounts payable period
• Cash conversion cycle = (inventory period + receivables period) -
accounts payable period

16. WC cashflow cycle
• The cash conversion cycle (CCC)

17. The cash conversion cycle (CCC)

18. Negative Cash Cycle: example
• Internet-based bookseller Amazon.com manages its cash cycle
extremely well
• It turns its inventory over 26 times a year, making its inventory period
very short
• It charges its customer's credit card when it ships a book and it gets
paid by the credit card firm usually in a day
• Finally, it takes about 46 days to pay the suppliers. All this means that
Amazon.com has a negative cash cycle

19. Working Capital in Various Industries (2012)

21. Working Capital in Various Industries
• Because of the characteristics of different industries, working capital
levels vary significantly.
• For example, grocery stores (Kroger) and fast-food restaurants
(Chipotle Mexican Grill) typically sell on a cash-only basis, and thus
have very short accounts receivable days
• Similar results hold for Southwest Airlines, because many of its
customers pay in advance for airline tickets with cash or credit cards.

22. Working Capital in Various Industries
• Inventory represents the largest percentage of sales for firms such as
Constellation Brands and KB Home, whose products have long
production and sales cycles, whereas The Washington Post holds
minimal inventory
• Note also the wide variation in the firms’ cash conversion cycles;
Amazon.com and Southwest’s cash conversion cycle is negative,
reflecting the fact that they receive cash from their customers before
having to pay suppliers
• Whereas firms such as Tiffany & Co. must spend cash to produce their
products more than one year before they receive revenues from them

24. • For example, current assets constitute about 60% of the total assets
of telecom companies, while they account for less than 10% of the
assets of railroads. For some companies “current assets” means
principally inventory; in others it means accounts receivable or cash
and securities
• For example, you can see that inventory constitutes the majority of
the current assets of retail firms, receivables are more important for
oil companies, and cash and short-term securities make up the bulk
of the current assets of software companies

25. Problem 1. CCC?

26. Answer 1.
• It is takes on average of about six weeks for this company to collect
money from their customers and pay it back to their suppliers

27. Problem 2. CCC?

28. Answer 2.
• It is takes around 60 days for this company to collect money from
their customers and pay it back to their suppliers