Describe the cash conversion cycle, its funding requirements, and the key strategies for managing it.

Resource: Principles of Managerial Finance, Ch. 15

Complete the following spreadsheet exercise: Eboy Corporation, p. 647

Please see Highlighed Assignment in yellow due in 36 hours since posted (due Monday 8 pm)

CHAPTER 15

15 Working Capital and Current Assets Management
Learning Goals

LG 1 Understand working capital management, net working capital, and the related trade-off between profitability and risk.
LG 2 Describe the cash conversion cycle, its funding requirements, and the key strategies for managing it.
LG 3 Discuss inventory management: differing views, common techniques, and international concerns.
LG 4 Explain the credit selection process and the quantitative procedure for evaluating changes in credit standards.
LG 5 Review the procedures for quantitatively considering cash discount changes, other aspects of credit terms, and credit monitoring.
LG 6 Understand the management of receipts and disbursements, including float, speeding up collections, slowing down payments, cash concentration, zero-balance accounts, and investing in marketable securities.

Why This Chapter Matters to You

In your professional life

ACCOUNTING You need to understand the cash conversion cycle and the management of inventory, accounts receivable, and receipts and disbursements of cash.

INFORMATION SYSTEMS You need to understand the cash conversion cycle, inventory, accounts receivable, and receipts and disbursements of cash to design financial information systems that facilitate effective working capital management.

MANAGEMENT You need to understand the management of working capital so that you can efficiently manage current assets and decide whether to finance the firm’s funds requirements aggressively or conservatively.

MARKETING You need to understand 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 You need to understand the cash conversion cycle because you will be responsible for reducing the cycle through the efficient management of production, inventory, and costs.

In your personal life

You often will be faced with short-term purchasing decisions, which tend to focus on consumable items. Many involve trade-offs between quantity and price: Should you buy large quantities so as to pay a lower unit price, hold the items, and use them over time? Or should you buy smaller quantities more frequently and pay a slightly higher unit price? Analyzing these types of short-term purchasing decisions will help you make the most of your money.
Treasury Risk Survey 2013 Worries about Liquidity Occupy the Minds of Treasury Managers

In its annual survey of corporate treasury managers, Global Treasury News discovered that the number one risk on the minds of treasury professionals at North American and European companies in 2013 was liquidity risk. Liquidity risk refers to the possibility that a firm will not have cash or access to cash through the credit markets when it is needed. Concerns about liquidity risk in 2013 were probably a lingering effect of the global financial crisis in 2008. During that period, many firms found that funding sources they had relied on in the past, such as bank credit lines and commercial paper, suddenly dried up. Firms then scrambled to conserve cash, and that, in turn, contributed to a severe global recession. Not surprisingly, in the years after the crisis, firms began to build up their cash reserves. A 2012 study by Moody’s found that U.S. companies were holding more than $1.2 trillion in cash, an all-time high.

Although holding large cash reserves can protect firms against a liquidity crisis, there are downsides to that strategy. Firms typically invest their cash reserves in short-term, low-risk assets, and returns on those assets in 2013 were at historic lows. For example, yields on short-term Treasury bills in 2013 ranged from 0.01 to 0.20 percent, depending on maturity. The company with the largest cash balance during this period was Apple, Inc. With more than $100 billion in cash, Apple attracted criticism from shareholders who wanted the company to either put the cash in investments that would earn higher returns or distribute the cash to stockholders through dividends or share repurchases.

Cash is just one component of a firm’s working capital, but the issues that firms must balance when deciding how much cash to hold also arise in the management of other working capital items such as receivables, inventories, and payables. This chapter explains the trade-offs involved in managing working capital and how managers should evaluate those trade-offs.
15.1 Net Working Capital Fundamentals

LG 1

My Finance Lab Video

The balance sheet provides information about the structure of a firm’s investments on the one hand and the structure of its financing sources on the other hand. The structures chosen should consistently lead to the maximization of the value of the owners’ investment in the firm.
WORKING CAPITAL MANAGEMENT

The importance of efficient working capital management is indisputable given that a firm’s viability relies on the financial manager’s ability to effectively manage receivables, inventory, and payables. 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.

working capital (or short-term financial) management

Management of current assets and current liabilities.

Firms are able to reduce financing costs or increase the funds available for expansion by minimizing the amount of funds tied up in working capital. Therefore, it should not be surprising to learn that working capital is one of the financial manager’s most important and time-consuming activities. Surveys by CFO magazine and Duke University have found that corporate CFOs spend almost 30 hours per month engaged in working capital and cash management, which is more time than they spend on any other single activity. Similar surveys have found that CFOs believe that their efforts to manage working capital effectively add as much value to the firm as any other activity in which they engage.
Matter of fact

CFOs Value Working Capital Management

A survey of CFOs from firms around the world suggests that working capital management is at the top of the list of most valued finance functions. Among 19 different finance functions, CFOs viewed working capital management as equally important as capital structure, debt issuance and management, bank relationships, and tax management. Their satisfaction with the performance of working capital management was quite the opposite, however. CFOs viewed the performance of working capital management as being better only than the performance of pension management. Consistent with their view that working capital management is a high-value but low-satisfaction activity, it was identified as the finance function second most in need of additional resources.1

Next, we use net working capital to consider the relationship between current assets and current liabilities and then use the cash conversion cycle to consider the key aspects of current asset management. In Chapter 16, we consider current liability management.

1. Henri Servaes and Peter Tufano, “CFO Views on the Importance and Execution of the Finance Function,” CFO Views (January 2006), pp. 1–104.
NET WORKING CAPITAL

Current assets, commonly called working capital, represent the portion of investment that circulates from one form to another in the ordinary conduct of business. This idea embraces the recurring transition from cash to inventories to accounts receivable and back to cash. As cash substitutes, marketable securities are also part of working capital.

working capital

Current assets, which represent the portion of investment that circulates from one form to another in the ordinary conduct of business.

Current liabilities represent the firm’s short-term financing, because they include all debts of the firm that come due in 1 year or less. These debts usually include amounts owed to suppliers (accounts payable), employees and governments (accruals), and banks (notes payable), among others. (You can refer to Chapter 3 for a full discussion of balance sheet items.)

As noted in Chapter 11, net working capital is defined as the difference between the firm’s current assets and its current liabilities. When current assets exceed current liabilities, the firm has positive net working capital. When current assets are less than current liabilities, the firm has negative net working capital.

net working capital

The difference between the firm’s current assets and its current liabilities.

The conversion of current assets from inventory to accounts receivable to cash provides the cash used to pay current liabilities. The cash outlays for current liabilities are relatively predictable. When an obligation is incurred, the firm generally knows when the corresponding payment will be due. What is difficult to predict are the cash inflows: the conversion of the current assets to more liquid forms. The more predictable its cash inflows, the less net working capital a firm needs. Because most firms are unable to match cash inflows to cash outflows with certainty, they usually need current assets that more than cover outflows for current liabilities. In general, the greater the margin by which a firm’s current assets cover its current liabilities, the better able it will be to pay its bills as they come due.
TRADE-OFF BETWEEN PROFITABILITY AND RISK

A trade-off exists between a firm’s profitability and its risk. Profitability, in this context, is the relationship between revenues and costs generated by using the firm’s assets—both current and fixed—in productive activities. A firm can increase its profits by (1) increasing revenues or (2) decreasing costs. Risk, in the context of working capital management, is the probability that a firm will be unable to pay its bills as they come due. A firm that cannot pay its bills as they come due is said to be insolvent. It is generally assumed that the greater the firm’s net working capital, the lower its risk. In other words, the more net working capital, the more liquid the firm and therefore the lower its risk of becoming insolvent. Using these definitions of profitability and risk, we can demonstrate the trade-off between them by considering changes in current assets and current liabilities separately.

profitability

The relationship between revenues and costs generated by using the firm’s assets—both current and fixed—in productive activities.

risk (of insolvency)

The probability that a firm will be unable to pay its bills as they come due.

insolvent

Describes a firm that is unable to pay its bills as they come due.
Changes in Current Assets

We can demonstrate how changing the level of the firm’s current assets affects its profitability–risk trade-off by using the ratio of current assets to total assets. This ratio indicates the percentage of total assets that is current. For purposes of illustration, we will assume that the level of total assets remains unchanged. The effects on both profitability and risk of an increase or decrease in this ratio are summarized in the upper portion of Table 15.1. When the ratio increases—that is, when current assets increase—profitability decreases. Why? The answer is 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.
TABLE 15.1 Effects of Changing Ratios on Profits and Risk

Ratio

Change in ratio

Effect on profit

Effect on risk

Current assets over Total assets

Increase

Decrease

Decrease

Increase

Decrease

Increase

Current liabilities over Total assets

Increase

Decrease

Increase

Decrease

Increase

Decrease

The risk effect, however, decreases as the ratio of current assets to total assets increases. The increase in current assets increases net working capital, thereby reducing the risk of insolvency. In addition, as you go down the asset side of the balance sheet, the risk associated with the assets increases: 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.

In an effort to manage the risk effect, firms have been steadily moving away from riskier current asset components, such as inventory. Figure 15.1 shows that over time current assets consistently account for about 60 percent of total assets in U.S. manufacturing firms, but inventory levels are dropping dramatically. That current assets relative to total assets remains fairly constant while inventory investment is shrinking indicates that U.S. manufacturing firms are substituting less risky current assets for inventory, the riskiest current asset. Indeed, Figure 15.1 shows that cash levels are increasing relative to total assets.
FIGURE 15.1 Yearly Medians for All U.S.–Listed Manufacturing Companies
Changes in Current Liabilities

We also can demonstrate how changing the level of the firm’s current liabilities affects its profitability–risk trade-off by using the ratio of current liabilities to total assets. This ratio indicates the percentage of total assets that has been financed with current liabilities. Again, assuming that total assets remain unchanged, the effects on both profitability and risk of an increase or decrease in the ratio are summarized in the lower portion of Table 15.1. When the ratio increases, profitability increases. Why? Here it is because the firm uses more of the less-expensive current liabilities financing and less long-term financing. 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. However, when 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.
REVIEW QUESTIONS
15–1

Why is working capital management one of the most important and time-consuming activities of the financial manager? What is net working capital?
15–2

What is the relationship between the predictability of a firm’s cash inflows and its required level of net working capital? How are net working capital, liquidity, and risk of insolvency related?
15–3

Why does an increase in the ratio of current assets to total assets decrease both profits and risk as measured by net working capital? How do changes in the ratio of current liabilities to total assets affect profitability and risk?
15.2 Cash Conversion Cycle

LG 2

Central to working capital management is an understanding of the firm’s cash conversion cycle. The 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. This cycle frames discussion of the management of the firm’s current assets in this chapter and that of the management of current liabilities in Chapter 16. Here, we begin by demonstrating the calculation and application of the cash conversion cycle.

cash conversion cycle (CCC)

The length of time required for a company to convert cash invested in its operations to cash received as a result of its operations.
CALCULATING THE CASH CONVERSION CYCLE

A firm’s operating cycle (OC) is the time from the beginning of the production process to collection of cash from the sale of the finished product. The operating cycle encompasses two major short-term asset categories, inventory and accounts receivable. It is measured in elapsed time by summing the average age of inventory (AAI) and the average collection period (ACP):

operating cycle (OC)

The time from the beginning of the production process to collection of cash from the sale of the finished product.

OC = AAI + ACP

(15.1)
Matter of fact

Increasing Speed Lowers Working Capital

A firm can lower its working capital if it can speed up its operating cycle. For example, if a firm accepts bank credit (like a Visa card), it will receive cash sooner after the sale is transacted than if it has to wait until the customer pays its accounts receivable.

However, the process of producing and selling a product also includes the purchase of production inputs (raw materials) on account, which results in accounts payable. Accounts payable reduce the number of days a firm’s resources are tied up in the operating cycle. The time it takes to pay the accounts payable, measured in days, is the average payment period (APP). The operating cycle less the average payment period yields the cash conversion cycle. The formula for the cash conversion cycle is

CCC = OC − APP

(15.2)

Substituting the relationship in Equation 15.1 into Equation 15.2, we can see that the cash conversion cycle has three main components—(1) average age of the inventory, (2) average collection period, and (3) average payment period—so

CCC = AAI + ACP − APP

(15.3)

Clearly, if a firm changes any of these time periods, it changes the amount of resources tied up in the day-to-day operation of the firm.
Example 15.1

My Finance Lab Solution Video

In its 2012 annual report, Whirlpool Corporation reported that it had revenues of $18.1 billion, cost of goods sold of $15.2 billion, accounts receivable of 2.0 billion, and inventory of $2.4 billion. From this information (and assuming for simplicity that cost of goods sold equals purchases), we can determine that the company’s average age of inventory was 58 days, its average collection period was 40 days, and its average payment period was 89 days. Thus, the cash conversion cycle for Whirlpool was just 9 days (58 + 40 − 89). Figure 15.2 presents Whirlpool’s cash conversion cycle as a time line.

The resources Whirlpool had invested in this cash conversion cycle (assuming a 365-day year) were

With roughly $700 million committed to working capital, Whirlpool was surely motivated to make improvements. Changes in any of the component cycles will change the resources tied up in Whirlpool’s operations. For example, if Whirlpool could reduce its collection period from 40 days to 30 days, holding all else equal, its working capital requirement would fall by more than $500 million. It is clear why companies pay close attention to working capital management.
FUNDING REQUIREMENTS OF THE CASH CONVERSION CYCLE

We can use the cash conversion cycle as a basis for discussing how the firm funds its required investment in operating assets. We first differentiate between permanent and seasonal funding needs and then describe aggressive and conservative seasonal funding strategies.
FIGURE 15.2 Time Line for Whirlpool’s Cash Conversion Cycle

Whirlpool’s operating cycle in 2007 was 98 days, and its cash conversion cycle was 9 days.
Permanent versus Seasonal Funding Needs

If the firm’s sales are constant, its investment in operating assets should also be constant, and the firm will have only a permanent funding requirement. If the firm’s sales are cyclic, its investment in operating assets will vary over time with its sales cycles, and the firm will have seasonal funding requirements in addition to the permanent funding required for its minimum investment in operating assets.

permanent funding requirement

A constant investment in operating assets resulting from constant sales over time.

seasonal funding requirement

An investment in operating assets that varies over time as a result of cyclic sales

Type of paper Academic level Subject area
Number of pages Paper urgency Cost per page:
 Total: