Ch9. Working Capital Management — Liquidity and Short-Term Financing

What Is Working Capital?

Working Capital: The funds required for a firm’s day-to-day operations.

Net Working Capital (NWC) = Current Assets − Current Liabilities

Current Assets:     Cash, Short-term investments, Accounts receivable, Inventory
Current Liabilities: Accounts payable, Short-term borrowings, Accrued expenses

Working Capital Management Goal: Maintain sufficient liquidity while avoiding excessive idle investment.

Cash Conversion Cycle (CCC)

CCC: The number of days between paying cash for inputs and collecting cash from customers.

CCC = Days Inventory Outstanding (DIO)
    + Days Sales Outstanding (DSO)
    − Days Payable Outstanding (DPO)

DIO = 365 / Inventory Turnover
    = Average Inventory / COGS × 365

DSO = 365 / Receivables Turnover
    = Average Accounts Receivable / Net Sales × 365

DPO = 365 / Payables Turnover
    = Average Accounts Payable / Purchases × 365

Shorter CCC = Cash is tied up for less time → more efficient use of working capital.

Cash Management

Optimal Cash Balance Models

Baumol Model: Balances transaction costs against opportunity costs.

Optimal Cash Balance:
C* = √(2 × F × T / r)

F: Fixed cost of converting securities to cash
T: Total cash demand over the period
r: Opportunity cost (interest rate on short-term investments)

Total Cost = Transaction Cost + Opportunity Cost
           = (T/C) × F + (C/2) × r

Miller-Orr Model: Sets upper and lower cash balance limits for firms with irregular cash flows.

Accounts Receivable Management

Granting Credit — Trade-Off:
Costs:   Opportunity cost of tied-up funds + Bad debt expense + Admin costs
Benefits: Incremental profits from higher sales

Relaxing Credit Standards:
↑ Sales → ↑ Contribution margin
↑ A/R   → ↑ Opportunity cost
↑ Bad debt → ↑ Credit losses

The 5 Cs of Credit:

Character:  Credit history and willingness to pay
Capacity:   Ability to repay (cash flow analysis)
Capital:    Net worth / financial strength
Collateral: Assets pledged as security
Conditions: Economic environment and industry outlook

Inventory Management

EOQ (Economic Order Quantity):

EOQ = √(2 × D × O / H)

D: Annual demand (units)
O: Fixed cost per order
H: Annual holding (carrying) cost per unit

Total Inventory Cost = Ordering Cost + Holding Cost
                     = (D/Q) × O + (Q/2) × H

At Q = EOQ, ordering cost = holding cost → total cost is minimized

Short-Term Financing

Short-Term Financing Instruments:
① Invoice discounting / A/R financing (receivables as collateral)
② Factoring: Outright sale of receivables
③ Bank line of credit / revolving credit facility
④ Commercial Paper (CP): Unsecured short-term notes issued by corporations
⑤ Trade credit: Maximize the use of accounts payable payment terms

Spontaneous Financing: Accounts payable, accrued expenses (interest-free)
Negotiated Financing:  Bank loans (interest-bearing)

Key Concept Cards

Cash Conversion Cycle (CCC) ★★★★★ : DIO + DSO − DPO. The shorter the CCC, the more efficiently cash is being used. Memory tip: CCC = Inventory + Receivables − Payables

EOQ ★★★★★ : √(2DO/H). The order quantity that minimizes total inventory cost (ordering + holding costs equal at EOQ). Memory tip: EOQ = √(2DO/H)

5 Cs of Credit ★★★★☆ : Character · Capacity · Capital · Collateral · Conditions. Memory tip: Character, Capacity, Capital, Collateral, Conditions

Practice Quiz

Q. Annual demand = 1,200 units, fixed order cost = $50, annual holding cost per unit =$ 2. What is the EOQ?

EOQ = √(2 × 1,200 × $50 /$ 2) = √(60,000) ≈ 245 units

Q. DIO = 30 days, DSO = 45 days, DPO = 50 days. What is the CCC?

CCC = 30 + 45 − 50 = 25 days

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