Working Capital Management
After reading this chapter, students should be able to:
◆ Define basic working capital terminology.
◆ Calculate the inventory conversion period, the receivables collection period, and the payables deferral period to determine the cash conversion cycle.
◆ Distinguish among relaxed, restricted, and moderate current asset investment policies, and explain the effect of each on risk and expected return.
◆ Identify and distinguish among the three different current asset financing policies.
◆ Construct a cash budget, and explain its purpose.
◆ Identify two meanings for cash, and explain why firms are likely to hold marketable securities.
◆ List the four elements of a firm’s credit policy, and briefly explain how one would monitor a firm’s accounts receivable by calculating its DSO and reviewing its aging schedule.
◆ Distinguish between free and costly trade credit, calculate both the nominal and effective annual percentage costs of not taking discounts, given specific credit terms, and explain what stretching accounts payable is and how it reduces the cost of trade credit.
◆ Discuss some of the key features of bank loans and calculate simple and “add-on” interest.
◆ Explain why large, financially strong corporations issue commercial paper.
◆ Explain what accruals (accrued liabilities) are, and what is meant by the term “spontaneous funds.”
◆ Define what a “secured” loan is, and what type of collateral can be used to secure a loan.
We have never found working capital an interesting topic to students, hence it is, to us, a somewhat more difficult subject to teach than most. Perhaps that’s because it comes near the end of the course, when everyone is tired. More likely, though, the problem is that working capital management is really more a matter of operating efficiently than thinking conceptually correctly—i.e., it is more practice than theory—and theory lends itself better to classroom teaching than practice. Still, working capital management is important, and it is something that students are likely to be involved with after they graduate. Since we have only one chapter on working capital, we try to cover the entire chapter. However, the chapter is modular, so it is easy to omit sections if time pressures require. What we cover, and the way we cover it, can be seen by scanning the slides and Integrated Case solution for Chapter 16, which appears at the end of this chapter solution. For other suggestions about the lecture, please see the “Lecture Suggestions” in Chapter 2, where we describe how we conduct our classes.
DAYS ON CHAPTER: 2 OF 58 DAYS (50-minute periods)
Answers to End-of-Chapter Questions
16-1The cash conversion cycle is the length of time funds are tied up in working capital, or the length of time between paying for working capital and collecting cash from the sale of the working capital. Holding other things constant, if you reduce the CCC you are reducing the amount of funds tied up. These funds have a cost; therefore, a reduction in funds will lower the firm’s costs and thus raise its profitability. Here we have made an assumption that you can reduce working capital without harming sales.
16-2The extended DuPont equation is: ROE = Profit margin on sales x Total assets turnover x Equity multiplier. A relaxed current assets investment policy means that relatively large amounts of cash, marketable securities, and inventories are carried, and a liberal credit policy results in a high level of receivables. This policy minimizes operating problems, thus the impact on sales is minimized; however, it results in a low assets turnover because assets are increased. Therefore, ROE is reduced.
16-3When most of us use the term cash, we mean currency (paper money and coins) plus bank demand deposits. However, when...