Corporate Finance Fundamentals
Module 8: Working Capital Management
Module Overview
Welcome to Module 8! While previous modules focused on long-term strategic decisions, this module examines the day-to-day financial management that keeps a company running smoothly.
Working capital management is about managing short-term assets and liabilities—cash, inventory, receivables, and payables. Poor working capital management can sink even a profitable company. Good management frees up cash and improves returns.
Learning Objectives:
By the end of this module, you will be able to:
- Define working capital and net working capital
- Calculate and interpret the cash conversion cycle
- Manage cash effectively using various techniques
- Optimize inventory management
- Manage accounts receivable and credit policy
- Manage accounts payable strategically
- Understand short-term financing options
- Balance working capital efficiency with risk
- Apply working capital concepts to real business situations
Estimated Time: 5-6 hours
8.1 Introduction to Working Capital
What is Working Capital?
Working Capital = Current Assets - Current Liabilities
Current Assets:
- Cash and cash equivalents
- Marketable securities
- Accounts receivable
- Inventory
- Prepaid expenses
Current Liabilities:
- Accounts payable
- Short-term debt
- Accrued expenses
- Unearned revenue
Gross vs. Net Working Capital
Gross Working Capital:
Gross Working Capital = Total Current Assets
Net Working Capital (NWC):
Net Working Capital = Current Assets - Current Liabilities
Example:
Company has:
- Cash: $200,000
- Accounts receivable: $500,000
- Inventory: $400,000
- Current liabilities: $600,000
Gross Working Capital = $200K + $500K + $400K = $1,100,000
Net Working Capital = $1,100,000 - $600,000 = $500,000
Why Working Capital Matters
1. Liquidity
- Can the company pay its bills?
- Avoid bankruptcy
- Maintain operations
2. Operational Efficiency
- How efficiently are resources used?
- Faster cycles = better returns
3. Cash Flow
- Working capital changes affect cash
- Growth often requires working capital investment
4. Profitability
- Excess working capital is costly
- Too little creates problems
- Balance is critical
The Working Capital Trade-off
More Working Capital:
- ✓ Greater liquidity (safety)
- ✓ Less risk of stockouts
- ✓ Better customer service
- ✗ More cash tied up
- ✗ Lower returns on assets
- ✗ Higher carrying costs
Less Working Capital:
- ✓ Less cash tied up
- ✓ Higher returns on assets
- ✓ Lower carrying costs
- ✗ Greater liquidity risk
- ✗ Risk of stockouts
- ✗ Potential customer dissatisfaction
Goal: Optimize working capital—enough for operations, not too much to be wasteful.
Working Capital Investment
Growing companies need working capital investment:
Example:
Company grows sales from $10M to $15M (50% growth).
If working capital is 20% of sales:
- Old WC need: $10M × 20% = $2M
- New WC need: $15M × 20% = $3M
- Additional WC investment: $1M
This $1M must be financed!
Growth requires not just investment in fixed assets, but also working capital.
8.2 The Cash Conversion Cycle
What is the Cash Conversion Cycle?
Cash Conversion Cycle (CCC) measures how long cash is tied up in operations.
Formula:
CCC = Days Inventory Outstanding (DIO)
+ Days Sales Outstanding (DSO)
- Days Payable Outstanding (DPO)
Or:
CCC = Inventory Period + Collection Period - Payment Period
Components of CCC
1. Days Inventory Outstanding (DIO)
How long inventory sits before being sold.
DIO = (Inventory / COGS) × 365
Example:
- Inventory: $400,000
- COGS: $2,000,000
DIO = ($400,000 / $2,000,000) × 365 = 73 days
Inventory sits for 73 days on average.
2. Days Sales Outstanding (DSO)
How long it takes to collect from customers.
DSO = (Accounts Receivable / Sales) × 365
Example:
- Accounts Receivable: $500,000
- Annual Sales: $3,000,000
DSO = ($500,000 / $3,000,000) × 365 = 61 days
Takes 61 days to collect payment.
3. Days Payable Outstanding (DPO)
How long the company takes to pay suppliers.
DPO = (Accounts Payable / COGS) × 365
Example:
- Accounts Payable: $300,000
- COGS: $2,000,000
DPO = ($300,000 / $2,000,000) × 365 = 55 days
Company takes 55 days to pay suppliers.
Calculating Cash Conversion Cycle
Using the examples above:
CCC = DIO + DSO - DPO
CCC = 73 + 61 - 55
CCC = 79 days
Interpretation: Cash is tied up in operations for 79 days.
The Cash Flow Timeline:
Day 0: Buy inventory (or start production)
Day 73: Sell product (inventory period)
Day 134: Collect cash from customer (73 + 61)
Day 55: Pay supplier (happens earlier!)
Net: Cash tied up from Day 55 to Day 134 = 79 days
Why CCC Matters
Shorter CCC = Better
- Less cash tied up
- More efficient operations
- Better cash flow
- Higher returns
Example:
Two companies, same $10M sales:
Company A: CCC = 80 days
- Working capital need: ($10M / 365) × 80 = $2.19M
Company B: CCC = 40 days
- Working capital need: ($10M / 365) × 40 = $1.10M
Company B needs $1.09M less working capital!
Can use that cash elsewhere or avoid borrowing.
Negative Cash Conversion Cycle
Some companies have negative CCC!
Example: Amazon (historically)
- DIO: 35 days (efficient warehouses)
- DSO: 20 days (credit card payments)
- DPO: 90 days (negotiates long payment terms)
CCC = 35 + 20 - 90 = -35 days
Negative CCC means: Amazon gets paid by customers before paying suppliers!
They operate with suppliers' money.
Other examples: Dell (historically), Walmart (sometimes)
This is the holy grail of working capital management.
Improving Cash Conversion Cycle
Reduce DIO:
- Better inventory management
- Faster production
- Reduce obsolete inventory
- Just-in-time systems
Reduce DSO:
- Faster invoicing
- Better collection efforts
- Incentives for early payment
- Stricter credit policies
Increase DPO:
- Negotiate longer payment terms
- Take advantage of payment terms
- (But maintain supplier relationships!)
Example: CCC Improvement
Current:
- DIO: 60 days
- DSO: 45 days
- DPO: 30 days
- CCC: 75 days
After improvements:
- DIO: 50 days (better inventory management)
- DSO: 40 days (faster collection)
- DPO: 40 days (negotiated terms)
- CCC: 50 days
Improvement: 25 days shorter CCC
For $20M revenue company:
Cash freed up = ($20M / 365) × 25 days = $1.37M
$1.37M cash freed up!
8.3 Cash Management
Why Hold Cash?
Three Motives (per Keynes):
1. Transaction Motive
- Need cash for day-to-day operations
- Pay bills, payroll, suppliers
2. Precautionary Motive
- Safety buffer for emergencies
- Unexpected expenses
- Revenue shortfalls
3. Speculative Motive
- Take advantage of opportunities
- Quick acquisitions
- Bulk purchase discounts
The Cash Management Trade-off
More Cash:
- ✓ Greater safety
- ✓ Ready for opportunities
- ✗ Low return (cash earns little)
- ✗ Opportunity cost
Less Cash:
- ✓ Higher returns (invest elsewhere)
- ✓ Less idle resources
- ✗ Risk of cash shortage
- ✗ May need expensive emergency financing
Target Cash Balance
How much cash should we hold?
Rule of Thumb: 2-4 weeks of operating expenses
Example:
- Monthly operating expenses: $1M
- Weekly expenses: $250K
- Target cash: $500K - $1M (2-4 weeks)
But varies by:
- Business volatility
- Access to credit
- Seasonality
- Growth rate
Float Management
Float is the difference between book balance and bank balance.
Types of Float:
1. Disbursement Float
- Checks written but not yet cleared
- Time between writing check and bank payment
- Company has use of funds during this time
2. Collection Float
- Checks received but not yet cleared
- Time between receiving check and bank credit
- Can't use funds during this time
Net Float = Disbursement Float - Collection Float
Example:
Company wrote $500,000 in checks (not yet cleared). Company received $400,000 in checks (not yet cleared).
Net Float = $500,000 - $400,000 = $100,000
Book balance: $1,000,000 Available balance: $1,100,000 (can use net float)
Float Management Techniques
Accelerate Collections:
1. Lockbox System
- Customers mail payments to PO box
- Bank picks up and deposits immediately
- Reduces mail and processing float
- Can reduce collection time by 2-5 days
2. Wire Transfers and ACH
- Electronic payment
- Same-day availability
- No mail or check-clearing delay
3. Concentration Banking
- Multiple local bank accounts
- Daily sweep to central account
- Reduces idle balances
Delay Disbursements (Ethically):
1. Controlled Disbursement
- Write checks on remote banks
- Takes longer to clear
- Extends disbursement float
2. Zero-Balance Accounts
- Disbursement account starts at zero
- Transfer exact amount needed daily
- Minimizes idle cash
3. Timing of Payments
- Pay on due date, not before
- Use full credit period
- Electronic payments allow precise timing
Note: Always maintain ethical practices and supplier relationships!
Cash Concentration
Goal: Consolidate cash from multiple accounts to maximize investment returns.
Example:
Company has:
- 10 regional bank accounts
- Average total balance: $5M
- Currently earns 1% (local bank rates)
After consolidation:
- One main account: $5M
- Invest in money market: 4%
Old return: $5M × 1% = $50,000
New return: $5M × 4% = $200,000
Benefit: $150,000/year
Investing Excess Cash
Short-term investments for idle cash:
1. Money Market Funds
- Highly liquid
- Low risk
- Returns: 3-5% (varies with rates)
- Next-day availability
2. Treasury Bills
- No default risk
- Maturities: 4 weeks to 1 year
- Slightly lower return (safer)
- Very liquid
3. Commercial Paper
- Short-term corporate debt
- Maturities: 1-270 days
- Slightly higher return (more risk)
- Large minimum ($100K+)
4. Certificates of Deposit (CDs)
- Bank deposits
- Fixed terms
- FDIC insured (up to limits)
- Early withdrawal penalties
Criteria for Short-term Investments:
- Safety: Low default risk
- Liquidity: Can convert to cash quickly
- Return: Earn something on idle cash
Never invest operating cash in risky securities!
8.4 Inventory Management
Why Hold Inventory?
Benefits of Inventory:
- Avoid stockouts (lost sales)
- Smooth production
- Take advantage of bulk discounts
- Buffer against supply disruptions
Costs of Inventory:
- Carrying costs (storage, insurance, obsolescence)
- Opportunity cost of cash tied up
- Risk of obsolescence
- Handling and tracking
Inventory Turnover
Inventory Turnover Ratio:
Inventory Turnover = COGS / Average Inventory
Days Inventory Outstanding:
DIO = 365 / Inventory Turnover
Example:
Company has:
- COGS: $5,000,000
- Average inventory: $800,000
Turnover = $5,000,000 / $800,000 = 6.25 times
DIO = 365 / 6.25 = 58.4 days
Inventory turns over 6.25 times per year (every 58 days).
Higher turnover = Better (generally)
- Less cash tied up
- Lower carrying costs
- Fresher inventory
Industry Variations:
| Industry | Typical Turnover |
|---|---|
| Grocery | 15-20× |
| Retail (apparel) | 4-6× |
| Auto dealers | 6-8× |
| Manufacturing | 6-10× |
| Jewelry | 1-2× |
Economic Order Quantity (EOQ)
EOQ Model determines optimal order quantity to minimize total inventory costs.
Total Cost = Ordering Costs + Carrying Costs
Formula:
EOQ = √[(2 × D × S) / H]
Where:
- D = Annual demand (units)
- S = Order cost per order
- H = Holding cost per unit per year
Example:
Company needs:
- Annual demand: 10,000 units
- Order cost: $100 per order
- Holding cost: $5 per unit per year
EOQ = √[(2 × 10,000 × $100) / $5]
EOQ = √[2,000,000 / 5]
EOQ = √400,000
EOQ = 632 units
Order 632 units at a time.
Number of orders per year:
Orders = 10,000 / 632 = 15.8 ≈ 16 orders
Total annual cost:
Ordering cost = 16 × $100 = $1,600
Carrying cost = (632/2) × $5 = $1,580
Total = $3,180
Just-in-Time (JIT) Inventory
JIT Philosophy: Minimize inventory by receiving goods only when needed.
Benefits:
- Minimal inventory carrying costs
- Reduced waste
- Quality focus (defects discovered quickly)
- Less warehouse space needed
Requirements:
- Reliable suppliers
- Excellent logistics
- Good demand forecasting
- Strong supplier relationships
Example: Toyota
- Pioneered JIT manufacturing
- Parts arrive hours before assembly
- Minimal on-site inventory
- Very high efficiency
Risks:
- Supply chain disruptions
- No buffer for demand spikes
- Requires perfect execution
COVID-19 revealed JIT vulnerabilities:
- Chip shortages halted auto production
- Companies reconsidering inventory strategies
- Balance needed between efficiency and resilience
ABC Analysis
ABC Classification prioritizes inventory management efforts.
A Items (High Value):
- 10-20% of items
- 70-80% of value
- Tight control, frequent review
- Example: Expensive components, critical parts
B Items (Moderate Value):
- 20-30% of items
- 15-20% of value
- Moderate control
- Example: Standard parts
C Items (Low Value):
- 50-70% of items
- 5-10% of value
- Simple controls, larger safety stocks
- Example: Nuts, bolts, office supplies
Example:
Warehouse with 1,000 SKUs:
A Items:
- 150 SKUs (15%)
- $1.5M value (75%)
- Count weekly, tight monitoring
B Items:
- 250 SKUs (25%)
- $350K value (17.5%)
- Count monthly
C Items:
- 600 SKUs (60%)
- $150K value (7.5%)
- Count quarterly, simple reorder systems
Focus management attention where it matters most!
8.5 Accounts Receivable Management
The Credit Policy Decision
Trade Credit: Selling on credit (allow customers to pay later).
Trade-off:
- Selling on credit increases sales
- But delays cash collection
- And creates bad debt risk
Components of Credit Policy
1. Credit Period
- How long customers have to pay
- Standard: Net 30, Net 60
- Longer period = More sales, but more costly
2. Credit Standards
- Who gets credit?
- Creditworthiness requirements
- Stricter = Fewer sales, less bad debt
- Looser = More sales, more bad debt
3. Collection Policy
- How aggressively to collect
- Reminders, calls, legal action
- Aggressive = Faster collection, potentially lost customers
- Lenient = Slower collection, better customer relations
4. Discounts
- Incentives for early payment
- Example: 2/10 net 30
- (2% discount if paid in 10 days, otherwise due in 30)
Credit Terms Example: 2/10 Net 30
Terms: "2/10 net 30"
Meaning:
- 2% discount if paid within 10 days
- Full amount due in 30 days
Invoice: $10,000
Option 1: Pay in 10 days
- Payment: $10,000 × 0.98 = $9,800
Option 2: Pay in 30 days
- Payment: $10,000
Cost of not taking discount:
Cost = Discount % / (1 - Discount %) × (365 / Extra days)
Cost = 2% / 98% × (365 / 20)
Cost = 0.0204 × 18.25
Cost = 37.2% annual rate
Not taking the discount costs 37.2% per year!
Smart customers always take the discount.
Credit Analysis: The Five Cs
1. Character
- Willingness to pay
- Payment history
- Reputation
2. Capacity
- Ability to pay
- Cash flow
- Income stability
3. Capital
- Financial resources
- Net worth
- Equity cushion
4. Collateral
- Assets to secure credit
- Can be liquidated if default
5. Conditions
- Economic environment
- Industry trends
- Company-specific factors
Credit Scoring
Credit scores help automate decisions:
Consumer Credit:
- FICO scores: 300-850
- >700: Good credit
- <600: Poor credit
Business Credit:
- Dun & Bradstreet scores
- Experian business scores
- Payment history
- Financial statements
Example Policy:
Score > 700:
- Automatic approval
- Standard terms
Score 600-700:
- Manager approval required
- May require deposit
Score < 600:
- Decline or
- Cash only
Monitoring Receivables
Key Metrics:
1. Days Sales Outstanding (DSO)
DSO = (Accounts Receivable / Average Daily Sales)
2. Aging Schedule
Shows how old receivables are:
Age Amount %
0-30 days $300,000 60%
31-60 days $100,000 20%
61-90 days $50,000 10%
90+ days $50,000 10%
Total $500,000 100%
Warning signs:
- Increasing DSO
- Growing percentage in older buckets
- Individual large past-due accounts
3. Collection Period vs. Credit Terms
If credit terms are net 30 but DSO is 45:
- Customers paying late
- Need better collection efforts
- Or reconsider credit standards
Managing Collection
Progressive Collection Steps:
Day 30: Invoice due
- Send friendly reminder
Day 45: 15 days past due
- Phone call reminder
- Confirm invoice received
Day 60: 30 days past due
- Formal collection letter
- Stop further credit
Day 75: 45 days past due
- Final warning
- Threat of legal action
Day 90+: 60+ days past due
- Collection agency
- Legal action
- Write off as bad debt
Balance: Collect money vs. maintain customer relationship
8.6 Accounts Payable Management
Managing Payables Strategically
Accounts Payable represents free financing from suppliers.
Strategy: Take full credit period, but:
- Don't damage supplier relationships
- Don't miss discounts (usually worth taking)
- Maintain reputation
Evaluating Payment Terms
Example: Should you take 2/10 net 30?
Invoice: $100,000
Option 1: Pay in 10 days
- Pay: $98,000
- Save: $2,000
Option 2: Pay in 30 days
- Pay: $100,000
- Keep cash for extra 20 days
Decision rule: If your cost of capital < 37.2%, take the discount!
Most companies should take the discount.
Cost of alternative financing (if needed):
- Bank loan at 8% < 37.2%
- Better to borrow and take discount
Stretching Payables
Stretching: Paying later than agreed terms.
Example:
- Terms: Net 30
- Actually pay: Day 45
Benefits:
- Extra 15 days of cash
- Free financing
Costs:
- Damage supplier relationships
- May lose future credit
- Reputation damage
- Late fees (sometimes)
- Risk being cut off
Only stretch when:
- Cash crisis (temporary)
- Won't damage key relationships
- Calculated decision
Better strategy: Negotiate longer terms upfront.
Negotiating Better Terms
Request longer payment terms:
From: Net 30 To: Net 45 or Net 60
Supplier's view:
- Might accept if you're valued customer
- Large, consistent orders
- Long relationship
Your benefit:
- Extra 15-30 days of free financing
- Better cash flow management
- No damage to relationship
Win-win negotiation:
- Offer something in return
- Larger orders
- Longer commitment
- Electronic payments (lower processing cost)
Payables Management Ratios
Days Payable Outstanding:
DPO = (Accounts Payable / COGS) × 365
Payables Turnover:
Turnover = COGS / Average Accounts Payable
Example:
Company has:
- Accounts Payable: $600,000
- COGS: $4,000,000
DPO = ($600,000 / $4,000,000) × 365 = 54.75 days
Turnover = $4,000,000 / $600,000 = 6.67 times
Company pays suppliers every ~55 days, about 6.7 times per year.
Compare to credit terms:
- If terms are Net 30, paying in 55 days means stretching
- If terms are Net 60, paying in 55 days is good
8.7 Short-Term Financing
When to Use Short-Term Financing
Temporary needs:
- Seasonal cash requirements
- Bridge until receivables collected
- Cover temporary shortfall
- Finance specific project
Not for long-term needs!
- Fixed assets
- Permanent working capital
- Long-term investments
Sources of Short-Term Financing
1. Trade Credit (Accounts Payable)
Most common source!
- Suppliers extend credit
- Usually 30-60 days
- Often no explicit cost (if no discount offered)
Cost: Opportunity cost of discounts not taken
2. Bank Lines of Credit
Revolving credit facility:
- Pre-approved borrowing limit
- Draw and repay as needed
- Pay interest only on amount used
- Commitment fee on unused portion
Example:
- $5M line of credit
- Interest rate: Prime + 2% (~8%)
- Commitment fee: 0.5% on unused
- Currently using: $2M
Cost:
Interest: $2M × 8% = $160,000
Commitment fee: $3M × 0.5% = $15,000
Total cost: $175,000
3. Commercial Paper
Unsecured short-term debt:
- Issued by large, creditworthy companies
- Maturities: 1-270 days
- Sold at discount to face value
- Lower cost than bank loans (if rated highly)
Example:
- Issue $10M commercial paper
- 90-day maturity
- Rate: 4%
Proceeds:
Discount = $10M × 4% × (90/360) = $100,000
Proceeds = $10M - $100,000 = $9,900,000
4. Factoring
Sell receivables to factor:
- Factor buys receivables at discount
- Immediate cash
- Factor collects from customers
Example:
- Receivables: $1M
- Factor pays: $950,000 (5% discount)
- Factor collects: $1M from customers
Cost: $50,000 (5% of receivables)
Used when:
- Need immediate cash
- Poor credit (can't get bank loan)
- Want to outsource collections
5. Secured Loans
Collateralized by assets:
- Inventory
- Receivables
- Equipment
Advance rate: Percentage of collateral value
Example:
- Receivables: $500,000
- Advance rate: 80%
- Can borrow: $400,000
If receivables grow to $600,000:
- Can borrow: $480,000
- Automatic increase!
6. Asset-Based Lending
Comprehensive secured lending:
- Based on all current assets
- Inventory + Receivables
- Regular audits of collateral
- Borrowing base adjusts
Typical advance rates:
- Receivables: 75-85%
- Inventory: 50-65%
Example:
- Receivables: $1M (80% advance) = $800K
- Inventory: $800K (60% advance) = $480K
- Total borrowing base: $1,280K
Comparing Short-Term Financing Costs
Effective Annual Rate (EAR) for comparison:
Example: Bank Discount Loan
Loan amount: $100,000 Interest: $8,000 Term: 1 year But interest deducted upfront!
Proceeds = $100,000 - $8,000 = $92,000
Effective rate = $8,000 / $92,000 = 8.7%
Higher than stated 8%!
Example: Compensating Balance
Loan: $100,000 Rate: 8% Must maintain 10% balance
Usable funds = $100,000 - $10,000 = $90,000
Interest = $100,000 × 8% = $8,000
Effective rate = $8,000 / $90,000 = 8.9%
Always calculate effective cost for comparison!
8.8 Managing Working Capital for Value
Working Capital Policies
Aggressive Policy:
- Low working capital
- Minimize current assets
- Maximize current liabilities
- Higher risk, higher return
Conservative Policy:
- High working capital
- More current assets
- Fewer current liabilities
- Lower risk, lower return
Moderate Policy:
- Balance between aggressive and conservative
- Match assets and liabilities
Working Capital Ratios
Current Ratio:
Current Ratio = Current Assets / Current Liabilities
Interpretation:
-
2.0: Conservative
- 1.5-2.0: Moderate
- < 1.5: Aggressive
Quick Ratio:
Quick Ratio = (Current Assets - Inventory) / Current Liabilities
More stringent test of liquidity.
Example:
Company A (Conservative):
- Current Assets: $500K
- Current Liabilities: $200K
- Current Ratio: 2.5
- Inventory: $200K
- Quick Ratio: 1.5
Company B (Aggressive):
- Current Assets: $300K
- Current Liabilities: $250K
- Current Ratio: 1.2
- Inventory: $100K
- Quick Ratio: 0.8
Company A: More liquidity, less efficient Company B: Less liquidity, more efficient (risky)
Return on Working Capital
How efficiently is working capital deployed?
Return on Working Capital = EBIT / Net Working Capital
Example:
Company has:
- EBIT: $500,000
- Net Working Capital: $1,000,000
Return = $500,000 / $1,000,000 = 50%
Higher is better (more profit per dollar of working capital).
Cash-to-Cash Cycle
Another name for cash conversion cycle.
Formula:
Cash-to-Cash = DIO + DSO - DPO
World-class companies:
- Manufacturing: 30-60 days
- Retail: 20-40 days
- Technology: 40-60 days
Best-in-class examples:
- Amazon: Negative (historically)
- Walmart: ~5 days
- Dell: ~Negative (historically)
Seasonal Working Capital Needs
Many businesses have seasonal patterns:
Retailers:
- Build inventory before holidays
- Peak receivables after holidays
- Cash flow trough in fall
Agriculture:
- Need cash for planting (spring)
- Collect after harvest (fall)
Construction:
- Slow winter
- Peak summer
Managing seasonal needs:
- Forecast seasonal pattern
- Arrange seasonal line of credit
- Build cash reserves during peak
- Use for trough periods
Example: Toy Retailer
Quarter Sales WC Need Financing
Q1 (Jan) $2M $500K Line: $200K
Q2 (Apr) $3M $800K Line: $500K
Q3 (Jul) $5M $1,500K Line: $1,200K
Q4 (Oct) $12M $3,000K Line: $2,500K
Q1 (Jan) $2M $500K Repay line
Peak need: Q4 (Christmas) Pay down: Q1 (after collection)
8.9 Working Capital in Different Industries
Industry Variations
Grocery Stores:
- Very low DSO (cash sales)
- High inventory turnover
- Negotiate long payment terms
- Often negative CCC
Example: Grocery
- DIO: 20 days
- DSO: 3 days (mostly cash)
- DPO: 35 days
- CCC: -12 days (negative!)
Manufacturing:
- Longer production cycle
- Moderate receivables
- Significant inventory
- Longer CCC
Example: Manufacturing
- DIO: 60 days
- DSO: 45 days
- DPO: 35 days
- CCC: 70 days
Software/SaaS:
- Minimal inventory
- Subscription revenue (upfront)
- Low DSO
- Very efficient
Example: SaaS
- DIO: 0 days (no inventory)
- DSO: 15 days
- DPO: 30 days
- CCC: -15 days
Construction:
- Long project cycles
- Progress billings
- Significant receivables
- Retainage (held back)
Example: Construction
- DIO: 30 days
- DSO: 75 days
- DPO: 45 days
- CCC: 60 days
Best Practices by Industry
Retail:
- Focus on inventory turnover
- Negotiate extended payment terms
- Minimize cash sales (credit cards okay)
Manufacturing:
- JIT inventory where possible
- Strong supplier relationships
- Efficient production scheduling
Services:
- Invoice promptly
- Aggressive collection
- Minimal inventory concerns
Technology:
- Subscription/upfront payment models
- Minimal working capital needs
- Focus on growth
Module 8 Practice Problems
Problem Set 1: Working Capital Basics
-
Calculate NWC: Company has:
- Cash: $150,000
- Accounts Receivable: $400,000
- Inventory: $300,000
- Accounts Payable: $250,000
- Short-term debt: $200,000
Calculate net working capital.
-
Working Capital Change: Sales grow from $5M to $6M. Working capital is 25% of sales.
How much additional working capital investment is needed?
Problem Set 2: Cash Conversion Cycle
-
Calculate CCC: Company data:
- Inventory: $500,000
- COGS: $3,000,000
- Accounts Receivable: $400,000
- Sales: $4,000,000
- Accounts Payable: $350,000
Calculate: a. DIO b. DSO c. DPO d. Cash Conversion Cycle
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CCC Improvement: Current CCC: 85 days
- DIO: 60 days
- DSO: 50 days
- DPO: 25 days
Management wants to reduce CCC to 60 days. Propose specific changes to achieve this.
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Cash Freed Up: Company has $20M annual sales. Current CCC: 75 days After improvements: 50 days
How much cash is freed up?
Problem Set 3: Inventory Management
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Inventory Turnover:
- COGS: $8,000,000
- Average Inventory: $1,200,000
Calculate: a. Inventory turnover b. Days inventory outstanding
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EOQ Calculation:
- Annual demand: 50,000 units
- Order cost: $200 per order
- Holding cost: $8 per unit per year
Calculate: a. Economic order quantity b. Number of orders per year c. Total annual inventory cost
Problem Set 4: Receivables Management
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Credit Terms Analysis: Terms offered: 2/10 net 45 Invoice amount: $50,000
a. Payment if discount taken? b. Cost of not taking discount (annual rate)? c. Should a company with 10% cost of capital take the discount?
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Aging Schedule: Total receivables: $1,000,000
Age Amount 0-30 $600,000 31-60 $250,000 61-90 $100,000 90+ $50,000 a. Calculate percentage in each category b. If historical bad debt is 1% for 0-30, 3% for 31-60, 10% for 61-90, and 50% for 90+, estimate total bad debt.
Problem Set 5: Short-Term Financing
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Line of Credit Cost: $3M line of credit
- Interest rate: 7%
- Commitment fee: 0.5% on unused portion
- Average usage: $1.8M
Calculate total annual cost.
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Factoring Decision: Company has $2M in receivables. Collection period: 60 days Factor offers: 4% discount, immediate cash Company's cost of capital: 12% annual
Should company factor? Compare costs.
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Effective Interest Rate: Bank discount loan:
- Face value: $200,000
- Interest: $12,000 (deducted upfront)
- Term: 1 year
Calculate effective annual rate.
Problem Set 6: Comprehensive Problem
-
Working Capital Optimization:
ABC Manufacturing:
Current situation:
- Sales: $30M annually
- COGS: $18M
- Inventory: $3M
- Accounts Receivable: $5M
- Accounts Payable: $2M
- Current Liabilities (other): $1M
- Cash: $1M
Proposed improvements:
- Reduce inventory by 20% through better management
- Reduce DSO from current to 50 days
- Increase DPO from current to 50 days
- Maintain minimum cash of $500K
Calculate: a. Current CCC b. Current NWC c. After improvements: New CCC d. After improvements: New NWC e. Cash freed up from improvements f. If company's WACC is 12%, what's the annual value of the improvement?
Additional Resources
Excel Templates
Download templates for:
- Cash conversion cycle calculator
- Working capital analysis
- EOQ calculator
- Credit terms analysis
- Aging schedule tracker
Further Reading
Books:
- "Cash Flow Reboot" by Michael Levi
- "Working Capital Management" by Lorenzo Preve and Virginia Sarria-Allende
Articles:
- "How to Manage Working Capital" - Harvard Business Review
- Industry-specific working capital benchmarks
Looking Ahead to Module 9
You now understand the day-to-day financial management that keeps companies operating smoothly. Working capital management may not be glamorous, but it's essential—many profitable companies have failed due to poor working capital management.
In Module 9, we'll explore Valuation Fundamentals—bringing together everything you've learned:
- Discounted cash flow (DCF) valuation
- Relative valuation methods
- Understanding what drives value
- Practical valuation applications
This is where theory meets practice in determining what companies are worth.
Prepare for Module 9 by:
- Reviewing time value of money (Module 3)
- Understanding cost of capital (Module 6)
- Recognizing that value comes from cash flows
Summary
Congratulations on completing Module 8! You now understand:
✓ Working capital and net working capital ✓ The cash conversion cycle and its components ✓ Cash management techniques and float ✓ Inventory management and EOQ ✓ Accounts receivable and credit policy ✓ Accounts payable management ✓ Short-term financing options ✓ Working capital policies and trade-offs ✓ Industry variations in working capital
Working capital management is where finance meets operations. It's about the practical, day-to-day decisions that affect cash flow, liquidity, and ultimately, value. Companies can have great strategies and strong balance sheets but fail if they can't manage working capital effectively.
The companies that excel at working capital management free up cash, improve returns, and gain competitive advantages. Now you have the tools to optimize working capital in any business.
Ready for valuation? Proceed to Module 9: Valuation Fundamentals to learn how to determine what companies are worth.
"Cash is king." — Common business wisdom
"Revenue is vanity, profit is sanity, but cash is reality." — Anonymous
You now understand how to manage that reality effectively.
See you in Module 9!