💼Advanced Corporate Finance Unit 7 – Working Capital Management

What's Working Capital Management?

• Working capital management involves optimizing current assets and current liabilities to ensure smooth business operations
• Focuses on managing cash, inventories, accounts receivable, and accounts payable efficiently
• Aims to maintain sufficient liquidity while minimizing the cost of holding current assets
• Ensures timely payment of short-term obligations (accounts payable, short-term loans)
• Helps businesses strike a balance between profitability and liquidity
• Involves making decisions about short-term financing and investment
• Requires continuous monitoring and adjustment to adapt to changing business conditions

Why Working Capital Matters

• Adequate working capital ensures businesses can meet their short-term financial obligations
• Insufficient working capital can lead to liquidity problems and potential bankruptcy
• Excess working capital may indicate inefficient use of resources and missed investment opportunities
• Effective working capital management improves cash flow and reduces the need for external financing
• Enhances a company's ability to seize opportunities and respond to market changes quickly
• Contributes to better credit ratings and stronger relationships with suppliers and creditors
• Supports business growth and expansion by providing the necessary financial resources

Components of Working Capital

• Current assets
  • Cash and cash equivalents (short-term investments, marketable securities)
  • Accounts receivable (money owed by customers)
  • Inventories (raw materials, work-in-progress, finished goods)
  • Prepaid expenses (insurance, rent)
• Current liabilities
  • Accounts payable (money owed to suppliers)
  • Short-term loans and borrowings
  • Accrued expenses (salaries, taxes)
  • Unearned revenue (advance payments from customers)
• Net working capital calculated as current assets minus current liabilities

Strategies for Managing Working Capital

• Optimize inventory levels
  • Implement just-in-time (JIT) inventory management to reduce holding costs
  • Use economic order quantity (EOQ) model to determine optimal order sizes
• Manage accounts receivable effectively
  • Establish clear credit policies and perform credit checks on customers
  • Offer discounts for early payment to encourage faster collection
  • Use factoring or invoice discounting to accelerate cash inflows
• Negotiate favorable terms with suppliers
  • Extend payment terms to conserve cash
  • Take advantage of early payment discounts when financially feasible
• Implement cash management techniques
  • Use cash budgeting and forecasting to anticipate cash needs
  • Invest excess cash in short-term instruments (money market funds, certificates of deposit)
  • Establish a line of credit for emergency funding
• Monitor and analyze working capital metrics regularly
  • Calculate and track key ratios (current ratio, quick ratio, inventory turnover)
  • Identify trends and take corrective actions as needed

Cash Conversion Cycle

• Measures the time it takes for a company to convert cash outflows into cash inflows
• Calculated as days inventory outstanding (DIO) + days sales outstanding (DSO) - days payable outstanding (DPO)
• DIO = (Average Inventory ÷ Cost of Goods Sold) × 365
• DSO = (Average Accounts Receivable ÷ Net Credit Sales) × 365
• DPO = (Average Accounts Payable ÷ Cost of Goods Sold) × 365
• A shorter cash conversion cycle indicates more efficient working capital management
• Reducing the cash conversion cycle frees up cash for other purposes
• Strategies to shorten the cycle include reducing inventory levels, accelerating collections, and extending payment terms

Working Capital Ratios

• Current ratio = Current Assets ÷ Current Liabilities
  • Measures a company's ability to meet short-term obligations
  • A ratio above 1 indicates sufficient liquidity
• Quick ratio (Acid-test ratio) = (Current Assets - Inventories) ÷ Current Liabilities
  • Assesses a company's ability to meet short-term obligations using only highly liquid assets
  • Excludes inventories, which may take longer to convert into cash
• Inventory turnover ratio = Cost of Goods Sold ÷ Average Inventory
  • Measures how efficiently a company manages its inventory
  • Higher turnover indicates better inventory management and faster sales
• Receivables turnover ratio = Net Credit Sales ÷ Average Accounts Receivable
  • Assesses how quickly a company collects payments from customers
  • Higher turnover suggests more efficient credit and collection policies

Financing Working Capital

• Short-term financing options
  • Bank overdrafts (allows temporary negative cash balances)
  • Lines of credit (pre-approved borrowing limits)
  • Trade credit (credit extended by suppliers)
  • Factoring (selling accounts receivable to a third party)
• Long-term financing options
  • Long-term loans (secured or unsecured)
  • Bonds (debt securities issued to investors)
  • Equity financing (issuing shares to raise capital)
• Factors influencing financing decisions
  • Cost of capital (interest rates, dividend expectations)
  • Flexibility and control (debt vs. equity)
  • Collateral requirements and debt covenants
  • Company's credit rating and financial stability

Real-World Applications

• Walmart's supply chain management
  • Efficient inventory management through advanced technology and data analytics
  • Collaborative relationships with suppliers to optimize stock levels and reduce costs
• Apple's cash management strategy
  • Maintains a large cash reserve to support product development and strategic investments
  • Invests excess cash in short-term, low-risk instruments to preserve liquidity
• Amazon's working capital optimization
  • Negative cash conversion cycle due to rapid inventory turnover and extended payment terms with suppliers
  • Continually reinvests cash generated from operations into growth initiatives
• Tesla's working capital challenges
  • High inventory levels and slow inventory turnover due to production delays and supply chain issues
  • Relies on customer deposits and external financing to support working capital needs