CHAPTER 15 Wo r k i ng C a p i t a l Management SOURCE: © Greg Girard/Contact Press Images 86 DELL REVOLUTIONIZES W O R K I N G C A P I TA L MANAGEMENT $ DELL COMPUTER D ramatic improvements in computer technology Second, Dell uses information technology to collect and the growth in the Internet have dramatically data that enables it to better customize products for its transformed the computer industry Some customers For example, a recent Fortune article companies have succeeded while others have failed described how Dell has been able to capture most of the Despite some recent setbacks, Dell Computer has clearly Ford Motor Company’s PC business: been one that has succeeded: Its sales have grown from roughly $5 billion in 1995 to more than $30 billion in Look at what the company does for one big 2000 customer, Ford Motor Dell creates a bunch of There are a lot of reasons behind Dell’s remarkable different configurations designed for Ford employees success over the past decade Perhaps the number one in different departments When Dell receives an order reason is the company’s impressive success in managing via the Ford Intranet, it knows immediately what its working capital, which is the focus of this chapter type of worker is ordering and what kind of computer The key to Dell’s success is its ability to build and he or she needs The company assembles the proper deliver customized computers very quickly hardware and even installs the right software, some Traditionally, manufacturers of custom-design products of which consists of Ford-specific code that’s stored had two choices They could keep a large supply of at Dell Since Dell’s logistics software is so inventory on hand to meet customer needs, or they sophisticated, it can the customization quickly could make their customers wait for weeks while the and inexpensively customized product was being built Dell uses information technology to revolutionize working capital management First, it uses information technology to better coordinate with its suppliers If a supplier wants to business with Dell, it must be able to provide the necessary components quickly and cheaply Suppliers that adapt and meet Dell’s demands are rewarded with increased business, and those that don’t lose their Dell business Sound working capital management is necessary if a company wants to compete in the information age, and the lessons taught by Dell extend to other industries Indeed, Michael Dell, founder and CEO of Dell Computer, recently discussed in an interview with The Wall Street Journal how traditional manufacturers, such as the automobile companies, can use the experience of Dell to improve their operations The 687 article included Michael Dell’s five points on how to build a better car: information more easily, and in ways they never could before Think about what could be done with the capital Use the Internet to lower the costs of linking manufacturers with their suppliers and dealers that would be freed up by shedding excessive inventory and other redundant assets ■ Turn over to an outside specialist any operation that isn’t central to the business Accelerate the pace of change, and get employees conditioned to accept change SOURCES: J William Gurley and Jane Hodges, “A Dell for Every Industry,” Fortune, October 12, 1998, 167–172; and Gary McWilliams and Joseph B White, “Dell to Detroit: Get into Gear Online!” The Wall Street Journal, December 1, 1999, B1 Experiment with Internet businesses Set up trials to see what happens when customers can access About 60 percent of a typical financial manager’s time is devoted to working capital management, and many students’ first jobs will involve working capital This is particularly true in smaller businesses, where most new jobs in the United States are being created Working capital policy involves two basic questions: (1) What is the appropriate amount of current assets for the firm to carry, both in total and for each specific account, and (2) how should current assets be financed? This chapter addresses current asset holdings and their financing As you will see in this chapter, sound working capital management goes beyond finance Indeed, most of the ideas for improving working capital management often stem from other disciplines For example, experts in business logistics, operations management, and information technology often work with the marketing group to develop a better way to deliver the firm’s products Where finance comes into play is in evaluating the profitability of alternative systems, which are generally costly to install For example, assume that a firm’s information technology and marketing groups decide that they want to (1) develop new software and (2) purchase computer terminals that will be installed in their customers’ premises Customers will then keep track of their own inventories and automatically order new supplies when inventory 688 CHAPTER 15 ■ W O R K I N G C A P I TA L M A N A G E M E N T levels hit specified targets The system will improve inventory management for both the manufacturer and its customers and also help “lock in” good customers Significant costs will be incurred to develop and install the new system, but if it is adopted, the company can meet its customers’ needs better, and with smaller inventory, and also increase sales In many respects, this scenario looks like a typical capital budgeting project — it has an up-front cost followed by a series of positive cash flows The finance group can use the capital budgeting techniques described in Chapters 11 and 12 to evaluate whether the new system is worth the cost and also whether it should be developed in-house or purchased from an outside source As with other chapters in this text, the textbook’s CD-ROM contains an Excel file, 15MODEL.xls, that will guide you through the chapter’s calculations ■ W O R K I N G C A P I TA L T E R M I N O L O G Y We begin our discussion of working capital policy by reviewing some basic definitions and concepts: Working capital, sometimes called gross working capital, simply refers to current assets used in operations Net working capital is defined as current assets minus current liabilities Net operating working capital is defined as current assets minus noninterest-bearing current liabilities More specifically, net operating working capital is often expressed as cash and marketable securities, accounts receivable, and inventories, less accounts payable and accruals.1 The current ratio, which was discussed in Chapter 3, is calculated by dividing current assets by current liabilities, and it is intended to measure liquidity However, a high current ratio does not ensure that a firm will have the cash required to meet its needs If inventories cannot be sold, or if receivables cannot be collected in a timely manner, then the apparent safety reflected in a high current ratio could be illusory The quick ratio, or acid test, also attempts to measure liquidity, and it is found by subtracting inventories from current assets and then dividing by current liabilities The quick ratio removes inventories from current assets because they are the least liquid of current assets Therefore, the quick ratio is an “acid test” of a company’s ability to meet its current obligations The best and most comprehensive picture of a firm’s liquidity position is shown by its cash budget This statement, which forecasts cash inflows and Working Capital A firm’s investment in short-term assets — cash, marketable securities, inventory, and accounts receivable Net Working Capital Current assets minus current liabilities Net Operating Working Capital Current assets minus noninterest-bearing current liabilities This definition assumes that cash and marketable securities on the balance sheet are at their normal long-run target levels and that the company is not holding any excess cash Excess holdings of cash and marketable securities are generally not included as part of net operating working capital W O R K I N G C A P I TA L T E R M I N O L O G Y 689 Working Capital Policy Basic policy decisions regarding (1) target levels for each category of current assets and (2) how current assets will be financed outflows, focuses on what really counts, namely, the firm’s ability to generate sufficient cash inflows to meet its required cash outflows We will discuss cash budgeting in detail later in the chapter Working capital policy refers to the firm’s policies regarding (1) target levels for each category of current assets and (2) how current assets will be financed Working capital management involves both setting working capital policy and carrying out that policy in day-to-day operations The term working capital originated with the old Yankee peddler, who would load up his wagon with goods and then go off on his route to peddle his wares The merchandise was called working capital because it was what he actually sold, or “turned over,” to produce his profits The wagon and horse were his fixed assets He generally owned the horse and wagon, so they were financed with “equity” capital, but he borrowed the funds to buy the merchandise These borrowings were called working capital loans, and they had to be repaid after each trip to demonstrate to the bank that the credit was sound If the peddler was able to repay the loan, then the bank would make another loan, and banks that followed this procedure were said to be employing “sound banking practices.” SELF-TEST QUESTIONS Why is the quick ratio also called an acid test? How did the term “working capital” originate? Differentiate between net working capital and net operating working capital THE CASH CONVERSION CYCLE As we noted above, the concept of working capital management originated with the old Yankee peddler, who would borrow to buy inventory, sell the inventory to pay off the bank loan, and then repeat the cycle That concept has been applied to more complex businesses, where it is used to analyze the effectiveness of a firm’s working capital management Firms typically follow a cycle in which they purchase inventory, sell goods on credit, and then collect accounts receivable This cycle is referred to as the cash conversion cycle, and it is discussed in detail in the next section Sound working capital policy is designed to minimize the time between cash expenditures on materials and the collection of cash on sales A N I L L U S T R AT I O N We can illustrate the process with data from Real Time Computer Corporation (RTC), which in early 2001 introduced a new minicomputer that can perform one billion instructions per second and that will sell for $250,000 RTC expects 690 CHAPTER 15 ■ W O R K I N G C A P I TA L M A N A G E M E N T to sell 40 computers in its first year of production The effects of this new product on RTC’s working capital position were analyzed in terms of the following five steps: RTC will order and then receive the materials it needs to produce the 40 computers it expects to sell Because RTC and most other firms purchase materials on credit, this transaction will create an account payable However, the purchase will have no immediate cash flow effect Labor will be used to convert the materials into finished computers However, wages will not be fully paid at the time the work is done, so, like accounts payable, accrued wages will also build up The finished computers will be sold, but on credit Therefore, sales will create receivables, not immediate cash inflows At some point before cash comes in, RTC must pay off its accounts payable and accrued wages This outflow must be financed The cycle will be completed when RTC’s receivables have been collected At that time, the company can pay off the credit that was used to finance production, and it can then repeat the cycle Cash Conversion Cycle Model Focuses on the length of time between when the company makes payments and when it receives cash inflows Inventory Conversion Period The average time required to convert materials into finished goods and then to sell those goods The cash conversion cycle model, which focuses on the length of time between when the company makes payments and when it receives cash inflows, formalizes the steps outlined above.2 The following terms are used in the model: Inventory conversion period, which is the average time required to convert materials into finished goods and then to sell those goods Note that the inventory conversion period is calculated by dividing inventory by sales per day For example, if average inventories are $2 million and sales are $10 million, then the inventory conversion period is 73 days: Inventory conversion period

Inventory Sales per day (15-1) $2,000,000 $10,000,000/365
73 days Receivables Collection Period The average length of time required to convert the firm’s receivables into cash, that is, to collect cash following a sale Thus, it takes an average of 73 days to convert materials into finished goods and then to sell those goods.3 Receivables collection period, which is the average length of time required to convert the firm’s receivables into cash, that is, to collect cash following a sale The receivables collection period is also called the days See Verlyn D Richards and Eugene J Laughlin, “A Cash Conversion Cycle Approach to Liquidity Analysis,” Financial Management, Spring 1980, 32–38 Some analysts define the inventory conversion period as inventory divided by daily cost of goods sold However, most published sources use the formula we show in Equation 15-1 In addition, some analysts use a 360-day year; however, unless stated otherwise, we will base all our calculations on a 365-day year THE CASH CONVERSION CYCLE 691 sales outstanding (DSO), and it is calculated by dividing accounts receivable by the average credit sales per day If receivables are $657,534 and sales are $10 million, the receivables collection period is Receivables Receivables
DSO
collection period Sales/365
(15-2) $657,534
24 days $10,000,000/365 Thus, it takes 24 days after a sale to convert the receivables into cash Payables deferral period, which is the average length of time between the purchase of materials and labor and the payment of cash for them For example, if the firm on average has 30 days to pay for labor and materials, if its cost of goods sold are $8 million per year, and if its accounts payable average $657,534, then its payables deferral period can be calculated as follows: Payables Deferral Period The average length of time between the purchase of materials and labor and the payment of cash for them Payables Payables deferral
Purchases per day period

Payables (15-3) Cost of goods sold/365 $657,534 $8,000,000/365
30 days The calculated figure is consistent with the stated 30-day payment period.4 Cash conversion cycle, which nets out the three periods just defined and which therefore equals the length of time between the firm’s actual cash expenditures to pay for productive resources (materials and labor) and its own cash receipts from the sale of products (that is, the length of time between paying for labor and materials and collecting on receivables) The cash conversion cycle thus equals the average length of time a dollar is tied up in current assets Cash Conversion Cycle The average length of time a dollar is tied up in current assets We can now use these definitions to analyze the cash conversion cycle First, the concept is diagrammed in Figure 15-1 Each component is given a number, and the cash conversion cycle can be expressed by this equation: (1)  (2)  (3)
(4) Inventory Receivables Payables Cash conversion  collection  deferral
conversion period period period cycle (15-4) To illustrate, suppose it takes Real Time an average of 73 days to convert raw materials to computers and then to sell them, and another 24 days to collect on receivables However, 30 days normally elapse between receipt of raw 692 CHAPTER 15 ■ Some sources define the payables deferral period as payables divided by daily sales W O R K I N G C A P I TA L M A N A G E M E N T FIGURE 15-1 The Cash Conversion Cycle Model (1) Inventory Conversion Period ( 73 Days) (3) Payables Deferral Period ( 30 Days) Receive Raw Materials Finish Goods and Sell Them (2) Receivables Collection Period (24 Days) (4) Cash Conversion Cycle (73  24  30
67 Days) Pay Cash for Purchased Materials Days Collect Accounts Receivables materials and payment for them In this case, the cash conversion cycle would be 67 days: Days in Cash Conversion Cycle
73 days  24 days  30 days
67 days To look at it another way, Cash inflow delay  Payment delay
Net delay (73 days  24 days)  SHORTENING THE 30 days
67 days CASH CONVERSION CYCLE Given these data, RTC knows when it starts producing a computer that it will have to finance the manufacturing costs for a 67-day period The firm’s goal should be to shorten its cash conversion cycle as much as possible without hurting operations This would improve profits, because the longer the cash conversion cycle, the greater the need for external financing, and that financing has a cost The cash conversion cycle can be shortened (1) by reducing the inventory conversion period by processing and selling goods more quickly, (2) by reducing the receivables collection period by speeding up collections, or (3) by lengthening the payables deferral period by slowing down the firm’s own payments To the extent that these actions can be taken without increasing costs or depressing sales, they should be carried out BENEFITS We can illustrate the benefits of shortening the cash conversion cycle by looking again at Real Time Computer Corporation Suppose RTC must spend approximately $197,250 on materials and labor to produce one computer, and it takes about nine days to produce a computer Thus, it must invest $197,250/9
$21,917 for each day’s production This investment must be financed for 67 days — the length of the cash conversion cycle — so the company’s working THE CASH CONVERSION CYCLE 693 capital financing needs will be 67  $21,917
$1,468,439 If RTC could reduce the cash conversion cycle to 57 days, say, by deferring payment of its accounts payable an additional 10 days, or by speeding up either the production process or the collection of its receivables, it could reduce its working capital financing requirements by $219,170 Recall that free cash flow (FCF) is equal to NOPAT minus net investments in operating capital Therefore, if working capital decreases, FCF increases by that same amount RTC’s reduction in its cash conversion cycle would lead to an increase in FCF of $219,170 Notice also that reducing the cash conversion cycle reduces the ratio of net operating working capital to sales (NOWC/Sales) If sales stay at the same level, then the reduction in working capital is simply a one-time cash inflow However, if sales are expected to grow, and if the NOWC/Sales ratio remains at its new level, then less working capital will be required to support the additional sales, leading to an increase in projected FCF for each future year The combination of the one-time cash inflow and the long-term improvement in working capital can add substantial value to companies Two professors, Hyun-Han Shin and Luc Soenen, studied more then 2,900 companies during a recent 20-year period and found a strong relationship between a company’s cash conversion cycle and its performance.5 In particular, their results show that for the average company a 10-day improvement in the cash conversion cycle was associated with an increase in pre-tax operating profit from 12.76 to 13.02 percent They also demonstrated that companies with a cash conversion cycle 10 days shorter than average also had an annual stock return that was 1.7 percentage points higher than that of an average company, even after adjusting for differences in risk Given results like these, it’s no wonder firms now place so much emphasis on working capital management! SELF-TEST QUESTIONS Define the following terms: inventory conversion period, receivables collection period, and payables deferral period Give the equation for each term What is the cash conversion cycle? What is its equation? What should the firm’s goal be regarding the cash conversion cycle? Explain your answer What are some actions the firm can take to shorten its cash conversion cycle? A LT E R N AT I V E C U R R E N T ASSET INVESTMENT POLICIES The cash conversion cycle highlights the strengths and weaknesses of the company’s working capital policy, which depend critically on current asset manage5 See Hyun-Han Shin and Luc Soenen, “Efficiency of Working Capital Management and Corporate Profitability,” Financial Practice and Education, Fall/Winter 1998, 37–45 694 CHAPTER 15 ■ W O R K I N G C A P I TA L M A N A G E M E N T FIGURE 15-2 Alternative Current Asset Investment Policies (Millions of Dollars) Current Assets ($) Relaxed 40 Moderate 30 Restricted 20 10 POLICY Relaxed 50 100 150 200 Sales ($) CURRENT ASSETS TO SUPPORT SALES OF $100 TURNOVER OF CURRENT ASSETS $30 3.3 Moderate 23 4.3 Restricted 16 6.3 NOTE: The sales/current assets relationship is shown here as being linear, but the relationship is often curvilinear Relaxed Current Asset Investment Policy A policy under which relatively large amounts of cash, marketable securities, and inventories are carried and under which sales are stimulated by a liberal credit policy, resulting in a high level of receivables ment and the financing of current assets In the remaining part of this chapter, we consider each of these items in more detail We begin by describing alternative current asset investment policies, after which we consider a more detailed analysis of the various components of working capital We conclude by discussing different strategies for financing current assets Figure 15-2 shows three alternative policies regarding the total amount of current assets carried Essentially, these policies differ with regard to the amount of current assets carried to support any given level of sales, hence in the turnover of those assets The line with the steepest slope represents a relaxed current asset investment (or “fat cat”) policy, where relatively large amounts of cash, marketable securities, and inventories are carried, and where sales are stimulated by the use of a credit policy that provides liberal financing to customers and a corresponding high level of receivables A LT E R N AT I V E C U R R E N T A S S E T I N V E S T M E N T P O L I C I E S 695 ... Lease payments 15 15 15 15 15 15 (12) Other expenses 10 15 20 15 10 10 (13) Taxes 30 (14) Payment for plant construction (15) Total payments 20 100 $265 $350 $465 $ 415 $230 $ 215 ($ 11) ($ 37)... term ? ?working capital? ?? originate? Differentiate between net working capital and net operating working capital THE CASH CONVERSION CYCLE As we noted above, the concept of working capital management. .. financing As you will see in this chapter, sound working capital management goes beyond finance Indeed, most of the ideas for improving working capital management often stem from other disciplines