Working Capital

Concept of working capital management Evaluating techniques for working capital Operating cycle and cash conversion cycle

Learning outcomes

Introduction Working capital management is the management

of the short-term investment and financing of a company.

Definition: Basic metrics used to evaluate the company's

efficiency and its short-term financial health

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Working capital

FormulaWorking capital= current asset – current liabilities

WC = CA – CLGoals

◦ Adequate cash flow for operations◦ Most productive use of resources

Working capital

Working capital

Current Assets

Cash Account receivable Prepaid expense Merchandise

Inventory Marketable securities

Current Liabilities

Accounts payable Accrued expenses

FormulaCurrent Assets/Current Liabilities

Anything below 1 indicates negative W/C (working capital).

While anything over 2 means that the company is not investing excess assets.

Most believe that a ratio between 1.2 and 2.0 is sufficient

Working Capital Ratio

Operating Cycle

Is used to measure the efficiency of working capital

The operating cycle is the length of time it takes a company’s investment in inventory to be collected in cash from customers.

Acquire Inventory for Cash

Sell Inventory for Credit

Collect on Accounts Receivabl

e

Cash Conversion Cycle The net operating

cycle (or the cash conversion cycle) is the length of time it takes for a company’s investment in inventory to generate cash, considering that some or all of the inventory is purchased using credit.

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Acquire Inventory for Credit

Sell Inventory for Credit

Collect on Accounts

Receivable

Pay Suppliers

Formula

Cash Conversion Cycle

1. Days Inventory outstanding (DIO): is the average number of days a company hold their inventory before sell

Formula: DIO= 365/ inventory turnover**inventory turnover= COGS/average

inventory** **Avg. inventory= (beg.+ ending inventory)/2

Cash Conversion Cycle

2. Day sales outstanding (DSO): is the average number of days a company takes to collect revenue after sales has been made.

Formula: DSO= 365/ Account receivable turnover**A/R turnover= Sales/average A/R ** **Avg. A/R= (beg.+ ending A/R)/2

Cash Conversion Cycle

3. Days payable outstanding (DPO): is the average number of days a company takes to pay its suppliers.

Formula: DPO= 365/ Account payable turnover**A/P turnover= COGS/average A/P ** **Avg. A/P= (beg.+ ending A/P)/2

Cash Conversion Cycle

Case:

Case:

Case:

Competitor’s ScenarioItem 1/31/2004 1/31/2003

Revenue 6000

COGS 7000

Inventory 1000 2000

A/R 500 400

A/P 800 900

Average inventory (1000+2000)/2 = 1500

Average A/R (400+500)/2= 450

Average A/P (800+900)/2 = 850

DIO = $1,500 / ($7,000/ 365) = 78.2 days

DSO = $450 / ($6,000 / 365 days) =

27.3days

DPO = $850 / ($7,000/ 365) = 44.3 days

CCC = 78.2+27.3- 44.3= 61.26 days

Competitor’s Scenario

Items Kohler’s company X company

DIO 85 days 78 daysDSO 38 days 27 daysDPO 31 days 44 daysCCC 92 days 61 days

Competitive Analysis