Working Capital Management

Case on Pepsi: Managing the Cash Conversion Cycle

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Wor ki ng- Ca pi tal Mana gement

Working Capital Concepts

Net Working Capital = Current Assets – Current Liabilities Gross Working Capital: The firm’s investment in current assets

Significance of Working Capital Management • In a typical manufacturing firm, current assets exceed one-half of total assets. • Current liabilities are the principal source of external financing for small firms. • Requires continuous, day-to-day managerial supervision. • Working capital management affects the company’s risk, return, and share price.

TYPES OF WORKING CAPITAL

• Permanent working capital • Temporary /Variable working capital

Permanent Working Capital

AMOUNT

The amount of current assets required to meet a firm’s long-term minimum needs.

Permanent current assets

TIME

Temporary Working Capital The amount of current assets that varies with seasonal requirements.

AMOUNT

Temporary current assets

Permanent current assets

TIME

Determining Financial Mix How current assets will be financed?

• Matching approach or Hedging approach • Conservative approach • Aggressive approach

Balance Sheet • Current Liabilities • Long-Term Debt Preferred Stock Common Stock

Current Assets Fixed Assets

• To illustrate, let’s finance all current assets with current liabilities, and finance all fixed assets with long-term financing.

Balance Sheet Current Liabilities Current Assets Long-Term Debt Preferred Stock Fixed Assets Common Stock Suppose we use long-term financing to finance some of our current assets. This strategy would be less risky, but more expensive!

Balance Sheet Current Liabilities

Current Assets

Long-Term Debt Preferred Stock Fixed Assets Common Stock Suppose we use current liabilities to finance some of our fixed assets. This strategy would be less expensive, but more risky!

Financing Current Assets: Short-Term and Long-Term Mix Spontaneous Financing: Trade credit, and other payables and accruals, that arise spontaneously in the firm’s day-to-day operations.

The Hedging Principle • Permanent Assets – Fixed assets and permanent current assets are financed with long-term debt and equity and spontaneous sources of financing

• Temporary Assets --Seasonal needs are financed with short-term loans

Financing Needs and the conservative Approach • Permanent current assets and seasonal portion of current assets are financed with long-term debt and equity which is less risky, but more expensive! • Short term funds are used in emergency situation

Financing Needs and the Aggressive Approach

• Permanent current assets and seasonal portion of current assets are financed with short term sources of financing but less expensive, but more risky!

Trade off between Profitability and Risk Example: The three possible current assets holdings of the firm are Rs.5,00,000/-, Rs. 4,00,000/- and Rs. 3,00,000/-. It is assumed that fixed asset level is constant. The firm has the following data: Sales Rs.15,00,000/EBIT Rs. 1,50,000/Fixed Assets Rs. 5,00,000/-

Effect of Alternative working capital policies

Impact on Liquidity

Policy A

ASSET LEVEL ($)

Liquidity Analysis Policy Liquidity A High B Average C Low Greater current asset levels generate more liquidity; all other factors held constant.

Policy B Policy C

Current Assets

0 50,000

OUTPUT (units)

Impact on Profitability

As current asset levels decline, total assets will decline and the ROI will rise.

Policy A

ASSET LEVEL ($)

Profitability Analysis Policy Profitability A Low B Average C High

Policy B Policy C

Current Assets

0 50,000

OUTPUT (units)

Impact on Risk

Risk increases as the level of current assets are reduced.

Policy A

ASSET LEVEL ($)

Risk Analysis Policy Risk A Low B Average C High

Policy B Policy C

Current Assets

0 50,000

OUTPUT (units)

Summary of Current Assets SUMMARY OF CURRENT ASSET ANALYSIS Policy A B C

Liquidity Profitability Risk High Low Low Average Average Average Low High High

1. Profitability varies inversely with liquidity. 2. Profitability moves together with risk. (risk and return go hand in hand!)

The Operating Cycle and the Cash Cycle The Operating Cycle (OC) is the time between ordering materials and collecting cash from receivables. A firm’s operating cyc le (OC) is the time from the beginning of the production process to collection of cash from the sale of the finished product. The operating cycle is the sum of the inventory period and the accounts receivable period, whereas the cash cycle is equal to the operating cycle less the accounts payable period.

In vento ry convers io n period, which is the average time required to convert materials into finished goods and then to sell those goods. If average inventories are 2,00,000 and sales are 10,00,000, then the inventory conversion period is 73 days: Inventory conversion period = __Inventory__ Sales per day = __2,00,000___ = 73 days 10,00,000/365

Receivabl es col lect ion per iod, 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 sales outstanding (DSO). If receivables are Rs.65754 and sales are Rs.10,00,000. The receivable collection period is Receivables collection period = ___Accounts receivable___ Average credit sales per day or Receivables collection period = DSO = Receivables Sales/365 = _65754__ = 24 days 10,00,000/365

Payabl es peri od, which is the average length of time between the purchase of materials and the payment of cash for them. If the firm on average has 30 days to pay for materials, if its cost of goods sold are 8,00,000 per year, and if its accounts payable average 65754 then its payables deferral period can be calculated as follows: Payabl es peri od = ____Payables____ Purchases per day = ______Payables_____ = __65754__ = 30 days purchases/365 8,00,000/365

The Operating Cycle

Cash cycle = Operating cycle – Account s payabl e peri od

Cash Conversion Cycle Cash conversion cycle, the cash conversion cycle can be expressed by this equation:

Days in Cash Conversion Cycle = 73 days + 24 days – 30 days = 67 days

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