Working Capital Management

1
Fall 2008

• Chapter 21 - II
• Working Capital Management

2
ALTERNATIVE WORKING CAPITAL POLICIES

• Do all companies follow the same working capital
  policy?
• No. Uncertainty in sales, costs, lead times on
  inventory shipments, payment periods, and
  collection periods force companies to hold safety
  stocks in w/c.
• Otherwise, everyone would hold minimal levels of
  w/c.

3

• At the extremes are the restrictive vs relaxed
  working capital policies
• With a restrictive w/c policy, firms minimize
  their safety stocks of cash and inventories, and
  are tight with their credit terms (even at the
  risk of losing some sales).
• Risk is higher, but so is expected profit.

4

• With a relaxed w/c policy, firms carry higher
  levels of safety stocks of cash and inventories,
  and are more liberal with their credit terms.
• Risk is lower, but so is expected profit.

5

• A restrictive w/c policy requires the NOWC to
  work harder. (NOWC turn.)
• Policy NOWC/Sales Sales/NOWC
• Relaxed 30 3.3x
• Moderate 23 4.3x
• Restrictive 16 6.3x
• Comparison within the same industry

6

• How do you tell if a firm with low liquidity is
  pursuing a restrictive policy, or is poorly
  managed and experiencing cash flow difficulties?
• Look at profitability
• A restrictive policy should be marked by low
  liquidity ratios and high ROIC
• A company in trouble should be marked by low
  liquidity and low profit.

7
In-Class Exercise

• Determine the ROIC for MicroDrive Corp for
  2006.
• If the industry average for ROIC is 15.0,
  MicroDrive appears to be
• a) following an aggressive w/c policy
• b) poorly managed and in difficulty

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Final Thoughts on W/C Policy

• Many companies today strive for zero working
  capital, defined as
• view w/c as an idle resource providing little in
  value
• assume value is created by fixed assets that
  produce the product demanded by consumers

9

• Inventory is created by inefficiencies between
  production and sales
• Greater time delays and waste in the production
  process increase the need for inventories
  
• Dells move to a build-to-order system greatly
  reduced inventory at all levels

10

• Forecasting uncertainties still prevent inventory
  from being reduced to zero.
• As production processes become more efficient and
  JIT inventory processes apply universally, delays
  that create the need for inventory will be
  reduced.

11

• Trade credit exists because of inefficiencies in
  the financing market
• If trade credit were eliminated, about half of
  the working capital would also be
  eliminated.
• As the Fed continues to encourage the use of
  electronic forms of payment, the need for w/c
  investment will be reduced.

12
CASH MANAGEMENT

• Cash is a use of funds
• The average industrial firm holds cash (currency
  demand deposits) equal to roughly 1.5 of total
  assets.
• Cash typically earns no interest, but it is
  needed to pay for labor, raw materials, take
  trade discounts, buy fixed assets, pay interest
  on debt, pay taxes, and pay dividends.

13

• Why do companies hold cash?
• for planned disbursements (transactions motive)
• for unplanned disbursements due to uncertainty in
  CF (precautionary motive)
• to meet compensating balance requirements of
  banks for providing services and loans