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Working Capital Management

The document discusses concepts related to working capital management including economic order quantity, reorder point, lead time, safety stock, cash conversion cycle, accounts receivable management, and short-term credit financing. Formulas are provided for calculating measures like economic order quantity, reorder point, cash conversion cycle, and costs of different sources of short-term financing.

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26 views3 pages

Working Capital Management

The document discusses concepts related to working capital management including economic order quantity, reorder point, lead time, safety stock, cash conversion cycle, accounts receivable management, and short-term credit financing. Formulas are provided for calculating measures like economic order quantity, reorder point, cash conversion cycle, and costs of different sources of short-term financing.

Uploaded by

Kitten
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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WORKING CAPITAL MANAGEMENT

INVENTORY MANAGEMENT
ECONOMIC ORDER QUANTITY (EOQ) – Refers to the order size (number of units) that minimizes the sum of ordering costs
and carrying costs.  “How many units should be ordered?”
Where: D  Annual Demand or usage in units
√2𝐷𝑂 O  Cots of placing one Order
𝐸𝑂𝑄 =
𝐶 C  Cost of Carrying one unit for one year
Carrying Costs = (EOQ ÷ 2) x C Where: (EOQ ÷ 2)  Average inventory in units
Ordering Costs = (D ÷ EOQ) x O Where: (D ÷ EOQ)  Number of orders per year
Frequency: 360 ÷ No. of orders per year
NOTE: If safety stock is maintained, then average inventory = (EOQ ÷ 2) + Safety Stock
REORDER POINT – Refers to the number of units at which goods should re-ordered to minimize on the sum of carrying costs
and stock-out costs.  “When the units should be reordered?”
STOCK-OUT COST are opportunity costs and other costs incurred when inventory units run out-of-stock
Reorder Point = Delivery Time Stock + Safety Stock
(Alternative Formula: Reorder Point = Maximum Lead Time x Average Usage per Unit of Time
Where: Delivery Time Stock = Normal Lead Time x Average Usage per unit of Time
Safety Stock = (Maximum Lead Time – Normal Lead Time) x Ave Usage per unit Time
Alternative Formula: (Maximum Usage – Normal Usage) x Normal Lead Time
LEAD TIME is period from the time the order is placed until such time the order is received.
 Normal/Average lead time – refers to usual delay in the receipt of ordered goods
 Maximum lead time – this adds to normal lead time a reasonable allowance for further delay.
SAFETY STOCK (Buffer Stocks) – extra number of units maintained to protect against stock-out costs during periods of
uncertain lead time and demand.
ECONOMIC LOT SIZE (ELS)  How many units to produce?
Where: P  Annual Production in units
√2𝑃𝑆 S  Setup costs per batch of production
𝐸𝐿𝑆 =
𝐶 C  Cost of Carrying one unit for one year
 When used for cash management, EOQ becomes the OPTIMAL CASH BALANCE or “Baumol Model”
CASH & MARKETABLE SECURITIES MANAGEMENT
 “Why would a firm hold cash when, being idle, it is a non-earning asset?”
Where: D  Annual Demand for Cash
√2𝐷𝑇 T  Cots Transaction
𝑂𝐶𝐵 =
𝑂 O  Opportunity Cost of Holding Cash
Opportunity Costs = (OCB ÷ 2) x O Where: (OCB ÷ 2)  Average Cash balance
Transaction Costs = (D ÷ OCB) x T Where: (D ÷ OCB)  Number of transactions per year
 "OCB" is the optimal amount of cash to be raised by selling marketable securities or by borrowing
 "D" is total amount of new cash needed for transactions during the year
 "T" refers to the fixed costs of trading securities or cost of borrowing
 "O" refers to the rate of return foregone on marketable securities or the cost of borrowing

CASH CONVERSION CYCLE (CCC) a.k.a. Cash flow cycle. CCC must be distinguished from the NORMAL OPERATING CYCLE
(NOC), which is the length of time within the firm purchases or produces inventory, sells it and receives cash.
NOC = Ave Age of Inventory + Ave Age of Receivables
CCC = Ave Age of Inventory + Ave Age of Receivables – Ave Age of Payables
(Alternative: CCC = NOC – Ave Age of Payables)
Where: Formula Other name(s)
Ave Age of Inventory Inventory ÷ Cost of goods Inventory Conversion Period, Days Sales in Inventory
sold per day
Ave Age of Receivables Receivables ÷ Sales per day Receivables collection period, days sales outstanding
Ave Age of Payables Payables ÷ Purchases per Payable deferral period, days payables outstanding
day

NORMAL OPERATING CYCLE: 150 Days


Age of Inventory: 90 days Age of AR: 60 days
 Buy Pay  ☚ Cash OUT Sell  Collect  ☚ Cash IN
(Day 0) (Day 30) (90 days) (150 days)
Age of AP: 30 days CASH CONVERSION CYCLE (CASH FLOW CYCLE): 120 Days
RECEIVABLE MANAGEMENT
Ave Daily Credit Sales 𝐶𝑟𝑒𝑑𝑖𝑡 𝑆𝑎𝑙𝑒𝑠 ÷ 360
Ave Accounts Receivable Balance 𝐴𝑣𝑒 𝐷𝑎𝑖𝑙𝑦 𝑜𝑟 𝑀𝑜𝑛𝑡ℎ𝑙𝑦 𝐶𝑟𝑒𝑑𝑖𝑡 𝑆𝑎𝑙𝑒𝑠 × 𝐴𝑣𝑒 𝐶𝑜𝑙𝑙𝑒𝑐𝑡𝑖𝑜𝑛 𝑃𝑒𝑟𝑖𝑜𝑑

SHORT-TERM CREDIT FINANCING


Cost of Trade Credit with 𝐷𝑖𝑠𝑐 𝑅𝑎𝑡𝑒 360 𝑜𝑟 365
𝐶𝑜𝑠𝑡 = ×
Supplier 100% − 𝐷𝑖𝑠𝑐 𝑅𝑎𝑡𝑒 𝐶𝑟𝑒𝑑𝑖𝑡 𝑃𝑒𝑟𝑖𝑜𝑑 − 𝐷𝑖𝑠𝑐 𝑃𝑒𝑟𝑖𝑜𝑑
This type of financing cost is caused by foregoing cash discounts (Opportunity cost)
Cost of BANK LOANS 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 360 𝑜𝑟 365
𝐶𝑜𝑠𝑡 = ×
(Effective Annual Rate) 𝑁𝑒𝑡 𝑃𝑟𝑜𝑐𝑒𝑒𝑑𝑠 𝐿𝑜𝑎𝑛 𝑇𝑒𝑟𝑚

Cost of COMMERCIAL 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 + 𝐼𝑠𝑠𝑢𝑒 𝐶𝑜𝑠𝑡 360 𝑜𝑟 365


𝐶𝑜𝑠𝑡 = ×
PAPERS 𝐹𝑎𝑐𝑒 𝑉𝑎𝑙𝑢𝑒 − 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 − 𝐼𝑠𝑠𝑢𝑒 𝐶𝑜𝑠𝑡 𝑃𝑎𝑝𝑒𝑟 𝑇𝑒𝑟𝑚
𝐶𝑎𝑠ℎ 𝑂𝑢𝑡 360 𝑜𝑟 365
𝐸𝐴𝑅 = ×
𝐶𝑎𝑠ℎ 𝐼𝑛 𝑃𝑎𝑝𝑒𝑟 𝑇𝑒𝑟𝑚
Cost of FACTORING 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 + 𝐹𝑎𝑐𝑡𝑜𝑟 ′ 𝑠 𝐹𝑒𝑒 360 𝑜𝑟 365
𝐶𝑜𝑠𝑡 = ×
RECEIVABLES 𝐹𝑎𝑐𝑒 𝑉𝑎𝑙𝑢𝑒 − 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 − 𝐹𝑎𝑐𝑡𝑜𝑟 ′ 𝑠𝐹𝑒𝑒 − 𝐹ℎ𝑜𝑙𝑑𝑏𝑎𝑐𝑘 𝐶𝑜𝑠𝑡 𝑅𝑒𝑚𝑎𝑖𝑛𝑖𝑛𝑔 𝑀𝑎𝑡𝑢𝑟𝑖𝑡𝑦 𝑉𝑎𝑙𝑢𝑒

WORKING CAPITAL & LIQUIDITY RATIO


NET WORKING CAPITAL Current Assets – Current Liabilities
CURRENT RATIO Current Assets ÷ Current Liabilities
QUICK OR ACID – TEST RATIO Quick Assets ÷ Current Liabilities

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