THE COMPONENTS OF WORKING CAPITAL
Short-term, or current, assets and liabilities are collectively known as working capital. Table 2.1 gives a breakdown of current assets and liabilities for all manufacturing corporations in the United States in 1999. Total current assets were $1,352 billion and total current liabilities were $1,046 billion.
Current Assets. One important current asset is accounts receivable. Accounts receivable arise because companies do not usually expect customers to pay for their purchases immediately. These unpaid bills are a valuable asset that companies expect to be able to turn into cash in the near future. The bulk of accounts receivable consists of unpaid bills from sales to other companies and are known as trade credit. The remainder arises from the sale of goods to the final consumer. These are known as consumer credit.
Another important current asset is inventory. Inventories may consist of raw materials, work in process, or finished goods awaiting sale and shipment. Table 2.1 shows that firms in the United States have about the same amount invested in inventories as in accounts receivable.
The remaining current assets are cash and marketable securities. The cash consists partly of dollar bills, but most of the cash is in the form of bank deposits. These may be demand deposits (money in checking accounts that the firm can pay out immediately) and time deposits (money in savings accounts that can be paid out only with a delay).
The principal marketable security is commercial paper (short-term unsecured debt sold by other firms). Other securities include Treasury bills, which are short-term debts sold by the United States government, and state and local government securities.
In managing their cash companies face much the same problem you do. There are always advantages to holding large amounts of ready cash—they reduce the risk of running out of cash and having to borrow more on short notice. On the other hand, there is a cost to holding idle cash balances rather than putting the money to work earning interest. In later we will tell you how the financial manager collects and pays out cash and decides on an optimal cash balance.
Current Liabilities. We have seen that a company’s principal current asset consists of unpaid bills. One firm’s credit must be another’s debit. Therefore, it is not surprising that a company’s principal current liability consists of accounts payable—that is, outstanding payments due to other companies.
The other major current liability consists of short-term borrowing. We will have
more to say about this later in this material.
WORKING CAPITAL AND THE CASH CONVERSION CYCLE
The difference between current assets and current liabilities is known as net working capital, but financial managers often refer to the difference simply (but imprecisely) as working capital. Usually current assets exceed current liabilities—that is, firms have positive net working capital. For United States manufacturing companies, current assets are on average 30 percent higher than current liabilities.
To see why firms need net working capital, imagine a small company, Simple Souvenirs, that makes small novelty items for sale at gift shops. It buys raw materials such as leather, beads, and rhinestones for cash, processes them into finished goods like wallets or costume jewelry, and then sells these goods on credit. Figure 2.1 shows the whole cycle of operations.
If you prepare the firm’s balance sheet at the beginning of the process, you see cash (a current asset). If you delay a little, you find the cash replaced first by inventories of raw materials and then by inventories of finished goods (also current assets). When the goods are sold, the inventories give way to accounts receivable (another current asset) and finally, when the customers pay their bills, the firm takes out its profit and replenishes the cash balance.
The components of working capital constantly change with the cycle of operations, but the amount of working capital is fixed. This is one reason why net working capital is a useful summary measure of current assets or liabilities.
Figure 2.2 depicts four key dates in the production cycle that influence the firm’s investment in working capital. The firm starts the cycle by purchasing raw materials, but it does not pay for them immediately. This delay is the accounts payable period. The firm processes the raw material and then sells the finished goods. The delay between the initial investment in inventories and the sale date is the inventory period. Some time after the firm has sold the goods its customers pay their bills. The delay between the date of sale and the date at which the firm is paid is the accounts receivable period.
The top part of Figure 2.2 shows that the total delay between initial purchase of raw materials and ultimate payments from customers is the sum of the inventory and accounts receivable periods: first the raw materials must be purchased, processed, and sold, and then the bills must be collected. However, the net time that the company is out of cash is reduced by the time it takes to pay its own bills. The length of time between the firm’s payment for its raw materials and the collection of payment from the customer is known as the firm’s cash conversion cycle. To summarize,
Cash conversion cycle = (inventory period + receivables period) – accounts payable period
The longer the production process, the more cash the firm must keep tied up
in inventories. Similarly, the longer it takes customers to pay their bills, the
higher the value of accounts receivable. On the other hand, if a firm can delay
paying for its own materials, it may reduce the amount of cash it needs. In
other words, accounts payable reduce net working capital.
THE WORKING CAPITAL TRADE-OFF
Of course the cash conversion cycle is not cast in stone. To a large extent it is within management’s control. Working capital can be managed. For example, accounts receivable are affected by the terms of credit the firm offers to its customers. You can cut the amount of money tied up in receivables by getting tough with customers who are slow in paying their bills. (You may find, however, that in the future they take their business elsewhere.) Similarly, the firm can reduce its investment in inventories of raw materials. (Here the risk is that it may one day run out of inventories and production will grind to a halt.)
These considerations show that investment in working capital has both costs and
benefits. For example, the cost of the firm’s investment in receivables is the interest that could have been earned if customers had paid their bills earlier. The firm also forgoes interest income when it holds idle cash balances rather than putting the money to work in marketable securities. The cost of holding inventory includes not only the opportunity cost of capital but also storage and insurance costs and the risk of spoilage or obsolescence. All of these carrying costs encourage firms to hold current assets to a minimum.
While carrying costs discourage large investments in current assets, too low a level of current assets makes it more likely that the firm will face shortage costs. For example, if the firm runs out of inventory of raw materials, it may have to shut down production. Similarly, a producer holding a small finished goods inventory is more likely to be caught short, unable to fill orders promptly. There are also disadvantages to holding small “inventories” of cash. If the firm runs out of cash, it may have to sell securities and incur unnecessary trading costs. The firm may also maintain too low a level of accounts receivable. If the firm tries to minimize accounts receivable by restricting credit sales, it may lose customers.
An important job of the financial manager is to strike a balance between the
costs and benefits of current assets, that is, to find the level of current assets
that minimizes the sum of carrying costs and shortage costs.
In the Appendix we pointed out that in recent years many managers have tried to
make their staff more aware of the cost of the capital that is used in the business. So, when they review the performance of each part of their business, they deduct the cost of the capital employed from its profits. This measure is known as residual income or economic value added (EVA), which is the term coined by the consulting firm Stern Stewart. Firms that employ EVA to measure performance have often discovered that they can make large savings on working capital. Herman Miller Corporation, the furniture manufacturer, found that after it introduced EVA, employees became much more conscious of the cash tied up in inventories.
The company also started to look at how rapidly customers paid their bills. It found that, any time an item was missing from an order, the customer would delay payment until all the pieces had been delivered. When the company cleared up the problem of missing items, it made its customers happier and it collected the cash faster.
Short-term, or current, assets and liabilities are collectively known as working capital. Table 2.1 gives a breakdown of current assets and liabilities for all manufacturing corporations in the United States in 1999. Total current assets were $1,352 billion and total current liabilities were $1,046 billion.
Current Assets. One important current asset is accounts receivable. Accounts receivable arise because companies do not usually expect customers to pay for their purchases immediately. These unpaid bills are a valuable asset that companies expect to be able to turn into cash in the near future. The bulk of accounts receivable consists of unpaid bills from sales to other companies and are known as trade credit. The remainder arises from the sale of goods to the final consumer. These are known as consumer credit.
Another important current asset is inventory. Inventories may consist of raw materials, work in process, or finished goods awaiting sale and shipment. Table 2.1 shows that firms in the United States have about the same amount invested in inventories as in accounts receivable.
The remaining current assets are cash and marketable securities. The cash consists partly of dollar bills, but most of the cash is in the form of bank deposits. These may be demand deposits (money in checking accounts that the firm can pay out immediately) and time deposits (money in savings accounts that can be paid out only with a delay).
The principal marketable security is commercial paper (short-term unsecured debt sold by other firms). Other securities include Treasury bills, which are short-term debts sold by the United States government, and state and local government securities.
In managing their cash companies face much the same problem you do. There are always advantages to holding large amounts of ready cash—they reduce the risk of running out of cash and having to borrow more on short notice. On the other hand, there is a cost to holding idle cash balances rather than putting the money to work earning interest. In later we will tell you how the financial manager collects and pays out cash and decides on an optimal cash balance.
Current Liabilities. We have seen that a company’s principal current asset consists of unpaid bills. One firm’s credit must be another’s debit. Therefore, it is not surprising that a company’s principal current liability consists of accounts payable—that is, outstanding payments due to other companies.
The other major current liability consists of short-term borrowing. We will have
more to say about this later in this material.
WORKING CAPITAL AND THE CASH CONVERSION CYCLE
The difference between current assets and current liabilities is known as net working capital, but financial managers often refer to the difference simply (but imprecisely) as working capital. Usually current assets exceed current liabilities—that is, firms have positive net working capital. For United States manufacturing companies, current assets are on average 30 percent higher than current liabilities.
To see why firms need net working capital, imagine a small company, Simple Souvenirs, that makes small novelty items for sale at gift shops. It buys raw materials such as leather, beads, and rhinestones for cash, processes them into finished goods like wallets or costume jewelry, and then sells these goods on credit. Figure 2.1 shows the whole cycle of operations.
If you prepare the firm’s balance sheet at the beginning of the process, you see cash (a current asset). If you delay a little, you find the cash replaced first by inventories of raw materials and then by inventories of finished goods (also current assets). When the goods are sold, the inventories give way to accounts receivable (another current asset) and finally, when the customers pay their bills, the firm takes out its profit and replenishes the cash balance.
The components of working capital constantly change with the cycle of operations, but the amount of working capital is fixed. This is one reason why net working capital is a useful summary measure of current assets or liabilities.
Figure 2.2 depicts four key dates in the production cycle that influence the firm’s investment in working capital. The firm starts the cycle by purchasing raw materials, but it does not pay for them immediately. This delay is the accounts payable period. The firm processes the raw material and then sells the finished goods. The delay between the initial investment in inventories and the sale date is the inventory period. Some time after the firm has sold the goods its customers pay their bills. The delay between the date of sale and the date at which the firm is paid is the accounts receivable period.
The top part of Figure 2.2 shows that the total delay between initial purchase of raw materials and ultimate payments from customers is the sum of the inventory and accounts receivable periods: first the raw materials must be purchased, processed, and sold, and then the bills must be collected. However, the net time that the company is out of cash is reduced by the time it takes to pay its own bills. The length of time between the firm’s payment for its raw materials and the collection of payment from the customer is known as the firm’s cash conversion cycle. To summarize,
Cash conversion cycle = (inventory period + receivables period) – accounts payable period
The longer the production process, the more cash the firm must keep tied up
in inventories. Similarly, the longer it takes customers to pay their bills, the
higher the value of accounts receivable. On the other hand, if a firm can delay
paying for its own materials, it may reduce the amount of cash it needs. In
other words, accounts payable reduce net working capital.
THE WORKING CAPITAL TRADE-OFF
Of course the cash conversion cycle is not cast in stone. To a large extent it is within management’s control. Working capital can be managed. For example, accounts receivable are affected by the terms of credit the firm offers to its customers. You can cut the amount of money tied up in receivables by getting tough with customers who are slow in paying their bills. (You may find, however, that in the future they take their business elsewhere.) Similarly, the firm can reduce its investment in inventories of raw materials. (Here the risk is that it may one day run out of inventories and production will grind to a halt.)
These considerations show that investment in working capital has both costs and
benefits. For example, the cost of the firm’s investment in receivables is the interest that could have been earned if customers had paid their bills earlier. The firm also forgoes interest income when it holds idle cash balances rather than putting the money to work in marketable securities. The cost of holding inventory includes not only the opportunity cost of capital but also storage and insurance costs and the risk of spoilage or obsolescence. All of these carrying costs encourage firms to hold current assets to a minimum.
While carrying costs discourage large investments in current assets, too low a level of current assets makes it more likely that the firm will face shortage costs. For example, if the firm runs out of inventory of raw materials, it may have to shut down production. Similarly, a producer holding a small finished goods inventory is more likely to be caught short, unable to fill orders promptly. There are also disadvantages to holding small “inventories” of cash. If the firm runs out of cash, it may have to sell securities and incur unnecessary trading costs. The firm may also maintain too low a level of accounts receivable. If the firm tries to minimize accounts receivable by restricting credit sales, it may lose customers.
An important job of the financial manager is to strike a balance between the
costs and benefits of current assets, that is, to find the level of current assets
that minimizes the sum of carrying costs and shortage costs.
In the Appendix we pointed out that in recent years many managers have tried to
make their staff more aware of the cost of the capital that is used in the business. So, when they review the performance of each part of their business, they deduct the cost of the capital employed from its profits. This measure is known as residual income or economic value added (EVA), which is the term coined by the consulting firm Stern Stewart. Firms that employ EVA to measure performance have often discovered that they can make large savings on working capital. Herman Miller Corporation, the furniture manufacturer, found that after it introduced EVA, employees became much more conscious of the cash tied up in inventories.
The company also started to look at how rapidly customers paid their bills. It found that, any time an item was missing from an order, the customer would delay payment until all the pieces had been delivered. When the company cleared up the problem of missing items, it made its customers happier and it collected the cash faster.
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