Definitions:
Net Working Capital: Current assets minus current liabilities.
Cash Conversion Cycle: Period between firm’s payment for materials and collection on its sales.
Carrying Costs: Costs of maintaining current assets, including opportunity cost of capital.
Shortage Costs: Costs incurred from shortage in current assets.
Working Capital:
Cash ————–> Raw Materials
^ ||
|| V
Receivables <——— Finished Goods Inventory
The above diagram explains the cycle of short-term cash. We invest cash in the business to acquire raw materials and pay employees to make the products. The raw material eventually becomes finished goods, which is ready to be sold. Once sold the company enters into an agreement where the purchaser promises to pay for the good at a certain time in the future (accounts receivable). Once the person has paid, the company receives cash which may be used to buy new raw materials etc.
The longer the cash conversion cycle the longer the company must invest cash into the operations of the firm.
The purpose of short-term financing is determining the necessary cash required to maintain this cycle.
Too much cash:
- We lose the opportunity cost of investing the cash in a profitable project, leaving the cash to receive interest in the bank or distribute to shareholders
Too Little Cash:
- And we can’t pay supplies, we experience delays in production and loss in goodwill/reputation
How to reduce our working capital requirement:
A company can reduce its working capital requirements in three ways:
1. Inventory Period: Reduce the time it takes between paying supplies for raw materials and actually selling the product:
Inventory Period = Inventory / (Annual COGS/365)
2. Accounts Receivable Period: Reduce the time between selling the item and the customer paying
Accounts Receivable/ (Annual Sales/365)
3. Accounts Payable Period: Increase the time between obtaining raw materials and eventually paying suppliers.
Inventory Period
+
Accounts Receivable Period
+
Accounts Payable Period
=
Cash Conversion Cycle