Gross Working Capital and Net Working Capital

Gross Working Capital refers to the current assets of the firm. The principle components of current assets include cash and marketable securities, accounts receivables, and inventory.

Net Working Capital refers to current assets minus current liabilities. Principle components of current liabilities include short-term debt (less than one year), accounts payable, and accruals (expenses that have been incurred, but not yet paid).

Why is Working Capital Important?

Current Assets (and current liabilities) can be very large for many firms. For example, according to Intel's 2006 Balance Sheet, their working capital position was over $18 BILLION (about $10 billion in cash & short-term investments, $4 billion in A/R, and $4 billion in inventory). Intel also had about $8.5 billion in current liabilities at the same time ($0.2 billion in ST Debt, $8 billion in A/P, and the rest in other various accrual accounts). This gave them a net working capital of approximately $9.5 billion. Their total assets are around $48 billion. Therefore, not only is working capital a large dollar amount, but also a relatively large percentage of total assets.

Conservative vs Aggressive Working Capital Policy

Conservative (Relaxed) working capital policy refers to a situation where the firm allows for current assets to be a little larger and does less short-term borrowing. For example, the firm may hold a little extra cash to ensure that it doesn't run short in periods of higher than expected cash outflows. Also, it may allow for higher levels of accounts receivable. Selling merchandise on credit may help increase sells. However, the looser our credit terms, the more likely some of our receivables will never be collected. Higher levels of inventory can also be a marketing advantage. By carrying a wider selection of merchandise and avoiding running out of popular items, we may better appeal to consumers. Higher levels of cash, accounts receivable, and inventory allow for potentially higher sales and less risk of running out of the necessary cash to meet our day-to-day needs. The downside is that we must finance this higher levels of current assets by either issuing more debt or by reducing our longer-term assets. Since more debt means more interest expense and long-term assets generally earn a higher percentage return than current assets, this is not a costless decision. We must consider the costs (higher financing costs and/or foregoing long-term capital investments) against the benefits (less risk and potentially higher sales).

Aggressive (Restrictive) working capital policy refers to a situation where the firm holds fewer current assets or borrows more on a short-term basis (as opposed to long-term borrowing which usually costs a little more). By holding less cash (which earns no return), we can allocate our capital to other investments which earn more money. Also, by reducing our accounts receivable (fewer credit sales), we will have fewer un collectable accounts and can also move some of that capital to long-term projects. Inventory is another area that, if it can be reduced, will allow for more money to be moved to long-term projects 08/15/2007that the lower inventory and accounts receivables may cost us sales and we run the risk of cash outages that may require emergency borrowing or liquidation of some investments. The benefit is having more money allocated to long-term projects and/or less overall financing required.

Cash Conversion Cycle

The Cash Conversion Cycle is an analysis of how long it takes between the time we pay for our inventory and then ultimately turn it into cash from sale. We can think of this as having three segments. First, how long does it take us to turnover our inventory. Second, how long does it take us to collect the sale. Third, how long can we wait between the time we order the inventory and ultimately have to pay for it. The quicker we can manage the first two items, the better. The longer it takes us to complete the third item, the better. In formula terms, we can think of the Cash Conversion Cycle as follows:
CCC = Inventory Conversion Period + Receivables Collection Period - Payables Deferral Period
CCC = [Inventory/(Sales/360)] + [Accounts Receivable/(Sales/360)] - [Accounts Payable/(Sales/360)]

Maturity Matching Principle

The Maturity Matching Principle is based on the idea of attempting to finance our assets with obligations that are equivalent in time to the life of the assets. In other words, finance our ST assets with ST liabilities and finance our LT assets with LT Liabilities or Equity. Since ST financing is USUALLY (although not always) cheaper than LT financing, some companies are more aggressive and try to finance some of their LT assets with ST liabilities. On the other hand, since ST financing is riskier (since it needs repaid quicker) than LT liabilities, some companies are more conservative and finance a portion of their ST assets with LT liabilities. (Note: That can get confusing if you read through it too quickly, so it might be worthwhile to re-read it one more time.)

Sources of Short-Term Borrowing

In addition to considering the current asset side, firms must analyze where they will get their short-term financing from. While there are many available sources, some of the key ones are listed below

• Accruals
• Accounts Payable
• Short-Term Bank Loans
• Commercial Paper

Accruals refer to expenses that have been earned, but not yet paid. One primary source of accruals is labor costs. Consider a company that pays its employees biweekly. After one week, the employees have earned a full weeks wages. However, the company will not pay those wages for another full week. In the meantime, the firm can use that money to for other purposes (to pay other bills, invest in short-term securities, hold as cash balances, etc.). In essence, accruals are free financing in that the people owed are not paid interest on what they are owed. It is also spontaneous in that the firm does not need to go out and apply for this financing, but is generated from their business activities. Also, while this may not sound like that big of a deal, consider that Intel had $1.696 BILLION dollars in accrued compensation and benefits on their 2000 balance sheet. If they average that throughout the year and earn 5% on it, they will generate almost $85 million in interest revenue. This does not include the more than $2.2 BILLION in other accruals that Intel had at the same time.

Accounts Payable or sometimes referred to as Trade credit is another source of spontaneously generated financing. Whenever the firm purchases an item on a credit basis they are generating short-term financing. Many times the credit terms may be stated as something similar to 1.5/10 net 45. This means that if you pay the balance off within 10 days, you get a 1.5% discount. If not, the full amount is due within 45 days. The first 10 days is free financing. We are no better off paying on day 2 then we are on day 10. In fact we are worse off. If we wait until day 10, we have use of those funds for an additional 8 days. Once we go beyond 10 days, we are paying for the financing -- and many times paying quite a lot. To estimate the effective annual rate for waiting until day 45 to pay the balance, we can use the following formula
k_eff = (1 + (discount %)/(100% - discount %)) ^{(365/(date paid - first due date))} - 1
In our example, paying on day 45 would result in an effective annual rate of 17.07%. Once we pass the first due date, we have no incentive to pay before the final due date.

Short-term bank loans can take a variety of forms. Some use inventory as collateral, some are unsecured, and some use accounts receivable as collateral. We can also look at differences based on set loans (a specific amount for a specific period of time) vs lines-of-credit loans where the borrower can borrow up to a set amount with flexible timing once the borrower has been approved. The effective rate of these various agreements varies based on the specific structure. Also, while I refer to these as "bank" loans, they need not come from a commercial bank. There are many different places where a borrower can find financing.

Commercial Paper is similar to a short-term bond issued by a corporation. This form of short-term financing tends to be very cheap, but can only be issued by larger, more creditworthy firms and in large increments. Due to SEC regulations, commercial paper usually has a time to maturity of less than 270 days. Commercial paper is issued at a discount and matures for its face value. For example, a piece of commercial paper with a face value of $100,000 that matures in 6 months may be issued for $97,500. The interest is the difference between the face value and the issue price.

Choosing a Source of Short-Term Financing

When choosing which source of short-term financing we should use, a number of considerations must be made. These include:

• Cost of Financing -- Which source offers the lowest effective annual rate?
• Flexibility -- It may be worth it to pay a little more for a loan that offers more flexibility.
• Size of Loan -- While accruals are free which makes them very attractive, it is likely that they will not be enough to meet all of our short-term financing needs. On the other hand, commercial paper may have to be issued in much larger amounts than our current needs. We want to be careful not to borrow more (or less) than we need.
• Length of Loan -- A slightly higher effective annual rate on a 30-day loan alternative may be worthwhile if the cheaper loan is only available for 60-days and we only need the financing for 30-days.

Cash Management

One of the main objectives of cash management is to speed up the inflows and slow down the outflows. In other words, we want to get our receivables collected as quickly as possible and make sure our payments are paid as slowly as possible (as long as they are paid on time -- this does not mean paid late.) To do this we try to take advantage of FLOAT. There are three types of float -- mail float, processing float, and transit float. Mail float refers to the time the payment is in the mail system. Processing float refers to the time between when the payment hits our desk and we get it deposited into the bank. Transit float refers to the time between when we make our deposit and the Federal Reserve clears the payment and actually transfers the payment from the customers account to our account. Our collections department works to make mail float and processing float as short as possible. One way to do this is through a Lockbox.

A LOCKBOX SYSTEM is essentially a service offered by a bank to speed up the collection of our payments. Instead of the checks being mailed to our office, they are mailed to a PO Box. The bank collects the payments from the PO box, deposits the checks into our account, and then mails copies to our office. This can speed up the collection float by a matter of days.

A CONCENTRATION BANK is a plan to allow us to reduce the necessary cash on hand for operations. Most large firms have many depository bank accounts spread out throughout the country. With a concentration bank, the balances from these smaller depository accounts are "swept" into the concentration bank at the end of each day. This allows the cash to be "concentrated" in one larger account and makes it easier and more efficient to manage.