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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 usiness 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. One sewing machine operator commented:

We used to have these stacks of fabric sitting here on the tables until we needed them . . . We were going to use the fabric anyway, so who cares that we`re buying it and stacking it up there? Now no one has excess fabric. They only have stuff we`re working on today. And it`s changed the way we connect with suppliers, and we`re having [them] deliver fabric more often.2

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.3 We will look more carefully at the costs and benefits of working capital later in this material.

CARRYING COSTS

Costs of maintaining current assets, including opportunity cost of capital.

SHORTAGE COSTS

Costs incurred from shortages in current assets