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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.

In the Appendix we showed you how the firm`s financial statements can be used to estimate the inventory period, also called days` sales in inventory:

Inventory period = average inventory annual costs of goods sold/365

The denominator in this equation is the firm`s daily output. The ratio of inventory to daily output measures the average number of days from the purchase of the inventories to the final sale. We can estimate the accounts receivable period and the accounts payable period in a similar way:1

Accounts receivable period = average accounts receivable annual sales/365 Accounts payable period = average accounts payable annual cost of goods sold/365

Because inventories are valued at cost, we divide inventory levels by cost of goods sold rather than sales revenue to obtain the inventory period. This way, both numerator and denominator are measured by cost. The same reasoning applies to the accounts payable period. On the other hand, because accounts receivable are valued at product price, we divide average receivables by daily sales revenue to find the receivables period.

NET WORKING CAPITAL Current assets minus current liabilities. Often called working capital.

CASH CONVERSION CYCLE Period between firm`s payment for materials and collection on its sales.

Cash Conversion Cycle

Table 2.2 provides the information necessary to compute the cash conversion cycle for manufacturing firms in the United States in 1999. We can use the table to answer four questions. How long on average does it take United States manufacturing firms to produce and sell their product? How long does it take to collect bills? How long does it take to pay bills? And what is the cash conversion cycle? The delays in collecting cash are given by the inventory and receivables period. The delay in paying bills is given by the payables period. The net delay in collecting payments

is the cash conversion cycle. We calculate these periods as follows:

Inventory period = average inventory annual cost of goods sold/365 = (470 + 468)/2 = 48.7 days 3,518/365 Receivables period = average accounts receivable annual sales/365 = (471 + 481)/2 = 43.8 days 3,968/365 Payables period = average accounts payable annual cost of goods sold/365 = (304 + 303)/2 = 31.5 days 3,518/365

The cash conversion cycle is

Inventory period + receivables period accounts payable period = 48.7 + 43.8 31.5 = 61.0 days

It is therefore taking United States manufacturing companies an average of 2 months from the time they lay out money on inventories to collect payment from their customers.