Workbook

Working Capital Management

By William McNally

1. Introduction
In this workbook you will:

Learn the meaning of working capital

Learn how to measure working capital management with net working
capital, and the operating and cash cycles
Learn about two approaches to working capital management:
conservative and aggressive

2.

Issues to Study

What amounts of current assets should a firm hold?

What types and amounts of short-term financing should a firm employ?
How do firms ensure they have enough cash to meet on-going
obligations?

3.

Working Capital Management in Action

The instructor will show a YouTube video titled:

IS in Action Walmart Supply Chain
o http://youtu.be/SUe-tSabKag

4.

Working Capital

Gross working capital is equal to short-term assets.

Net working capital is current assets minus current liabilities.
o Net working capital is the amount of long-term capital that is used
to fund short-term assets.
Net working capital is capital invested in the business that does not earn
an active return, because it does not produce goods (services) for sale.

The cost of net working capital is the return on capital foregone because
it is not actively invested.
The benefit of net working capital is that it is necessary for the operation
of a business.

QUESTION: On the balance sheet, below, shade in the area that represents net
working capital.

Balance Sheet
Assets

Liabilities & Owners Equity

Current
Assets

Current
Liabilities

Fixed
Assets

5.

Long-term
Liabilities

Owners
Equity

Working capital management refers to the management of all short-term

assets and liabilities.
Working capital management is the same as short-term financial
management.

Measuring Working Capital

5.1

Hersheys Inventory Error

Like most candy manufacturers, Hershey Foods typically has a significant

percentage of sales around Halloween.
In 1998-99, Hershey spent more than $100 million on a new order
management, supply chain planning, and Customer Relationship Management
(CRM) system to transform the companys IT infrastructure and supply chain.
When disaster hits, the company is later criticized for a big bang approach to
implementation, trying to go live with all these systems in parallel.
Expected to go live in April, 1999, the schedule slips, and rather than wait
until the following year, Hershey switches over in the summer. The system has

major issues. In many cases, Hershey has product on the dock, but cant get
transactions to work that will enable it to put the candy in a truck and ship it
to customers. Inventory is not visible to the order management system for
allocation so the orders wont process.

The company ultimately says at least $150 million in orders were missed.
Quarterly profit drops 19% in the 3rd quarter, and it takes another hit in the
4th quarter. The fiasco makes headlines across the business press. The stock
drops from $57 in August, 1999 to $38 by January, 2000.1
Selected Data for Hershey is provided below.
Selected Financial Information
The Hershey Company
($000s)
2001
2000
Sales
Cost of Goods Sold
Accounts receivable, net
Inventories
Total current assets
Total assets
Accounts payable
Total current liabilities

5.2

4,557,241
2,665,566
361,726
512,134
1,167,541
3,247,430
133,049
606,444

4,220,976
2,471,151
379,680
605,173
1,295,348
3,447,764
149,232
766,901

1999

1998

3,970,924
2,354,724
352,750
602,202
1,279,980
3,346,652
136,567
712,829

4,435,615
2,625,057
451,324
493,249
1,133,966
3,404,098
156,937
814,824

Inventory Management

The amount of time that items (raw materials and finished goods) stay in
inventory is measured by the average inventory period:

This is the average amount of time from the day a raw material arrives to
the day a finished product is shipped.

The 11 Greatest Supply Chain Disasters Supply Chain Digest, January 2006, p.8.

To have a low value for this ratio a company has to have a good inventory
management system, a quick and responsive supply chain, accurate
sales forecasting and tight production scheduling.

QUESTION: What is Hersheys Average Inventory Period for 1999? Complete

the table, below.

Selected Financial Information

The Hershey Company
2001
2000
Average Inventory Period
70.1
89.4

5.3

1999

1998
68.6

Net Working Capital

Net Working Capital = Current Assets Current Liabilities

QUESTION: What is Net working capital at Hershey in 1999? Complete the

table, below.

Selected Financial Information

The Hershey Company
2001
2000
Net Working Capital
561,097
528,447

5.4

1999

1998
319,142

NWC to Total Capital

The net-working-capital to total capital ratio measures the proportion of longterm capital (debt and equity) invested in short-term assets.

This should be minimized, as short-term assets do not (usually) generate

operating revenue.
QUESTION: What is the NWC-to-total capital ratio at Hershey in 1999?
Complete the table, below.

NWC/TC

5.5

Selected Financial Information

The Hershey Company
2001
2000
21.2%
19.7%

1999

1998
12.3%

Geralds Fresh Produce

In his first year of business, Gerald sold fresh produce to restaurants in the tricity area. He bought his produce at the Food Terminal in the big city. Gerald
would buy the produce early in the morning and deliver it directly to his
restaurant clients the same day using his own truck (the companys only
asset). Vendors at the Food Terminal didnt know Gerald and so they required
him to pay cash. Gerald charged a 100% markup on his costs and his typical
monthly sales were $20,000. The restaurant owners demanded credit from
Gerald and were very slow to pay. Gerald spent a great deal of his time
collecting, and found that the restaurants would usually take two months to
pay their bills. Geralds financial statements for his first year of business are
shown in the table, below, under Year 1.

Geralds New Business Plan

Reflecting on his first year of business, Gerald didnt like chasing restaurant
owners for payment and didnt like tying up his equity in working capital.
Gerald decided on a big change to his business. Instead of selling to
restaurants he decided to set up a produce stall at the Farmers Market and
sell for cash. Another change was that, after a year of doing business, the
produce vendors at the Food Terminal were willing to let him purchase on one
months credit. In the second year, Gerald continued to have retail sales of
$20,000 per month. Geralds financials for the second year of business are
shown, below, under Year 2. Answer the questions that follow.

Financial Statements
Geralds Fresh Produce
Year 1
Year 2
Sales
240,000
240,000
Cost of Goods Sold
120,000
120,000
Selling, General & Admin
20,000
20,000
Depreciation
8,001
5,867
EBIT
91,999
94,133
Taxes (@30%)
27,600
28,240
Net Income
64,399
65,893
Cash
Accounts Receivable
Inventory
Current assets
Gross Fixed Assets
Accumulated Depr.
Net Fixed Assets
Total Assets

62,400
40,000
102,400
30,000
8,001
21,999
124,399

184,160
184,160
30,000
13,868
16,132
200,292

Accounts Payable
Total Current Liabilities
Common Stock
Retained Earnings
Owner's Equity
Total Liabilities & Owner's Equity

60,000
64,399
124,399
124,399

10,000
10,000
60,000
130,292
190,292
200,292

5.6

Average Collection Period

The amount of time that it takes to collect accounts receivable is measured by

the average collection period:

This is the average amount of time from the day of a sale until the
customer pays their invoice.

If customers pay in one month, then the average collection period is 30

days.
For cash businesses, the average collection period is zero.

QUESTION: What is Geralds Average Collection Period in Year 1 and Year 2

Complete the table, below.

Selected Financial Information

Geralds Fresh Produce
Year 1
Year 2
Average Collection Period

5.7

Average Payable Period

The amount of time that it takes a company to pay its suppliers is measured by
the average payables period:

This is the average amount of time from the day of a purchase of a raw
material until the company pays the supplier.
If the company pays its invoice in one month, then the average payables
period is 30 days.
For C.O.D. purchases, the average payables period is zero.

QUESTION: What is Geralds Average Payable Period in Year 1 and Year 2

Complete the table, below.

Selected Financial Information

Geralds Fresh Produce
Year 1
Year 2
Average Payable Period

6.

Operating and Cash Cycle

Every business requires that money be disbursed to purchase raw materials

before money is collected from sales of finished products. That money is the
investment in net working capital.
The longer products stay in inventory before they are sold and the longer it
takes firms to collect their receivables, the greater is net working capital and
the higher is the cost. We can measure the length of time that it takes cash to
flow through a business using the operating and cash cycles. These measures
capture the size of net working capital, but they also help identify the source of
problems in working capital management.

The operating and cash cycles capture many facets of a business, such
as:
o inventory management
o supply chain integration
o sales forecasting
o production scheduling
o credit management
o collections
o supplier relationships

The figure, below, shows the operating and cash cycles. The firm, a rocket
manufacturer, buys parts from its suppliers. The parts are assembled and the
finished rocket is placed in inventory. The rocket is sold to a customer and
money is finally received when the account is collected. The length of time from
purchase of raw materials to final receipt of funds is called the operating cycle.
The operating cycle does not capture the time from disbursement of funds to
receipt of funds because raw materials are usually purchased on credit. Thus,
the cash cycle is equal to the operating cycle less the accounts payable period
(the amount of time that it takes to pay suppliers).

Operating and Cash Cycles

Operating Cycle = Average Inventory Period + Average Collection Period

Cash cycle = Operating Cycle Average payable Period

QUESTION: What is the cash conversion cycle for Geralds Fresh Produce in
Years 1 and 2?
ANSW ER:
Cash Conversion Cycle 1 =
Cash Conversion Cycle 2 =

7.

Working Capital Management

The Instructor will provide a short lecture on working capital management.

7.1

Video

YouTube video: Working Capital Management explained by Deutsche

bank.
o http://youtu.be/bHK77lbdyWA

8.

Solutions
Balance Sheet
Assets

Liabilities & Owners Equity

Current
Assets

Current
Liabilities

Fixed
Assets

Long-term
Liabilities

Average Inventory Period = 93.3

NWC = 567,151

NWC/TC = 567,151/(3,346,652 712,829) = 0.215 or 21.5%

Selected Financial Information

Geralds Fresh Produce
Year 1
Year 2
Average Collection Period
60.83
0
Selected Financial Information
Geralds Fresh Produce
Year 1
Year 2
Average Payable Period
0
30.42
Cash Conversion Cycle 1 = 60.83 + 0 0 = 60.83
Cash Conversion Cycle 2 = 0 + 0 30.42 = -30.42

Owners
Equity