Working capital management involves two basic questions: (1) What is the appropri-
ate amount of current assets, both in total and for each specific account, and (2) how
should those current assets be financed? Note that, sound working capital manage-
ment goes beyond finance. Indeed, the ideas for improving working capital manage-
ment often stem from other disciplines. For example, experts in logistics, operations
management, and information technology often work with the marketing group to
develop a better way to deliver the firm’s products. Where finance comes into play is
in evaluating the profitability of alternative proposals. In addition, financial managers
determine how much cash a company must keep on hand, and how much short-term
financing it should use.
Working Capital Terminology
We begin our discussion of working capital policy by reviewing some basic defini-
tions and concepts:
1.Working capital, sometimes called gross working capital, simply refers to current
assets used in operations.
2.Net working capital is defined as current assets minus current liabilities.
3.Net operating working capital (NOWC) is defined as operating current assets
minus operating current liabilities. Generally, NOWC is equal to cash, accounts
receivable, and inventories, less accounts payable and accruals.
The term working capital originated with the old Yankee peddler, who would load
up his wagon with goods and then go off on his route to peddle his wares. The mer-
chandise was called working capital because it was what he actually sold, or “turned
over,” to produce his profits. The wagon and horse were his fixed assets. He generally
owned the horse and wagon, so they were financed with “equity” capital, but he bor-
rowed the funds to buy the merchandise. These borrowings were called working capi-
tal loans,and they had to be repaid after each trip to demonstrate to the bank that the
credit was sound. If the peddler was able to repay the loan, then the bank would make
another loan, and banks that followed this procedure were said to be employing
“sound banking practices.”
How did the term “working capital” originate?
Differentiatebetweennetworkingcapitalandnetoperatingworkingcapital.
The Cash Conversion Cycle
As we noted above, the concept of working capital management originated with the
old Yankee peddler, who would borrow to buy inventory, sell the inventory to pay off
the bank loan, and then repeat the cycle. That concept has been applied to more
complex businesses, where it is used to analyze the effectiveness of a firm’s working
capital management.
Firms typically follow a cycle in which they purchase inventory, sell goods on
credit, and then collect accounts receivable. This cycle is referred to as the cash conver-
sion cycle,and it is discussed in detail in the next section. Sound working capital policy
is designed to minimize the time between cash expenditures on materials and the col-
lection of cash on sales.
The textbook's web site
contains an Excelfile that
will guide you through the
chapter’s calculations. The
file for this chapter is Ch 16
Tool Kit.xls,and we encour-
age you to open the file and
follow along as you read the
chapter.
The Cash Conversion Cycle 581
576 Working Capital Management
