CHAPTER 15 Working Capital Management
About 50% of the typical industrial or retail! rm’s assets are held as working capital,
and many students’! rst jobs focus on working capital management. This is particu-
larly true in smaller businesses, where the majority of new jobs are being created.
When you! nish this chapter, you should be able to:
- Explain how di" erent amounts of current assets and current liabilities a" ect! rms’
pro! tability and thus their stock prices. - Discuss how the cash conversion cycle is determined, how the cash budget is con-
structed, and how each is used in working capital management. - Explain how companies decide on the proper amount of each current asset—cash,
marketable securities, accounts receivable, and inventory. - Discuss how companies set their credit policies and explain the e" ect of credit
policy on sales and pro! ts. - Describe how the costs of trade credit, bank loans, and commercial paper are
determined and how that information impacts decisions for! nancing working
capital. - Explain how companies use security to lower their costs of short-term credit.
15-1 BACKGROUND ON WORKING CAPITAL
The term working capital originated with the old Yankee peddler who would load
up his wagon and go off to peddle his wares. The merchandise was called “work-
ing capital” because it was what he actually sold, or “turned over,” to produce his
pro! ts. The wagon and horse were his! xed assets. He generally owned the horse
and wagon (so they were! nanced with “equity” capital), but he bought his mer-
chandise on credit (that is, by borrowing from his supplier) or with money bor-
rowed from a bank. Those loans were called working capital loans, and they had to
be repaid after each trip to demonstrate that the peddler was solvent and worthy
of a new loan. Banks that followed this procedure were said to be employing
“sound banking practices.” The more trips the peddler took per year, the faster his
working capital turned over and the greater his pro! ts.
This concept can be applied to modern businesses, as we demonstrate in this
chapter. We begin with a review of two basic de! nitions that were covered in
Chapter 3:
- Working capital. Current assets are often called working capital because these
assets “turn over” (i.e., are used and then replaced during the year).^1 - Net working capital. When a! rm buys inventory on credit, its suppliers in effect
lend it the money used to! nance the inventory. The! rm could have borrowed
from its bank or sold stock to obtain the money, but it received the funds from
its suppliers. These loans are recorded as accounts payable, and they are typi-
cally “free” in the sense that they do not bear interest. Similarly, Allied pays its
workers every 2 weeks and pays taxes quarterly, so its labor force and the tax
authorities provide it with loans equal to its accrued wages and taxes. If we
subtract the sum of payables plus accruals from current assets, the difference is
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(^1) Any current assets not used in normal operations, such as excess cash held to pay for a plant under construc-
tion, are deducted and thus not included in working capital. Allied Food Products uses all of its current assets in
operations.