The combination of the one-time cash inflow and the long-term improvement in
working capital can add substantial value to companies. Two professors, Hyun-Han
Shin and Luc Soenen, studied more then 2,900 companies during a recent 20-year pe-
riod and found a strong relationship between a company’s cash conversion cycle and
its performance.^4 In particular, their results show that for the average company a
10-day improvement in the cash conversion cycle was associated with an increase in
pre-tax operating profit from 12.76 to 13.02 percent. They also demonstrated that
companies with a cash conversion cycle 10 days shorter than average also had an
annual stock return that was 1.7 percentage points higher than that of an average
company, even after adjusting for differences in risk. Given results like these, it’s no
wonder firms now place so much emphasis on working capital management!Define the following terms: inventory conversion period, receivables collection
period, and payables deferral period. Give the equation for each term.
What is the cash conversion cycle? What is its equation?
What should the firm’s goal be regarding the cash conversion cycle? Explain your
answer.
What are some actions the firm can take to shorten its cash conversion cycle?Alternative Net Operating Working Capital Policies
Table 16-1 shows three alternative policies regarding the total amount of net oper-
ating working capital carried. The first row illustrates arelaxed working capital
policy,where relatively large amounts of cash and inventories are carried, where
sales are stimulated by the use of a credit policy that provides liberal financing to
customers and a corresponding high level of receivables, and where a company
doesn’t take advantage of credit provided by accruals and accounts payable. Con-
versely, with therestricted working capital policy,the holdings of cash, invento-
ries, and receivables are minimized, and accruals and payables are maximized. Under
the restricted policy, NOWC is turned over more frequently, so each dollar of
NOWC is forced to “work harder.” Themoderate working capital policyis be-
tween the two extremes.
Under conditions of certainty — when sales, costs, lead times, payment periods,
and so on, are known for sure — all firms would hold only minimal levels of working
capital. Any larger amounts would increase the need for external funding without a
corresponding increase in profits, while any smaller holdings would involve late pay-
ments to suppliers along with lost sales due to inventory shortages and an overly
restrictive credit policy.(^4) See Hyun-Han Shin and Luc Soenen, “Efficiency of Working Capital Management and Corporate Prof-
itability,” Financial Practice and Education,Fall/Winter 1998, 37–45.
TABLE 16-1 Alternative Net Operating Working Capital (NOWC)
Policies (Millions of Dollars)
NOWC to Support NOWC/
Policy Sales of $100 Sales Turnover of NOWC
Relaxed $30 30% 3.3
Moderate 23 23 4.3
Restricted 16 16 6.3
Alternative Net Operating Working Capital Policies 585