Intermediate Financial Management (with Thomson One)

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
Self-Test Questions
CASH MANAGEMENT
A relaxed working capital policy is one in which 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. Conversely, with a restricted working capital policy,
the holdings of cash, inventories, 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.” A moderate
working capital policy is between 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 payments to suppliers along with lost sales due to inventory shortages
and an overly restrictive credit policy.
However, the picture changes when uncertainty is introduced. Here the firm
requires some minimum amount of cash and inventories based on expected payments,
expected sales, expected order lead times, and so on, plus additional holdings,
or safety stocks, which enable it to deal with departures from the expected
values. Similarly, accounts receivable levels are determined by credit terms, and the
tougher the credit terms, the lower the receivables for any given level of sales.
With a restricted policy, the firm would hold minimal safety stocks of cash and
inventories, and it would have a tight credit policy even though this meant running
the risk of losing sales. A restricted, lean-and-mean working capital policy
generally provides the highest expected return on this investment, but it entails the
greatest risk, while the reverse is true under a relaxed policy. The moderate policy
falls in between the two extremes in terms of expected risk and return.
Recall that NOWC consists of cash, inventory, and accounts receivable, less
accruals and accounts payable. Firms face a fundamental trade-off: Working capital
is necessary to conduct business, and the greater the working capital, the
smaller the danger of running short, hence the lower the firm’s operating risk.
However, holding working capital is costly—it reduces a firm’s return on invested
capital (ROIC), free cash flow, and value. The following sections discuss the individual
components of NOWC.
Identify and explain three alternative working capital policies.
What are the principal components of net operating working capital?
What are the reasons for not wanting to hold too little working capital? For not wanting to
hold too much?
Approximately 1.5 percent of the average industrial firm’s assets are held in the
form of cash, which is defined as demand deposits plus currency. Cash is often
Chapter 21 Working Capital Management • 725