Cost of Current Assets

Hey all,

I was reviewing Working Capital and learning about the CCC however I stumbled upon some confusion while reading.

A company can generate $100 sales with $30 or $23 or $16 worth of current assets, and the text argues that $16 worth of current assets is optimal because it is cheaper; and therefore larger amounts of current assets can result in increasing the need for external funding.

How does holding a larger amount of current assets cause a need to increase external funding? Can someone lay down a practical example? Is this directly related to the CCC?

Hi, Think about company A with an optimized supply chain setup with just-in-time supply of raw materials that enables the generation of a certain amount of revenues without any need of stocking these raw materials. If you compare such a company with company B, who’s supply chain is not optimized at all and therefore needs high amounts of stockings it becomes clear that company B’s capital needs are higher than A’s since B’s capital is tied up at least for a certain time in current assets.

A real example would be for instance a company like Dell Computers. They have almost no inventory, since every computer is produced just in time. Best, Oscar

Hey Oscar, thanks for your reply!

Great response, I was attempting to quantify it but I got stuck during an example:

Imagine you have two firms, Company A and Company B. Both have sales of $100, but their CCCs are different such that:

Company A: Takes it 30 days to pay its creditors, 40 days to produce and sell its inventory, and 30 days to collect its receivables. Company B: Takes it 30 days to pay its creditors, 30 days to produce and sell its inventory, and 20 days to collect its receivables.

As we can see, Company B has a shorter CCC, however, I am not sure if this examples pinpoints the fact that having a lower amount of current assets is more beneficial. I guess my confusion derives from the fact that both companies made $100 worth of sales, just with different amount of current assets - and I cannot seem to just quite wrap it around my head.

Also Oscar, in your example of the JIT methodology, wouldn’t the actual sales amount be supported by the same amount of current assets?

In your example tbe cash-conversion cycle for both companies is exactly the same: 40 days. (30+40-30 = 30+30-20). Both companies need 40 days to get every invested dollar back from the customer.

Yes sir, so can we conclude that the idea of optimal level of current assents is unrelated to the CCC?

No, it is the other way around: If a company can achieve a certain revenue with a low amount of net working capital, or even better a negative net working capital the better. Hence the lower the CCC the better.

Okay but how are you reflecting the amount of NWC in the CCC equation? Is it through lower days sales outstanding or lower amount of time to sell inventory?

CCC = DSO+DI-DPO = (avg. receivables/sales)*365 + (avg. inventory/COGS)*365 - (avg. payables/purchases)*365 which is approx (avg. NWC/sales)*365

The lower the NWC, the lower the cash conversion cycle is. In some business models cash-conversion cycles and NWC are even negative, which is an optimal situation. Before you even spend money on raw materials, inventory and so on, you get paid by the customer. And that is the reason why such companies need less external financing from banks or equity holders. Having such a low, or better, negative NWC means that the customer finances the operating business.